Core Concepts

Key Takeaways

• Internal Focus: Cost and management accounting are primarily for internal managers, providing detailed, specific-purpose reports to guide decisions.

• Cost is a Resource Measure: A cost represents the monetary value of resources used to achieve an objective, like creating a product or delivering a service.

• Budgeting is Planning: A budget is a quantitative financial plan that translates an organization's strategic goals into actionable steps for a future period.

• Classification is Key: Understanding how costs are classified by behavior (fixed/variable), traceability (direct/indirect), and function is essential for analysis and control.

• Sequential Process: The master budget is built in a logical sequence, starting with the sales forecast, which then drives all other operational and financial budgets.

Key Definitions

• Cost Accounting: A system for collecting, analyzing, and reporting cost information to internal management for planning, control, and decision-making.

• Budget: A detailed financial plan for a future period, used as a tool for planning, coordinating, and controlling activities and resources.

• Cost Object: Any item, such as a product, service, department, or customer, for which costs are measured and assigned.

Cost Accounting Fundamentals

Core Terminology

• Cost Accounting: The systematic process of ascertaining and controlling the costs of products or services.

• Cost Centre: A location, person, or piece of equipment for which costs can be accumulated. It's a management responsibility area.

• Cost Unit: A unit of product or service for which cost is calculated.

Key Insights

• The primary goal is to provide data for internal use.

• It helps determine selling prices, control costs, and evaluate operational efficiency.

Examples

• Cost Centre: The Assembly Department in a factory; a specific delivery truck in a logistics fleet.

• Cost Unit: Per chair manufactured; per passenger-kilometer in a bus service; per patient-day in a hospital.

Q: What is the main difference between a cost centre and a cost unit?

A: A cost centre is where costs are collected (e.g., the painting department), while a cost unit is what is being costed (e.g., one painted table).

Cost Classification

Costs are categorized to provide management with meaningful data for different purposes. This is the foundation of cost analysis.

By Traceability:

• Direct Costs: Easily and economically traced to a specific cost object (e.g., wood for a chair).

• Indirect Costs (Overheads): Cannot be easily traced to a specific cost object and must be allocated (e.g., factory rent).

By Behavior:

• Variable Costs: Total cost changes in direct proportion to activity level, but the cost per unit is constant (e.g., raw materials).

• Fixed Costs: Total cost remains constant within a relevant range of activity, but the cost per unit decreases as activity increases (e.g., factory insurance).

• Semi-variable Costs: Have both a fixed and a variable component (e.g., a utility bill with a fixed monthly charge plus a variable usage charge).

For Decision Making:

• Opportunity Cost: The potential benefit given up when one alternative is selected over another.

• Sunk Cost: A cost that has already been incurred and cannot be recovered. It is irrelevant for future decisions.

Q: Why is a sunk cost considered irrelevant for decision-making?

A: Because it is a past, unchangeable cost. Decisions should only be based on future costs and revenues that will differ between alternatives.

Cost vs. Financial Accounting

Comparisons

Costing Systems and Methods

Job vs. Process Costing

• Job Costing: A system where costs are assigned to distinct, identifiable jobs or batches. Each job is a unique cost object.

• Process Costing: A system where costs are averaged over a large number of identical or homogeneous units produced in a continuous flow.

Key Insights:

• The key distinction is whether the products are unique or uniform.

• Job Costing is suitable for customized production.

• Process Costing is suitable for mass production.

Examples:

• Job Costing: A construction company building a custom house, a marketing agency running a campaign for a client, a print shop printing wedding invitations.

• Process Costing: A Coca-Cola bottling plant, an oil refinery, a paper manufacturer.

Service Costing (Operating Costing)

 A costing method used to determine the cost of providing a service rather than manufacturing a tangible product.

Key Insights:

• It addresses the unique characteristics of services: intangibility, perishability, and inseparability.

• Often uses a composite cost unit to capture multiple factors.

Examples:

• Transport Company: ton-kilometer (cost to move one ton of goods over one kilometer).

• Hospital: patient-day (cost of keeping one patient in a bed for one day).

Cost Sheet Preparation

The Cost Sheet Structure

Cost Sheet: A formal statement that logically presents the various components of total cost, ultimately arriving at the total cost of sales and potential profit.

Key Insights:

• Provides a detailed cost breakdown for analysis and price setting.

• Tracks the flow of costs from raw materials through production to finished goods sold.

• Requires careful adjustment for opening and closing inventories at each stage (raw materials, WIP, finished goods).

Core Formulas

Direct Materials Consumed: Opening Stock + Purchases - Closing Stock

Prime Cost: Direct Materials + Direct Labour + Direct Expenses

Works (Factory) Cost: Prime Cost + Factory Overheads

Cost of Production: Works Cost + Administration Overheads

Cost of Goods Sold (COGS): Cost of Production + Opening Finished Goods - Closing Finished Goods

Cost of Sales (Total Cost): COGS + Selling & Distribution Overheads

Budgeting Principles and Preparation

The Role of Budgeting

• Planning: The process of setting goals and deciding how to achieve them.

• Budgeting: The process of creating a quantitative plan, usually in financial terms, to guide the acquisition and use of resources over a specific period.

Key Insights:

• Budgeting is the financial expression of a company's strategic plan.

• It serves as a benchmark for evaluating actual performance.

• It facilitates communication and coordination between different departments.

Types of Budgets

• Operating Budgets: Budgets that describe the income-generating activities of a firm (e.g., sales, production, and finished goods inventories).

• Financial Budgets: Budgets that detail the inflows and outflows of cash and the overall financial position (e.g., cash budget, capital expenditure budget).

• Master Budget: An integrated network of all operating and financial budgets that provides a comprehensive plan for the entire organization.

Budgeting Approaches

• Incremental Budgeting: Creating a new budget by making marginal adjustments to the previous period's budget. It is simple but can perpetuate past inefficiencies.

• Zero-Based Budgeting (ZBB): Requires managers to justify every expense from a "zero base" for each new period. It is rigorous and promotes efficiency but is time-consuming.

• Activity-Based Budgeting (ABB): Focuses on budgeting the costs of activities needed to produce products and services, linking resource allocation to strategic goals.

Q: What is the primary advantage of Zero-Based Budgeting over Incremental Budgeting?

A: ZBB forces a critical review of all expenses, eliminating waste and linking spending directly to current needs, whereas Incremental Budgeting may carry forward unnecessary costs from previous years.

The Master Budget Sequence

The Master Budget Sequence - Key Insights

• The preparation of a master budget is a sequential and interdependent process.

• The Sales Budget is the cornerstone and starting point for the entire process.

• The sales forecast dictates the production level, which in turn drives material, labor, and overhead budgets.

The Process Flow

• Sales Budget: Forecast of expected sales revenue.

• Production Budget: Units to be produced to meet sales needs and desired inventory levels.

• Direct Materials, Direct Labor & Overhead Budgets: Resources required to meet production targets.

• Selling & Administrative Expense Budget: Planned non-manufacturing expenses.

• Cash Budget: A detailed forecast of cash inflows and outflows.

• Budgeted Income Statement & Balance Sheet: Pro-forma financial statements based on all other budgets.

Interconnections & Recap

Summary

Cost accounting and budgeting are deeply interconnected pillars of internal financial management. Cost accounting provides the detailed, historical, and current cost data (e.g., cost per unit, cost behavior) that is essential for building an accurate and realistic budget. In turn, the budget sets the financial targets and standards against which actual costs, as measured by the cost accounting system, are compared and controlled. Together, they create a continuous cycle of planning, execution, measurement, and control that enables an organization to manage its resources effectively and achieve its strategic objectives.