Chapter 1

‘’…….Come to learn; Go to Serve…..
’’
CHAPTER-I
INTRODUCTION
This introductory chapter of the course explains the intertwining roles of managers and
management accountants in choosing an organization’s strategy, and in planning and controlling
its operations. Its main purpose is to emphasize the management accountant’s role in providing
information for managers. In addition to this, the chapter will brief you about the different cost
terms, concepts and their classifications.
The work of manager’s focuses on (1) planning, which includes setting objectives and outlining
how to attain these objectives; and (2) control, which includes the steps to take to ensure that
objectives are realized. To carry out these planning and control responsibilities, managers need
information about the organization. From an accounting point of view, this information often
relates to the costs of organization.
Managers as internal users of information use the outputs of accounting system:

a) To administer each operational/functional areas for which they are responsible, and,
b) To coordinate those operations/functions within the framework of the organization as a
whole.
In general, the current course (Cost and Management Accounting-I) and the continuing part of it
that you will take later (Cost and Management Accounting-II) elucidate in detail how accounting
assists managers while undertaking the above tasks.
1.1. Management Accounting, Financial Accounting and Cost Accounting

In general, accounting systems identify transactions; economic events that affect the concerned
organization, and process the data in those transactions into information that is helpful to both
internal and external users of accounting information.
Processing any economic transaction entails collecting, categorizing, summarizing, analyzing

and reporting. For example, costs are collected by cost categories (Material, Labor,
Transportation, etc.); summarized to determine total costs by week, month, quarter, or year; and
analyzed to evaluate how costs have changed relative to revenue, say, from one period to the
next. Accounting systems finally report the analyzed information to users in the form of financial
Targeted group: 2nd year students of Accounting and Finance (Weekend program)
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‘’…….Come to learn; Go to Serve…..’’
statements (Income Statement, Balance Sheet, and Statement of Cash Flows) and performance
reports (such as the cost of operating a plant or providing services).
Basically, Management Accounting and Financial Accounting have different roles.

Management Accounting measures and reports financial and non-financial information that
helps managers make decisions to fulfill organizational goals. Mangers use management
accounting information to choose, communicate, and implement strategy. They also use
management accounting information to coordinate product design, production, and marketing
decisions. Therefore, management accounting focuses on internal reporting.
Examples of activities performed by managerial accountants are:

1. Determining the cost of providing a service or making a good
2. Assist management in profit planning and formalizing the plans into budgets
3. Determine the behavior of costs and how profit will change as sales and production
volumes change
4. Compare actual costs and financial results with budgeted costs and results
5. Providing cost and sales information necessary for management to use to make a
decision.
On the contrary, Financial Accounting focuses on reporting to external parties. It measures and
records business transactions and provides financial statements that are based on the GAAP
(Generally Accepted Accounting Principles), the broad rules that assure the user of the
underlying framework supporting the information. Managers are responsible for financial
statements issued to investors (potential investors who want to invest in the concerned company),
government regulatory institutions and other outsider institutions which are interested on the
status of the firm (Suppliers and Banks for instance). Hence, managers are interested in both
management accounting and financial accounting.
 Cost accounting refers to the measurement and reporting of financial and non-financial
information relating to the cost of acquiring or utilizing resources in an organization. Cost
accounting includes those parts of both management accounting and financial accounting
in which cost information is collected and analyzed.

Some concepts in cost accounting, therefore, form a bridge between financial and managerial
accounting topics. One of such concepts is that of product costing for a manufacturing company.
Not only is this information used internally in decision making (e.g., should a company make or
buy a component used in manufacturing a product?), product costing is also used to determine
the historical basis to account for the cost of products sold during a period and the cost of the
unsold inventory that remains as an asset on the statement of financial position at the end of the
period.
Though, the above discussed branches of accounting disciplines have their own distinct nature,
some books frequently use cost accounting and managerial accounting interchangeably
(Managerial Accounting by Garrison and Noreen is among others).
Management Accounting Vs. Financial Accounting

Financial accounting reports are prepared for the use of external parties such as shareholders and
creditors, whereas managerial accounting reports are prepared for managers inside the
organization.
This contrast in basic orientation results in a number of major differences between financial and
managerial accounting, even though both financial and managerial accounting often rely on the
same underlying financial data. In addition to the differences in who the reports are prepared for,
financial and managerial accounting also differ in their emphasis between the past and the future,
in the type of data provided to users, and in several other ways. These differences are discussed
in the following paragraphs.
 Emphasis on the Future:
Since planning is such an important part of the manager's job, managerial accounting has a
strong future orientation. In contrast, financial accounting primarily provides summaries of past
financial transactions. These summaries may be useful in planning, but only to a point. The
future is not simply a reflection of what has happened in the past. Changes are constantly taking
place in economic conditions, and so on. All of these changes demand that the manager's

planning be based in large part on estimates of what will happen rather than on summaries of
what has already happened.
 Relevance of Data:
Financial accounting data are expected to be objective and verifiable. However, for internal use
the manager wants information that is relevant even if it is not completely objective or verifiable.
By relevant, we mean appropriate for the problem at hand. For example, it is difficult to verify
estimated sales volumes for a proposed new store in a Gondar town by Addis Tire PLC, but this
is exactly the type of information that is most useful to managers in their decision making. The
managerial accounting information system should be flexible enough to provide whatever data
are relevant for a particular decision.
 Less Emphasis on Precision:

Timeliness is often more important than precision to managers. If a decision must be made, a
manager would rather have a good/reasonable estimate now than wait a week for a more
precise answer. A decision involving tens of millions of dollars does not have to be based on
estimates that are precise down to the penny, or even to the dollar.
Estimates that accurate to the nearest million dollars may be precise enough to make a good
decision. Since precision is costly in terms of both time and resources, managerial accounting
places less emphasis on precision than does financial accounting.
 Emphasis on Non-financial Information:
In addition, managerial accounting places considerable weight on non monitory data, for
example, information about customer satisfaction is tremendous importance even though it
would be difficult to express such data in monitory form to be a concern of financial accounting.
 Segments of an Organization:
Financial accounting is primarily concerned with reporting for the company as a whole. By
contrast, managerial accounting forces much more on the parts, or segments, of a company.
These segments may be product lines, sales territories divisions, departments, or any other
categorizations of the company's activities that management finds useful. Financial accounting
does require breakdowns of revenues and cost by major segments in external reports, but this is
secondary emphasis. In managerial accounting segment reporting is the primary emphasis.

 Generally Accepted Accounting Principles (GAAP)

Financial accounting statements prepared for external users must be prepared in accordance with
generally accepted accounting principles (GAAP). External users must have some assurance that
the reports have been prepared in accordance with some common set of ground rules. These
common ground rules enhance comparability and help reduce fraud and misrepresentations, but
they do not necessarily lead to the type of reports that would be most useful in internal decision
making.
For example, GAAP requires that land be stated at its historical cost on financial reports.
However if, management is considering moving a store to a new location and then selling the
land the store currently sits on, management would like to know the current market value of the
land, a vital piece of information that is ignored under generally accepted accounting principles
(GAAP).
 Managerial Accounting Is Not Mandatory
Financial accounting is mandatory; that is, it must be done. Various outside parties such as the
tax authorities require periodic financial statements. Managerial accounting, on the other hand, is
not mandatory. A company is completely free to do as much or as little as it wishes. No
regularity bodies or other outside agencies specify what is to be done, for that matter, weather
anything is to be done at all. Since managerial accounting is completely optional, the important
question is always, "Is the information useful?" rather than, "Is the information required
The distinction of managerial accounting from financial accounting is summarized in the table
below.
Financial Accounting Managerial Accounting
► Reports to those outside the ► Reports to those inside the organization
organization owners, lenders, tax for planning, directing and motivating,
authorities and regulators. controlling and performance evaluation.
► Emphasis is on summaries of ► Emphasis is on decisions affecting the

financial consequences of past future.

activities.
► Objectivity and verifiability of data are ► Relevance of items relating to decision
emphasized. making is emphasized.
► Precision of information is required. ► Timeliness of information is required.
► Only summarized data for the entire ► Detailed segment reports about
organization is prepared. departments, products, customers,
and employees are prepared.
► Produces general purpose reports to its ► Provides special purpose reports to
users. managers.
► Must follow Generally Accepted ► Need not follow Generally Accepted
Accounting Principles (GAAP). Accounting Principles (GAAP).
► It is Mandatory for firms to prepare and ► Not mandatory prepare and publish
publish external reports in the form of managerial accounting reports.
financial statements.
► It describes the performance of the ► It can be prepared for any period (for
business over a specific period referred daily, weekly, monthly, quarterly or
to as “accounting period”. Usually annually) to help management.
covers one quarter or one year.
► Reports should keep specific formats by ► No specific formats are required to
different government regulatory prepare managerial accounting reports.
agencies. E.g. Tax authorities.
► Verification of the accuracy of financial ► Internal reports of managerial
statements through an audit procedure is accounting are not subject to auditing.
must.
1.2.Role of Management Accountants in an Organization

Management accountants perform three important roles- scorekeeping, attention directing, and
problem solving.
a) Scorekeeping- accumulating data and reporting reliable results to all levels of

management. Examples are the recording of sales, purchase of materials, and payroll
payments.
b) Attention Directing- making visible both opportunities and problems on which
managers need to focus. Examples are highlighting rapidly growing markets where the
company may be underfunding investment and highlighting products with higher than
expected rework rates or customer return rates. Attention directing should focus on all
opportunities to add value to an organization and not just on cost reduction opportunities.

c) Problem Solving- making comparative analysis to identify the best alternatives in

relation to the organizations goals. An example is comparing the financial advantages of
leasing a fleet of vehicles rather than owning those vehicles.
1.3. Guidelines for Management Accountants

There are three major guidelines that help management accountants provide the most value to
their companies in strategic and operational decision making. Those are:
 Employing a cost-benefit approach,
 Give full recognition to behavioral and technical considerations, and
 Use different costs for different purposes.
1.4 Objectives of Cost Accounting
 To ascertain the cost of production on per unit basis, for example, cost per kg, cost per
meter, cost per liter, cost per ton etc.
 It helps in the determination of selling price on the basis of cost of production.
 Cost accounting helps in cost control and cost reduction.
 Ascertainment of division wise, activity wise and unit wise profitability becomes possible
through cost accounting.
 Helps in locating wastages, inefficiencies and other loopholes in the production
processes/services offered.
 Helps in presentation of relevant data to the management decision making.
 Helps in estimation of costs for the future.
1.5 Cost Terminologies and Classifications:

1.5.1 Cost Related Terminologies
 Cost: accountants define cost as a resource sacrificed or forgone to achieve a specific
objective. A cost is usually measured as the monetary amount that must be paid to
acquire goods and services.
 Cost object: in order to make informed or good decisions, managers want to know how
much a particular thing (such as a product, machine, service, or process) costs. We call

this thing as a cost object, which is anything for which a separate measurement of cost is
required.
 Cost pool: A cost pool is a grouping of individual cost items possessing identical nature.
Cost pools can range from broad, such as all costs within a manufacturing plant, to
narrow, such as the costs of operating machine.
 Cost Accumulation and Cost Assignment: a costing system in general accounts for
costs in two basic stages: cost accumulation and followed by cost assignment. Cost
accumulation is the collection of cost data in some organized way by a means of an
accounting system. Cost assignment on the other hand is a general term that is used to
describe the process of tracing of accumulated costs that have a direct relation with the
cost object(s) and allocating part of accumulated costs that have an indirect relation to the
cost object(s).
 Cost tracing: is a term used to describe the assignment of direct costs to a particular cost
object.
 Cost Allocation: is a term used to describe the assignment of indirect costs to a particular
cost object.
 Cost Accountancy
Cost Accountancy is a broader term and is defined as, ‘the application of costing and cost
accounting principles, methods and techniques to the science and art and practice of cost
control and the ascertainment of profitability as well as presentation of information for
the purpose of managerial decision making.’
 Cost behavior: it refers to how a cost will react or respond to changes in the level of
business activity. As the level of activity rises and falls, a particular cost may rise and fall
as well-or it may remain constant.
 Cost driver: is a variable, such as an activity level or volume, the change of which
causally affect costs over a given time span. That is, there is a specific cause-and-effect
relationship between change in level of activity or volume and change in level of cost.
Variable costs have proportionate relation with their cost drivers while fixed cost have no
cost driver in the short run but may have in the long run. Examples of cost derivers are
direct labor hours, machine hours, units produced, and units sold.

 Range: is the band of normal activity level or volume in which there is a specific
relationship between the level of activity or volume and the cost in question.
1.5.2 Costing Systems

A. Historical Costing: - costs are ascertained only after they are incurred. For example, costs
incurred in the month of April, 2007 may be ascertained and collected in the month of May.
B. Absorption Costing: - costs are absorbed in the product units irrespective of their nature. In
other words, all fixed and variable costs are absorbed in the products.
C. Marginal Costing:- only variable costs are charged to the products and fixed costs are
written off to the Costing Profit and Loss A/c. Since fixed costs are largely period costs, they
should not enter into the production units. Naturally, the fixed costs will not enter into the
inventories and they will be valued at marginal costs only.
D. Uniform Costing:- This is not a distinct method of costing but is the adoption of identical
costing principles and procedures by several units of the same industry or by several
undertakings by mutual agreement.
1.5.3 Essentials of a good Costing system
For availing of maximum benefits, a good costing system should possess the following
characteristics.
Should be suitable to its nature and size of the business and its information needs.
 It is economical (the benefits derived from the same should be more than the cost of
operating of the same).
 Should be simple to operate and understand. Complications should be avoided.
 Ensure proper system of accounting for material, labor and overheads.
 Before designing a costing system, need and objectives of the system should be identified.
 Ensure that the final aim of ascertaining of cost as accurately possible should be achieved
1.5.4 Costing Centers
A. Cost Center: - the smallest organizational sub unit of a production or service, function,
activity or item of equipment whose costs may be attributed to cost units. For example, a
production dept, stores dept, sales dept can be cost centers. Similarly, an item of equipment
like a lathe, fork-lift, and truck or delivery vehicle can be cost center, a person like sales
manager can be a cost center.

B. Profit Center: - is any sub unit of an organization to which both revenues and costs are
assigned. Cost center is an activity to which only costs are assigned but a profit center is one
where costs and revenues are assigned so that profit can be ascertained.
1.5.5 Cost Classifications
A. Manufacturing and Non-manufacturing Costs:
Manufacturing firms are involved in acquiring raw materials producing finished goods and then
administrative, marketing and selling activities. All these activities require costs to be incurred.
These costs are normally classified by manufacturing companies as manufacturing and non-
manufacturing costs.
o Manufacturing Costs:
Manufacturing costs are those costs that are directly involved in manufacturing of products.
Manufacturing cost is divided into three broad categories by most companies.
1. Direct materials cost

2. Direct labor cost
3. Manufacturing overhead cost.

1. Direct Materials Cost:
The materials that go into final product are called raw materials. This term is somewhat
misleading, since it seems to imply unprocessed natural resources like wood pulp or iron ore.
Actually raw materials refer to any materials that are used in the final product; and the finished
product of one company can become raw material of another company. For example plastic
produced by manufacturers of plastic is a finished product for them but is a raw material for a
computer manufacturing company.
Direct Materials are those materials that become an integral part of the finished product and that
can be physically and conveniently traced to it. Examples include tiny electric motors that are
used by radio manufacturers. Sometimes it is not worth the effort to trace the costs of relatively
insignificant materials to the end products. Such minor items would include the

solder/connectors used to make electrical connection in a TV or the glue used to assemble a

chair. Materials such as solder or glue are called indirect materials and are included as part of
manufacturing overhead.
2. Direct Labor Cost:
The term direct labor is reserved for those labor costs that can be essentially traced to individual
units of products. Direct labor is sometime called touch labor, since direct labor workers
typically touch the product while it is being made. The labor cost of assembly line workers, for
example, is a direct labor cost.
Labor costs that cannot be physically traced to the creation of products, or that can be traced only
at a great cost and inconvenience, are termed indirect labor and treated as part of manufacturing
overhead, along with indirect materials. Indirect labor includes the labor costs of janitors,
supervisors, materials handlers, and night security guards. Although the efforts of these workers
are essential to production, it would be either impractical or impossible to accurately trace their
costs to specific units of product. Hence, such labor costs are treated as indirect labor.
In some industries, major shifts are taking place in the structure of labor costs. Sophisticated
automated equipment, run and maintained by skilled workers, is increasingly replacing direct
labor. In a few companies, direct labor has become such a minor element of cost that it has
disappeared altogether as a separate cost category. However the vast majority of manufacturing
and service companies throughout the world continue to recognize direct labor as a separate cost
category.
Direct Materials cost combined with direct labor cost is called prime cost.
In equation form:
Prime Cost = Direct Materials Cost + Direct Labor Cost
3. Manufacturing Overhead Cost:

Manufacturing overhead, the third element of manufacturing cost, includes all costs of
manufacturing except direct material and direct labor. Examples of manufacturing overhead

include items such as indirect material, indirect labor, maintenance and repairs on production
equipment and heat and light, property taxes, depreciation, and insurance on manufacturing
facilities. Indirect materials are minor items such as solder and glue in manufacturing industries.
These are not included in direct materials costs.

Indirect labor is a labor cost that cannot be trace to the creation of products or that can be traced
only at great cost and inconvenience. Indirect labor includes the labor cost of janitors,
supervisors, materials handlers and night security guards. Costs incurred for heat and light,
property taxes, insurance, depreciation and so forth associated with selling and administrative
functions are not included in manufacturing overhead.
Manufacturing overhead is known by various names, such as indirect manufacturing cost, factory
overhead, and factory burden. All of these terms are synonymous with manufacturing overhead.
Manufacturing overhead cost combined with direct labor is called conversion cost.
In equation form:
Conversion Cost = Direct Labor Cost + Manufacturing Overhead Cost
o Non-manufacturing Costs:
Non-manufacturing costs are those costs that are not incurred to manufacture a product.
Examples of such costs are salary of sales person and advertising expenses. Generally non-
manufacturing costs are further classified into two categories.
1) Marketing and Selling Costs
2) Administrative Costs
 Marketing or Selling Costs:
Marketing or selling costs include all costs necessary to secure customer orders and get the
finished product into the hands of the customers. These costs are often called order getting or
order filling costs. Examples of marketing or selling costs include advertising costs, shipping
costs, sales commission and sales salary.
 Administrative Costs:

Administrative costs include all executive, organizational, and clerical costs associated with
general management of an organization rather than with manufacturing, marketing, or selling.
Examples of administrative costs include executive compensation, general accounting,
secretarial, public relations, and similar costs involved in the overall, general administration of
the organization as a whole.
Summary of manufacturing and non-manufacturing costs
Manufacturing Costs
Direct Materials:
Materials that can be physically and conveniently traced to a product, such as

wood in a table.
Direct Labor:
Labor costs that can be physically and conveniently traced to a product such
as assembly line workers in a plant. Direct labor is also called touch labor
cost.
Manufacturing Overhead:
All costs of manufacturing a product other than direct materials and direct
labor, such as indirect materials, indirect labor, factory utilities, and
depreciation of factory equipment.
Non-manufacturing Costs
Marketing or selling costs:
All costs necessary to secure customer orders and get the finished product or
service into the hands of the customer, such as sales commission, advertising,
and depreciation of delivery equipment and finished goods warehouse.
Administrative Costs:
All costs associated with the general management of the company as a whole,

such as executive compensation, executive travel costs, secretarial salaries,

and depreciation of office building and equipment.
B. Product Cost versus Period Cost:

In addition to the distinction between manufacturing and non-manufacturing costs, there are
other ways to look at costs. Costs can also be classified as either product cost or period cost.
 Product Costs:
For financial accounting purposes, product costs include all the costs that are involved in
acquiring or making product. In the case of manufactured goods, these costs consist of direct
materials, direct labor, and manufacturing overhead. Product costs are viewed as "attaching" to
units of product as the goods are purchased or manufactured and they remain attached as the
goods go into inventory awaiting sale. So initially, product costs are assigned to an inventory
account on the balance sheet. When the goods are sold, the costs are released from inventory as
expense (typically called Cost of Goods Sold) and matched against sales revenue. Since product
costs are initially assigned to inventories, they are also known as inventoriable costs. The
purpose is to emphasize that product costs are not necessarily treated as expense in the period in
which they are incurred. Rather, as explained above, they are treated as expenses in the period in
which the related products are sold. This means that a product cost such as direct materials or
direct labor might be incurred during one period but not treated as an expense until a following
period when the completed product is sold.
 Period Costs:
Period costs: Are all the costs that are not included in product costs. These costs are expensed
on the income statement in the period in which they are incurred, using the usual rules of accrual
accounting that we learn in financial accounting. Period costs are not included as part of the cost
of either purchased or manufactured goods. Sales commissions and office rent are good

examples of period costs. Both items are expensed on the income statement in the period in
which they are incurred. Thus they are said to be period costs. Other examples of period costs are
selling and administrative expenses.
C. Cost Classifications for Predicting Cost Behavior (Variable cost, Fixed

costs and Semi-variable Costs):
Quite frequently, it is necessary to predict how a certain cost will behave in response to a change
in activity. For planning purposes, a manager must be able to anticipate which of these will
happen; and if a cost can be expected to change, the manager must know by how much it will
change. To help make such distinctions, costs are often characterized as variable or fixed.
 Variable Cost:
A variable cost is a cost that varies, in total, in direct proportion to changes in the level of
activity. The activity can be expressed in many ways, Such as units produced, units sold, miles
driven, beds occupied, hours worked and so forth. Direct material is a good example of variable
cost.
The cost of direct materials will vary in direct proportions to the number of units produced.
When we speak the term variable cost we mean that the total cost rise and fall as the activity
rises and falls. One interesting aspect of variable cost is that a variable cost is constant if
expressed on a per unit basis. For a cost to be variable, it must be variable with respect to
something. That something is its activity base/cost deriver. An activity base is a measure of
whatever causes the incurrence of variable cost. An activity base is also referred to as cost driver.
Some of the most common activity bases are direct labor hours, machine hours, units produced,
and units sold. Other activity bases (cost drivers) might include the number of miles driven by
sales persons, the number of pounds of laundry cleaned by a hotel, the number of calls handed by
technical support staff at a software company, and the number of beds occupied in a hospital or

hotel. To plan and control variable costs, a manger must be well acquainted with the various
activity bases within the firm.
People sometimes get the notion that if a cost doesn't vary with production or with sales, then it
is not really a variable cost. This is not correct. As suggested by the range of bases listed below,
costs are caused by many different activities within an organization. Whether a cost is considered
to be variable depends on whether it is caused by the activity under consideration.
For example, if a manager is analyzing the cost of service calls under a product warranty, the
relevant activity measure will be the number of service calls made. Those costs that vary in total
with the number of service calls made are the variable cost of making service calls.
Nevertheless, unless stated otherwise, you can assume that the activity base under consideration
is the total volume of goods and services provided by the organization.
Some of the most frequently encountered variable costs are listed below. This is not a complete
list of all costs that can be considered variable. More, some costs listed here may behave more
like fixed than variable costs in some organizations.
Most Frequently Encountered Variable Costs

Type of organization Costs that are normally variable with respect to volume of output
Merchandising company Cost of goods (merchandise) sold
Manufacturing company  Manufacturing costs:
Direct materials
Direct labor
 Variable portion of manufacturing overhead:
Indirect materials
Lubricants
Supplies
Power
Both merchandising and  Selling, general and administrative costs:
manufacturing companies Commissions
clerical costs, such as invoicing
Shipping costs
Service organizations  Supplies, travel, clerical

 Fixed Cost:
A fixed cost is a cost that remains constant, in total, regardless of changes in the level of activity.
Unlike variable costs, fixed costs are not affected by changes in activity. Consequently, as the
activity level rises and falls, the fixed costs remain constant in total amount unless influenced by
some outside forces, such as price changes. Rent is a good example of fixed cost. Fixed cost can
create confusion if they are expressed on per unit basis. This is because average fixed cost per
unit increases and decreases inversely with changes in activity. Examples of fixed cost include
straight line depreciation, insurance property taxes, rent, supervisory salary etc.
 Semi-variable Costs:- Certain costs are partly fixed and partly variable. In other words,
they contain the features of both types of costs. These costs are neither totally fixed nor
totally variable. Maintenance costs, supervisory costs etc are examples of semi-variable
costs. These costs are also called as ‘stepped costs’
Summary of variable and fixed cost behavior
Behavior of the cost (within the relevant range)

Cost
In Total Per Unit
Variable Cost Total variable cost increases and Variable cost remains constant per
decreases in proportion to changes unit
in the activity level.
Fixed cost Total fixed cost is not affected by fixed cost per unit decreases as the
changes in the activity level within activity level rises, and increases as
the relevant range. the activity level falls
D. Cost Classifications for Assigning Costs to Cost Objects (Direct and

Indirect Cost):
For the purpose of assigning costs to cost objects, costs are classified as
1) Direct cost
2) Indirect cost.
 Direct Cost:

A direct cost is a cost that can be easily and conveniently traced to the particular cost object
under consideration. For example, if a company is assigning costs to its various regional and
national sales offices, then the salary of the sales manager in that office would be a direct cost of
that office.
 Indirect Cost:
An indirect cost is a cost that cannot be easily and conveniently traced to the particular cost
object under consideration. For example a soup factory may produce dozens of verities of
canned soups. The factory manager's salary would be an indirect cost of a particular verity such
as chicken noodle soup. The reason is that the factory manager's salary is not caused by any one
variety of soup. To be traced to a cost object such as a particular product, the cost must be caused
by the cost object. This salary of manager is called common cost of producing the various
products of the factory. A common cost is a cost that is incurred to support a number of costing
objects but cannot be traced to them individually. A common cost is a particular type of indirect
cost. A particular cost may be direct or indirect, depending on the cost object. While, in the
above example, the soup factory manager's salary is an indirect cost of manufacturing chicken
noodle soup, it is a direct cost of the manufacturing division. In the first case, the cost object is
the chicken noodle soup product. In the second case, the cost object is the entire manufacturing
division.
E. Classification according to time: - Costs can also be classified according to time. This
classification is explained below.
i. Historical Costs: - These are the costs which are incurred in the past, i.e. in the past year,
past month or even in the last week or yesterday. The historical costs are ascertained
after the period is over. In other words it becomes a post-mortem analysis of what has
happened in the past. Though historical costs have limited importance, still they can be
used for estimating the trends of the future, i.e. they can be effectively used for predicting
the future costs.
ii. Predetermined Cost: - These costs relating to the product are computed in advance of
production, on the basis of a specification of all the factors affecting cost and cost data. Pre-
determined costs may be either standard or estimated. Standard Cost is a predetermined
calculation of how much cost should be under specific working conditions. It is based on

technical studies regarding material, labor and expenses. The main purpose of standard cost
is to have some kind of benchmark for comparing the actual performance with the
standards. On the other hand, estimated costs are predetermined costs based on past
performance and adjusted to the anticipated changes. It can be used in any business
situation or decision making which does not require accurate cost.
F. Classification of costs for Management decision making:-

For decision making certain types of costs are relevant. Classification of costs based on the
criteria of decision making can be done in the following manner.
i. Marginal Cost:-
Marginal cost is the change in the aggregate costs due to change in the volume of output by one
unit. For example, suppose a manufacturing company produces 10,000 units and the aggregate
costs are Br. 25,000; if 10,001 units are produced the aggregate costs may be Br. 25,020 which
means that the marginal cost is Br. 20. Marginal cost is also termed as variable cost and hence
per unit marginal cost is always same, i.e. per unit marginal cost is always fixed. Marginal cost
can be effectively used for decision making in various areas.
ii. Differential Costs:-

Differential costs are also known as incremental cost. This cost is the difference in total cost that
will arise from the selection of one alternative to the other. In other words, it is an added cost of a
change in the level of activity. This type of analysis is useful for taking various decisions like
change in the level of activity, adding or dropping a product, change in product mix, make or buy
decisions, accepting an export offer and so on.
iii. Opportunity Costs:-
It is the value of benefit sacrificed in favor of an alternative course
of action. It is the maximum amount that could be obtained at any given point of time if
a resource was sold or put to the most valuable alternative use that would be practicable.

Opportunity cost of goods or services is measured in terms of revenue which could have
been earned by employing that goods or services in some other alternative uses.
iv. Relevant Cost:-
The relevant cost is a cost which is relevant in various decisions of management. Decision
making involves consideration of several alternative courses of action. In this process, whatever
costs are relevant are to be taken into consideration. In other words, costs which are going to be
affected matter the most and these costs are called as relevant costs. Relevant cost is a future cost
which is different for different alternatives. It can also be defined as any cost which is affected
by the decision on hand.
v. Replacement Cost: -
This cost is the cost at which existing items of material or fixed assets can be replaced. Thus this
is the cost of replacing existing assets at present or at a future date.
vi. Abnormal Costs:-
It is an unusual or a typical cost whose occurrence is usually not regular and is unexpected. This
cost arises due to some abnormal situation of production. Abnormal cost arises due to idle time,
may be due to some unexpected heavy breakdown of machinery. They are not taken into
consideration while computing cost of production or for decision making.
vii. Controllable Costs:-
In cost accounting, cost control and cost reduction are extremely important. In fact, in the
competitive environment, cost control and reduction are the key words. Hence it is essential to
identify the controllable and uncontrollable costs. Controllable costs are those which can be
controlled or influenced by a conscious management action. For example, costs like telephone,
printing stationery etc can be controlled while costs like salaries etc cannot be controlled at least
in the short run. Generally, direct costs are controllable while uncontrollable costs are beyond the
control of an individual in a given period of time.
viii. Shutdown Cost:-

These costs are the costs which are incurred if the operations are shut down and they will
disappear if the operations are continued. Examples of these costs are costs of sheltering the
plant and machinery and construction of sheds for storing exposed property. Computation of

shutdown costs is extremely important for taking a decision of continuing or shutting down
operations.
ix. Capacity Cost:-
These costs are normally fixed costs. The cost incurred by a company for providing production,
administration and selling and distribution capabilities in order to perform various functions.
Capacity costs include the costs of plant, machinery and building for production, warehouses and
vehicles for distribution and key personnel for administration. These costs are in the nature of
long-term costs and are incurred as a result of planning decisions.
x. Urgent Costs:- These costs are those which must be incurred in order to continue operations
of the firm. For example, cost of material and labor must be incurred if production is to take
place.
G. Cost Classifications based on Financial Statements:

Merchandising and manufacturing firms, both prepare financial statement reports for creditors,
stockholders, and others to show the financial condition of the firm and the firm's earnings
performance over some specified intervals. Merchandising companies simply purchase goods
and resale them to customers. Financial statement reports are therefore simple in case of
merchandising companies. The financial statements prepared by manufacturing companies are
more complex than the statements prepared by a merchandising company.
Manufacturing companies are more complex organizations than merchandising companies

because the manufacturing companies must produce its goods as well as market them. The
production process gives rise to many costs that do not exist in a merchandising company, and
somehow these costs must be accounted for on the manufacturing company's financial
statements. In this section, we focus our attention on how this accounting is carried out in the
balance sheet and income statement.
Balance Sheet:
The balance sheet or statement of financial position of a manufacturing company is similar to
that of a merchandising company. However, the inventory accounts differ between two types of
companies. A merchandising company has only one type of inventory-goods purchased from

suppliers that are awaiting resale to customers. In contrast manufacturing companies have three
classes of inventories-raw materials, work-in-process, and finished goods.
Example:
We will use the data of two companies A and B-to illustrate the concept discussed in this section.
Company A is involved in manufacturing a product Alpha and B is involved in purchasing books
about business and finance from publishers and authors and reselling them to customers.
The footnotes to A's annual reports reveal the following information concerning its inventories.
A Manufacturing Corporation
Inventory Accounts
Beginning Balance Ending Balance
Raw materials $60,000 $50,000
Work in process $90,000 $60,000
Finished goods $125,000 $175,000
A's inventory largely consists of raw materials used in manufacturing product alpha. The work in
process inventory consists of partially completed alpha. The finished goods inventory consists of
alpha that is ready to be sold to the customers or whole sellers. In contrast the inventory account
at B-a book reseller-consists entirely of the costs of books the company has purchased from
publishers for resale to the public. In merchandising companies like B these inventories may be
called merchandising inventories. The beginning and ending balances in this account appears as
follows
B-Bookstore
Inventory Accounts

Beginning Balance Ending Balance
Merchandising Inventory
$100,000 $150,000

Income Statement:
Following are comparative income statements of merchandising and manufacturing companies.
B-Bookstore (Merchandising Co.)
Income Statement
Sales $1,000,000
Cost of goods sold:
Beginning merchandising inventory $200,000
Add: Purchases 550,000
Goods available for sale 750,000
Less: Ending merchandising inventory 150,000 $600,000
Gross margin $400,000
Less operating expenses:
Selling expenses $100,000
Administrative Expenses 200,000 300,000
Net operating income $100,000
A-Manufacturing Co.
Income Statement
Sales $1,500,000
Cost of goods sold:
Beginning finished goods inventory $125,000
Add: Cost of goods manufactured* $850,000
(See schedule)
Goods available for sale $975,000
Less: Ending finished goods inventory $175,000 800,000
Gross margin $700,000

Less: Operating expenses

Selling expenses 250,000
Administrative expenses 300,000 550,000
Net operating income $150,000
*Schedule of Cost of Goods Manufactured
A-Manufacturing Co.
Direct Materials:
Beginning raw materials inventory $60,000
Add: Purchases of raw materials 400,000
Raw materials available for use 460,000
Less: Ending raw materials inventory 50,000
Raw materials used in production $410,000

Direct Labor 60,000

Manufacturing overhead:
6,000
Insurance factory 100,000
Indirect labor 50,000
Machine rental 75,000
Utilities factory 21,000
Supplies 90,000
Depreciation, factory 8,000
Property taxes, factory
350,000
Total overhead costs
$820,000
Total manufacturing cost 90,000
Add: Beginning work in process $910,000
60,000
Less: Ending work-in-process Cost of $850,000
goods manufactured
At first glance, the income statements of merchandising and manufacturing firms like A and B
companies are very similar. The only apparent difference is in the labels of some of the entries in
the computation of cost of goods sold. In this example, the computation of cost of goods sold
relies on the following basic equation for the inventory accounts:
 Basic Equation for Inventory Accounts:
Beginning balance + Additions to inventory = Ending balance + withdrawals from inventory

At the beginning of the period, the inventory contains some beginning balances. During the
period, additions are made to the inventory through purchases or other means. The sum of the
beginning balance and additions to the account is the total amount of inventory available. During
the period, withdrawals are made from inventory. Whatever is left at the end of the period after
these withdrawals is the ending balance.
These concepts are applied to determine the cost of goods sold for a merchandising company like
B-bookstore as follows:
 Cost of Goods Sold in a Merchandising Company:
Beginning merchandising inventory + Purchases = Ending merchandising inventory + Cost of

goods sold
Or
Cost of goods sold = Beginning merchandising inventory + Purchases − Ending
merchandising inventory.
To determine the cost of goods sold in a merchandising company, we only need to know the
beginning and ending merchandising inventory account and the purchases. Total purchases can
be easily determined in a merchandising company by simply adding together all purchases from
suppliers.
The cost of goods sold for a manufacturing company like A manufacturing company is
determined as follows:
 Cost of Goods Sold Equation in a Manufacturing Company:
Beginning finished goods inventory + Cost of goods manufactured = Ending finished goods
inventory + Cost of goods sold or

Cost of goods sold = Beginning finished goods inventory + Cost of goods manufactured −
Ending finished goods inventory
To determine the cost of goods sold in a manufacturing company like A manufacturing

company, we need to know the cost of goods manufactured and the beginning and ending
balances of finished goods inventory account. The cost of goods manufactured consists of the
manufacturing costs associated with goods that were finished during the period. The cost of
goods manufactured figure for A manufacturing company is derived from the schedule of cost of
goods manufactured below the comparative income statements.
 Schedule of Cost of Goods Manufactured:
At first glance the schedule of cost of goods manufactured (below comparative income
statements) appears complex and perhaps even intimating. However, it is all quite logical. The
schedule of cost of goods manufactured contains the three elements of cost--direct materials,
direct labor, and manufacturing overhead. The direct material cost is not simply the cost of
materials purchased during the period rather is the cost of materials used during the period. The
purchases of raw materials are added to the beginning balance to determine the cost of the
materials available for use. The ending materials inventory is deducted from this amount to
arrive at the amount of materials used during the period. This is further explained by the
following equation:
Materials available for use = Beginning balance of materials + materials purchased during the
period
The sum of three cost elements (materials, labor and overhead) is the total manufacturing cost.
See the following equation:
Manufacturing cost = Direct materials + Direct labor + Manufacturing overhead

This manufacturing cost is not equal to the cost of goods manufactured. Some of the materials,
direct labor and manufacturing overhead costs incurred during the period relate to goods that are
not yet completed. The cost of goods manufactured consists of the manufacturing costs
associated with the goods that were finished during the period. Consequently adjustments need to
be made to the total manufacturing cost of the period for the partially completed goods that were
in process at the beginning and at the end of the period. Beginning work in process inventory
must be added to the total manufacturing cost and ending work in process inventory must be
deducted to arrive at the cost of goods manufactured. This is further explained by the following
equation:
Cost of goods manufactured = Manufacturing cost + Beginning balance of work in process
inventory − Ending balance of work in process inventory
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‘’…….Come to learn; Go to Serve…..

Managers as internal users of information use the outputs of accounting system:

1.1. Management Accounting, Financial Accounting and Cost Accounting

Processing any economic transaction entails collecting, categorizing, summarizing, analyzing

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Basically, Management Accounting and Financial Accounting have different roles.

Examples of activities performed by managerial accountants are:

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Management Accounting Vs. Financial Accounting

 Emphasis on the Future:

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 Less Emphasis on Precision:

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 Generally Accepted Accounting Principles (GAAP)

 Managerial Accounting Is Not Mandatory

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financial consequences of past future.

1.2.Role of Management Accountants in an Organization

a) Scorekeeping- accumulating data and reporting reliable results to all levels of

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c) Problem Solving- making comparative analysis to identify the best alternatives in

1.3. Guidelines for Management Accountants

1.5 Cost Terminologies and Classifications:

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1.5.2 Costing Systems

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1.5.5 Cost Classifications

A. Manufacturing and Non-manufacturing Costs:

1. Direct materials cost

3. Manufacturing overhead cost.

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solder/connectors used to make electrical connection in a TV or the glue used to assemble a

2. Direct Labor Cost:

Prime Cost = Direct Materials Cost + Direct Labor Cost

3. Manufacturing Overhead Cost:

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These are not included in direct materials costs.

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Summary of manufacturing and non-manufacturing costs

Materials that can be physically and conveniently traced to a product, such as

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such as executive compensation, executive travel costs, secretarial salaries,

B. Product Cost versus Period Cost:

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C. Cost Classifications for Predicting Cost Behavior (Variable cost, Fixed

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Most Frequently Encountered Variable Costs

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Summary of variable and fixed cost behavior

Behavior of the cost (within the relevant range)

D. Cost Classifications for Assigning Costs to Cost Objects (Direct and

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F. Classification of costs for Management decision making:-

ii. Differential Costs:-

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viii. Shutdown Cost:-

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