January 27, 2012

Cost Accounting - Introduction

Cost accounting measures and reports financial and nonfinancial information that relates to the cost of acquiring or consuming resources by the organization.

Cost is a resource sacrificed or forgone to achieve a specific objective. It is usually measured as the monetary amount (or money) that must be paid to acquire goods and services.

Cost accounting measures and reports financial and nonfinancial information that relates to the cost of acquiring or consuming resources by the organization.

Cost Terminology

Cost is a resource sacrificed or forgone to achieve a specific objective. It is usually measured as the monetary amount (or money) that must be paid to acquire goods and services.

Budgeted cost is provided in the plan. Forecasted cost is an estimate. Actual cost is the cost actually incurred at the time of transaction.

Cost Object: Cost object is anything for which a separate measurement of cost is desired.
A cost system accumulates costs and the assigns them to various cost objects. This cost accumulation process follows the financial accounting system process of documents of financial transactions, journal entry, ledger entry. In ledger accounts, cost accounting system require more accounts that deal with various cost centers of the organization.

Cost accumulation is the collection cost using documents like purchase orders, invoices, various expense vouchers, and issue receipts of materials, wage and salary schedules. These documents are entered in journals and ledgers like the financial accounting or book keeping procedure.

Cost assignment is a term that encompasses both (1) tracing accumulated costs to a cost object, and (2) allocating accumulated costs to a cost object.

Direct cost: Directs of a cost object are related to the particular cost object and they can be traced to the cost object through accounting documents as and when they are incurred in an economically feasible way.

Indirect cost: Indirect costs are also related to the cost objects but they cannot be identified with cost objectsa the time they are incurred in an economically feasible way. Hence they are accumulated without explict reference to the cost obejcts at the time they are incurred and then allocated to various cost objects at a later date to find out the costs of cost objects.

Variable cost: A variable cost with reference to a cost object changes in total in proportion to changes in the level of total activity or volume of output. With reference to an automobile, petrol is an example of variable cost. If one drives more, more petrol is consumed.
Fixed cost: A fixed cost remains unchanged for a given time period despite changes in the level of activity or volume of output. Insurance premium for a car, an annual tax for a car can be given as examples. They are not related to the distance travelled by a car in a period.

Cost driver: Cost driver is a factor, that has a causal relation with a cost over a given time span. In the case of variable costs, activity volume or output volume are cost drivers. that is at the total variable cost level, more output would mean more total cost.

Fixed cost: Fixed cost has no cost driver in the short term. But in the long term it also has cost drivers.

Inventoriable costs: These costs are regarded as an asset when they are incurred and then become cost of goods sold when the product is sold.

Period costs: These costs are treated as expenses of the period in which they are incurred because it is presumed that they do not benefit future periods.

Prime cost and conversion costs are terms used in manufacturing companies. Prime costs are all direct manufacturing costs. Conversion costs are all manufacturing costs other than direct material costs.

Overhead cost: Costs which are not directly related to the production of goods being produced and sold are classified under overhead costs. They are essential for the production and selling process but they are not accounted directly on the job cards or batch cards of the goods being produced and sold.

Cost Accounting: A Managerial Emphasis, Charles T. Horngren, George Foster, and Srikant M. Datar, Prentice Hall Inc.,2000

Video Lecture by Prof Bassell On Cost Classification and Terminology



Value Chain Analysis - IMA Guideline

A summary of IMA guideline

I. Need

     Value chain analysis is a strategic tool to measure the customer's perceived value. The analysis enables companies to determine the strategic advantages and disadvantages of their value creating processes and activities.

II. Value Chain - Definition

Customer value accumulates along the  chain of activities that a firm performs and delivers an end product or service to customers.
Activities and processes are performed by the firm to understand market, design, produce, sell (market), deliver and support its product.
A firm's value chain structure and the way the individual activities in the  value chain are  performed are a reflection of the firm's history, its current strategy, its approach to implementing its strategy and the underlying economics of the activities.
The activities in a value chain are categorised as primary and support activities.

III. Competing in the Market, Customer Value and Competitive Advantage

In order to compete in a market as a supplier of a product or service a firm must supply what customers want to buy. It has to create customer value so that customer pays a price for the offering. In any market there are competitors. The firm has to be provide some unique benefits to a certain section of persons in the target market to survive the competition.
The competitive advantage of a firm derives from the difference between the value it offers to customers and its cost of creating that customer value.
Thus the competitive advantage is obtained from two sources:
1. Differentiation advantage. Customer perceives more value from the firm's products.
2. Low cost advantage. The firm is able to provide the service or product at a cost lower than the market average.

IV. The Role of Management Accountant

Champion the use of value chain analysis.

V. Value Chain Analysis - Procedure

Internal cost analysis
Internal differentiation analysis
Vertical linkage analysis

VI. Strategic Frameworks for Value Chain Analysis

From the strategy theory the following concepts or frameworks are relevant for value chain analysis
Industry structure analysis
Core competencies
Segmentation analysisi

VII. Limitations of Value Chain Analysis

It is not an exact science. It is not easy. Finding costs, revenues and assets for each activity sometimes presents serious difficulties.
Despite such difficulties, experience indicates that value chain analysis yields firm swith invaluable information on their competitive situation, cost structure, and linkages with suppliers and customers.

VIII. Organizational and Managerial Accounting Challenges

Value chain analysis offers an opportunity to integrate strategic planning and management accounting. Management accounting department has to champion this to maintain its critical role as the information profession.

Index of articles on Cost Accounting, Costing and Cost Management

Cost Accounting, Costing and Cost Management - Article Directory

Originally posted in Knol

Post updated 24.9.2012

The Role of Accounting in Organizations

Accounting is a major means of helping managers of an organization, equity investors of an organization, potential equity investors, creditors and bond holders of an organization, potential creditors and bond holders of an organization, suppliers and customers of an organization and other stake holders to take decisions.


Purposes of Accounting Systems

Accounting is a major means of helping managers of an organization, equity investors of an organization, potential equity investors, creditors and bond holders of an organization, potential creditors and bond holders of an organization, suppliers and customers of an organization and other stake holders to take decisions.
Accounting provides information for three major purposes:
1. External reporting: These reports are used investors, creditors, government authorities, and other outside parties.
2. Routine internal reporting: These reports which are periodically generated are used by managers of the company for their internal decisions.
3. Nonroutine internal reporting: This information or reports are generated to support projects and other decisions that come up as the need arises from them.
While the reports are prepared in different formats and basic data is manipulated or summarized in various ways to facilitate decision making, there is one data base maintained by the accounting system that contains data in the form debits and credits to various accounts maintained in the accounting system. Accountants combine these data items in various ways to provide information to internal or external users.

Distinction Between Financial Accounting, Cost Accounting and Management Accounting

Horngren’s distinction between them is interesting.
Management accounting as a discipline focuses on accounting information that facilitates decision making by managers of the organization. If focuses on routine and nonroutine accounting reports.
Financial accounting measures and records business transactions and provides financial statements that are based on generally accepted accounting principles (GAAP). Executive compensation is tied to profit figures reported in the financial statements and equity share valuation is also based to a large extent on these financial statements.
Cost accounting provides information to facilitate both management accounting and financial accounting. Its focus is measuring and reporting financial and nonfinancial information that is related to the cost of acquiring or consuming resources by an organization.

Cost Management

Cost management is an activity of managers related to planning and control of costs. Managers have to take decisions regarding use of materials, processes, product designs and have to plan costs or expenses to support the operating plan for their department or section. All these activities come under cost management. Information from accounting systems help managers in cost management activities.  But the cost accounting system and the reports it generates is not the cost management system. Accounting system can be interpreted as a part of cost management system of an organization.
Cost management is not cost reduction alone. It is much broader.  Organization increase advertising expenditure to increase sales, increase research and development expenditures to promote new products. Here the concerned managers are deliberately incurring additional costs in a period (compared to the previous period) as they expect profits from such decisions or expenditures. Cost management system has to ensure that a cost is incurred with the expectation of profit.

The Role of Management Accounting

The role of management accounting is also described as problem solving, score keeping and attention directing.
Problem solving: The role of accounting in problem solving is to provide information useful in evaluating alternatives.
Scorekeeping: Scorekeeping records the results of various actions of the managers and helps in assessing whether the results expected from the various actions are realized or not.
Attention directing: The scorekeeping function in combination with expected results, and comparative analysis of scores of various companies, divisions and departments, comparative analysis of present period scores or results with previous periods show opportunities of focusing attention of managers to improve things.


Value Chain

Value chain is a visualization of complete business as a sequence of activities in which usefulness is added to the products or services produced and sold by an organization. Management accountants provide decision support for managers in each activity of value chain.

Design of Management Accounting System

The design of management accounting system has to take into consideration the decision needs of the managers. Also it has to take into consideration the new themes and challenges that managers face currently.
Horngren identified four such themes in the tenth edition of his book.
1. Customer focus: The challenge for managers it invest sufficient resources to enhance customer satisfaction. But every action of the organization has to result enhanced profitability or maintained profitability for the organization.
2. Key Success Factors: These are nonfinancial factors which have an effect on the economic viability of the organization.
Cost, quality, time and innovation are important key success factors. Management accounting systems need to have provisions for tracking the performance of the organization and its divisions as well as competitors on these success factors.
3. Continuous improvement: Continuous improvement or kaizen is a popular theme. Innovation related to this area in costing is kaizen costing .
4. Value Chain and Supply Chain Analysis: Value chain as a strategic framework for analysis of competitive advantage was promoted by Michael Porter. Management accountants have to become familiar with the framework and provide information to implement the framework by strategic planners.
The term supply chain describes the flow of goods, services and information from cradle (the mines sources of raw materials) to grave (where discarded products or dumped), regardless of whether those activities occur in the same organization or many organizations.

Key Guidelines for Management Accounting System Design

Cost Benefit Approach: In the system design resource allocation decisions are to be made. Examples would be software to buy and associates to employ. A cost-benefit approach should be used for all such decisions. Resources should be spent only when there is profit to the organization due to that expenditure.  Each incremental addition to the accounting system must be supported by incremental profit to the organization.
Behavioral and Technical Considerations: Management has human dimension and it has to focus on how to help individuals to do their jobs better. Managing people involves discussion of managers with his associates on improving performance. The behavioral responses of people to reports highlighting their underperformance have to be understood. Management accounting should lead to cordial relations and climate.
Different Costs for Different Purposes: It is to be noted that there are several cost concepts and cost measures can be created for each of these concepts. Cost accountants have to careful to provide appropriate cost to the managers. The accounting system has to have some precautions to make sure that the accountant understands the decision situation of a manager and provides appropriate cost measures.

Professional Ethics

Like other professionals, accountants also face ethical dilemmas. They need ethical guidelines.  Institute of Management Accountants (IMA), USA published guidance note on ethics to be followed by management accountants.
Competence, confidentiality, integrity and objectivity are important themes of the guidance note.


Horngren, Charles T., George Foster, and Srikant Datar, Cost Accounting: Managerial Emphasis, Tenth Edition, Prentice Hall, Inc., Upper Saddle River, New Jersey, USA, 2000
Cost Accounting - Horngren et al., Book Information and Review

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