ACC305 Cost Accounting Course Material Summary – Unit 1 Basic Concept of Cost Accounting, Definitions and Practice Questions | Download ACC306 Summary
ACC305 Cost Accounting – Unit 1: Basic Concept of Cost Accounting
This study summary covers ACC305 Cost Accounting, a 300-level course from the National Open University of Nigeria (NOUN), School of Management Sciences. This first unit introduces the basic concepts of cost accounting, including its meaning, purposes, the differences between cost and financial accounting, cost classification, contribution and profit, and relevant and irrelevant costs.
Learning Objectives
By the end of this unit, you should be able to:
- Define cost accounting
- State the purposes of cost accounting
- Distinguish between cost accounting and financial accounting
- Discuss the essential elements of effective cost accounting information
- Explain the nature of cost classification
- Explain the importance of contribution in decision making
- Describe the relationship between contribution and profit
- Define relevant and irrelevant costs
Meaning of Cost Accounting
Formal Definition: Cost accounting is the process of collecting, summarizing, analyzing and reporting in monetary terms tailor-made information to management showing the costs and benefits of pursuing each alternative course of action open to management (Eddy, 2004:3).
Simple Explanation: Cost accounting converts raw financial data into usable information that helps management make decisions. When cost accountants speak of cost accounting, they have in mind the ascertainment of: (a) the cost of manufacturing a product; (b) the cost of giving a service; or (c) the way in which cost can be controlled.
The three basic elements of manufacturing costs are direct materials, direct labour and manufacturing overhead, because manufacturing involves the conversion of raw materials to finished goods through the utilization of labour and overhead support.
Note that the cost figures useful to management for long-term pricing strategy will be different from those for short-term pricing, especially when the firm is operating at capacity.
Differences between Cost Accounting and Financial Accounting
The main distinctions are:
- Users: Cost accounting information is meant for internal decision makers (management), while financial accounting information is for both internal and external users.
- Objectives: Financial accounting enables management to render accounts of its stewardship in terms of profit generated in relation to assets invested. The primary purpose of cost accounting is to aid internal decision making.
- Regulation: Financial accounting must conform to Generally Accepted Accounting Principles (GAAP) and government regulation. In Nigeria, the Nigerian Accounting Standards Board (NASB) issues statements of accounting standards to guide published financial statements, in addition to the Companies and Allied Matters Act (CAMA) 1990. There is no such laid-down rule for cost accounting information, besides the unwritten rule that the information is useful enough for the decision that needs to be taken.
- Reporting focus: The primary emphasis of cost accounting is segment reporting – the costs and sales of individual products or parts of the business are prepared so management knows the profitability of each product or part. Financial accounting focuses on the totality of the business rather than individual parts.
- Time basis: Financial accounting information is historical (what happened), while cost accounting is both historical and future-based. Historical data is used, for example, in ascertaining the cost of material issued to a production department; future information aids decision making.
- Periodicity: Financial accounting information is prepared at specified periods (usually quarterly or yearly), whereas cost accounting information is prepared only when needed by management.
Essential Elements of Effective Cost Accounting Information
For cost accounting information to serve its role effectively, it should have the following essential elements:
- The statement containing the information should have an appropriate heading so management can know at a glance what the statement is all about.
- The officer receiving the report must be the appropriate person for the decision on hand.
- The information must be prepared timely if it is to be useful.
- The cost information sent should be sufficiently accurate if wrong decisions are to be avoided.
- The information should be clear and concise for easier understanding.
Cost Classification, Costing Methods and Cost Techniques
Cost Classification: Cost can be classified in accordance with the purpose for which the cost is needed. Possible classifications include: (1) behaviour of the cost in terms of whether it is fixed or variable; (2) the relevance or irrelevance of the cost to the decision on hand; and (3) direct or indirect.
Costing Method: This is a method of cost ascertainment that centres on the business. For a business that deals with a standardized product made under mass production methods or through a series of production steps called processes, the appropriate costing method is process costing. Where the product made or service rendered is non-standardized, the appropriate method is job costing or contract costing.
Cost Technique: This refers to the method used to determine the value of finished goods. Techniques that give different valuations include: (1) standard costing; (2) marginal costing; and (3) absorption costing.
Fixed and Variable Costs
Fixed cost is a cost that remains the same regardless of changes in the level of activity. Variable cost is a cost that increases in direct proportion to the increase in the level of activity. Example: in producing a one-page handout for a group of students, the cost of the stencil used for typing the one page is a fixed cost, while the cost of duplicating paper used is a variable cost.
The Relationship between Contribution and Profit
Contribution is the difference between sales and variable cost of sales. The relationship between contribution and profit can be stated as:
Profit = Contribution – Fixed cost
So that: Contribution = Profit + Fixed cost
This means there are two ways of looking at contribution:
- Contribution = Sales – Variable cost
- Contribution = Profit + Fixed cost
Worked Example: A trader buys an article for N600 and sells it for N1,000. The N400 is the contribution per unit, rather than profit per unit, because no account has yet been taken of transport fare, rent and electricity for the shop. If 1,000 units are bought and sold during an accounting period: Contribution = 1,000 x N400 = N400,000. If the total fixed cost for the same period is N100,000, then Profit = N400,000 – N100,000 = N300,000.
The Importance of Contribution in Decision Making
Contribution is defined as the difference between sales and variable cost of the sales. The more units sold, the greater the contribution towards the recovery of fixed cost for the period. After the recovery of fixed cost, any additional contribution made (above the fixed cost) is known as profit.
The importance of contribution is derived from the fact that it is useful in a variety of decisions, including:
- Acceptance or rejection of special orders
- Pricing
- Addition or deletion of a product line
- Make or buy decisions
- The use of scarce resources
Relevant and Irrelevant Costs
Costs may be classified according to their relevance or irrelevance to the decision on hand. Relevant costs are costs that should be considered in a decision because they will be affected by (or differ between) the alternative courses of action. Irrelevant costs are costs that are not affected by the decision and should therefore be ignored for decision-making purposes. This classification helps management to focus only on the costs and benefits that change as a result of the decision.
Planning a Costing Estimate for a Manufacturing Company
A costing estimate must show clearly all the elements of cost involved – material, labour and overheads – distinguishing between those costs which are fixed and those which are variable. Marginal technique, showing contributions to fixed costs, is most useful. If the factory is working at full capacity, extra costs may be incurred by undertaking additional work, overtime, extra labour or additional machinery, and this must be reflected in the estimates. Material cost should be entered at current market price; material in stock may have cost more or less than this, but any resultant profit or loss is the result of good or bad buying and should not be reflected in the estimate.
Examination Practice Questions
Question 1
Question: Define cost accounting and state its purposes.
Correct Answer
Cost accounting is the process of collecting, summarizing, analyzing and reporting in monetary terms tailor-made information to management showing the costs and benefits of pursuing each alternative course of action open to management. The purposes of cost accounting include: (a) ascertainment of the cost of manufacturing a product; (b) ascertainment of the cost of giving a service; (c) cost control; and (d) provision of information showing the costs and benefits of each alternative course of action to aid management decision making.
Key Points Expected
- Correct definition covering collecting, summarizing, analyzing and reporting in monetary terms
- Tailor-made information for management
- Costs and benefits of alternative courses of action
- Purposes: product/service cost ascertainment and cost control
Question 2
Question: Distinguish between cost accounting and financial accounting.
Correct Answer
The main differences are: (1) Users – cost accounting information is meant for internal decision makers (management), while financial accounting information serves both internal and external users. (2) Objectives – financial accounting enables management to render accounts of stewardship in terms of profit generated in relation to assets invested, while the primary purpose of cost accounting is to aid internal decision making. (3) Regulation – financial accounting must conform to GAAP, NASB statements and CAMA 1990, whereas cost accounting has no such laid-down rules besides usefulness for the decision. (4) Reporting focus – cost accounting emphasises segment reporting (profitability of individual products or parts), while financial accounting focuses on the totality of the business. (5) Time basis – financial accounting is historical, while cost accounting is both historical and future-based. (6) Periodicity – financial accounting is prepared at specified periods (quarterly or yearly), while cost accounting is prepared only when needed by management.
Key Points Expected
- Internal vs external users
- Stewardship vs decision-making objectives
- GAAP/NASB/CAMA regulation vs no prescribed rules
- Segment reporting vs total business focus
- Historical vs historical and future basis
- Fixed period vs prepared as needed
Question 3
Question: Discuss the essential elements of effective cost accounting information.
Correct Answer
For cost accounting information to serve management effectively, it should: (1) have an appropriate heading so management can know at a glance what the statement is about; (2) be sent to the appropriate officer for the decision on hand; (3) be prepared timely, as untimely information loses its value; (4) be sufficiently accurate so that wrong decisions are not taken; and (5) be clear and concise for easier understanding.
Key Points Expected
- Appropriate heading
- Right officer/person
- Timeliness
- Sufficient accuracy
- Clarity and conciseness
Question 4
Question: Explain the relationship between contribution and profit, and discuss the importance of contribution in decision making.
Correct Answer
The relationship is: Profit = Contribution – Fixed cost, and Contribution = Profit + Fixed cost. Contribution can also be expressed as Sales – Variable cost. Thus contribution is the amount remaining from sales after recovering variable costs, which first goes towards recovering fixed costs; any amount above fixed costs is profit. Contribution is important in decision making because it is useful in a variety of decisions, including acceptance or rejection of special orders, pricing, addition or deletion of a product line, make or buy decisions, and the use of scarce resources. The more units sold, the greater the contribution towards the recovery of fixed costs.
Key Points Expected
- Profit = Contribution – Fixed cost
- Contribution = Sales – Variable cost and Contribution = Profit + Fixed cost
- Contribution first recovers fixed costs, then yields profit
- Decisions: special orders, pricing, product line, make or buy, scarce resources
Question 5
Question: Distinguish between costing methods and costing techniques, and explain the classification of costs.
Correct Answer
A costing method is a method of cost ascertainment that centres on the business. For a standardized product made under mass production or through processes, process costing is used; for non-standardized products or services, job costing or contract costing is used. A costing technique is the method used to determine the value of finished goods, for example standard costing, marginal costing and absorption costing. Costs can be classified: by behaviour (fixed or variable); by relevance to the decision (relevant or irrelevant); and by identifiability (direct or indirect).
Key Points Expected
- Method = ascertainment: process costing vs job/contract costing
- Technique = valuation: standard, marginal, absorption costing
- Classification by behaviour, relevance and direct/indirect
Unit Revision Points
- Cost accounting is a set of procedures used in refining raw data into usable information for management decision making, for ascertainment of the cost of products and services and for cost control.
- Cost accounting is internal, decision-focused, segment-based, not bound by GAAP, and prepared only when needed.
- Financial accounting is external/stewardship-oriented, GAAP-bound, historical, total-business focused and periodic.
- Effective cost information must be timely, accurate, clear, concise, correctly headed and sent to the right person.
- Fixed costs remain constant regardless of activity; variable costs change in direct proportion to activity.
- Contribution = Sales – Variable cost; Profit = Contribution – Fixed cost.
- Contribution is vital for special order decisions, pricing, product line decisions, make or buy, and scarce resource use.
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