What is Accounting?

Accounting is an information system. It exists to provide information for the enduser. It is possible to distinguish between two branches of accounting.
1. 2. 3.

Financial Accounting Management Accounting Cost Accounting

Financial Accounting
The purpose of financial accounting is to report the financial performance of the company. Its main focus is on external reporting to a number of group viz.

Owners (Shareholders) Loan creditors (banks) Trade creditors (suppliers) Sundry creditors (suppliers of services) Government agencies (tax authorities) Employees (trade unions)

Management Accounting
Management accounting is the application of professional knowledge and skill in the preparation and presentation of accounting information in such a way as to assist management in the formulation of policies and in planning and controlling the operations of the organization.
a) b) c)

Formulating the policies- strategic planning Planning the activities of the organization Controlling the activities of the organization.

Cost Accounting
Cost accounting is the branch of accounting dealing with the recording, classification, allocation, and reporting current and prospective costs. Measurement of cost involves the methods and techniques used in defining the components of cost (material, labour & overhead), determining the basis of cost measurement techniques.

Difference between financial and cost accounting.

No. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. Basis Objective Costs and profits Control / Report Decision making Responsibility Time frame Type of reports Legal need Tra nsactions Reader Formats Access Unit of value Financial Accounting Financial performance and position Shows overall costs and profit / loss Emphasis on reporting Limited use Does not fix responsibility Focus on historical data General reports like P&L Account, Balance Sheet, Cash Flow Statement Statutory requirement Records external transactions Everybody Standard, as per law Everybody, except for some Monetary Cost Accounting Ascertain cost and cost control Shows details for each product, process, job, contract, etc Emphasis on control and reporting Designed for decision making Can effectively fix responsibility Focus on present and future Can generate special reports and analysis Voluntary, except for some cases Records internal and external transactions Internal management Tailor made Very limited access Monetary a nd physical

Difference between financial and management accounting.

Financial accounts describe the Management accounts performance of a business over a are used to help specific period and the state of management record, plan affairs at the end of the period. The and control the activities of specific period is often referred to a business and to assist in as the trading periodand is the decision making usually one year long. The period process. They can be end date as the Balance Sheet prepared for any period. Date Companies that are incorporated There is no legal under the Companies Act 1956 are requirement to prepare required by law to prepare and management accounts. publish financial accounts. The level of detail required in these accounts reflects the size of the business with smaller companies being required to prepare only brief accounts.

Difference between the financial and management accounting.

There is no pre- determined The format of published financial format for management accounts is determined by several accounts. They can be as different regulatory elements: detailed or brief Company Law management wishes. Accounting standards Stock Exchange Management accounts can Financial accounts concentrate on focus on specific areas of a the business as a whole rather business activities. For than analyzing the components example, they can provide parts of the business. For example, insights into performance of: sales are aggregated to provide a products, separate business figure for total sales rather than location, departments/ publish a detailed analysis of sales divisions. by product, market etc.

Difference between financial and management accounting.

Most financial accounting information is of a monetary nature.

mama

By definition, financial accounts present a historic perspective on the financial performance of the business.

Management accounts usually includes a variety of non-financial information. For example, management often include analysis of: employees (number, costs, productivity, etc.), sales turnover volumes (units sold etc.), customer transactions (number of calls received) Management accounts largely focus on analyzing historical performance. However, they also usually include some forwardlooking elements e.g. a sales budget;

What is Cost Unit?

A cost unit is a unit of product, service or time in relation to which cost may be ascertained or expressed.
Industry Cars Cement Chemicals Bricks Shoes Pencils Cost unit Per Car Tone Tone, kilogram, liter etc 1,000 bricks Pair or dozen pairs Dozen or gross

ELEMENTS OF COST
Element of cost

Materials

Labour

Expenses

Direct

Indirect

Direct

Indirect

Direct

Indirect

Material
The substance from which the finished product is made is known as material.
a)

Direct Material: is one which can be directly or easily identified in the product Eg: timber in funiture, cloth in dress, etc. Indirect Material: one which cannot be easily identified in the product.

b)

EXAMPLES OF INDIRECT MATERIAL

At factory level lubricants, oil, consumables, etc. At office level Printing & stationery, Brooms, Dusters, etc. At selling & dist. level Packing materials, printing & stationery, etc.

Labour
The human effort required to convert the material into finished product is called labour.
a)

Direct Labour: is one which can be conveniently identified or attributed wholly to a particular job, product or process. E.g. Wages paid to carpenter. Indirect labour: is one which cannot be conveniently identified or attributed wholly to a particular job, product or process.

b)

EXAMPLES OF INDIRECT LABOUR

At factory level foremens salary, works managers salary, gate keepers salary,etc At office level Accountants salary, GMs salary, Managers salary, etc. At selling and dist.level salesmen salaries, Logistics manager salary, etc.

Other Expenses
Are those expenses other than materials and labour.
a)

Direct Expenses: are those expenses which can be directly allocated to particular job, process or product. E.g: excise duty, royalty, special hire charges. Indirect expenses: are those expenses which cannot be directly allocated to particular job, process or product.

b)

Examples of other expenses

At factory level factory rent, factory insurance, lighting, etc. At office level office rent, office insurance, office lighting, etc. At sales & dist.level advertising, show room expenses like rent, insurance, etc.

CLASSIFICATION OF COST
Cost classification is the process of grouping costs according to their common characteristics. A suitable classification of costs is important, in order to identify the cost with cost centres or cost units The same cost figures are classified according to different ways of costing depending upon the purpose to be achieved and requirements of a particular concern.

The important ways of classification are:

1.

3.

By nature or Element: The costs are divided into three categories, Materials, Labour and Expenses. Materials can be further classified as raw material, spare parts, consumable stores, packing material etc. This classification is important as it helps to find out the total cost and valuation of WIP. By Functions: The costs are divided on the basis of managerial activities involved in the operation of a business undertaking. Eg; Production, Administration, Selling and Distribution

3. As Direct or Indirect: Total cost is divided into direct costs and indirect costs. Direct costs are those costs which are incurred for and may be conveniently identified with a particular cost centre or cost unit. Indirect costs are those costs which are incurred for the benefit of number of cost centres or cost units and cannot be conveniently identified with a particular cost centre or cost unit. Eg: rent of building, management salaries

4.

By variability: Costs are classified according to their behaviour in relation to changes in the level of activity or volume of production. On this basis, costs are classified into three groups namely fixed, variable and semi-variable Fixed costs: Those which remain fixed in total amount with increase or decrease in the volume of output or productive activity for a given period of time. Eg; rent, insurance Fixed cost per unit decreases as production increases and increases as production declines.

Variable costs: Costs which vary in total in direct proportion to the volume of output. These costs per unit remain relatively constant with changes in production. They are also known as product costs as they depend on the quantum of out put rather than time. Eg: Direct material, direct labour, power, repairs etc. Semi variable costs: Costs which are partly fixed and partly variable. Eg: Telephone expenses include a fixed portion of annual charge plus variable charge according to calls.

5.

By controllability: The costs are classified according to whether or not they are influenced by the actions of a given member of the undertaking. On this it is classified as controllable costs and uncontrollable costs. Controllable costs: Costs which can be influenced by the action of a specified member of an undertaking. i.e. costs which are at least partly within the control of management Uncontrollable costs: costs which cannot be influenced by the action of a specified member of an undertaking.

6.

7.

By normality: Costs are classified according to whether these are costs which are normally incurred at a given level of output in the conditions in which that level of activity is normally attained. On this basis costs are classified as normal cost and Abnormal cost. Abnormal costs are not a part of cost of production and are charged to Costing P&L a/c. By Capital and Revenue (Financial Accounting Classification): The costs which are incurred in purchasing assets used to generate income or to increase income earning capacity is called capital cost. The benefit of such costs are spread over a number of years.

Expenditure incurred to maintain the earning capacity or to run the business is called revenue expenditure.
8.

By time: Costs are classified as Historical costs: The costs which are ascertained after their incurrence are called historical costs. The basic characteristics of such costs are (a) They are based on recorded facts. (b) They can be verified (c) They are mostly objective Predetermined costs: Costs are estimated costs. Computed in advance of production taking into consideration the previous periods costs and the factors affecting such costs. Such costs determined on scientific methods become standard cost.

1.

2.

9. According to planning and control: Budgeted costs: An estimate of expenditure for different phases of business operations, coordinated in a well conceived framework for a period of time in future which becomes a managerial targets to achieve. Standard costs: It is the predetermined cost based on a technical estimate for materials, labour and overhead for a selected period of time and for a prescribed set of working conditions.

10. For

managerial decisions: On this basis costs are classified as

1.Marginal costs: It is the total of variable costs. i.e.,

prime cost plus variable overheads. It is based on the distinction between fixed and variable cost. 2.Out of pocket costs: It is that portion of the cost which involves payment to outsiders. 3.Differential costs: The change in cost due to change in level of activity or pattern or method of production. 4.Sunk costs: It is an irrecoverable cost and is caused by complete abandonment of a plant. i.e., costs which are not relevant for decision making. 5.Imputed costs: Costs which appear in cost accounts only. These costs are also known as notional costs, which are considered for decision making.

6.Opportunity cost: It is the advantage, in measurable terms, which has been foregone due to not using the facility in the manner originally planned. 7.Replacement cost: It is the cost at which an asset or material identical to that which is being replaced or revalued, can be purchased. 8.Avoidable and unavoidable cost: Avoidable costs are those which can be eliminated if a particular product or department with which they are directly related is discontinued. Un avoidable costs are those which will cannot be eliminated with the discontinuation of a product or department.

Quality of Conformance
When the overwhelming majority of products produced conform to design specifications and are free from defects.

Prevention and Appraisal Costs

Prevention Costs

Support activities whose purpose is to reduce the number of defects

Appraisal Costs

Incurred to identify defective products before the products are shipped

Internal and External Failure Costs

Internal Failure Costs
Incurred as a result of identifying defects before they are shipped

External Failure Costs

Incurred as a result of defective products being delivered to customers

Examples of Quality Costs

Prevention Costs
Quality training Quality circles Statistical process control activities

Appraisal Costs
Testing & inspecting incoming materials Final product testing Depreciation of testing equipment

Internal Failure Costs

Scrap Spoilage Rework

External Failure Costs

Cost of field servicing & handling complaints Warranty repairs Lost sales

Distribution of Quality Costs

When quality of conformance is low, total quality cost is high and consists mostly of internal and external failure.
Companies can reduce their total quality cost by focusing on prevention and appraisal. The cost savings from reduced defects usually swamps the costs of the additional prevention and appraisal efforts.

Ventura Company Quality Cost Report For Years 1 and 2 Year 2 Amount Percent* Prevention costs: Systems development Quality training Supervision of prevention activities Quality improvement Total prevention cost Appraisal costs: Inspection Reliability testing Supervision of testing and inspection Depreciation of test equipment Total appraisal cost Internal failure costs: Net cost of scrap Rework labor and overhead Downtime due to defects in quality Disposal of defective products Total internal failure cost External failure costs: Warranty repairs Warranty replacements Allowances Cost of field servicing Total external failure cost Total quality cost $ 400,000 210,000 70,000 320,000 1,000,000

Year 1 Amount Percent* 0.54% 0.26% 0.08% 0.42% 1.30%

0.80% $ 270,000 0.42% 130,000 0.14% 40,000 0.64% 210,000 2.00% 650,000

600,000 580,000 120,000 200,000 1,500,000

1.20% 1.16% 0.24% 0.40% 3.00%

560,000 420,000 80,000 140,000 1,200,000

1.12% 0.84% 0.16% 0.28% 2.40%

900,000 1,430,000 170,000 500,000 3,000,000

1.80% 2.86% 0.34% 1.00% 6.00%

750,000 810,000 100,000 340,000 2,000,000

1.50% 1.62% 0.20% 0.68% 4.00%

400,000 870,000 130,000 600,000 2,000,000 7,500,000

0.80% 900,000 1.74% 2,300,000 0.26% 630,000 1.20% 1,320,000 4.00% 5,150,000 15.00% $ 9,000,000

1.80% 4.60% 1.26% 2.64% 10.30% 18.00%

Quality cost reports provide an estimate of the financial consequences of the companys current defect rate.

* As a percentage of total sales. In each year sales totaled $50,000,000.

$10 9 8 Quality Cost (in millions) 7 6 5 4 3 2 1 0

Quality Cost Reports: Graphic Form

20 18 Quality Cost as a Percentage of Sales 16 14 12 10 8 6 4 2 Prevention 2 Year 0 Appraisal Prevention 1 Year Prevention 2 Internal Failure Appraisal Internal Failure External Failure External Failure

External Failure

External Failure

Internal Failure Internal Failure Appraisal Appraisal Prevention 1

Quality reports can also be prepared in graphic form.