MANAGEMENT AND PUBLIC SECTOR ACCOUNTING ACC 416/ACC 423

INTRODUCTION TO PUBLIC SECTOR ACCOUNTING ACC 416/423

• Definitions:
• Accounting: -This refers to a systematic recording and analysis of financial transactions of a
business, or public sector.
• it is a generally a scientific study in which records of expenditure and income of a company,
individuals or government are kept coupled with other useful information for planning, decision
making and control.
• Finance: A branch of economics which is concerned with resource allocation as well as
resource management, acquisition and investment.
Definition of Public Sector Accounting:
• Government finance (or, Public Sector Finance as it is commonly known, deals with the
allocation of resources in accordance with the budget constraint of a public sector organization,
especially government.
• It is a composite activity of analysing, summarizing, recording and interpreting the financial
transactions of the Government Ministries, Departments and Spending Agencies.
• R. A. Adams (2004) in his book “Public Sector Accounting and Finance made simple” defines
Public sector accounting as a “process of recording, communicating, summarizing, analysing
and interpreting government financial statements and statistics in aggregate and details; it is
concerned with receipts, custody and disbursement and rendering of stewardship of public funds
entrusted.
OBJECTIVES OF PUBLIC SECTOR ACCOUNTING
The main purposes of public sector accounting are:
• Ascertaining the legitimacy of transactions and their compliance with established norms,
regulations and statutes. public sector disbursement should accord with the provisions,
appropriate acts and financial regulations. There should be due authorizations for all payments
so as to avoid an act of fund misappropriation.
• providing evidence of stewardship: The act rendering stewardship is being able to account
transparently and diligently for the resources entrusted. Government and public sector operators
are obliged to display due diligence and sense of probity in the collection and disposal of public
funds.
• Assisting planning and control: The future faces a lot risks and uncertainties. Therefore,
mapping out plans prevents an organization from drifting since plans of actions provides the
focus of activities which are being pursued. The unforeseen circumstance is built into plans so
as to avoid or prevent organization failure. The public sector establishments should act
accordance with the mandate of the government.
• Ensuring objective and timely reporting: Users of public sector accounting information are
anxious to bridge their knowledge gaps on what government is doing. they definitely treasure
prompt and accurate statistics to evaluate government performance.
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• Evaluating costs incurred and benefits derived: In Public sector, it is difficult to measure the
costs and benefits in financial terms in all aspects. The analysis of cost- benefit assesses the
economic and social advantages (benefits) and disadvantages (costs) of alternative courses of
actions, to ensure that comfort of the citizens is well catered for.
Other objectives are:
• Providing basis for decision making
• highlighting various sources of revenues receivable and expenditure to be incurred
• identifying the source of funds for capital projects
• evaluating the economy, efficiency and effectiveness with which the public sector institutions
pursue their goals and objectives
• ensuring that costs are matched by at least equivalent benefits accruing there from.
• providing details of outstanding long term commitments and financial obligations.
• providing means by which actual performance may be compared with the target set.
• Eliminating corruption
• Modernisation of the financial management system of the public sector entities;
USERS OF PUBLIC SECTOR ACCOUNTING INFORMATON:
• The users of public sector accounting information can be categorized into two namely; internal
and external users
• (i) Internal users: this consists of the people such as the president of the country, Ministers,
secretary to the treasury, accountant general, auditor general, chief executive officers of
parastatals such as ZESCO, Zittel, ZRA etc. and heads of government departments
• (ii) External users: This group comprises of: The National Assembly, members of the public,
foreign countries, international financial institutions such as international Monetary Fund(IMF),
Africa Development Bank (ADB), World Bank; creditors both locally and internationally,
political parties, Trade Unions and Researchers. International rating agencies such Fitch,
Morgan etc.

THE IMPORTANCE OF PUBLIC SECTOR ACCOUNTING TO THE USERS.

• The internal users require the accounting information in order to ascertain the various levels of
regulatory compliance and whether the actual expenditure is in accordance with the budget.
• Further they would like to ascertain whether or not adequate safeguards are available for the
protection of public resources
Conversely, the external users would need the information to ascertain the financial viability of
a public sector organizations and the efficiency and effective management
CONSTITUTIONAL AND REGULATORY FRAMEWORK OF PUBLIC SECTOR
ACCOUTING
The public sector accounting is regulated by the following:
• (i) The Constitution of a country. The constitution of the country is one of the legal
frameworks that regulate the receipt and disbursement of public funds.

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• Auditor general’ s office. The office of the auditor general is mandated by the constitution to
audit all government ministries and spending agencies. This is to ensure that accountability of
government resources is done. The auditor general’s report is submitted to the president like a
case of Zambia and thereafter to parliament.
• Accountant general’s office, an office mandated to prepare government financial statements.
• Finance (controls and Management) Act. The finance act of various countries provides
guidance on management and operation of government funds. The act would regulate on the
accounting system, books of accounts of accounts to be kept and the procedures to be followed
in preparation of government financial statements. In Zambia the acted was established in 1969
and repealed in 2004
• Financial Regulations: These are manuals of government Ministries/ government departments
which deals with financial and accounting matters. The regulations set out the procedures and
steps to followed in treating most of government transactions
• Finance/Treasury Circular: These are administrative tools which are used to amend the
existing provisions of Financial Regulations, Public Service Rules and introduction of new
policy guidelines. The circulars are usually issued by Secretary to be Cabinet or the Secretary to
the Treasury. In some cases, by the Permanent Secretary for Cabinet office or Ministry of
Finance of course under the guidance of their superior.
• Public Procurement Act: This is a procurement Act of each country which guides on
government procurements. For instance, in Zambia, we the Zambia Public Procurement
Authority (ZPPA), an Institution mandated to monitor and overseeing public procurements;
standard setting, developing legal framework and professional capacity for public procurement
in Zambia.
CONCEPTS AND PRINCIPLES APPLICABLE TO PUBLIC SECTOR ACCOUNTING
• concepts have been defined as broad basic assumptions which underlie the preparation of
financial statement of an enterprise. Public sector accounting is an integral but separate branch
of financial accounting sharing in common many concepts and principles applicable in the
private sector. These concepts include: Consistency, Materiality, Periodicity, Duality,
Historical, prudency, going concern etc.
BASES OF PUBLIC SECTOR ACCOUNTING
There are three bases on which financial statements of Public Sector Institutions are compiled.
These are:
• The Cash Basis
• The Accrual Basis
• The Commitment Basis
• (i) The Cash Basis: This is a basis of accounting under which revenue is recorded only when
cash is received, and expenditure recognized only when cash is paid, irrespective of the fact
that the transaction might have occurred in the previous accounting period
Advantages of Cash Basis:

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• It is simple to understand
• Its eliminates the existence of debtors and creditors
• It permits easy identification of those who authorize payments and collect revenue
• It allows for comparison between the amount provided in the budget and that actually spent.
• It saves time and easy to operate
• It permits the delegation of work in certain circumstances
• The cost of fixed assets is written off in the year of purchase resulting into fewer accounting
entries
Disadvantages of Cash Basis
• It takes unrealistic view of financial transactions as only the settlement of liabilities recognized.
• It does not provide for depreciation since assets are written off in the year of purchase
• It does not convey an accurate picture of financial affairs at the end of year.
• It cannot be used for economic decisions since it tends to hide basic information e.g. missing
information relating to fixed assets, debtors and creditors
• It does accord with ‘matching concept’
*Modified Cash Basis: under this basis books of accounts are left open for a maximum of three
months after the end of year, so as to capture substantial amount of income or expenses relating
to the year just ended
(ii) Accrual Basis
• Under this method, revenue is recognized when earned and expenditure acknowledged as
liabilities when known or benefits received, notwithstanding the fact that the receipts or
payments of cash has taken place wholly or partially in other accounting periods.
• It based on the principle of matching income and expenditure to the time a transaction occurs
rather than when payments are made or received. This means that an expense is recorded at the
point goods or services are received by an organisation rather than thirty days later when the
invoice for goods is paid. Similarly, income is recorded at the point the sale is made
• The accrual basis is practiced in private sector and all parastatals.
• The reason private sector uses this method is because private concern is for profit oriented
• Therefore, it is necessary to estimate the profit made in each period with the view to keeping
investment assets intact and making periodic distributions to shareholders by way of dividends.
Advantages of Accrual Basis:
• It takes a realistic view of financial transactions
• It gives an accurate picture of the state of financial affairs at the end of the accounting period
• It aligns itself with matching concept
• It can be used for both economic and investment decision-making as all parameters for
performance appraisal are available.
• It gives allowance for depreciation of assets used in generation revenue for the enterprise
• Disadvantages of Accrual Basis
• It is difficult to understand, especially by non-accountants.

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• It does not permit easy delegation of work in certain circumstances
(iii) Commitment Basis
• It is a basis that records anticipated expenditure evidenced by contract or purchase order.
• In public sector financing, budgetary and accounting systems are closely related to commitment
basis
Advantages of Commitment Basis
• It is an aid to financial control since it is regarded as a charge made on budget provision.
• It can give a separate payment tabulation when it is required/requested
• It takes a realistic view of financial transactions
• It reveals an accurate picture of state of financial affairs at the end of accounting period.
• It aligns itself with matching concept
• It can be used for both economic and investment decision-making as all parameters for
performance appraisal are available.
• It gives allowance for depreciation of assets used in generation revenue for the enterprise
Disadvantages of Commitment Basis
• The system involves extra work. Actual figures have to be substituted for commitment
provisions to finally determine the running balances under sub-head of expenditure
• Over expenditure is more under commitment basis in the expectation that the government may
finally release funds to settle the obligations
• At the end of the financial year, all commitments that are subject of unfulfilled orders have to be
written back to reflect the exact picture of transactions which took place during the year.
COMPARISON BETWEEN GOVERNMENT ACCOUNTING AND PRIVATE SECTOR
ACCOUNTING
• The main objective of commercial enterprise is to maximize profit while that of government is
to provide adequate welfare to people at reasonable costs.
• Government revenue is derived from the public in terms of taxation, fines, grants, fees, etc.,
whereas business concerns obtain their income from sale of goods and services
• In government financial transactions are recorded on ‘Cash basis’ while in private sector it is on
accrual basis.
• In Public sector accounting, tangible fixed assets such as land and building, plant and machinery
are not shown in the balance sheet whereas, in private sector accounting they are reflected,
showing Historical Cost, Accumulated Depreciation and Net Book Value (NBV) of each

COMPARISON BETWEEN GOVERNMENT ACCOUNTING AND PRIVATE SECTOR

ACCOUNTING
• In public sector accounting, current assets such as stocks and debtors are not shown on the
balance sheet where as in private sector accounting system both current assets and liabilities are
shown.

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• In government there is no Annual General Meeting (AGM) of stakeholders/shareholders, unlike
the private sector which has the AGM. In government what happens is just holding public
briefing on specific issues.
• In Public sector what operates mostly is the fund accounting, where as in private sector the
proprietary approach is adopted.
3.0 MEANING OF COSTING

Costing may be defined as ‘the technique According to Costing Weldon, refers to classifying,
‘recording, allocation and appropriation of expenses for the determination of cost of products or
services and for

the presentation of suitably arranged data for the purpose of control and guidance of
management. It includes the ascertainment of cost forever order, job, contract, process, service
units as may be appropriate. It deals with the cost of production, selling and distribution. From
the above definition, it will be understood that costing is basically the procedure of ascertaining
the costs incurred in the course of producing a product or service. As mentioned above, for any
business organization, ascertaining of costs is

must and for this purpose a scientific precisely this procedure which helps them to find out the
costs of products or services.

3.1.1 IMPORTANCE AND BASIC PRINCIPLES OF COSTING

As compared to financial accounting, the focus of cost accounting is different. In the modern
days of cut throat competition, many business organizations pay attention towards their cost of
production. Computation of cost on scientific basis and thereafter cost control and cost reduction
is of paramount importance. Hence it has become essential to study the basic principles and
concepts of cost accounting. These principles and concepts are discussed in the subsequent part
of this unit.

Cost: - Cost can be defined as the expenditure (actual or notional) incurred on or attributable to a
given thing. It can also be described as the resources that have been sacrificed or must be sacrificed
to attain a particular objective. In other words, cost is the amount of resources used for something
which must be measured in monetary terms. For example –Cost of preparing one cup of tea is the
amount incurred on the elements like material, labor and other expenses; similarly cost of offering
any services like banking is the amount of expenditure for offering that service. Thus cost of
production or cost of service can be calculated by ascertaining the resources used for the production
or services.

Cost Accounting: - Cost Accounting primarily deals with collection, analysis of relevant cost
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data for interpretation and presentation for solving various problems of management. Cost
accounting takes into cognizance, the cost of products, service or an operation. It is defining,
standard as, costs and ‘the actual costs of operations, processes, activities or products and the
analysis of variances, profitability or the social use of funds science, it is a science as it has well
defined rules and regulations, it is an art as application of any science requires art and it is a
practice as it has to be applied on continuous basis and is not a onetime exercise.

Cost Accountancy: - Cost Accountancy is a broader application of costing and cost accounting
principles, methods and techniques to the science, art and practice of cost control and the
ascertainment of profitability as well as presentation of information for the purpose of
managerial decision making. On the basis of the above definition, the following points will
emerge: Cost accounting is basically application of the costing and cost accounting principles.
This application is with specific purpose and that is for the purpose of cost control. Second, for
ascertainment of profitability and also for presentation of information to facilitate decision
making.

3.1.2 DIFFERENCE BETWEEN COSTING AND COST ACCOUNTING

Main differences between costing and cost accounting are given as under:

Basis of Distinction Costing Cost Accounting

1. Nature It is a technique and process of It is regarded as a
ascertaining costs specialized branch of
accounting.
2. Scope The costing techniques include It involves classification,
principles and rules which accumulation, assignment
govern the procedure of and control of costs.
ascertaining the cost of
products/services
3. Process The process of costing consists It involves establishment
of routines of ascertaining costs of budgets, standard costs
by historical or conventional or actual costs of
costing, standard costing or operations, classification,
marginal costing. recording and appropriate
allocation of expenditure.

3.1.3 ESSENTIALS OF A GOOD COSTING SYSTEM

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 For availing of maximum benefits, a good costing system should possess the following

characteristics.

A. Costing system adopted in any organization should be suitable to its nature and size of the
business and its information needs.

B. A costing system should be such that it is economical and the benefits derived should be more
than the cost of operating the cost system.

C. Costing system should be simple to operate and understand. Unnecessary complications should
be avoided.

D. Costing system should ensure proper system of accounting for material, labor and overheads and
there should be proper classification made at the time of recording of the transaction itself.

E. Before designing a costing system, need and objectives of the system should be identified.

F. The costing system should ensure that the final aim of ascertaining of cost as accurately possible
should be achieved.

3.1.4 CLASSIFICATION OF COSTING

An important step in computation and analysis of cost is the classification of costs into different
types. Classification helps in better control of the costs and also helps considerably in decision
making. Classification of costs can be made according to the following basis.

A. Classification according to elements: - Costs can be classified according to the elements.

There are three elements of costing, viz-a-viz: material, labor and expenses. Total cost of
production/services can be divided into the three elements to find out the contribution of each
element in the total costs.

B. Classification according to nature: - As per this classification, costs can be classified into
Direct and Indirect. Direct costs are the costs which are identifiable with the product unit or cost
centre while indirect costs are not identifiable with the product unit or cost centre and hence they
are to be allocated, apportioned and then absorbed in the production units. All elements of costs
like material, labor and expenses can be classified into direct and indirect.

They are mentioned below.

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i. Direct and Indirect Material Costs: - Direct material is the material which is identifiable with
the product. For example, in a cup of tea, quantity of milk consumed can be identified, quantity
of glass in a glass bottle can be identified and so these will be direct materials for these products.
Indirect material cannot be identified with the product, for example lubricants, fuel, oil, cotton
wastes etc. cannot be identified with a given unit of product and hence these are the examples of
indirect materials.

ii. Direct and Indirect Labor Costs: - Direct labor can be identified with a given unit of product,
for example, when wages are paid according to the piece rate, wages per unit can be identified.
Similarly, wages paid to workers who are directly engaged in the production can also be
identified and hence they are

direct wages. On the other hand, wages paid to workers like cleaners, gardeners, maintenance
workers etc. are indirect wages as they cannot be identified with the given unit of production.

iii. Direct and Indirect Expenses: - Direct expenses refers to expenses that are specifically
incurred and charged for specific or particular job, process, service, cost centre or cost unit.
These expenses are also referred to as chargeable expenses. Examples of these expenses are cost
of drawing, design and layout, royalties payable on use of patents, copyrights etc. consultation
fees paid to architects, surveyors etc. Indirect expenses on the other hand cannot be traced to
specific product, job, process, service or cost centre or cost unit. Several examples of indirect
expenses can be given like insurance, electricity, rent,

salaries, advertising etc. It should be noted that the total of direct expenses is

known as ‘Prime Cost’ while the total

‘Overheads’.

C. Classification according to behavior: - Costs can also be classified according to

their behavior. This classification is explained below.

i. Fixed Costs: - Out of the total costs, some costs remain fixed irrespective of changes in the
production level. These costs are referred to as fixed costs. The feature of these costs is that the
total costs remain unchanged while per unit fixed cost varies with the level of production.
Examples of these costs are salaries, insurance, rent, etc.

ii. Variable Costs: - These costs are variable in nature, i.e. they change according to
the level of production. Their variability is in the same proportion to the

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 production. For example, if the production units are 2,000 and the variable cost is #5 per unit,
the total variable cost will be #10,000 (i.e. 2,000 x #5), if the production units are increased to
5,000 units, the total variable costs will be #25,000, i.e. the increase is exactly in the same
proportion of the production. Another feature of the variable cost is that per unit variable cost
remains unchanged while the total variable costs will vary. In the example given above, per unit
variable cost remains #2 per unit while total variable costs change. Examples of variable costs
are direct materials, direct labor etc.

iii. 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 referred to as ‘stepped costs’.

D. Classification according to functions: - Costs can also be classified according

to the functions/activities. This classification can be done as mentioned below.

i. Production Costs: - All costs incurred for production of goods are known as production costs.

ii. Administrative Costs: - Costs incurred for administration are known as administrative costs.
Examples of these costs are office salaries, printing and stationery, office telephone, office rent,
office insurance etc.

iii. Selling and Distribution Costs: - All costs incurred for procuring an order are referred to as
selling costs while all costs incurred for execution of order are distribution costs. Market
research expenses, advertising, sales staff salary,
sales promotion expenses are examples of selling costs. Transportation

expenses incurred on sales, warehouse rent etc. are examples of distribution

costs.

iv. Research and Development Costs: - In recent times, research and development has become
one of the important functions of a business organization.

Expenditure incurred for this function can be classified as Research and

Development Costs.

E. Classification according to time: - Costs can also be classified according to time. This
classification is explained below.
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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: - One of the important functions of
cost accounting is to present information to management for the purpose of 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 #25,000, if 10,001 units are produced the aggregate costs may
be #25,020 which means that the marginal cost is #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

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 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 Favour of an alternative course of
action. It is the maximum amount that could be obtained at

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 any given point in 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, relevant costs are to be taken into consideration. In other words, costs which are
going to be affected matter the most and these costs are referred to 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. Thus in decision making relevant costs plays a vital
role.

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 or 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 and Uncontrollable 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 were to close
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 which are incurred by a company for
providing production, administration and selling and distribution capabilities in order to perform
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 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.

3.1.5 COSTING METHODS AND TECHNIQUES

It is necessary to understand the difference between the costing methods and

techniques. Costing methods are those which help a firm to compute the cost of
production or services offered by it. On the other hand, costing techniques are those which help
a firm to present the data in a particular manner so as to facilitate the decision making as well as
cost control and cost reduction. Costing methods and techniques are explained below.

Methods of Costing: - The following are the methods of costing.

I. Job Costing: - This costing method is used by firms which work on the basis of job work. There
are some manufacturing units which undertake job work and are called job order units. The main
feature of these organizations is that they produce according to the requirements and
specifications of the consumers. Each job may be different from the other one. Production is
only on specific order and there is no pre-demand production. Because of this situation, it is
necessary to compute the cost of each job and hence job costing system may be applicable. In
this system, each job is treated separately and a job cost sheet is prepared to find out the cost of
the job. The job cost sheet helps to compute the cost of the job in phases and finally arrive at the
total cost of production.

II. Batch Costing: - This method of costing is used in those firms where production is made on
continuous basis. Each unit coming out is uniform in all respects and production is made prior to
the demand, i.e. in anticipation of demand. One batch of production consists of the units
produced from the time machinery is set to the time when it will be shut down for maintenance.
For example, if production commences on 1st January 2007 and the machine is shut down for
maintenance on 1st April 2007, the number of units produced in that period will be the size of
one batch. The total cost incurred during that period
will be divided by the number of units produced and unit cost will be worked out. Firms
producing consumer goods like television, air-conditioners, washing machines etc. use batch
costing.

III. Process Costing: - Some of the products like sugar, chemicals etc. involve continuous
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 production process and hence process costing method is used to work out the cost of production.
The meaning of continuous process is that the input introduced in the process I travels through
continuous process before finished product is produced. The output of process I becomes input
of process II and the output of process II becomes input of the process III. If there is no
additional process, the output of process III becomes the finished product. In process costing,
cost per process is worked out and per unit cost is worked out

by dividing the total cost by the number of units. Manufacturing companies that engage in the
production of products such as sugar, edible oil, chemicals are examples of continuous
production process and they use process costing.

IV. Operating Costing: - This type of costing method is used in service sector to work out the cost
of services offered to the consumers. For example, operating costing method is used in hospitals,
power generating units, transportation sector etc. A cost sheet is prepared to compute the total
cost and it is divided by cost units for working out the per unit cost.

V. Contract Costing: - This method of costing is used in construction industry to work out the cost
of contract undertaken. For example, cost of constructing a bridge, commercial complex,
residential complex, highways etc. is worked out by use of this method of costing. Contract
costing is actually similar to job costing, the only difference being that in contract costing, one
construction job may take several months or even years before completion while in job costing,
each job may be of a short duration. In contract costing, as each contract may take a long period
for completion, the question of computing of profit is to be solved with the help of a well-
defined and accepted method.

3.1.6 TECHNIQUE OF COSTING

As mentioned above, costing methods are for computation of the total cost of
production/services offered by a firm. On the other hand, costing technique helps to present the
data in a particular format so that decision making becomes easy. Costing techniques also help
for controlling and reducing the costs. The following are the techniques of costing.

I. Marginal Costing: - This technique is based on the assumption that the total cost of production
can be divided into fixed and variable. Fixed costs remain same irrespective of the changes in
the volume of production while the variable costs vary with the level of production, i.e. they will
increase if the production increases and decrease if the production decreases. Variable cost per
unit always remains the same. In this technique, only variable costs are taken into account while
calculating production cost. Fixed costs are not absorbed in the production units. They are
written-off to the Costing Profit and Loss Account. The reason behind this is that the fixed costs
are period costs and hence should not be absorbed in the production. Secondly they are variable
on per unit basis and hence there is no equitable basis for charging them to the products. This
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 technique is effectively used for decision making in the areas like make or buy decisions,
optimizing of product mix, key factor analysis, fixation of selling price, accepting or rejecting an
export offer, and several other areas.

II. Standard Costing: - Standard costs are predetermined costs relating to material, labor and
overheads. Though they are predetermined, they are worked out on scientific basis by
conducting technical analysis. They are computed for all elements of costs such as material,
labor and overheads. The main objective of standard costing is to have a benchmark against the
actual performance. This means that the actual costs are compared with the standards. The
difference is called ‘variance’. The adverse variances a found out. Favorable variances may also
be analyzed to find out the reasons behind the same. Thus, standard costing is an important
technique for cost control and reduction.

III. Budgets and Budgetary Control: - Budget is defined as, ‘a monetary statement prepared prior
to a defined period of time for the policies

during that period for the purpose of achieving a given objective.’ this definition, it will be clear
that a budget is a statement, which may be expressed either in monetary form or quantitative
form or both. For example, a production budget can be prepared in quantitative form showing
the target production; it can also be prepared in monetary terms showing the expected cost of
production. Some budgets can be prepared only in monetary terms, e.g. cash budget showing the
estimated receipts and payments in a particular period
can be prepared in monetary terms only. Another feature of budget is that it is always prepared
prior to a defined period of time which means that budget is always prepared for future and a
defined future.
For example, a budget may be prepared for next 12 months or 6 months or even for 1 month, but
the time period must be certain and not vague. One of the important aspects of budgeting is that
it lays down the objective to be achieved during the defined period of time and for achieving the
objectives, whatever policies are to be pursued are reflected in the budget. Budgetary control
involves preparation of budgets and continuous comparison of actual with budgeted so that
necessary corrective measures can be taken. For example, when a production budget is prepared,
the production targets are laid down in the same for a particular period. After the period is over,
the actual production is compared with the budgeted and any deviation found will result to
taking necessary corrective measures. Budget and Budgetary Control is one of the important
techniques of costing used for cost control and also for performance evaluation. The success of
the technique depends upon several factors such as support from top management, involvement
of employees and coordination within the organization.

6.0TUTOR MARKED ASSIGNMENT

1. Discuss Costing Methods and Techniques.

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2. Attempt a classification of costing

DISTINCTION BETWEEN COST ACCOUNTING AND MANAGEMENT

ACCOUNTING

The distinction between cost accounting and management accounting may be made on

the following bases:

1. Scope: Scope of cost accounting is limited to providing cost information for managerial uses.
Scope of management accounting is broader than that of cost accounting as it provides all types
of information. Thus, management accounting is an extension of cost accounting.

2. Emphasis: The main emphasis of cost accounting is on cost ascertainment and cost control to
ensure maximum profit. On the other hand, the main emphasis of management accounting is on
planning, controlling and decision-making so as to provide a basis for ascertaining profit of the
entity.

3. Techniques Employed: Various techniques used by cost accounting include standard costing
and variance analysis, marginal costing and cost-volume-profit analysis, budgetary control,
uniform costing and inter-firm comparison. Management accounting also uses all these
techniques of cost accounting, but in addition, it also uses techniques like ratio analysis, funds
flow statement, statistical analysis, operations research and certain techniques from various
branches of knowledge in mathematics and economics.

4. Evolution: Evolution of cost accounting is mainly due to the limitations of financial accounting.
On the other hand, evolution of management accounting is due to the limitations of cost
accounting. In fact, management accounting is an extension of the managerial aspects of cost
accounting.
5. Data Base: Cost accounting is based on data derived from financial accounting,
but management accounting is based on data derived from cost accounting,
financial accounting and other sources.

In summary, cost accounting is that branch of accounting which aims at generating

information to control operations with a view to maximizing profits and efficiency
of

the company, and that is why Conversely, it is the management accounting is the type of
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 accounting which assists management in

planning and decision-making, and thus known as ‘decision

SELF ASSESSMENT EXERCISE 1

What is Cost Accounting, and what are the differences between Cost Accounting
and Management Accounting?

3.4 PARTS OF A COST ACCOUNTING SYSTEM

A cost accounting system requires five parts that include:

 An input measurement basis;

 An inventory valuation method;

 A cost accumulation method;

 A cost flow assumption; and

 A capability of recording inventory cost flows at certain

intervals. We shall look at them one after the other.

3.4.1 Input Measurement Bases

The bases of a cost accounting system begin with the type of costs that flow into
and through the inventory accounts. There are three alternatives: pure historical
costing, normal historical costing and standard costing.
 Pure Historical Costing: In pure historical cost system, only historical costs flow through the
inventory accounts. Historical costs refer to the costs that have been recorded. These are costs
for direct material, direct labor and factory overhead.

 Normal Historical Costing: Normal historical costing uses historical costs for direct material
and direct labor, but overhead is charged, or applied to the inventory using a predetermined
overhead rate per activity measure. Typical activity measures include direct labor hours, or
direct labor costs. The amount of factory overhead charged to the inventory is determined by
multiplying the predetermined rate by the actual quantity of the activity measure. The difference
between the applied overhead costs and the actual overhead coasts represents the overhead
variance.

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  Standard Costing: In a standard cost system, all manufacturing costs or applied, or charged to
the inventory using standard or predetermined prices, and quantities. The differences between
the applied costs and the actual costs are charged to variance accounts.

3.4.2 Inventory Valuation Methods

The inventory valuation methods encompass the following:

 Throughput method

 Direct or variable method

 Full absorption method

 Activity-based method

Throughput Method: The throughput method was developed to complement a concept referred
to as the Theory of Constraints (TOC). In this method, only direct material costs are charged to
the inventory. All other costs are expensed during the period.

Direct or Variable Method: In the direct (or variable method), only the variable manufacturing
costs are capitalized, or charged to the inventory. Fixed manufacturing costs flow into expense
in the period incurred. This method provides some advantages and some disadvantages for
internal reporting.

i. Full Absorption Method: Full absorption costing is a traditional method where all
manufacturing costs are capitalized in the inventory, that is, charged to the inventory and
become assets. This means that these costs do not become expenses until the inventory is sold.

ii. Activity-Based Method: Activity-based costing is a relatively new type of procedure that can
be used as an inventory valuation method. The technique was developed to provide more
accurate product costs. This improved accuracy is accomplished by tracing costs to products
through activities.

3.4.3 Cost Accumulation Method

Cost accumulation refers to the manner in which costs are collected and identified with specific
customers, jobs, batches, orders, departments and processes. The centre of attention for cost
accumulation can be individual customers, the products produced within individual segments
during a period, or the products produced by the entire plant

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 during a period. The company’s influenced by cost the type of production operation.
The four accumulation methods are job order, process, back flush, and hybrid (or mixed)
method.

 Job Order: In job order costing, costs are accumulated by jobs, orders, contracts, or lots. The
idea is that the work is done to specifications.

 Process: Costs are accumulated by departments, operations, or processes in process

costing. The work performed on each unit is standardized or uniform where a
continuous mass production or assembly operation is involved.

 Back Flush: Back flush is a simplified cost accumulation method that is sometimes
used by companies that adapt just-in-time (JIT) production systems. However, JIT is
not just a technique, or a collection of techniques. JIT has a very broad philosophy
that emphasizes simplification and continuous reduction of waste in all areas of
business activities.

 Hybrid (or Mixed) Methods: Hybrid or mixed systems are used in situations where
more than one cost accumulation method is required. For example, in some cases,
process costing is used for direct materials and job order costing is used for
conversion costs (that is, direct labor and factory overhead). In other cases, job order
costing might be used for direct materials, and process costing for conversion costs.
These are sometimes referred to as operational costing methods.

3.4.4 Cost Flow Assumptions

A cost flow assumption refers to how costs flow through the inventory accounts, not the flow of
work or products on a production line. This distinction is important because the flow of costs is
not always the same as the flow of work. The various types of cost flow assumptions include:

- Scientific identification (e.g., by job);

- First in, first out (FIFO);

- Last in, first out (LIFO); and

- Weighted average.

Costs flow through the inventory accounts by the job in a job order cost system which represents
an example of specific identifications. The requirements of the various jobs determine the times
of the cost flows. Simple jobs tend to move through the system faster than more complex jobs.
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 3.4.5 Recording Interval Capability

Inventory records can be maintained on a perpetual or periodic basis. Consequently, the

perpetual inventory method provides a company with the capability of maintaining continuous
records of the quantities of inventory and the costs flowing through the inventory accounts. The
periodic method, on the other hand, requires counting the quantity of inventory before inventory
records can be updated.

3.5 NECESSITY FOR COST ACCOUNTING SYSTEM

A company having a proper cost accounting system will help management in the following areas
as highlighted:

1. The analysis of profitability of individual products, services or jobs.

2. The analysis of the different departments or operations.

3. The analysis of cost behavior of various items of expenditure in the organization. This will help
in future cost estimation with reasonable accuracies.

4. It locates differences between actual results and expected results. Such differences can also be
traced to the individual cost centers with the efficient cost system.

5. It will assist in setting the process so as to cover costs and generate an acceptable level of profit.

6. The effects on profits of increase or decrease in output or shutdown of a product line or

department can be analyzed with the adoption of efficient cost accounting system.

7. The costing records serve to analyses the final accounts of a company in such a way as to give a
detailed explanation of the sources of profit or loss.

8. Cost accounting data generally serves as a base to which the tools and techniques of
management accounting can be applied to make it more purposeful and management oriented.

9. The cost ascertainment, allocation, distribution, can be effectively made under efficient costing
system.

10. Cost records serve as the base for Management Information System (MIS).

11. The cost system generates regular performance statements which management needs for control
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 purposes.

12. Cost accounting system is not only applicable to manufacturing organizations or functions but
also extended to service organizations and functions.

13. Cost comparisons between different departments, machines and alternative

processes help management to maintain maximum efficiency as possible with the
adoption of efficient cost system.

14. The cost information will help in making reliable estimates and will also help in
submission of tenders.

15. Costing checks recklessness and avoids occurrence of mistakes.

16. It provides invaluable aid to management in performing its functions of planning,

evaluation of performance, control and decision-making.

17. It helps in determination of break-in-points (BEP), that is, the level of activity where the firm
reaches ‘no profit, no

18. The costing system will aim at increasing operational efficiency and cost reduction,
which helps the consumers in getting reduced prices.
CONCLUSION

Cost accounting is used by manufacturing firms to record production activities using

a perpetual inventory system. In other words, it is an accounting system designed for
manufacturing firms for tracking the flow of inventory continually through the
various

stages of production.

A typical cost accounting system works by tracking raw materials as they go

through the production stages and slowly turn into finished goods in real time. When
the raw materials are put into production, the system records immediately the use of
materials by crediting the raw materials account and debiting the goods in process
account, in as much most products go through many stages of production before
they can be called finished goods.

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