Cost and Management Accounting Basics
What this domain tests
This domain tests cost classification, the cost sheet (prime cost to cost of sales), and the elementary tools of management accounting - contribution, P/V ratio, break-even point and margin of safety.
Core rules
- Elements of cost: material, labour and expenses, each divided into direct and indirect.
- Prime cost = direct material + direct labour + direct expenses. Works cost = prime cost + factory overheads + opening work-in-progress − closing work-in-progress. Cost of production = works cost + administration overheads. Cost of sales = cost of goods sold + selling and distribution overheads.
- By behaviour: fixed, variable and semi-variable costs. Fixed cost per unit falls as output rises; variable cost per unit stays constant.
- Contribution = sales − variable cost. P/V ratio = contribution ÷ sales. Break-even sales = fixed cost ÷ P/V ratio. Margin of safety = actual sales − break-even sales.
- Cost accounts normally exclude purely financial items such as interest on loans, donations and income tax.
Worked example
Sales ₹5,00,000; variable cost ₹3,00,000; fixed cost ₹1,20,000. Contribution = 5,00,000 − 3,00,000 = ₹2,00,000. P/V ratio = 2,00,000 ÷ 5,00,000 = 40%. Break-even sales = 1,20,000 ÷ 0.40 = ₹3,00,000. Margin of safety = 5,00,000 − 3,00,000 = ₹2,00,000. Profit = 2,00,000 − 1,20,000 = ₹80,000. Reasoning: each ₹100 of sales contributes ₹40 towards fixed cost; ₹1,20,000 of fixed cost therefore needs ₹3,00,000 of sales before any profit arises. Every rupee above that is profit.
Traps
Deducting fixed cost while computing contribution; using profit in place of contribution in the P/V ratio; treating office depreciation as a direct cost; adding selling overheads to works cost instead of to cost of sales.