Class-1
Content
COST ACCOUNTING AND
INVENTORY VALUTION
The valuation had a deep impact over the
projected profitability of a company, which in turn
affected the willingness of various stakeholders to
inject large amount of capital in the business. The
valuation also directly affected the taxes which
the company was obliged to pay to the
government since higher profits meant higher
taxes and vice versa.
• . Cost accounting is used in
(1)various decision making scenarios e.g.
whether to produce for captive consumption or
buy from outside suppliers,
(2) supply of information to the
government (cost audit),
(3)planning and control of expenses
(variance analysis) ,
(4)tracking expenses through a products life
cycle (life cycle costing),
(5) fixation of selling prices (cost plus and other
approaches) etc.
A prudent housewife who goes for shopping considers the quality and
price of each product before she buys it. In short, each economic
activity, if rationally viewed, has two aspects - firstly, the costs involved
in it and secondly, the benefits obtained out of it. This analysis is
technically known as cost-benefit analysis. It is very important in
industrial and commercial activities.
Definition of Costing, Cost
Accounting and Cost
Accountancy:
•
Costing is defined as “the technique and process of ascertaining costs”.
•
Cost Accounting is defined as "the process of accounting for cost which
begins with the recording of income and expenditure or the bases on
which they are calculated and ends with the preparation of periodical
statements and reports for ascertaining and controlling costs."
•
Cost Accountancy has been defined as “the application of costing and
cost accounting principles, methods and techniques to the science, art
and practice of cost control and the ascertainment of profitability. It
includes the presentation of information derived there from for the
purpose of managerial decision making.”
OBJECTIVES OF COST
ACCOUNTING
• The main objectives of Cost Accounting
are as follows :
– (i) Ascertainment of cost.
– (ii) Determination of selling price.
– (iii) Cost control and cost reduction.
– (iv) Ascertaining the profit of each activity.
– (v) Assisting management in decision-making.
Ascertainment of Cost:
• There are two methods of ascertaining costs, viz., Post
Costing and Continuous Costing.
• Post Costing means, analysis of actual information as
recorded in financial books. It is accurate and is useful in
the case of “Cost plus Contracts” where price is to be
determined finally on the basis of actual cost.
• Continuous Costing, aims at collecting information about
cost as and when the activity takes place so that as soon
as a job is completed the cost of completion would be
known. This involves careful estimates being prepared of
overheads. In order to be of any use, costing
Determination of selling price:
• Though the selling price of a product is
influenced by market conditions, which are
beyond the control of any business, it is
still possible to determine the selling price
within the market constraints. For this
purpose, it is necessary to rely upon cost
data supplied by Cost Accountants.
Cost control and cost reduction:
• The guidance and regulation, by executive
action of the cost of operating an undertaking”.
The word “guidance” indicates a goal or target to
be guided; ‘regulation’ indicates taking action
where there is a deviation from what is laid
down; executive action denotes action to
“regulate” must be initiated by executives i.e.
persons responsible for carrying out the job or
the operation; and all this is to be exercised
through modern methods of costing in respect of
expenses incurred in operating an undertaking.
To exercise cost control, broadly speaking the following steps should be
observed:
(i) Determine clearly the objective, i.e., pre-determine the desired
results;
(ii) Measure the actual performance;
(iii) Investigate into the causes of failure to perform according to plan;
and
(iv) Institute corrective action.
Cost Reduction, may be defined "as the achievement of real
and permanent reduction in the unit cost of goods manufactured or
services rendered without impairing their suitability for the use intended
or diminution in the quality of the product."
Cost reduction should not be confused with Cost control.
Cost saving could be a temporary affair and may be at the cost of
quality. Cost reduction implies the retention of the essential
characteristics and quality of the product and thus it must be confined to
permanent and genuine savings in the cost of manufacture,
administration, distribution and selling, brought about by elimination of
wasteful and inessential elements from the design of the product and
from the techniques carried out in connection therewith.
The three-fold assumptions involved in the definition of cost reduction may be
summarised as under :
(a) There is a saving in unit cost
(b) Such saving is of permanent nature.
(c) The utility and quality of the goods and services remain unaffected, if
not improved.
Ascertaining the profit of each
activity
The profit of any activity can be ascertained by
matching cost with the revenue of that activity.
The purpose under this step is to determine
costing profit or loss of any activity on an
objective basis.
Assisting management in
decision making :
• Decision making is defined as a process of
selecting a course of action out of two or
more alternative courses. For making a
choice between different courses of action,
it is necessary to make a comparison of
the outcomes, which may be arrived under
different alternatives. Such a comparison
has only been made possible with the help
of Cost Accounting information.
IMPORTANCE OF COST
ACCOUNTING TO BUSINESS
CONCERNS
• Management expects from cost accounting - information
and reports to help them in the discharge of the following
functions :
• (a) Control of material cost : Cost of material usually
constitute a substantial portion of the total cost of a
product. Therefore, it is necessary to control it as far as
possible. Such a control may be exercised by
• (i) Ensuring un-interrupted supply of material and spares
for production.
• (ii) By avoiding excessive locking up of funds/capital in
stocks of materials and stores.
• (iii) Also by the use of techniques like value analysis,
standardisation etc. to control material cost.
(B) Control of labour cost : It can be controlled if workers complete their work
within the standard time limit. Reduction of labour turnover and idle time too
help us, to control labour cost.
(c) Control of overheads : Overheads consists of indirect expenses which are
incurred in the factory, office and sales department ; they are part of
production and sales cost. Such expenses may be controlled by keeping a
strict check over them.
(d) Measuring efficiency : For measuring efficiency, Cost Accounting
department should provide information about standards and actual
performance of the concerned activity.
(e) Budgeting : Now–a–days detailed estimates in terms of quantities and
amounts are drawn up before the start of each activity. This is done to ensure
that a practicable course of action can be chalked out and the actual
performance corresponds with the estimated or budgeted performance. The
preparation of the budget is the function of Costing Department.
(f) Price determination: Cost accounts should provide information, which enables
the management to fix remunerative selling prices for various items of products
and services in different circumstances.
(g) Curtailment of loss during the off-season: Cost Accounting can also provide
information, which may enable reduction of overhead, by utilising idle capacity
during the off-season or by lengthening the season.
(h) Expansion: Cost Accounts may provide estimates of production of various
levels on the basis of which the management may be able to formulate its
approach to expansion.
(i) Arriving at decisions: Most of the decisions in a business undertaking involve
correct statements of the likely effect on profits. Cost Accounts are of vital help
in this respect. In fact, without proper cost accounting, decision would be like
taking a jump in the dark, such as when production of a product is stopped.
COST CONCEPTS AND TERMS
•
Cost
–
–
(a) The amount of expenditure (actual or notional) incurred on or attributable to a specified article, product or activity. (here the
word cost is used as a noun)
(b) To ascertain the cost of a given thing. (here the word cost is used as a verb)
•
Cost object – Anything for which a separate measurement of cost is desired. Examples of cost objects include a
product, a service , a project , a customer , a brand category , an activity , a department , a programme.
•
Direct costs – Costs that are related to the cost object and can be traced in an economically feasible way.
•
Indirect costs – Costs that are related to the cost object but cannot be traced to it in an economically feasible
way.
•
Pre-determined - A cost which is computed in advance before production or operations start, on the basis of
specification of all the factors affecting cost, is known as a predetermined cost.
•
Standard Cost - A pre-determined cost, which is calculated from managements ‘expected standard of efficient
operation’ and the relevant necessary expenditure. It may be used as a basis for price fixing and for cost control
through variance analysis.
•
Marginal Cost - The amount at any given volume of output by which aggregate costs are changed if the volume
of output is increased or decreased by one unit.
•
Cost of Sales - The cost which is attributable to the sales made.
•
Total Cost - The sum of all costs attributable to the cost object under consideration.
Cost Centre - It is defined as a location, person or an item of equipment (or group
of these) for which cost may be ascertained and used for the purpose of Cost
Control. Cost Centres are of two types, viz., Personal and Impersonal.
A Personal cost centre consists of a person or group of persons and an
Impersonal cost centre consists of a location or an item of equipment (or group of
these).
In a manufacturing concern there are two main types of Cost Centres
(i) Production Cost Centre : It is a cost centre where raw material is handled for
conversion into finished product. Here both direct and indirect expenses are
incurred. Machine shops, welding shops and assembly shops are examples of
production Cost Centres.
(ii) Service Cost Centre : It is a cost centre which serves as an ancillary unit to a
production cost centre. Power house, gas production shop, material service
centres, plant maintenance centres are examples of service cost centres.
Cost unit - It is a unit of product, service or time (or combination of these) in
relation to which costs may be ascertained or expressed. We may for instance
determine the cost per tonne of steel, per tonne kilometre of a transport
service or cost per machine hour. Sometime, a single order or a contract
constitutes a cost unit. A batch which consists of a group of identical items and
maintains its identity through one or more stages of production may also be
considered as a cost unit.
Cost units are usually the units of physical measurement like number, weight,
area, volume, length, time and value. A few typical examples of cost units are
given below :
Industry or Product Cost Unit Basis
Automobile −Number
Cement −Tonne/per bag etc.
Chemicals −Litre, gallon, kilogram, tonne etc.
Power −Kilo-watt hour
Steel −Tonne
Transport −Passenger kilometre
Differential cost - (Incremental and decremental costs). It represents the
change (increase or decrease) in total cost (variable as well as fixed) due to
change in activity level, technology, process or method of production, etc. For
example if any change is proposed in the existing level or in the existing method
of production, the increase or decrease in total cost or in specific elements of cost
as a result of this decision will be known as incremental cost or decremental cost.
Imputed costs - These costs are notional costs which do not involve any cash
outlay. Interest on capital, the payment for which is not actually made, is an
example of imputed cost. These costs are similar to opportunity costs.
Capitalised costs – These are costs which are initially recorded as assets and
subsequently treated as expenses.
Product costs - These are the costs which are associated with the purchase and
sale of goods (in the case of merchandise inventory). In the production scenario,
such costs are associated with the acquisition and conversion of materials and all
other manufacturing inputs into finished product for sale.
•
Opportunity cost - This cost refers to the value of sacrifice made or
benefit of opportunity foregone in accepting an alternative course of
action. For example, a firm financing its expansion plan by
withdrawing money from its bank deposits. In such a case the loss
of interest on the bank deposit is the opportunity cost for carrying
out the expansion plan.
•
Out-of-pocket cost - It is that portion of total cost, which involves
cash outflow. This cost concept is a short-run concept and is used in
decisions relating to fixation of selling price in recession, make or
buy, etc. Out–of–pocket costs can be avoided or saved if a particular
proposal under consideration is not accepted.
•
Shut down costs - Those costs, which continue to be, incurred
even when a plant is temporarily shutdown, e.g. rent, rates,
depreciation, etc. These costs cannot be eliminated with the closure
of the plant. In other words, all fixed costs, which cannot be avoided
during the temporary closure of a plant, will be known as shut down
costs.
Sunk costs - Historical costs incurred in the past are known as sunk costs. For
example, in the case of a decision relating to the replacement of a machine, the
written down value of the existing machine is a sunk cost .
Discretionary costs – Such costs are not tied to a clear cause and effect relationship
between inputs and outputs. They usually arise from periodic decisions regarding the
maximum outlay to be incurred. Examples include advertising, public relations,
executive training etc.
Period costs - These are the costs, which are not assigned to the products but are
charged as expenses against the revenue of the period in which they are incurred. All
non-manufacturing costs such as general and administrative expenses, selling and
distribution expenses are recognised as period costs.
Engineered costs - These are costs that result specifically from a clear cause and
effect relationship between inputs and outputs. The relationship is usually personally
observable. Examples of inputs are direct material costs, direct labour costs etc.
Examples of output are cars, computers etc.
ELEMENTS OF COST
MATERIAL COST
LABOUR COST
OTHER EXPENSES
1. DIRECT MATERIAL
1. DIRECT LABOUR
1.DIRECT EXP.
2. INDIRECT MATERIAL
2. INDIRECT LABOUR 2.INDIRECT EXP.
OVERHEADS
1.PRODUCTIN OR WORKS OVERHEADS.
2.ADMINISTRATION OVERHEADS
3.SELLING OVERHEADS
4.DISTRIBUTION OVERHEADS.
Direct materials : Materials which are present in the finished product(cost object) or
can be economically identified in the product are called direct materials. For example,
cloth in dress making; materials purchased for a specific job etc.
Direct labour : Labour which can be economically identified or attributed wholly to a
cost object is called direct labour. For example, labour engaged on the actual
production of the product or in carrying out the necessary operations for converting the
raw materials into finished product.
Direct expenses : It includes all expenses other than direct material or direct labour
which are specially incurred for a particular cost object and can be identified in an
economically feasible way.
Indirect materials : Materials which do not normally form part of the finished product
(cost object) are known as indirect materials. These are —
Stores used for maintaining machines and buildings (lubricants, cotton waste, bricks
etc.)
Stores used by service departments like power house, boiler house, canteen etc.
Indirect labour : Labour costs which cannot be allocated but can be apportioned to or
absorbed by cost units or cost centres is known as indirect labour. Examples of indirect
labour includes - charge hands and supervisors; maintenance workers; etc.
Indirect expenses : Expenses other than direct expenses are known as indirect
expenses. Factory rent and rates, insurance of plant and machinery, power, light,
heating, repairing, telephone etc., are some examples of indirect expenses.
Overheads : It is the aggregate of indirect material costs, indirect labour costs
and indirect expenses. The main groups into which overheads may be subdivided are
the following :
(i) Production or Works overheads (ii) Administration overheads
(iii) Selling overheads (iv) Distribution overheads
CLASSIFICATION OF COSTS
It means the grouping of costs according to their common characteristics. The
important ways of classification of costs are :
(1) By nature or element (2) By functions
(3) As direct and indirect (4) By variability
(5) By controllability (6) By normality
By Nature of Element - Under this classification the costs are divided into three
categories i.e., materials cost, labour cost and expenses. This type of classification is
useful to determine the total cost.
1.11.2 By Functions - Under this classification, costs are divided according to the
function for which they have been incurred. Some of the examples are :
Production cost - The cost of sequence of operations which begins with supplying
materials, labour and services and ends with primary packing of the product.
Selling cost - The cost seeking to create and stimulate demand (sometimes termed
‘marketing’) and of securing orders.
Distribution cost - The cost of the sequence of operations which begins with making the
packed product available for despatch and ends with making the reconditioned returned
empty package, if any available for re-use.
Administrative cost - The cost of formulating the policy, directing the organisation and
controlling the operations of an undertaking which is not related directly to a production,
selling and distribution, research or development activity or function.
Research cost - The cost of researching for new or improved products, new
applications of materials, or improved methods.
Development cost - The cost of the process which begins with the implementation of
the decision to produce a new or improved product or to employ a new or improved
method and ends with commencement of formal production of that product or by that
method.
Pre-production cost - The part of development cost incurred in making a trial
production run preliminary to formal product.
Conversion cost - The sum of direct wages, direct expenses and overhead cost of
converting raw materials to the finished stage or converting a material from one stage of
production to the next.
The three different purposes for computing product costs are as follows :
(i) Preparation of financial statements: Here focus is on inventoriable
costs for complying with Accounting Standard –2 , issued by the
Council of ICAI.
(ii) Product pricing: It is an important purpose for which product costs are
used. For this purpose, the cost of the other areas of the value chain
should be included to make the product available to the customer.
(iii) Contracting with government agencies: Normally such contracts are on a
cost plus basis. For this purpose government agencies may not allow the
contractors to recover research and development and marketing costs
under cost plus contracts.
By Variability - According to this classification costs are classified into three groups
viz., fixed, variable and semi-variable.
(a) Fixed costs - These are the costs which are incurred for a period, and which,
within certain output and turnover limits, tend to be unaffected by fluctuations
in the levels of activity (output or turnover). They do not tend to increase or
decrease with the changes in output. For example, rent, insurance of factory
building etc., remain the same for different levels of production. A fixed cost
can be depicted graphically as
(b)
(c)
FIXED COST
RS.1000
(a)
(a)
Activity Level
(b) Variable costs - These costs tend to vary with the volume of activity. Any
increase in the activity results in an increase in the variable cost and viceversa. For example, cost of direct labour, etc. Variable costs are depicted
graphically as follows,
TOTAL
VARIABLE COST
ACTIVITY LEVEL
(c) Semi-variable costs - These costs contain both fixed and variable components and
are thus partly affected by fluctuations in the level of activity. Examples of semi
variable costs are telephone bills, gas and electricity etc. Such costs are depicted
graphically as
TOTAL COST
VARIABLE COST
FIXED COST
Methods of segregating Semi-variable costs into fixed and variable costs –
The segregation of semi-variable costs into fixed and variable costs can be carried
out by using the following methods:
(a) Graphical method
(b) High points and low points method
(c) Analytical method
(d) Comparison by period or level of activity method
(e) Least squares method
By Controllability - Costs here may be classified into controllable and
uncontrollable costs.
(a) Controllable costs - These are the costs which can be
influenced by the action of a specified member of an
undertaking. A business organisation is usually divided into a
number of responsibility centres and an executive heads each
such centre. Controllable costs incurred in a particular
responsibility centre can be influenced by the action of the
executive heading that responsibility centre. Direct costs
comprising direct labour, direct material, direct expenses and
some of the overheads are generally controllable by the shop
level management.
(a) Uncontrollable costs - Costs which cannot be influenced by the action of a
specified member of an undertaking are known as uncontrollable costs. For
example, expenditure incurred by, say, the Tool Room is controllable by the
foreman incharge of that section but the share of the tool-room expenditure
which is apportioned to a machine shop is not to be controlled by the
machine shop foreman.
By Normality - According to this basis cost may be categorised as follows:
(a) Normal cost - It
is the cost which is normally incurred at a
given level of output under the conditions in which that
level of output is normally attained.
(b) Abnormal cost - It is the cost which is not normally
incurred at a given level of output in the conditions in
which that level of output is normally attained. It is
charged to Costing Profit and loss Account.
TYPES OF COSTING
Uniform Costing: When a number of firms in an industry agree among
themselves to follow the same system of costing in detail, adopting common
terminology for various items and processes they are said to follow a system of
uniform costing. In such a case, a comparison of the performance of each of the
firms can be made with that of another, or with the average performance in the
industry. Under such a system it is also possible to determine the cost of
production of goods which is true for the industry as a whole. It is found useful
when tax-relief or protection is sought from the Government.
Marginal Costing: It is defined as the ascertainment of marginal cost by
differentiating between fixed and variable costs. It is used to ascertain effect of
changes in volume or type of output on profit.
Standard Costing and variance analysis: It is the name given to the technique
whereby standard costs are pre-determined and subsequently compared with the
recorded actual costs. It is thus a technique of cost ascertainment and cost
control. This technique may be used in conjunction with any method of costing.
However, it is especially suitable where the manufacturing method involves
production of standardised goods of repetitive nature.
Historical Costing: It is the ascertainment of costs after they have been
incurred. This type of costing has limited utility.
Direct Costing: It is the practice of charging all direct costs to operations,
processes or products leaving all indirect costs to be written off against profits
in which they arise.
Absorption Costing: It is the practice of charging all costs, both variable and
fixed to operations, processes or products. This differs from marginal costing
where fixed costs are excluded.
METHODS OF COSTING
Job Costing: In this case the cost of each job is ascertained separately. It is suitable
in all cases where work is undertaken on receiving a customer’s order like a printing
press, motor workshop, etc. In case a factory produces a certain quantity of a part at
a time, say 5,000 rims of bicycle, the cost can be ascertained like that of a job. The
name then given is Batch Costing.
1.14.2 Batch Costing: It is the extension of job costing. A batch may represent a
number of small orders passed through the factory in batch. Each batch here is
treated as a unit of cost and thus separately costed. Here cost per unit is determined
by dividing the cost of the batch by the number of units produced in the batch.
1.14.3 Contract Costing : Here the cost of each contract is ascertained separately.
It is suitable for firms engaged in the construction of bridges, roads, buildings etc.
Single or Output Costing : Here the cost of a product is ascertained, the product
being the only one produced like bricks, coals, etc.
1.14.5 Process Costing : Here the cost of completing each stage of work is
ascertained, like cost of making pulp and cost of making paper from pulp. In
mechanical operations, the cost of each operation may be ascertained separately
; the name given is operation costing.
1.14.6 Operating Costing : It is used in the case of concerns rendering services
like transport, supply of water, retail trade etc.
1.14.7 Multiple Costing : It is a combination of two or more methods of costing
outlined above. Suppose a firm manufactures bicycles including its components;
the parts will be costed by the system of job or batch costing but the cost of
assembling the bicycle will be computed by the Single or output costing method.
The whole system of costing is known as multiple costing.
DIRECT EXPENSES
1.15.1. Meaning of Direct Expenses : Direct Expenses are also termed as
‘Chargeable expenses’. These are the expenses which can be allocated directly to
a cost object. Direct expenses are defined as ‘costs other than material and wages
which are incurred for a specific product or saleable services’.
Examples of direct expenses are :
(i) Hire charges of special machinery or plant for a particular production order or
job.
(ii) Payment of royalties.
(iii) Cost of special moulds, designs and patterns.
(iv) Experimental costs before undertaking the job concerned.
(v) Travelling and conveyance expenses incurred in connection with a particular
job.
(vi) Sub-contracting expenses or outside work costs if jobs are sent out for special
processing.
Characteristics of Direct Expenses :
(i) Direct expenses are those expenses, which are other than the direct
materials and direct labour.
(ii) These expenses are either allocated or charged completely to cost
centres or work orders.
(iii) These expenses are included in prime cost of a product.
INVENTORY VALUTION
The valuation had a deep impact over the
projected profitability of a company, which in turn
affected the willingness of various stakeholders to
inject large amount of capital in the business. The
valuation also directly affected the taxes which
the company was obliged to pay to the
government since higher profits meant higher
taxes and vice versa.
• . Cost accounting is used in
(1)various decision making scenarios e.g.
whether to produce for captive consumption or
buy from outside suppliers,
(2) supply of information to the
government (cost audit),
(3)planning and control of expenses
(variance analysis) ,
(4)tracking expenses through a products life
cycle (life cycle costing),
(5) fixation of selling prices (cost plus and other
approaches) etc.
A prudent housewife who goes for shopping considers the quality and
price of each product before she buys it. In short, each economic
activity, if rationally viewed, has two aspects - firstly, the costs involved
in it and secondly, the benefits obtained out of it. This analysis is
technically known as cost-benefit analysis. It is very important in
industrial and commercial activities.
Definition of Costing, Cost
Accounting and Cost
Accountancy:
•
Costing is defined as “the technique and process of ascertaining costs”.
•
Cost Accounting is defined as "the process of accounting for cost which
begins with the recording of income and expenditure or the bases on
which they are calculated and ends with the preparation of periodical
statements and reports for ascertaining and controlling costs."
•
Cost Accountancy has been defined as “the application of costing and
cost accounting principles, methods and techniques to the science, art
and practice of cost control and the ascertainment of profitability. It
includes the presentation of information derived there from for the
purpose of managerial decision making.”
OBJECTIVES OF COST
ACCOUNTING
• The main objectives of Cost Accounting
are as follows :
– (i) Ascertainment of cost.
– (ii) Determination of selling price.
– (iii) Cost control and cost reduction.
– (iv) Ascertaining the profit of each activity.
– (v) Assisting management in decision-making.
Ascertainment of Cost:
• There are two methods of ascertaining costs, viz., Post
Costing and Continuous Costing.
• Post Costing means, analysis of actual information as
recorded in financial books. It is accurate and is useful in
the case of “Cost plus Contracts” where price is to be
determined finally on the basis of actual cost.
• Continuous Costing, aims at collecting information about
cost as and when the activity takes place so that as soon
as a job is completed the cost of completion would be
known. This involves careful estimates being prepared of
overheads. In order to be of any use, costing
Determination of selling price:
• Though the selling price of a product is
influenced by market conditions, which are
beyond the control of any business, it is
still possible to determine the selling price
within the market constraints. For this
purpose, it is necessary to rely upon cost
data supplied by Cost Accountants.
Cost control and cost reduction:
• The guidance and regulation, by executive
action of the cost of operating an undertaking”.
The word “guidance” indicates a goal or target to
be guided; ‘regulation’ indicates taking action
where there is a deviation from what is laid
down; executive action denotes action to
“regulate” must be initiated by executives i.e.
persons responsible for carrying out the job or
the operation; and all this is to be exercised
through modern methods of costing in respect of
expenses incurred in operating an undertaking.
To exercise cost control, broadly speaking the following steps should be
observed:
(i) Determine clearly the objective, i.e., pre-determine the desired
results;
(ii) Measure the actual performance;
(iii) Investigate into the causes of failure to perform according to plan;
and
(iv) Institute corrective action.
Cost Reduction, may be defined "as the achievement of real
and permanent reduction in the unit cost of goods manufactured or
services rendered without impairing their suitability for the use intended
or diminution in the quality of the product."
Cost reduction should not be confused with Cost control.
Cost saving could be a temporary affair and may be at the cost of
quality. Cost reduction implies the retention of the essential
characteristics and quality of the product and thus it must be confined to
permanent and genuine savings in the cost of manufacture,
administration, distribution and selling, brought about by elimination of
wasteful and inessential elements from the design of the product and
from the techniques carried out in connection therewith.
The three-fold assumptions involved in the definition of cost reduction may be
summarised as under :
(a) There is a saving in unit cost
(b) Such saving is of permanent nature.
(c) The utility and quality of the goods and services remain unaffected, if
not improved.
Ascertaining the profit of each
activity
The profit of any activity can be ascertained by
matching cost with the revenue of that activity.
The purpose under this step is to determine
costing profit or loss of any activity on an
objective basis.
Assisting management in
decision making :
• Decision making is defined as a process of
selecting a course of action out of two or
more alternative courses. For making a
choice between different courses of action,
it is necessary to make a comparison of
the outcomes, which may be arrived under
different alternatives. Such a comparison
has only been made possible with the help
of Cost Accounting information.
IMPORTANCE OF COST
ACCOUNTING TO BUSINESS
CONCERNS
• Management expects from cost accounting - information
and reports to help them in the discharge of the following
functions :
• (a) Control of material cost : Cost of material usually
constitute a substantial portion of the total cost of a
product. Therefore, it is necessary to control it as far as
possible. Such a control may be exercised by
• (i) Ensuring un-interrupted supply of material and spares
for production.
• (ii) By avoiding excessive locking up of funds/capital in
stocks of materials and stores.
• (iii) Also by the use of techniques like value analysis,
standardisation etc. to control material cost.
(B) Control of labour cost : It can be controlled if workers complete their work
within the standard time limit. Reduction of labour turnover and idle time too
help us, to control labour cost.
(c) Control of overheads : Overheads consists of indirect expenses which are
incurred in the factory, office and sales department ; they are part of
production and sales cost. Such expenses may be controlled by keeping a
strict check over them.
(d) Measuring efficiency : For measuring efficiency, Cost Accounting
department should provide information about standards and actual
performance of the concerned activity.
(e) Budgeting : Now–a–days detailed estimates in terms of quantities and
amounts are drawn up before the start of each activity. This is done to ensure
that a practicable course of action can be chalked out and the actual
performance corresponds with the estimated or budgeted performance. The
preparation of the budget is the function of Costing Department.
(f) Price determination: Cost accounts should provide information, which enables
the management to fix remunerative selling prices for various items of products
and services in different circumstances.
(g) Curtailment of loss during the off-season: Cost Accounting can also provide
information, which may enable reduction of overhead, by utilising idle capacity
during the off-season or by lengthening the season.
(h) Expansion: Cost Accounts may provide estimates of production of various
levels on the basis of which the management may be able to formulate its
approach to expansion.
(i) Arriving at decisions: Most of the decisions in a business undertaking involve
correct statements of the likely effect on profits. Cost Accounts are of vital help
in this respect. In fact, without proper cost accounting, decision would be like
taking a jump in the dark, such as when production of a product is stopped.
COST CONCEPTS AND TERMS
•
Cost
–
–
(a) The amount of expenditure (actual or notional) incurred on or attributable to a specified article, product or activity. (here the
word cost is used as a noun)
(b) To ascertain the cost of a given thing. (here the word cost is used as a verb)
•
Cost object – Anything for which a separate measurement of cost is desired. Examples of cost objects include a
product, a service , a project , a customer , a brand category , an activity , a department , a programme.
•
Direct costs – Costs that are related to the cost object and can be traced in an economically feasible way.
•
Indirect costs – Costs that are related to the cost object but cannot be traced to it in an economically feasible
way.
•
Pre-determined - A cost which is computed in advance before production or operations start, on the basis of
specification of all the factors affecting cost, is known as a predetermined cost.
•
Standard Cost - A pre-determined cost, which is calculated from managements ‘expected standard of efficient
operation’ and the relevant necessary expenditure. It may be used as a basis for price fixing and for cost control
through variance analysis.
•
Marginal Cost - The amount at any given volume of output by which aggregate costs are changed if the volume
of output is increased or decreased by one unit.
•
Cost of Sales - The cost which is attributable to the sales made.
•
Total Cost - The sum of all costs attributable to the cost object under consideration.
Cost Centre - It is defined as a location, person or an item of equipment (or group
of these) for which cost may be ascertained and used for the purpose of Cost
Control. Cost Centres are of two types, viz., Personal and Impersonal.
A Personal cost centre consists of a person or group of persons and an
Impersonal cost centre consists of a location or an item of equipment (or group of
these).
In a manufacturing concern there are two main types of Cost Centres
(i) Production Cost Centre : It is a cost centre where raw material is handled for
conversion into finished product. Here both direct and indirect expenses are
incurred. Machine shops, welding shops and assembly shops are examples of
production Cost Centres.
(ii) Service Cost Centre : It is a cost centre which serves as an ancillary unit to a
production cost centre. Power house, gas production shop, material service
centres, plant maintenance centres are examples of service cost centres.
Cost unit - It is a unit of product, service or time (or combination of these) in
relation to which costs may be ascertained or expressed. We may for instance
determine the cost per tonne of steel, per tonne kilometre of a transport
service or cost per machine hour. Sometime, a single order or a contract
constitutes a cost unit. A batch which consists of a group of identical items and
maintains its identity through one or more stages of production may also be
considered as a cost unit.
Cost units are usually the units of physical measurement like number, weight,
area, volume, length, time and value. A few typical examples of cost units are
given below :
Industry or Product Cost Unit Basis
Automobile −Number
Cement −Tonne/per bag etc.
Chemicals −Litre, gallon, kilogram, tonne etc.
Power −Kilo-watt hour
Steel −Tonne
Transport −Passenger kilometre
Differential cost - (Incremental and decremental costs). It represents the
change (increase or decrease) in total cost (variable as well as fixed) due to
change in activity level, technology, process or method of production, etc. For
example if any change is proposed in the existing level or in the existing method
of production, the increase or decrease in total cost or in specific elements of cost
as a result of this decision will be known as incremental cost or decremental cost.
Imputed costs - These costs are notional costs which do not involve any cash
outlay. Interest on capital, the payment for which is not actually made, is an
example of imputed cost. These costs are similar to opportunity costs.
Capitalised costs – These are costs which are initially recorded as assets and
subsequently treated as expenses.
Product costs - These are the costs which are associated with the purchase and
sale of goods (in the case of merchandise inventory). In the production scenario,
such costs are associated with the acquisition and conversion of materials and all
other manufacturing inputs into finished product for sale.
•
Opportunity cost - This cost refers to the value of sacrifice made or
benefit of opportunity foregone in accepting an alternative course of
action. For example, a firm financing its expansion plan by
withdrawing money from its bank deposits. In such a case the loss
of interest on the bank deposit is the opportunity cost for carrying
out the expansion plan.
•
Out-of-pocket cost - It is that portion of total cost, which involves
cash outflow. This cost concept is a short-run concept and is used in
decisions relating to fixation of selling price in recession, make or
buy, etc. Out–of–pocket costs can be avoided or saved if a particular
proposal under consideration is not accepted.
•
Shut down costs - Those costs, which continue to be, incurred
even when a plant is temporarily shutdown, e.g. rent, rates,
depreciation, etc. These costs cannot be eliminated with the closure
of the plant. In other words, all fixed costs, which cannot be avoided
during the temporary closure of a plant, will be known as shut down
costs.
Sunk costs - Historical costs incurred in the past are known as sunk costs. For
example, in the case of a decision relating to the replacement of a machine, the
written down value of the existing machine is a sunk cost .
Discretionary costs – Such costs are not tied to a clear cause and effect relationship
between inputs and outputs. They usually arise from periodic decisions regarding the
maximum outlay to be incurred. Examples include advertising, public relations,
executive training etc.
Period costs - These are the costs, which are not assigned to the products but are
charged as expenses against the revenue of the period in which they are incurred. All
non-manufacturing costs such as general and administrative expenses, selling and
distribution expenses are recognised as period costs.
Engineered costs - These are costs that result specifically from a clear cause and
effect relationship between inputs and outputs. The relationship is usually personally
observable. Examples of inputs are direct material costs, direct labour costs etc.
Examples of output are cars, computers etc.
ELEMENTS OF COST
MATERIAL COST
LABOUR COST
OTHER EXPENSES
1. DIRECT MATERIAL
1. DIRECT LABOUR
1.DIRECT EXP.
2. INDIRECT MATERIAL
2. INDIRECT LABOUR 2.INDIRECT EXP.
OVERHEADS
1.PRODUCTIN OR WORKS OVERHEADS.
2.ADMINISTRATION OVERHEADS
3.SELLING OVERHEADS
4.DISTRIBUTION OVERHEADS.
Direct materials : Materials which are present in the finished product(cost object) or
can be economically identified in the product are called direct materials. For example,
cloth in dress making; materials purchased for a specific job etc.
Direct labour : Labour which can be economically identified or attributed wholly to a
cost object is called direct labour. For example, labour engaged on the actual
production of the product or in carrying out the necessary operations for converting the
raw materials into finished product.
Direct expenses : It includes all expenses other than direct material or direct labour
which are specially incurred for a particular cost object and can be identified in an
economically feasible way.
Indirect materials : Materials which do not normally form part of the finished product
(cost object) are known as indirect materials. These are —
Stores used for maintaining machines and buildings (lubricants, cotton waste, bricks
etc.)
Stores used by service departments like power house, boiler house, canteen etc.
Indirect labour : Labour costs which cannot be allocated but can be apportioned to or
absorbed by cost units or cost centres is known as indirect labour. Examples of indirect
labour includes - charge hands and supervisors; maintenance workers; etc.
Indirect expenses : Expenses other than direct expenses are known as indirect
expenses. Factory rent and rates, insurance of plant and machinery, power, light,
heating, repairing, telephone etc., are some examples of indirect expenses.
Overheads : It is the aggregate of indirect material costs, indirect labour costs
and indirect expenses. The main groups into which overheads may be subdivided are
the following :
(i) Production or Works overheads (ii) Administration overheads
(iii) Selling overheads (iv) Distribution overheads
CLASSIFICATION OF COSTS
It means the grouping of costs according to their common characteristics. The
important ways of classification of costs are :
(1) By nature or element (2) By functions
(3) As direct and indirect (4) By variability
(5) By controllability (6) By normality
By Nature of Element - Under this classification the costs are divided into three
categories i.e., materials cost, labour cost and expenses. This type of classification is
useful to determine the total cost.
1.11.2 By Functions - Under this classification, costs are divided according to the
function for which they have been incurred. Some of the examples are :
Production cost - The cost of sequence of operations which begins with supplying
materials, labour and services and ends with primary packing of the product.
Selling cost - The cost seeking to create and stimulate demand (sometimes termed
‘marketing’) and of securing orders.
Distribution cost - The cost of the sequence of operations which begins with making the
packed product available for despatch and ends with making the reconditioned returned
empty package, if any available for re-use.
Administrative cost - The cost of formulating the policy, directing the organisation and
controlling the operations of an undertaking which is not related directly to a production,
selling and distribution, research or development activity or function.
Research cost - The cost of researching for new or improved products, new
applications of materials, or improved methods.
Development cost - The cost of the process which begins with the implementation of
the decision to produce a new or improved product or to employ a new or improved
method and ends with commencement of formal production of that product or by that
method.
Pre-production cost - The part of development cost incurred in making a trial
production run preliminary to formal product.
Conversion cost - The sum of direct wages, direct expenses and overhead cost of
converting raw materials to the finished stage or converting a material from one stage of
production to the next.
The three different purposes for computing product costs are as follows :
(i) Preparation of financial statements: Here focus is on inventoriable
costs for complying with Accounting Standard –2 , issued by the
Council of ICAI.
(ii) Product pricing: It is an important purpose for which product costs are
used. For this purpose, the cost of the other areas of the value chain
should be included to make the product available to the customer.
(iii) Contracting with government agencies: Normally such contracts are on a
cost plus basis. For this purpose government agencies may not allow the
contractors to recover research and development and marketing costs
under cost plus contracts.
By Variability - According to this classification costs are classified into three groups
viz., fixed, variable and semi-variable.
(a) Fixed costs - These are the costs which are incurred for a period, and which,
within certain output and turnover limits, tend to be unaffected by fluctuations
in the levels of activity (output or turnover). They do not tend to increase or
decrease with the changes in output. For example, rent, insurance of factory
building etc., remain the same for different levels of production. A fixed cost
can be depicted graphically as
(b)
(c)
FIXED COST
RS.1000
(a)
(a)
Activity Level
(b) Variable costs - These costs tend to vary with the volume of activity. Any
increase in the activity results in an increase in the variable cost and viceversa. For example, cost of direct labour, etc. Variable costs are depicted
graphically as follows,
TOTAL
VARIABLE COST
ACTIVITY LEVEL
(c) Semi-variable costs - These costs contain both fixed and variable components and
are thus partly affected by fluctuations in the level of activity. Examples of semi
variable costs are telephone bills, gas and electricity etc. Such costs are depicted
graphically as
TOTAL COST
VARIABLE COST
FIXED COST
Methods of segregating Semi-variable costs into fixed and variable costs –
The segregation of semi-variable costs into fixed and variable costs can be carried
out by using the following methods:
(a) Graphical method
(b) High points and low points method
(c) Analytical method
(d) Comparison by period or level of activity method
(e) Least squares method
By Controllability - Costs here may be classified into controllable and
uncontrollable costs.
(a) Controllable costs - These are the costs which can be
influenced by the action of a specified member of an
undertaking. A business organisation is usually divided into a
number of responsibility centres and an executive heads each
such centre. Controllable costs incurred in a particular
responsibility centre can be influenced by the action of the
executive heading that responsibility centre. Direct costs
comprising direct labour, direct material, direct expenses and
some of the overheads are generally controllable by the shop
level management.
(a) Uncontrollable costs - Costs which cannot be influenced by the action of a
specified member of an undertaking are known as uncontrollable costs. For
example, expenditure incurred by, say, the Tool Room is controllable by the
foreman incharge of that section but the share of the tool-room expenditure
which is apportioned to a machine shop is not to be controlled by the
machine shop foreman.
By Normality - According to this basis cost may be categorised as follows:
(a) Normal cost - It
is the cost which is normally incurred at a
given level of output under the conditions in which that
level of output is normally attained.
(b) Abnormal cost - It is the cost which is not normally
incurred at a given level of output in the conditions in
which that level of output is normally attained. It is
charged to Costing Profit and loss Account.
TYPES OF COSTING
Uniform Costing: When a number of firms in an industry agree among
themselves to follow the same system of costing in detail, adopting common
terminology for various items and processes they are said to follow a system of
uniform costing. In such a case, a comparison of the performance of each of the
firms can be made with that of another, or with the average performance in the
industry. Under such a system it is also possible to determine the cost of
production of goods which is true for the industry as a whole. It is found useful
when tax-relief or protection is sought from the Government.
Marginal Costing: It is defined as the ascertainment of marginal cost by
differentiating between fixed and variable costs. It is used to ascertain effect of
changes in volume or type of output on profit.
Standard Costing and variance analysis: It is the name given to the technique
whereby standard costs are pre-determined and subsequently compared with the
recorded actual costs. It is thus a technique of cost ascertainment and cost
control. This technique may be used in conjunction with any method of costing.
However, it is especially suitable where the manufacturing method involves
production of standardised goods of repetitive nature.
Historical Costing: It is the ascertainment of costs after they have been
incurred. This type of costing has limited utility.
Direct Costing: It is the practice of charging all direct costs to operations,
processes or products leaving all indirect costs to be written off against profits
in which they arise.
Absorption Costing: It is the practice of charging all costs, both variable and
fixed to operations, processes or products. This differs from marginal costing
where fixed costs are excluded.
METHODS OF COSTING
Job Costing: In this case the cost of each job is ascertained separately. It is suitable
in all cases where work is undertaken on receiving a customer’s order like a printing
press, motor workshop, etc. In case a factory produces a certain quantity of a part at
a time, say 5,000 rims of bicycle, the cost can be ascertained like that of a job. The
name then given is Batch Costing.
1.14.2 Batch Costing: It is the extension of job costing. A batch may represent a
number of small orders passed through the factory in batch. Each batch here is
treated as a unit of cost and thus separately costed. Here cost per unit is determined
by dividing the cost of the batch by the number of units produced in the batch.
1.14.3 Contract Costing : Here the cost of each contract is ascertained separately.
It is suitable for firms engaged in the construction of bridges, roads, buildings etc.
Single or Output Costing : Here the cost of a product is ascertained, the product
being the only one produced like bricks, coals, etc.
1.14.5 Process Costing : Here the cost of completing each stage of work is
ascertained, like cost of making pulp and cost of making paper from pulp. In
mechanical operations, the cost of each operation may be ascertained separately
; the name given is operation costing.
1.14.6 Operating Costing : It is used in the case of concerns rendering services
like transport, supply of water, retail trade etc.
1.14.7 Multiple Costing : It is a combination of two or more methods of costing
outlined above. Suppose a firm manufactures bicycles including its components;
the parts will be costed by the system of job or batch costing but the cost of
assembling the bicycle will be computed by the Single or output costing method.
The whole system of costing is known as multiple costing.
DIRECT EXPENSES
1.15.1. Meaning of Direct Expenses : Direct Expenses are also termed as
‘Chargeable expenses’. These are the expenses which can be allocated directly to
a cost object. Direct expenses are defined as ‘costs other than material and wages
which are incurred for a specific product or saleable services’.
Examples of direct expenses are :
(i) Hire charges of special machinery or plant for a particular production order or
job.
(ii) Payment of royalties.
(iii) Cost of special moulds, designs and patterns.
(iv) Experimental costs before undertaking the job concerned.
(v) Travelling and conveyance expenses incurred in connection with a particular
job.
(vi) Sub-contracting expenses or outside work costs if jobs are sent out for special
processing.
Characteristics of Direct Expenses :
(i) Direct expenses are those expenses, which are other than the direct
materials and direct labour.
(ii) These expenses are either allocated or charged completely to cost
centres or work orders.
(iii) These expenses are included in prime cost of a product.
