Cost Accounting

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BAF Cost Accounting Notes
Costing - Meaning Cost accounting is the process of determining and accumulating the cost of product or activity. It is a process of accounting for the incurrence and the control of cost. It also covers classification, analysis, and interpretation of cost. In other words, it is a system of accounting, which provides the information about the ascertainment, and control of costs of products, or services. It measures the operating efficiency of the enterprise. Cost Accounting is an essential part of accountancy which has been developed to meet the managerial needs of business organizations. Present Age is the Age of Competition. The success of a business to the large extent depends to a great extent upon his ability to reduce the cost of a production to the minimum. This would require a vigilant control of all expenses. Costing Accounting serves as a means in this direction. It indicate the cost of production, item wise and profit per unit. It helps the management in cost and control reduction. Cost Management has been developed because of the limitations of financial accounting and needs of management. The main objective of Financial Accounting is recording of business transactions and ascertaining the results. It does not give importance to cost control aspects. Where as costing, costing gives most importance to cost control aspects. In short, cost accounting deals with the cost of production, selling and distribution. Cost Accounting: It is a formal system of accounting for costs by means of which cost of products and services are ascertained and controlled Cost Accountancy: This is the widest of all the terms. It is the application of costing and cost accounting principles, methods and techniques to the science, art and practice of cost control and ascertainment of profitability. Costing – Definitions: The following are some of the important definitions regarding costing. Costing is the classifying, recording and appropriate allocation of expenditure for the determination of the costs of products or services. – Wheldon. Cost accounting is the science of recording and presenting the business transactions pertaining to; the production of goods and services, where by these records become a method of measurement and a means of control.

Objectives of Cost Accounting The objectives of Cost Accounting may be classified into two categories namely a) Primary Objectives and b) Subsidiary Objectives. A) Primary Objectives 1. 2. 3. B) Cost Ascertainment Cost Presentation Cost Control

Subsidiary Objectives A) 1. Primary Objects: The main advantage of Cost Accounting is cost ascertainment Cost Ascertainment: It implies i) Collection and analysis of expenses ii) Measurement of production and iii) Linking of production to expenses. i) Collection of expenses: There are various systems of Costing like historical Costs, estimated costs, standard costs for collection of expenses. ii) Measurement of production: There are various methods of costing like process costing, job costing, output costing for measuring the quantity of production. iii) Linking the production to expenses: There are various techniques like absorption costing and marginal costing, for linking production with the expenses. 2. Cost Presentation: The second object of costing is Cost reporting. Appropriate cost information should be sent to right persons in right time in proper form. Different printed forms are used for efficient reporting. 3. Cost Control: Another important object of Costing is Cost Control. There are various methods to ensure cost control. They are: 1. 2. 3. 4. Setting up of standards and budgets for expenses and production performance. Comparing the actual with standards to find out variations. Analysing the reasons for such variation Taking corrective action to eliminate variations.


Subsidiary Objectives: 1. 2. 3. 4. 5. To assists the management in determining the selling price. To helps the Management to prevent the wastage in material, men and machinery. To help the management to carry on production with utmost efficiency. To facilitate the presentation of financial and other statements very quickly. To helps the management for formulating the operational policies such as a) b) c) d) Determination of cost volume profit relationship. Shutting down or operating at loss. Making a buying from outside suppliers. Replacing the old production methods by improved methods.

Nature and Scope of Cost Accounting There is no ready made system of Cost Accounting suited to all business concerns. Hence it is necessary to devise a system suited to each type of business. As such, the benefits to be derived from Cost Accounting depend upon the need for it, suitability of the system designed and it efficient working. Cost accounting is an organized boy of knowledge. As such it consists of certain principles and rules subject to which the technique of Cost Accounting should be applied. Although Cost Accounting is an organized body of knowledge, principles of Cost Accounting cannot be verified with experiments. Hence, this discipline is not an exact science. 1. Cost book-keeping: It involves maintaining complete record of all costs incurred from their incurrence to their charge to departments, products and services. Such recording is preferably done on the basis of double entry system. 2. 3. Cost system: Systems and procedures are devised for proper accounting for costs. Cost ascertainment: Ascertaining cost of products, processes, jobs, services, etc., is the important function of cost accounting. Cost ascertainment becomes the basis of managerial decision making such as pricing, planning and control. 4. Cost Analysis: It involves the process of finding out the causal factors of actual costs varying from the budgeted costs and fixation of responsibility for cost increases. 5. Cost comparisons: Cost accounting also includes comparisons between cost from alternative courses of action such as use of technology for production, cost of making different products and activities, and cost of same product/ service over a period of time.


Cost Control: Cost accounting is the utilisation of cost information for exercising control. It involves a detailed examination of each cost in the light of benefit derived from the incurrence of the cost. Thus, we can state that cost is analysed to know whether the current level of costs is satisfactory in the light of standards set in advance.


Cost Reports: Presentation of cost is the ultimate function of cost accounting. These reports are primarily for use by the management at different levels. Cost Reports form the basis for planning and control, performance appraisal and managerial decision making.

The importance of cost accounting. The importance of cost accounting are as follows: 1. Importance to Management Cost accounting provides invaluable help to management. It is difficult to indicate where the work of cost accountant ends and managerial control begins. The advantages are as follows: Helps in ascertainment of cost Cost accounting helps the management in the ascertainment of cost of process, product, Job, contract, activity, etc., by using different techniques such as Job costing and Process costing. Aids in Price fixation By using demand and supply, activities of competitors, market condition to a great extent, also determine the price of product and cost to the producer does play an important role. The producer can take necessary help from his costing records. Helps in Cost reduction Cost can be reduced in the long-run when cost reduction programme and improved methods are tried to reduce costs. Elimination of wastage As it is possible to know the cost of product at every stage, it becomes possible to check the forms of waste, such as time and expenses etc. are in the use of machine equipment and material. Helps in identifying unprofitable activities With the help of cost accounting the unprofitable activities are identified, so that the necessary correct action may be taken.

Advantages of Costing Primarily Costing is developed to meet the necessities of Management. It is an important tool in the hands of Management to run the business efficiently. But there are various other agencies also who are benefited by cost accounting. The advantage of costing of various agencies can be summarized as under. 1. Advantages to the Management: a) b) c) d) Cost Accounts enable the Management to ascertain the true cost of each article, process or contact or any other unit of production. They help in fixing price and in forming the price fixation policy particularly when an industry produces several commodities. They provide a reliable basis upon which tenders and estimates may be prepared. They assist the management in developing cost calculations for new products and designs and to determine the profitableness or otherwise of the proposed changes. 2. Advantages to Creditors Cost Accounts help the creditors to study the financial position and strength of the business concerns to which they desire to give loans. It has become a policy of many banks that no loans will be made to industrial units unless such concerns have complete cost accounting systems which produce cost reports showing satisfactory trends. 3. Advantages to employees The personnel of many business enterprises have benefited by the establishment of incentives in the form of piece rates and bonus plans which may be used to compensate all classes of workers, including supervisors, clerks, departments heads and major executives. 4. Advantages to the Public Cost accounts aid in reducing and controlling costs which means supplying of goods to the consumers at lower prices. 5. Advantages to the public enterprises: Cost accounts play an important role in public enterprises i.e., enterprises owned by the Government. Efficiency of Public Enterprises can be measured and maintained only through a systematic collection of costing data and its study. 6. Advantages to the Government Cost Accounts enable the assessment of Income Tax, Excise duty etc. It facilitates the formulation of policies with regard to public finance, Industry, business, commerce, foreign, trade etc.

Distinguish between Cost Accounting and Finance Accounting The main differences between financial accounting and cost accounting are given as under: Point of Distinction Purpose Financial Accounting Cost Accounting provides information an to

It provides information about the It

business in a general way. It tells management for proper planning, about the profit and loss and operation, financial position of the business to making. Form of Accounts owners and other outside parties These accounts are kept in such a These accounts are generally kept way as to meet the requirements of voluntarily Act. to meet the Companies Act and Income Tax requirements of management. But now Companies Act has made it obligatory to keep cost records in Recording some manufacturing industries. It classified, records and analyses It records the expenditure in an the transaction in a subjective objective manner i.e., according to manner i.e. according to the nature the purposes for which the costs Control of expense It lays emphasis on the recording aspect without attaching importance to control are incurred It provides a detailed system of overhead costs with the help of standard costing and budgetary Periodicity of Reporting Analysis of Profit control It reports operating results and It gives information through cost financial position usually at the end reports to management as and of the year Financial accounts are when desired the Cost accounting is only a part of financial accounts and control decision-

any control for materials, labour and

accounts of the whole business. the

They independent in nature and discloses profit or loss of each disclose the net profit or loss of the product, job or service Reporting of Costs Nature of Transactions business as a whole The costs are reported aggregate in financial accounts Financial accounts relate in The costs are broken down on a unit basis in cost accounts to Cost accounts relate to

commercial transactions of the transactions connected with the business and include all expenses manufacture of goods and services viz., manufacturing, office, selling and include only those expenses and which enter into the production.

Cost accounts are concerned with internal transactions which do not form the basis of payment or Information receipt of cast. Monetary information is only used Non-monetary information like units (i.e., only monetary transactions is also used (i.e., it deals with are recorded0 Fixation of Selling Price Financial accounts are monetary as well as non-monetary information) not Cost accounting provides sufficient

maintained with the object of fixing data for fixation of selling prices. selling prices

Limitations of Cost Accounting In spite of various advantages, costing suffers with the following limitations.

1. Lack of Uniform Procedure: As costing contains estimates, two cost
Accountants may arrive two different results from the same information. Hence Cost accounting results can be taken as mere estimates.

2. Very expensive: As the installation cost of costing is very expensive only big
business concerns use costing.

3. Absence of a ready made system: There is no stereo typed costing system
applicable to all industries and even firms in the same industry.

4. Varied cost concepts: Since different costs are used for different purposes, no
one cost is suitable for all purposes. For example, actual costs are different from standard costs and both are different from estimated costs. Different Methods of Costing: The following are the important methods of costing: 1. Job Costing: It refers to a system of costing in which costs are ascertained in terms of specific job or orders. This is also known as terminal or contract costing. The unit of cost is the job, order, or contract, and the accounts show the cost of each order. This method is suitable for contractors, builders, constructional engineers, printers, municipal engineers, garages, shipbuilding, repair shops, film studios, furniture manufacturer, and road construction, 2. books, pharmaceuticals etc. Contract Costing: It is a method of costing applied to ascertain the costs incurred on each contract and profit earned or less incurred on each sub-contract. This system is suitable to all types of contractors and ship builders.


Batch Costing:

It is a form of job costing in which a batch of identical products

constitutes the cost unit. Each batch is separately costed, from which unit costs are determined for the units produced. It is useful for biscuit factories, bakeries, confectionery, medicines, hardware, pottery and ready made garments etc. 4. Unit Costing (Output or Single Costing): It is a method of costing by the unit of production where manufacture is continuous and the units are identical. When all the units produced are identical, the cost per unit is ascertained by dividing the total expenditure with the number of units produced in a given period. It may be employed in conjunction with batch, operation or process costing. This method is suitable for such industries as collieries, quarries, flour-mills, steel-works, paper mills, breweries, cement and brick work, oil drilling etc. 5. Operating Cost: The method of costing applied in the costing of service rendered like transport companies, power supply undertakings, municipal services, hospitals, water-works, road carrier, hostels, railways, etc., is called operating costing. Transport companies use a ton-KM, or passenger – KM as the unit of cost, while an electricity supply undertaking measures costs per kilowatt hour. 6. Operation Costing: This is a method of unit costing by operations in connection with mass production and repetitive production. It is particularly useful where the production is put in hand in large quantities of standardized units, as is usually necessary to ensure working at minimum cost. 7. Process Costing: This is sometimes referred to as Continuous or Average Costing. This is a method of costing production by processes in which a) the product of the process becomes the material of a subsequent process. B) the different products and by products are produced simultaneously at the same process, or c) the products, different only in shape, are not separately distinguishable from one another during one or more processes of manufacture. 8. Multiple Costing: This is sometimes refereed to as composite costing. It is used where there are a variety of component parts separately produced subsequently assembled in a complex organization. The cost of each product will have to be ascertained by adopting different types of costing. Eg., Job Costing from one product, process costing for another, and some other method for a third. 9. Departmental Costing: This is a method of ascertaining the cost of operating a department or cost centre. This is frequently necessary because of the need of control of expenditure in a department e.g., the cost of running a Research Department. Types of Costing:

1. 2.

Uniform Costing: It is called as such when all or majority of the members of the same industry adopt a particular method of costing. Marginal Costing: It is the ascertainment of Marginal cost by differentiating between fixed and variable cost. It is used to ascertain the effect of changes in volume or type of output on profit.


Standard Costing: Standard Costing is a system of costing under which the cost of a product is determined in advance on the basis of predetermined standard.


Historical Costing: Historical costing is a costing under which costs are ascertain after they have been incurred. Its aim is to ascertain the costs actually incurred on work done in the past.


Absorption Costing: It is the practice of charging all costs both fixed and variable to operations, processes, jobs or products.

Cost Control Cost Control has been defined as the guidance and regulation by executive action of the costs of operating and undertaking. It is regarded as an important derivative of cost accounting. Cost accounting is inseparably connected with cost control with the help of cost data. Cost Control may be classified under three broad divisions. a) b) c) Physical Cost Control Managerial Cost Control Mechanic Cost Control Control over production and distribution The use of Cost data for regulating current operations The accounting techniques which are involved in providing for cost control.

Cost Centre:

A cost centre is a location, Pearson or item of equipment (or group of

these) for which costs may be ascertained and used for the purpose of cost control. Cost centres may be production cost centres or service cost centres. Production cost centres engage in regular production where as service cost centres engage in regular production where as service cost centres serve as aids to production centres. Unit of Cost: A unit of cost is a small unit which is natural to the business and with

which expenditure may most conveniently identified. It is important in determining the method of costing that should be installed in a business concern. The unit adopted must be

practical i.e., neither tool small nor too big. Unit of production means the unit in which a commodity or service is divided. Cost Audit: Cost audit is the verification of the correctness of cost accounts and of

the adherence to the cost accounting plan. Cost audit is essential where cost accounting is carried out on a large scale. It also assists the external auditor in the verification of the cost records and statements. Classification of Costs Cost classification is the process of grouping costs according to their common characteristics. There are various ways of classifying costs. Costs may be classified according to 1. Elements: Costs are classified primarily according to the factors upon which expenditure is incurred viz; Materials, labour or wages and expenses. In otherwords the cost is composed of three elements namely material, labour and expenses. 2. Functions: functions. 3. Behaviour; in the volume. a) b) c) 4. Variable Costs Semi-variable Costs Fixed Costs With the increase or decrease in production, some costs will increase A business perform a number of functions like manufacturing,

administration, selling and distribution. Costs are classified on the basis of these

or decrease, while some costs will change but not in direct proportion to the change

Controllability: Under this, costs are classified according to whether they are capable control or not. The broad divisions under this are i) ii) Controllable Costs: These costs are directly regulated by Management. All variable cost are controllable cost. Uncontrollable Costs: Uncontrollable costs are those which cannot be influenced by management action. All the fixed costs are generally uncontrollable.



There are two types of costs, which display the Normality

characteristic. They are

i) ii)

Normal Cost: It is cost which is normally incurred at given level of output I the conditions in which that level of output is normally attained. Abnormal Costs: It is a cost which is not normally incurred at a given level output in the conditions in which that level of output is normally attined. Elements of Costs

Cost is composed of three elements namely materials, labour and other expenses. These elements of cost are further analysed into different elements as shown below.

From the above chart it is very clear that each element is classified into direct expenditure and indirect expenditure. Direct Expenditure: Direct expenditure comprises those expenses which can be conveniently identified wholly with a particular unit of cost. Indirect expenditures includes all other expenses incurred for the undertaking as a whole and not identifiable wholly with a particular unit of cost. Hence direct expenditure includes the elements of Direct Materials, Direct Labour and direct chargeable expenses. Indirect Expenditure: Indirect expenditure includes the elements of Indirect Material,

Indirect Labour and Indirect Expense. Indirect Expenditure comprising the above three elements is referred to by cost accountants as overhead. For the purpose of classification, Overhead is further sub-divided into the following. 1. 2. Works or factory overhead. Office and Administrative Overhead.


Selling and Distribution Overhead.

By grouping the above elements of cost, the following divisions of cost are obtained 1 Prime Cost or Flat Cost or Direct Cost This comprises Direct Materials, Direct labour and Direct Expenses 2 Works Cost or Factory Cost or Production Cost 3 Office Cost or Cost of Production or Gross Cost 4 Total Cost or Cost of Sales or Selling Cost Prime Cost This consists of Prime Cost plus works or factory expenses This consists of works cost plus administrative overhead This is made up of cost of production plus Selling and Distribution Overhead. Direct Materials + Direct Labour + Direct Expenses Works Cost or Factory Cost or Production Cost Office Cost or Cost of Production or Gross Cost Total Cost or Cost of Sales or Selling Cost Works or Factory Overhead + Administrative Overhead Office Cost or Cost of Production + Selling and Distribution Overhead Prime Cost + Works or Factory Overhead

The difference between the cost of sales and selling price represents profit or loss 1. Direct materials: Direct Materials are those materials which can be identified in

the product and can be conveniently measured and directly charged to the product. Direct Materials directly enter the production and from a part of cost of production. Example: Flour in the bread, clay in bricks, leather in bricks, wood in furniture etc. 2. Indirect Materials: Materials which do not form part of the product are called indirect materials. Example: Consumable Stores, Lubricants, Cotton Waste, Service Department, materials.


Direct Labour: Direct Labour consists of wages paid to workers engaged in converting raw-materials into finished products. These wages can be conveniently charged to particular products or Jobs or Process. Example: Wages paid to workers engage in the production of a particular article. Salaries of Inspectors, Analysts etc., Specially required for such production.


Indirect Labour: Indirect Labour is not engaged in production process but only assist production operations. Example: Salaries paid to clerical staff. Wages of Foreman, Wages of Repairers, Time Keepers etc.


Expenses: All the costs other than men and material is termed as expenses. Expenses again divided into i) Direct Expenses : Direct Expenses are those which can be identified and allocated to cost centres and cost units. Example: Patents, Royalties, Designs, Drawings etc. ii) Indirect Expenses : Direct Expenses are those which can be identified and allocated to cost centres and cost units. Ex. Rent, Depreciation, Insurance etc.


Overheads: Overheads consists of all expenses than direct expenses. In general terms, overheads comprise of all expenses incurred for or in connection with general organization of the whole or part of the undertaking. Overheads may be sub-divided into i) works or Factory Overheads, ii) Administrative Overheads, iii) Selling Overheads, iv) Distribution Overheads, v) Research and Development Overheads.

Tenders, Quotations and Estimations: Output costing is particularly employed when Tenders, Quotations and Estimations have to be submitted. The manufacturer has to fix a competitive price keeping in view the likely impact of the inflationary trends on the inputs. Before submitting a tender or fixing price, a manufacturer must have a detailed information regarding cost of raw materials, wages different overheads, and past profit. On the basis of this information, he can prepare an estimated cost sheet. Such an estimate can incorporate the likely increase or decrease in price levels of various components of production. It must, however, be noted here that the amount of overheads in these cases is to be estimated on some basis.

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