L-24-COST ACCOUNTING
PAGE 33 —
CHAPTER 24: COST ACCOUNTING
Introduction
Michael E. Porter in his theory of Generic Competitive Strategies has described ‘Cost Leadership’ as one of the three strategic dimensions (others are ‘Product differentiation’ and ‘Focus or Niche’) to achieve competitive advantage in Industry.
Cost Leadership implies producing goods or Provision of services at Lowest cost while maintaining quality to have better competitive price. Cost Leadership can be achieved if an entity has a robust Cost & Management Accounting System in place.
Cost Accounting is also considered a subset of managerial accounting, its end goal is to advise the management on how to optimize business practices and processes based on cost efficiency and capability. Cost accounting provides the detailed cost information that management needs to control current operations and plan for the future.
Some Definitions
Cost — Cost is the amount of resource given up in exchange of some goods or services. It can be defined as the amount of expenditure (actual or notional) incurred on or attributable to a specified article, product or activity.
Costing — It is a technique and process of ascertaining costs. These techniques consist of principles and rules which govern the procedure of ascertaining cost of product or services.
Cost Accounting — It is defined as the process of accounting for cost. It may be regarded as a specified branch of accounting which involves classification, accumulation, assignment and control of costs.
Cost Accountancy — Cost Accountancy is defined as “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 the presentation of information for the purpose of managerial decision-making.”
Cost Management — It is an application of management accounting concepts, methods of collections, analysis and presentation of data to provide the information needed to plan, monitor and control costs.
PAGE 34 — COST ACCOUNTING VS FINANCIAL ACCOUNTING
Cost Accounting vs Financial Accounting
Cost Accounting refers to that branch of accounting which deals with ascertainment of costs incurred in the production of units of an organization. On the other hand, financial accounting refers to the accounting concerned with recording financial data of an organization, in order to know the financial performance and financial position of the business.
Objectives of Cost Accounting
The page contains a flowchart headed “Objectives of Cost Accounting” with the following structure:
OBJECTIVES OF COST ACCOUNTING
|
----------------------------------------------------------------
| | | | |
Ascertainment Determination Cost Cost Assisting
of Cost of Selling Price Control Reduction management
and Profitability in
decision
making
Cost Control
|
+-- Determination of pre-determined standard
+-- Measurement of actual performance
+-- Comparison
+-- Analysis of variance and action
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Cost ascertainment: The main objective of Cost Accounting is accumulation and ascertainment of Cost of a particular Cost Object.
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Determination of selling price and Profitability: To determine Selling Price of the cost Object. Though in a competitive business environment selling prices are determined by external factors but cost accounting system provides a basis for Price Fixation and rate negotiation.
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Cost control: It ensures that expenditures are in consonance with predetermined set standard and any variation from these set standards is noted and reported on continuous basis.
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Cost reduction: To reduce costs. No cost is termed as lowest and every possibility of cost reduction is explored.
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Assisting management in decision making: Cost & Management Accounting by providing relevant information, assist management in planning, implementing, measuring, controlling and evaluating various activities.
PAGE 35 — COST OBJECTS AND ELEMENTS OF COST
Cost Objects
Cost Object is anything for which a separate measurement of cost is required. Cost object may be a product, a service, a project, etc.
Examples of cost objects
| Cost Object | Examples |
|---|---|
| Product | Smart phone, Tablet computer, SUV Car, Book etc. |
| Service | An airline flight from Delhi to Mumbai, Concurrent audit assignment, Utility bill payment facility etc. |
| Project | Metro Rail project, Road projects etc. |
| Activity | Quality inspection of materials, Placing of orders etc. |
| Process | Refinement of crudes in oil refineries, melting of billets or ingots in rolling mills etc. |
| Department | Production department, Finance & Accounts, Safety etc. |
ELEMENTS OF COST
The Cost of a product consists of three elements i.e., Material, Labor & Expenses.
The page contains a diagram:
COST
|
-----------------------------------------
| | |
MATERIAL LABOUR EXPENSES
| | |
--------------- --------------- ---------------
| | | | | |
DIRECT INDIRECT DIRECT INDIRECT DIRECT INDIRECT
MATERIAL MATERIAL LABOUR LABOUR EXPENSES EXPENSES
\ / \ / \ /
\ / \ / \ /
\ / \ / \ /
---------- PRIME COST ------
\________________________________________/
|
OVERHEADS
The formulas shown are:
Direct material + Direct labour + Direct expenses = Prime Cost
Indirect material + Indirect labour + Indirect expenses = Overheads
The page also contains the labels:
- Cost
- Material
- Direct material
- Indirect Material
- Labour
- Direct Labour
- Indirect Labour
- Expenses
- Direct expenses
- Indirect Expenses
- Prime cost
- Overheads
PAGE 36 — TOTAL COST AND CLASSIFICATION OF COSTS
Total Cost of a Product
In order to calculate total cost of a product, we have to sum up all the costs i.e.
| Particulars | Amount |
|---|---|
| Direct Material | XXX |
| (+) Direct labour | XXX |
| (+) Direct Expense | XXX |
| Prime cost | XXX |
| (+) Factory overhead (Production overhead) | XXX |
| Factory cost | XXX |
| (+) Office and administration overhead | XXX |
| Cost of production | XXX |
| (+) Selling and distribution overhead | XXX |
| Cost of sales (Total cost) | XXX |
| (+) profit/ (loss) | XXX |
| Sales | XXX |
Overheads Diagram
The page contains a diagram:
OVERHEADS
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---------------------------------------------
| | |
Factory/Production Office & Administration Selling and
Overhead Overhead Distribution
Overhead
Classification of costs
1. By nature or element
1. Materials: — The materials directly contributed to a product and those easily identifiable in the finished product are called direct materials. For example, paper in books, wood in furniture, plastic in a water tank, and leather in shoes are direct materials. Other, usually lower cost items or supporting material used in the production of in a finished product are called indirect materials. For example, the length of thread used in a garment.
PAGE 37 — CLASSIFICATION OF COSTS
2. Labour: — Any wages paid to workers or a group of workers which may directly co-relate to any specific activity of production, maintenance, transportation of material, or product, and directly associate in the conversion of raw material into finished goods are called direct labour. Labour costs which cannot be allocated but can be apportioned to or absorbed by a product are called indirect labour. E.g., salary of supervisor in factory.
3. Expenses: — All expenses other than material or labour are called as expenses. The expenses which are specially incurred for a particular Cost Object and can be identified are termed as Direct Expense. E.g., Hire Charges of Special Machinery. Expenses other than direct expenses are known as Indirect Expenses. For e.g., Factory Rent, electricity etc.
2. By Functions
1. Manufacturing and Product Cost: This is the total of costs involved in manufacture, construction and fabrication of units of production.
2. Commercial Cost: This is the total of costs incurred in the operation of a business undertaking other than the cost of manufacturing and production.
Commercial cost may further be sub-divided into:
(a) Administrative cost, and
(b) Selling and distribution cost.
3. By Degree of traceability to product
1. Direct Cost: Costs that can be directly related to the production of goods and services. For example, for a company that produces furniture, the funds that are spent on wood, paint, varnish, and the labour cost for hiring a craftsman will be direct costs. This is because these costs can be directly associated with the production of the furniture.
2. Indirect Cost: Costs that cannot be directly associated with the production of goods and services. Taking the previous example into consideration; indirect costs for a furniture business would be the rent that is paid for the building and office space, utility bills, administrative expenses, etc.
4. By changes in Activity or volume
1. Fixed Cost: Fixed costs are commonly described as those which remain fixed in total amount with increase or decrease in the volume of output or productive activity for a given period of time. Fixed cost per unit decreases as production increases and increases as production declines. Examples of fixed costs are rent, insurance of factory building, factory manager’s salary etc. These fixed costs are constant in total amount but fluctuate per unit as production changes.
PAGE 38 — CLASSIFICATION OF COSTS
2. Variable Cost: Variable costs are those which vary in total in direct proportion to the volume of output. These costs per unit remain relatively constant with changes in production. Thus, variable costs fluctuate in total amount but tend to remain constant per unit as production activity changes. Examples are direct material costs, Direct labour costs, Power, repairs etc.
3. Semi Variable Cost: Semi-variable costs are those which are partly fixed and partly variable. For example, telephone expenses include a fixed portion of monthly charge plus variable charge according to calls; thus, total telephone expenses are semi-variable.
5. By controllability
1. Controllable Cost: Costs are those which can be influenced by the action of a specified member of an undertaking, that is to say, costs which are at least partly within the control of management. Generally speaking, all direct costs including direct materials, direct labour and some of the overhead expenses are controllable by lower level of management.
2. Uncontrollable Cost: Costs are those which cannot be influenced by the action of a specified member of an undertaking, that is to say, which are not within the control of management. Most of the fixed costs are uncontrollable. For example, rent of the building is not controllable and so is managerial salaries.
6. By Normality
1. Normal Cost: It is the cost which is normally incurred at a given level of output in the conditions in which that level of output is normally attained. It is a part of cost of production.
2. 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 not a part of cost of production and charged to costing profit and loss account.
7. By Relationship with accounting period
1. Capital Cost: The cost which is incurred in purchasing an asset either to earn income or increasing the earning capacity of the business is called capital cost, for example, the cost of a rolling machine in case of steel plant. Such cost is incurred at one point of time but the benefits accruing from it, is spread over a number of accounting years.
PAGE 39 — CLASSIFICATION OF COSTS
2. Revenue Cost: If any expenditure is done in order to maintain the earning capacity of the concern such as cost of maintaining an asset or running a business it is revenue expenditure e.g., cost of materials used in production, labour charges paid to convert the material into production, salaries, depreciation, repairs and maintenance charges, selling and distribution charges etc.
8. By Time
1. Historical Cost: The costs which are ascertained after being incurred are called historical costs. Such costs are available only when the production of particular thing has already been done. Such costs are only of historical value and not at all helpful for cost control purposes.
2. Pre-determined Cost: Such costs are estimated costs i.e., computed in advance of production taking into consideration the previous period costs and the factors affecting such costs. Predetermined cost determined on scientific basis becomes standard cost. Such costs when compared with actual costs will give the reasons of variance and will help the management to fix the responsibility and to take remedial action to avoid its recurrence in future.
9. According to planning
1. Budgeted Cost: It is the estimated cost of a specified period, calculated using standard cost for the estimated output or activity levels of that period.
2. Standard Cost: It is the cost of best practice that may remain same for a longer period or may not change period to period.
10. By Association with the product
1. Product Costs: Costs which are traceable to the product (directly related to the production) and are included in inventory valuation. It comprises direct materials, direct labour and manufacturing overheads in case of manufacturing concerns.
2. Period Costs: Costs which are incurred on the basis of time such as rent, salaries etc. These are charged to the period in which these are incurred and treated as expense.
11. For Managerial decisions
1. Marginal Cost: It is the total of variable costs i.e., prime cost plus variable overheads. It is based on the distinction between fixed and variable costs.
2. Out of pocket Cost/Explicit Costs: This is that portion of the costs which involves payment to outsiders i.e., gives rise to cash expenditure as opposed to such costs as depreciation, which do not involve any cash expenditure. Such costs are relevant for price fixation during recession or when make or buy decision is to be made. Out of Pocket costs can be avoided or saved if a particular proposal under consideration is not accepted.
PAGE 40 — MANAGERIAL COSTS AND METHODS OF COSTING
3. Differential Cost: The change in costs due to change in the level of activity, technology or method of production is known as differential cost. If the change increases the cost, it will be called incremental cost. If there is decrease in cost resulting from decrease in output, the difference is known as decremental cost.
4. Sunk Cost: A sunk cost is an irrecoverable cost historical cost incurred in the past and the future cost obligation of which already has been decided is a sunk cost. For example, in the case of decision related to the replacement of a machine, the written down value of the of existing machine less its salvage value is a sunk cost. Such costs are not relevant for decision-making and are not affected by increase or decrease in volume. Thus, expenditure which has taken place and is irrecoverable in a situation is treated as sunk cost.
5. Imputed or Notional Cost: The value of a benefit where no actual cost is incurred”. Even though such costs do not involve any cash outlay but are taken into consideration while making managerial decisions. Example of such costs are: Notional rent charged on business premises owned by the proprietor, interest on capital for which no interest has been paid.
6. Opportunity Cost: It refers to the value of sacrifice made or benefit of opportunity foregone in accepting an alternative course of action.
7. Replacement Cost: It is the cost at which there could be purchase of an asset or material identical to that which is being replaced or revalued. It is the cost of replacement at current market price.
Methods of costing:
Costing methods are those which help a firm to compute the cost of production or services offered by it.
1. Single or output costing — Similar units of a single product, produced by single process. Under this method, the cost of a product is ascertained, the product being the only one produced like bricks, cement etc.
2. Job Costing — When production/work is carried out according to the requirements of customers. It is suitable in all cases where work is undertaken on receiving a customer’s order like a printing press.
3. Batch Costing — It is an extension of Job Costing. It is a form of job costing that is applied when the articles are produced in batches, i.e., a group of like units are
PAGE 41 — METHODS OF COSTING AND TECHNIQUE OF COSTING
produced. Here cost per unit is determined by dividing the cost of the batch by the number of units produced in the batch.
4. Process Costing — Under this method, the cost of completing each stage of work is ascertained, like cost of making pulp and cost of making paper from pulp. It includes series of processes or continuous process.
5. 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.
6. 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.
7. Multiple costing — It is a combination of two or more methods of costing. For ex. In case of bicycle manufacturing the parts will be computed by the system of job or batch costing but the cost of assembling the bicycle will be computed by single or output method. The whole system of costing is known as multiple costing.
Name of the Industry — Method of Costing
| Name of the Industry | Method of Costing |
|---|---|
| Sugar Industry | Process costing |
| Toy Making | Batch costing |
| Printing | Job costing |
| Hospital | Service/Operating |
| House building | Contract costing |
| Oil refining | Process Costing |
| Bicycle manufacturing | Multiple costing |
| Coal | Single unit or output |
Technique of Costing
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.
1. 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.
PAGE 42 — COSTING TECHNIQUES AND COST SHEET
Fixed costs are not absorbed in the production units. They are written off to the costing profit and loss account.
2. Absorption costing: It is the practice of charging all costs, both variable and fixed to probations, processes or products. This differs from marginal costing where fixed costs are excluded.
3. Standard Costing: Standard costs are predetermined costs relating to material, labour 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, labour and overheads. The main objective of fixation of standard cost is to have benchmark against which the actual performance can be compared. This means that the actual costs are compared with the standards. The difference is called as ‘variance’. If actual costs are more than the standard, the variance is adverse whereas if actual costs are less than the standard, the variance is favourable. The adverse variances are analyzed and reasons for the same are found out. Favourable variances may also be analyzed to find out the reasons behind the same. Standard costing, thus is an important technique of cost control and reduction.
4. Budget and Budgetary control: Budget is defined as a quantitative and/ or 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. Budget is always prepared for future and that too for a defined future. Budgetary control involves preparation of budgets and continuous comparison of actual with budgets so that necessary corrective action can be taken.
Cost sheet
Cost sheet is a statement designed to show the output of a particular accounting period along with break-up of costs.
VISUAL / DIAGRAM CHECK
The source contains visual elements on the following pages, and they have been transcribed above:
- Page 34: “Objectives of Cost Accounting” flowchart, including the Cost Control sub-steps: determination of pre-determined standard, measurement of actual performance, comparison, and analysis of variance and action.
- Page 35: “Examples of cost objects” table and the Elements of Cost hierarchy/diagram showing Material, Labour, Expenses, their Direct/Indirect branches, and the resulting Prime Cost and Overheads.
- Page 36: Overheads diagram showing Factory/Production Overhead, Office & Administration Overhead, and Selling and Distribution Overhead; plus the complete cost-build-up table from Direct Material through Sales.
- Page 41: Industry-to-method-of-costing table.
All text visible in the source’s parsed pages has been included, and the image-based tables/diagrams have been converted into text/Markdown representations without intentionally omitting their visible content.
