Introduction to Cost Accounting

Samir K Mahajan

MEANING OF COST , COSTING AND COS ACCOUNTING

Cost is amount of resources given up in exchange for some goods and services. Theresources given up are expressed in the form of money or money’s equivalent in monetaryunits.

Costing is the technique and processes for ascertaining cost. These techniques consists ofthe rules or principles which govern the procedure of ascertaining cost or output.

Cost accounting is a specialised branch of accounting which involves classifying, recording,analysing, standardising, comparing, reporting and recommending. Cost accounting isconcerned with

o Ascertaining costo Controlling the costo Reducing the cost

DIFFERENCE BETWEEN COST ACCOUNTING and FINANCIAL ACCOUNTING

Cost Accounting is a branch of accounting and has been developed due to limitations offinancial accounting. Financial accounting is primarily concerned with record keepingdirected towards the preparation of Profit and Loss Account and Balance Sheet. Thelimitations of Financial Accounting which led to the development of cost accountingare as follows.

o Financial accounting aims at finding out results of accounting year in the form of Profitand Loss Account and Balance Sheet. Cost Accounting aims at computing cost ofproduction/service in a scientific manner and facilitate cost control and cost reduction.

o Financial accounting reports the results and position of business to government,creditors, investors, and external parties. Cost Accounting is an internal reporting systemfor an organization’s own management for decision making.

SOME CLASSIFICATION OF COST

Costs may be classified on different bases. They can be classified as follows:

By time (historical, predetermined)

By traceability (direct, indirect)

By nature of elements (material, labour, overhead)

By association (product or period)

By changes in activities or volume (fixed, variable, semi-variable)

By function (manufacturing, administration, selling, research and development)

CLASSIFICATION ON THE BASIS OF TIME

Historical costs: Historical costing or actual costing is a system where costs areascertained after they are incurred. It is a post-mortem of the costs. Historical costingdoes not help in finding mistakes and inefficiencies, which all lead to variation in profit.

Predetermined costs: Costs are calculated before they are incurred, i.e., before theproduction process is completed. These predetermined costs may further be classifiedinto estimated costs and standard costs

o Estimated costs: Costs are estimated before goods are produced. As these are purelyestimates, they lack accuracy.

o Standard costs (Budgeted costs, projected costs, model costs, measured costs,specification costs) : Due to these disadvantages and limitations of historical costing, thestandard costing technique was introduced. A standard cost is a predeterminedcalculation of how much costs should be under specific working conditions. It is atechnique of cost control. Actual costs are compared with these standard costs. Theobjective of standard cost is to ascertain the quotation and determination of price policy.

CLASSIFICATION BY TRACEABILITY

Traceable cost can be easily identified with cost centres (product or job or process or production unit). By traceability costs may be direct or indirect. These terms should be understood properly, as the same will be applied in case of materials, labour and other expenses.

Direct costs: In general, production is carried on in different cost centres. Costs whichcan be directly identifiable with cost centres, processes or production units are knownas direct costs.

Indirect costs: If costs cannot be identifiable with cost centres or cost units, they aretermed as “indirect costs”. Such costs that cannot be easily identifiable with cost centreshave to be apportioned on some equitable basis.

CLASSIFICATION OF COST BY ELEMENTS or NATURE

Elements of costs may be broadly divided into material, labour and other expenses. Theseelements are further analysed into different sub-elements as shown in the followingdiagram:

Material Costs: Commodities or substances from which products are produced arecalled materials. It may be in a raw or a manufactured state. They may be furtherdivided into direct and indirect. Material costs include

cost by elements or nature

o Direct materials: Direct materials are thosematerials which enter into and form part ofthe finished product. e.g., wood in furniture,chemicals in drugs, leather in shoes. etc.Direct materials include:

All specially purchased or requisitionedfor a particular process or job or order

All components—purchased or produced All materials passing from one process to

another All primary packing materials

o Indirect materials: Materials which cannotbe traced as part of the finished productare known as indirect materials. IndirectMaterial Cost is used for ancillarypurposes of the business. Consumable stores such as Fuel,

lubricating oil, grease, cotton etc. (formaintenance of plant and machinery)

Tools of small value for general use Printing and stationery materials Stores of small value used

Labour Costs : This is the cost, incurred in the form of remuneration paid to the employees orlabours of the organisation. The workforce required to convert material into finished productis called labour. It can be direct or indirect. Labour costs can also be classified into direct labourand indirect labour.

o Direct labour: When employees areemployed directly in making the product(manufacturing process) and their work canbe easily identified in the process ofconversion of raw materials into finishedgoods, such labour is called direct labour.The cost incurred on direct labour is calleddirect wages. These costs are easilyidentified with the individual cost centreExample: Wages paid to the driver of a busin a transport service.

o Indirect labour: Indirect Labour Cost is thecost incurred on those employees who donot directly take part in the manufacturingprocess. These costs ancillary toproduction is known as indirect labour. Thecost incurred on indirect labour is calledindirect wages. These costs may not betraced to specific units of output or costscentres. Example: wages of store keepers,director’s salary, salary of foreman, timekeepers, salary or employees, supervisorsetc.

cost by elements or nature

Expenses: Expenses are the costs of services provided to the organisation. It can be direct or indirect. :Expenses also can be direct and indirect.

o Direct expenses: Direct expenses arecharge to production directly anddoes not include direct material costand direct labour cost. Example: costof special pattern, drawing or layout;secret formula, hire charges ofmachinery, tools or equipment,consultancy fees to a specific job.Generally, direct expenses form asmall part of total cost.

o Indirect expenses: Expenses whichcannot be charged to productiondirectly and which are neither indirectmaterial cost nor indirect wages costare treated as indirect expenses.Indirect Examples: Rent, rates, taxes,power, insurance, depreciation,lighting, telephone expenses, insurance

cost by elements or nature

OVERHEADS : Overheads include the cost of indirect material, indirect labour and indirectexpenses. These cannot be associated directly with specific products. Overheads may beclassified into :

o Production or manufacturing or factory overhead: Production or factory overhead is theaggregate of

indirect material cost (lubricants, cotton waste, hand tools, works stationery) , indirect wages (gate-keeper’s salary, time-keeper’s salary, manager’s salary) and indirect expenses (factory rent, factory insurance factory lighting) incurred in respect of

manufacturing activity.

o Administration overhead: Such cost includes indirect materials (rooms, storage, dusters, printing and stationary materials), indirect labour (office accountant, Directors’ remuneration, office manager, clerks), indirect expenses (lighting, rents insurance) incurred in general administration and office.

o Selling and Distribution overhead: Such expenses are generally incurred when the product is insaleable condition. Such overhead is the sum total of

o indirect material cost (printing and stationary material, packing, rates and taxes for finishedgoods),

o indirect labour (salaries and commission of sales man, sales manager salaries), and

o indirect expenses(advertising, transportation, insurance, rent , go-down expenses) incurred increating and stimulating demand for a firm’s products and securing orders and fordelivering/dispatching products and making them available to customers.

CLASSIFICATION OF COSTS BY ASSOCIATION (PRODUCT AND PERIOD)

Cost can be Product cost and Period cost.

Product Costs: Costs that become part of the cost of goods manufactured are called product costs. Suchcosts are charged on manufacturing process either directly as material and labour costs or indirectly asoverheads. Examples of products costs are raw material, labour, factory depreciation, fuel and packagingcosts. Product costs are further classified into direct material, direct labour and factory overhead.

Period Costs: Period costs are not charged on the manufacturing process and therefore these cannot beassigned to cost goods manufactured. Period costs are thus expensed in the period in which they areincurred. Example of period costs are advertising, sales commissions, office supplies, office depreciation,legal and research and development costs. Period costs may be further classified into selling costs andadministrative costs.

CLASSIFICATION OF COSTS BY CHANGES IN ACTIVITIES OR VOLUME OR BEHAVIOUR

Cost can be fixed, variable and semi-variable.

Fixed Cost: Fixed costs are those which are not expected to change in total within thecurrent budget year, irrespective of variations in the volume of activity. Such costs arefixed for a given period over a relevant range of output, on the assumption thattechnology and methods of manufacturing remain unchanged. Example: Rent, rates,taxes, insurance, management salary etc

To illustrate, a factory manufacturing CDs incurs a fixed cost of Rs. 1,00,000 per annum(which includes rent, depreciation of plant and machinery, insurance of all fixed assets,salaries of staff). The existing volume of production is 10,000 CDs per annum. If theproduction increases to 20,000 CDs, the total fixed cost remains the same i.e., Rs. 1,00,000only. But the average fixed cost per unit will come down from (Rs. 1,00,000 ÷ 10,000) Rs. 10to (Rs. 1,00,000 ÷ 20,000) Rs. 5 per unit.

Variable Cost or marginal costs or engineeredcosts : Variable costs vary directly andproportionally with the output. The totalvariable costs change corresponding to thelevels of output but variable cost per unit isconstant. Example: Materials used tomanufacture a product, wages of workers in amanufacturing process.

To illustrate, let direct material cost to produce oneunit of a product be Rs. 25. The existing volume ofproduction is 10,000 units per annum, then theexisting direct material cost is 10,000 units × Rs. 25= Rs. 2,50,000. In case, if the production increasesto 20,000 units, the direct material cost would beRs. 25 × 20,000 units = Rs. 5,00,000. This showsthat the direct material cost per unit remainsconstant but total material cost rises with anincrease in activity level.

Semi-Variable Costs: Semi-variable costsconsist of features of both fixed and variablecosts. Due to the fixed part of the element,they do not change in direct proportion tooutput. Due to the variable part of theelement, they tend to change with volume.Semi-variable costs change in the samedirection of output but not in the sameproportion. Example: electricity charges,stationery, telephone expenses.

To illustrate, telephone expenses is a semi-variable cost. Annual rental is Rs.1000. Forevery call used the charge per call is Re. 1.Here the annual rental is the fixed part of theelement—remains unchanged—whereas thecall made forms the variable element. It variesas per usage.

FUNCTIONAL CLASSIFICATION OF COSTS

Production costs: They are the cost of operating a production department in which manual and machineoperations are performed directly upon any part of product manufactured. This includes the cost of directmaterials, direct labour, direct expenses, primary packing expenses and all overhead expenses pertaining toproduction.

Administration costs: These expenses include all indirect expenses incurred in formulating the policy, directingthe organization and controlling the operation of a concern. The expenses relating to selling and distribution,production, development and research functions are not to be included under this head.

Selling and distribution costs: These expenses include all expenses incurred with selling and distributionfunctions. Research and development costs: These include the cost of discovering new ideas, processes orproducts by research and the cost of implementation of such results on a commercial basis.

Pre-production costs: when a new manufacturing unit is started or a new product is launched, certain expensesare incurred. There would be trial runs. All such costs are called preproduction costs. They are charged to thecost of future production because they are treated as deferred revenue expenditure.

Research and Development Cost: They include cost of discovering new ideas, processes, products byexperiments and implementing such results on a commercial basis.

METHOD/ TECHNIQUES OF COSTING

For ascertaining cost and managerial decision making, following techniques of costing areusually used:

Uniform Costing: The practice in which common methods of costing for differentundertakings in the same industry are used is known as uniform costing.

Historical Costing: In this technique, ascertainment of cost is done after they have beenincurred but the utility of this technique is limited.

Direct Costing: The practice of charging all direct costs to operations, processes orproducts while leaving all indirect costs to be written off against profits in which theyarise are called as direct costing.

Absorption Costing: In this all costs, both variable and fixed are charged to production,operations or processes.

Method/TECHNIQUES OF COSTING contd

Marginal Costing: The method of ascertaining marginal cost by differentiating betweenfixed and variable costs. This technique is used to ascertain effect of changes in volume ortype of output over the profits.

Standard /Budget Costing: The preparation of standard costs and applying them tomeasure the variations from actual cost and analysing the causes of variations with a viewto maintain maximum efficiency in production is known as standard costing.

Activity Based Costing: ABC is a system that focuses on activities as fundamental costobjects and utilizes the cost of these activities as building blocks or compiling the costs ofother cost objects.