Complied by Srinibas Jena – HOD– F&B service – BSHMT – UUC. Page 1 of 31. COST DYNAMICS

A) Elements of Cost 1B) Classification of Cost 1 02

For reference: during the 17th century in France, the Royal Wallpaper Manufactory had a Cost Accounting System. Some iron masters and potters in 18th century in England too had begun to produce Cost Accounting information before the Industrial Revolution.

Modern Cost Accounting developed during the 19th century as a response to management information needs arising out of conditions resulting from the industrial revolution. Mechanization of production & transportation led to the creation of excess capacity by competing groups of investors. This excess capacity forced its owners to wage owners to wage commercial warfare against on another, producing waves of industrial bankruptcies (insolvency, ruin, liquidation, economic failure, and impoverishment), particularly during the second half of the 19 th century. One of the factors underlying this situation was soon recognised; it was knowledge of the consequences on their own economics. By the end of the 19 th century, firms in competitive industries formed trade associations to exchange cost information and eventually developed uniform cost accounting systems for this purpose.

During World War I and II the social importance of cost accounting grew with the growth of each country’s defence expenditure. In the absence of competitive markets for most of the material required to fight war, the Government in several countries placed COST-PLUS contracts under which the price to be paid was the cost of production plus an agreed rate of profit. The reliance on cost information by the parties to defence contracts continued after World War II as well. But during World War II, many Governments also brought down legislation which had the effect of placing almost a blanket control over prices.

Costing: the technique and process of ascertaining costs Cost Accounting: 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: 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.

Cost Dynamics: Do you believe that efficiency and productivity increases lead to lower costs? If you believe that it is cheaper to produce more ‘or’ that productivity leads to reduced costs, you have been fooled by your cost management system. (www. smartpros.com).

Is it cheaper to make 15 units than 05 units, assuming that the same amount of labour is used in each case? Do you believe that efficiency and labour remains same, yet more materials are required to make 15 units than it takes to make 05, how can it be cheaper to make more? If a worker is more efficient, yet the salary paid to the worker is the same, how have costs gone down?

Traditional accounting approaches such as ABC get this problem wrong, but ‘Explicit Cost Dynamics’ (ECD) gets it right, according to Dr. Reginald Thomas Yu-lee, author of Explicit Cost Dynamics ‘&’ Essentials of Capacity Management.

Explicit: open, clear, overt, plain, unambiguous, unequivocal, precise and implicit (antonym)

ECD is a cost management tool that focuses on ensuring that managers understand the impact of their decisions and actions on the bottom line and that cash flow. ECD does this by not allocating costs to products and services and by mathematically modelling how revenues and costs are incurred.What is different about ECD?

The difference between ECD & other approaches is that ECD completely avoids cost allocation. Cost allocation results in ratios such as costs/units. Such ratios, however, create problems. These ratios have cost dynamics that are often the opposite of the bottom line cost dynamics.

Managing the costs/unit ratio allows one to believe that the more that is done, the less it costs. With a fixed numerator such as OVERHEAD (Indirect Material + Indirect Labour + Indirect Expenses), for instance, making more units causes the cost per unit to go down. This is the OPPOSITE what the bottom line sees.

The bottom line sees increases, as the overhead remains the same and more materials are consumed when making more units. The numerator is often the value tied to the bottom line; however, managers often try to manage costs by manipulating the denominator.

If managers are making decisions using the ratio, and if the ratio is the opposite of the bottom line cost dynamics, what does this say about the chances for long term predictability and success?

Rather than allocate costs, ECD understands how costs are incurred. ECD defines costs as resources (capacity), actions and items. ECD describes the cost dynamics of each as they appear on the bottom line. If, for instance, more products are manufactured, ECD predicts the bottom line cost impact more completely and effectively than any other coat management technique that exists.

ECD predicts a cost increase in this case and also reminds the manager that unless the units are sold, profitability and cash flow have been reduced by X and Y respectively.

Complied by Srinibas Jena – HOD– F&B service – BSHMT – UUC. Page 2 of 3

A) Elements of Cost:Elements of Cost

Material Cost

Labour Cost

Overhead Expenses

Direct Material Cost

Indirect Material Cost

Direct Labour Cost

Indirect Labour Cost

Direct Expenses

Indirect Expenses

Overheads

Production ‘or’ works overhead

AdministrationOverhead

Selling Overhead

DistributionOverhead

1. Direct Material: materials which are present in the finished product ‘or’ can be identified in the product are called direct material. For example, Lamb in food dishes making; and materials purchased for specific jobs etc. any additional items purchased to complete the production of a Lamb dish is treated as indirect, because it is used in small quantities ‘or’ due to any suitable reason.

a. Indirect material: materials which do not normally form part of the finished product are known as indirect materials. These are – stores used for maintaining machines & buildings (lubricants, cotton waste, bricks etc.). It also includes stores used by service departments like power house, boiler house, canteen etc.

2. Direct Labour: labour which can be identified ‘or’ attributed wholly to a particular job, product or process or expended in converting raw materials into finished products is called Direct labour. For example, labour engaged on the actual production of the product ‘or’ carrying out the necessary operations for converting the raw materials into finished product.

a. Indirect Labour: A labour cost which cannot be allocated but can be apportioned to ‘or’ absorbed by cost

units ‘or’ cost centres is known as Indirect labour. Examples include – charge hands and supervisors ; maintenance workers; etc. In a Food & Beverage outlet charges for hiring professionals such as Chefs, part-time workers etc. is apportioned as Indirect Labour Cost.

apportioned - (share out, allocate, allot, dole out, assign, dish out, divide up, and distribute)

3. Direct Expenses: it includes all expenses other than DM ‘or’ DL which are specially incurred for a particular product ‘or’ process. Examples of Direct Expenses includes – excise duty, royalty, surveyor’s fees etc.

a. 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 expenses.

4. Overheads: it is the aggregate of IMC+ILC+IE. The main groups are production or works overheads, administration overheads, selling overheads and distribution overheads.

Note:1. Cost Centre: it is defined as a location, person ‘or’ item of equipment (or group of those) for which cost may be

ascertained & used for the purpose of cost control.2. 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; though 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 & value. Typical examples of cost units are given below:

Industry ‘or’ Product Cost Unit Basis

1. automobile Number

2. cement Tonne per bag etc.

3. chemicals Litre, gallon, kilogram, tonne etc.

4. power Kilowatt hour

5. steel Tonne

6. transport Passenger kilometre

7. agriculture Number, tonne, quintal etc.

Complied by Srinibas Jena – HOD– F&B service – BSHMT – UUC. Page 3 of 3

B) Classification of Cost: It means the grouping of costs according to their common characteristics. The important ways of classification of costs are:

01)By nature or element: under this classification, costs are classified into 3 categories: MC, LC and expenses and is useful to determine total cost.

02)By functions: under this classification, according to the function for which they have been incurred. Some examples are-

a. Production cost: the cost of sequence of operations which begins with supplying materials, labour and services and ends with primary packing of the product

b. Selling cost: the cost seeking to create and stimulate demand (sometime termed ‘marketing’) and securing orders.

c. 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.It also includes expenditure incurred in transporting articles to central or local storage. Distribution costs include expenditure incurred in moving articles to and form prospective customers as in case of

goods on sale or return basis. In the gas, electricity and water industry distribution means pipes, mains and services which may be regarded as the equivalent of packaging and transportation.

03)As Direct and Indirect: under this classification, costs are divided as direct costs and indirect costs. Direct costs are those costs which can be identified either with a cost centre ‘or’ with a cost unit. Costs which cannot be identified either with a cost centre or with a cost unit are known as indirect costs.

04)By Variability: according to this classification costs are classified into 3 groups viz. a. Fixed Costs: these are the costs which remains constant at all levels of production. They do not tend

to increase or decrease with the changes in volume of production. For example, rent, insurance of factory building etc., remain the same for different levels of production.

b. Variable Cost: these costs tend to vary with the volume of output. Any increase in the volume of production results in an increase in the volume of production results in an increase in the variable cost and vice-versa. For example, cost of material. Cost of labour, etc.

c. Semi-variable Cost: these costs are partly fixed and partly variable in relation to output. For example, telephone bill, electricity bill, etc.

05)By Controllability: costs 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. Direct costs comprising direct labour, direct material, direct expenses ad some of the overhead are generally controllable at the shop level

b. 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 controlled by the FOREMAN INCHARGE of that section but the share of the tool-room expenditure which apportioned to a machine shop is not to be controlled by the machine shop foreman.

06)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 & Loss Account.