CHAPTER 1 BASIC COST CONCEPTS 1. BASICS

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1 CHAPTER 1 BASIC COST CONCEPTS 1. BASICS 1. Define the term Cost. Compare it with Value and Price. 1) Meaning of Cost: (a) Cost refers to the expenditure incurred in producing a product or in rendering a service. (b) Cost is a measurement, in monetary terms, of the amount of resources used for the purpose of production of goods or rendering services. (c) Cost is expressed from the producer or manufacturer s viewpoint, (i.e. not that of consumer / end user). (d) Cost ascertainment is based on uniform principles and techniques. 2) Comparative Analysis between Value, Price and Cost Particulars Value Price Cost (a) Meaning Relative Worth of Amount paid by Expenditure a commodity to an consumer in incurred in individual at a exchange for a producing a particular point of product / service. product or in time. rendering a service. (b) Ascertainment User s viewpoint. Consumer s viewpoint Producer s viewpoint (c) Differentiation / Different persons Price differentiation Ascertained on the Subjectivity attach different / discrimination is basis of uniform values to a product possible on principles. Hence it at different points customer / time is objectively of time. basis. determined. (d) Inference Opinion Policy Fact 2. Define the terms Costing, Cost Accounting and Cost Accountancy. 1) Costing: The technique and process of ascertaining costs. 2) Cost Accounting: The process of accounting for cost which begins with 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. 3) 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. 3. List the objectives of Cost Accounting The primary objective of study of cost is to contribute to profitability through Cost Control and Cost Reduction. The following objectives of Cost Accounting can be identified 1) Ascertainment of Cost: This involves collection of cost information, by recording them under suitable heads or account, and reporting such information on a periodical basis. 2) Determination of Selling Price: Selling Prices are influenced by internal and external factors. However, generally, prices cannot be fixed below cost. Hence, Cost Accounting is required for determination of appropriate Selling Prices. 3) Ascertaining the profit of each activity: Profit of each department / activity / product can be determined by comparing its revenue with appropriate cost. So, Cost Accounting ensures profit measurement on an objective basis Page 1

2 4) Assisting Management in decision making: Business decisions are taken after analyzing cost and benefits of each option, and the Manager chooses the least cost option. Thus, Cost Accounting and reporting system assists Managers in their decision making process. 5) Cost Control and Cost Reduction: In the long run, higher profits can be achieved only through Cost Control and Cost Reduction. Cost Accounting seeks to ensure profit by providing support for cost control / reduction decisions. 4. Distinguish between Cost Reduction and Cost Control. Particulars Cost Reduction Cost Control 1. Permanence Permanent, Real and genuine savings in cost. Could be a temporary saving also. 2. Saving Focus Saving in Cost per unit. Saving either in Total Cost or Cost per unit. 3. Product Product s Utility, Quality & Quality Maintenance is not a Quality Characteristics are retained. guarantee. 4. Performance Evaluation It is not concerned with maintenance of performance according to standards. The process involves setting up a target, investigating variances and taking remedial measures to correct them. 5. Nature of Continuous process of critical Control is achieved through Standards examination includes analysis and challenge of standards. compliance with standards. Standards by themselves are not examined. 6. Dynamism Fully dynamic approach. Less dynamic than Cost 7. Coverage Universally applicable to all areas of business. Does not depend upon standards, though target amounts may be set. 8. Nature of Emphasis here is partly on present Costs costs and largely on future costs. 9. Analysis To find out substitute ways and new means. 10. Nature of Function (a)value Engineering, (b) Standardization and Simplication, (c) Work Study, (d) Variety Reduction, (e) Quality Measurement & Research, (f) Operations Research, (g) Market Research, (h) Job Evaluation and Merit Rating, (i) Improvement in Product Design, (j) Mechanisation and Automation, etc. Reduction. Limited applicability to those items of cost for which standards can set. Emphasis on present and past behavior of costs. Competitive analysis of actual results with established norms. Budgetary Control and Standard Costing. 5. Compare Cost Accounting with Financial Accounting. Does Cost Accounting supplement Financial Accounting? Discuss. The broad areas of difference between Financial and Cost Accounting are Particulars Financial Accounting Cost Accounting 1. Users of Information Financial Statements are used by Internal management and also outside parties like Government, Detailed cost information is presented to internal management for proper planning, decision Page 2

3 2. Statutory Compliance 3. Nature / Objectivity Creditors, Customers, Employees, etc. Requirements of Statutes like Companies Act, Income Tax Act, etc. are met through Financial Accounting. Transactions are recorded in a subjective manner. Accounting Policies may differ from one Firm to another Firm. 4. Focus Focus of accounting is on recording the transactions. 5. Nature of Cost Generally Historical Costs are used for recording purposes. Projected Financial Statements may also be drawn for budgeting purposes. 6. Stock Valuation Stocks are valued at Cost or Net Realisable Value whichever is less. 7. Cost Cost / Expenditure and Profits are Analysis generally shown as a whole for the period. 8. Time Period Financial Statements are generally prepared at the end of the financial period, usually one year, for reporting purposes. 9. Forecasting & Planning 10. Utility for decisions 11. Control and Assessment Has limited use for forecasting and planning. Only broad parameters like GP, NP, ROI, EPS, etc. can be laid down. Helps only for future decisions with respect to product pricing, make or buy, asset retainment vs replacement, etc. Financial Accounting suffers from limitations of lack of analysis of information, and absence of detailed control and assessment parameters. making and cost control. Generally Cost Accounting is voluntary, except in cases where Cost Accounting Records Rules mandatorily apply to the enterprise. Expenditure is recorded in an objective manner. Costing principles and techniques are generally uniform to all Firms. Focus of accounting is to control cost. It considers both historical costs and predetermined, i.e. Standard Costs. It also extends to plans and policies to improve future performance. Stocks are valued generally at Cost. Costs are analysed product wise, department wise, activity wise, etc. Cost data and reports are presented on a continuous basis for the Cost Period. The cost period (also called Control Period) may be shorter than the financial year. Specific and detailed plan for each product / activity / sub level can be laid down. Hence, more useful for budgeting. Helps Current & future decisions, e.g. product price reduction and higher volume in order to earn target profit, resource re allocation, etc. Better tools of control, analysis and assessment are available, some examples are Variance Analysis, Budgetary Control, & Marginal Costing. Note: Cost Accounting supplements Financial Accounting for analysis and decision making purposes, as described above Page 3

4 COST CLASSIFICATION BASES Time Period based Current Historical Pre determined Functions based Production Administration Selling Distribution R & D Pre production Conversion Variability based Fixed Variable Semi variable COST Elements based Materials Labour Expenses Relationship based Direct Indirect Controllability based Controllable Non Controllable Normality based Normal Abnormal Payment based Explicit Implicit Cause & Effect based Engineered Discretionary Decision making based Relevant Irrelevant Attributabillity based Product Period 6. How are Costs analysed based on Behaviour / Nature / Variability? On the basis of Behaviour / Nature / Variability, Costs are classified as under Type and Description 1. Fixed Cost is the cost which does not vary with the change in the volume of activity in the short run. These costs are not affected by temporary fluctuation in activity of an enterprise. These are also known as Period Costs. 2. Variable Cost is the cost of elements which tends to directly vary with the volume of activity. Variable Cost has two parts (a) Variable Direct Cost, and (b) Variable Indirect Costs. Variable Indirect Costs are termed as Variable Overhead. 3. Semi Variable Costs contain both fixed and variable elements. They are partly affected by fluctuation in the level of activity. 7. Distinguish between Committed Fixed Costs and Discretionary Fixed Costs. Examples Salaries, Rent, Insurance, Audit Fees, Depreciation, etc. Materials Consumed, Direct Labour, Sales Commission, Utilities, Freight, Packing, etc. Factory Supervision, Maintenance, Power, Telephone, etc. Particulars Committed Fixed Costs Discretionary Fixed Costs 1. Meaning These are Fixed Costs that arise from the possession of Assets, i.e. Plant, Building and Equipment (e.g. Depreciation, Rent, Taxes, Insurance Premium etc.) or 2. Short Run control A basic organization (e.g. Salaries of Staff) These costs remain unaffected by any short term changes in volume of production. These are Fixed Costs incurred as a result of Management s discretion / decision. It arises from periodic (usually yearly) decisions regarding the maximum outlay to be incurred. (e.g. advertising) These cannot be changed or altered in the very short run Page 4

5 3. Effect on Any reduction in Committed Fixed Discretionary Fixed Costs can Long term Costs under normal activities of the change from year to year, without Objectives concern would have adverse effects on disturbing the long term the concern s long term objectives. objectives. So, these are escapable costs. 4. Control Such costs cannot be controlled. These costs can be controlled. 5. Inference Also known as Unavoidable Fixed Costs. 8. How are Costs classified on the basis of Elements? On the basis of elements, Costs are classified as under Type and Description 1. Material Cost is the cost of material of any nature used for the purpose of production of a product or a service. 2. Labour Cost means the payment made to the employees, permanent or temporary, for their services. (N 01) 3. Expenses are other than Material Cost or Labour Cost, which are involved in an activity. 9. How are Costs classified on the basis of Relationship? Also known as Avoidable Fixed Costs. Explanation Material Cost includes cost of Procurement, Freight Inwards, Taxes & Duties, Insurance, etc, directly attributable to the acquisition. Trade Discounts, Rebates, Duty Drawbacks, Refunds on account of MODVAT, CENVAT, Sales Tax and other similar items are deducted in determining the costs of material. Labour Cost includes Salaries and Wages paid to permanent employees, temporary employees and also to employees of the contractor. Salaries & Wages include all Fringe Benefits like PF Contribution, Gratuity, ESI, Overtime, Incentives, Bonus, Ex-Gratia, Leave Encashment, Wages for Holidays and Idle Time, etc. Expenditure on account of utilities, payment for bought out services, job processing charges, etc. can be termed as Expenses. Based on Relationship, costs are classified into Type and Description 1. Direct Costs: Costs which are directly related to / identified with / allocated to a Cost Centre or a Cost Object, in an economically feasible way, are called Direct Cost. Total of all Direct Costs is called Prime Cost. 2. Indirect Costs: All Costs other than Direct Costs are called Indirect Costs. Total of all Indirect Costs is called as Overheads (or Oncost), since they are generally incurred over various products (Cost Units), various departments (Cost Centres) and over various heads of expenditure accounts. Components Direct Material Cost, Direct Labour Cost, and Direct Expenses. Indirect Material, Indirect Labour, and Indirect Expenses. A summary of Direct and Indirect Costs is given below Item and Description Example 1. Direct Material: Costs of Material which can Raw Materials Consumed for production for be directly allocated to a Cost Centre or a Cost a product or service, which are identifiable Object in an economically feasible way. in the product or service. 2. Direct Labour: Cost of Wages of workers Wages include all Fringe Benefits like PF Page 5

6 who are readily identified or linked with a Cost Centre or Cost Object. 3. Direct Expenses: Expenses other than Direct Material or Direct Labour, which can be identified or linked with the Cost Centre or Cost Object. 4. Indirect Material: Cost of Material which cannot be directly allocable to a particular Cost Centre or Cost Object. 5. Indirect Labour: Wages of Employees which are not directly allocable to a particular Cost Centre. 6. Indirect Expenses: Expenses other than of the nature of Material or Labour, and cannot be directly allocable to a particular Cost Centres. Contribution, Gratuity, ESI, Overtime, Incentives, Bonus, Ex Gratia, Leave Encashment, Wages for holidays and idle time, etc. Expenses for special moulds used in a particular Cost Centre, Hire Charges for tools & equipments for a Cost Centre, Royalties in connection to a product, Job Processing Charges, etc. Consumable Spares and Parts, Lubricants, etc, i.e. materials which are of small value and cannot be identified in or allocated to a product / service. Salaries of Staff in the Administration and Accounts Department, Salaries of Security Staff, etc. (N 01) Insurance, Taxes and Duties, etc. not being allocable to a particular Cost Centre. 10. Distinguish between Controllable & Uncontrollable Costs. One the basis of controllability, Costs are classified into 1) Controllable Costs: These are costs which can be influenced and controlled by managerial action. 2) Non Controllable Costs: These are costs that cannot be influenced and controlled by a specific member(s) of the organization. Note: The line of difference between controllable and non controllable costs is very thin. No cost is uncontrollable. Controllability is a relative term and is subject to the following factors (a) Time: Certain costs are controllable in the long run and not in the short run. (b) Location: Certain costs are not influenced and decided at a particular location / cost centre. For example, if rent agreements of all factory premises are executed centrally at the Head Office, Factory Mangers cannot control the incurrence of Rent Cost. (c) Product / Output: Certain costs are controllable by reference to one product or market segment and not by reference to the other. For example, some products require more advertising and sales promotion efforts than other products. 11. How are Costs classified on the basis of Normality? On the basis of Normality / Expectation, Costs are classified into Type Description Treatment 1. Normal Cost Costs which can be reasonably expected to be incurred under normal, routine and regular 2. Abnormal Cost operating conditions. Cost that is normally incurred at a given of output in the conditions in which that level of output is achieved. Costs over and above normal cost, which is not incurred under normal operating conditions, e.g. fines and penalties, abnormal wastages, etc. Unusual or a typical cost whose occurrence is usually irregular and unexpected and due to some abnormal situation of production. They are included in the Cost Sheet as regular cost and used for decision - making purpose. They are not considered in the cost of production for decision making, and are charged to Profit & Loss A/c Page 6

7 12. Distinguish between Product Cost and Period Cost. Why should Product Costs be computed? On the basis of attributability to the product, Costs are classified as under Particulars Product Cost Period Cost (N 08) 1. Meaning These are costs which are assigned to the product and are included in inventory These are costs which are not assigned to the products but valuation. These are also called as are charged as expenses Inventoriable Costs. against the revenue of the period in which they are 2. Examples Manufacturing Costs, e.g. Cost of Raw Materials, Direct Wages, Production OH, Depreciation of Plant, Equipments, etc. 3. Inclusion in Inventory Valuation Note: These are included in inventory valuation. They are treated as assets till the goods to which they are assigned are actually sold. incurred. Non Manufacturing Costs, e.g. General Administration Costs, Salesmen Salary, Depreciation of Office Assets, etc. These are not included in Inventory Valuation. They are written off as expense in the period in which they are incurred. Absorption vs Marginal Costing: Under Absorption Costing System, Total Manufacturing Costs (i.e. Variable and Fixed) are regarded as Product Costs. However, under Marginal Costing system, only variable Manufacturing Costs are considered as Product Costs. Purposes of computing Product Costs are as under (a) Preparation of Financial Statements focus on Inventory Valuation and reporting profits. (b) Product Pricing focus on costs assigned & incurred on the product till it is made available to customer / user. (c) Cost plus Contracts with Government Agencies focus is on reimbursement of costs specifically assigned to the particular job / contract. 13. List the various items of costs on the basis of relevance to decision-making. On the basis of relevance to decision making, Costs are classified into (A) Relevant, and (B) Irrelevant Costs. (A) Relevant Costs: These are costs which are relevant and useful for decision making purposes. (N 07) 1) Marginal Cost: Marginal Cost is the total Variable Cost, i.e. Prime Cost plus Variable Overheads. It is assumed that variable Cost varies directly with production whereas Fixed Cost remains constant irrespective of volume of production. Marginal Cost is relevant for decision making, as this cost will be incurred in future for additional units of production. 2) Differential Cost: It is the change in costs due to change in the level of activity or pattern or method of production. Where the change results in increase in cost it is called Incremental Cost, whereas if costs are reduced due to decrease of output, the difference is called Decremental Costs. (RTP, M 08) 3) Opportunity Cost: This refers to the value of sacrifice made or benefit of opportunity foregone in accepting an alternative course of action. For example, a Firm may finance its expansion plan by withdrawing money from its bank deposits. Then, interest lost on the Bank Deposit is the opportunity cost for carrying out the expansion plan. Similarly, if a person quits his job and enters into business, the salary forgone from employment constitutes opportunity Page 7

8 cost. Opportunity Cost is a relevant cost where alternatives are available. However, opportunity cost is not recorded in formal accounts and is computed only for decision making and analytical purposes. (RTP, M 03, M 08, M 09) 4) Out of pocket Costs: These are costs which entail current or near future outlays of cash for the decision at hand. Such costs are relevant for decision making, as these will occur in near future. 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. (M 09) 5) 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 and is relevant for decision making. 6) Imputed Costs: These are notional costs appearing in the cost accounts only, e.g. notional rent charges, interest on capital for which no payment has been made. Where alternative capital investment projects are being evaluated, it is necessary to consider the imputed interest on capital before a decision is arrived at, as to which is the most profitable project. These costs are similar to Opportunity Costs. (RTP, N 95, N 09) (B) Irrelevant Costs: These are costs which are not relevant or useful for decision making. 1) Sunk Cost: It is a cost which has already been incurred or sunk in the past. It is not relevant for decision making. Thus, if a Firm has obsolete stock of materials originally purchased for Rs.50,000 which can be sold as scrap now for Rs.18,000 or can be utilized in a special job, the value of stock already available Rs.50,000 is a sunk cost and is not relevant for decision making. (N 00, M 03, M 05) 2) Absorbed Fixed Cost: Fixed Costs do not change due to increase or decrease in activity. Although such Fixed Costs are absorbed in cost of production at a normal rate, they are irrelevant for managerial decision making. However, if Fixed Costs are specific, they become relevant. 3) Committed Cost: It is a cost in respect of which decision has already been taken, and such decision cannot be altered, e.g. entering into irrevocable agreements for Rent, Technical Collaboration, etc. Committed Costs are not relevant for decision making. This should be contrasted with Discretionary Costs, which are avoidable costs. 14. Write short notes on explicit and Implicit Costs. Define Explicit Costs. How is it different from Implicit Costs? Particulars Explicit Costs Implicit Costs 1. Meaning Costs which involve some cash payment or outflow of resources. Cost which do not involve any cash payment at all. 2. Also known as Out of Pocket Costs. Economic / Notional / Imputed Costs. 3. Measurement These are actually incurred, and hence can be easily and They are not actually incurred. They cannot be easily measured objectively measured. and involve subjective estimation. 4. Recording in books Recorded in books of account. Not recorded in books of account. 5. Purposes Accounting, Reporting, Cost Decision Making like asset Control & Decision Making. 6. Examples Salaries, Wages, Advertisement, etc. replacement, make or buy, etc. Interest on own Capital, Rent of own premises, Salary of Proprietor, etc. which are not actually paid. Note: Depreciation is considered as Deemed Explicit Cost, since the cost of Assets purchased (by making a cash outlay in the past) is written off / apportioned during the life time of those assets Page 8

9 15. Enumerate the types of costs on the basis of Functions. On the basis of Functions to which they relate, Costs are classified as under 1) Production Cost: The cost of the set of operations commencing with supply of materials, labour and services and ending with the primary packing of product. Thus it is equal to the total of Direct Materials, Direct Labour, Direct Expenses and Production Overheads. In a wider sense, it includes all Direct Costs and all Indirect Costs related to the production (including Research and Development Cost apportioned, if any) 2) Administration Cost: The cost of formulating the policy, directing the organization and controlling the operations of the undertaking, which is not directly related to Production, Selling, Distribution, Research or Development activity or function. Examples: Office Rent, Accounts and Secretarial Department Expenses, Audit and Legal Expenses, Directors Remuneration, etc. (N 96) 3) Selling Cost: The cost of seeking to create and stimulate demand and of securing orders. These are also called Marketing Costs. Examples: Market Research, Advertisement, Salaries, Commission and Travel Expenses of Salesmen, Show room Expenses, Cost of Samples, etc. (N 99) 4) Distribution Cost: The cost of the sequence of operations which begins with making the packed product available for dispatch and ends with making the reconditioned returned empty package, if any, available for re use. Examples: Distribution Packing (secondary packing), Carriage Outwards, Maintenance of Delivery Vans, cost of transporting articles to central or local storage, cost of moving articles to and from prospective customers (as in Sale or Return), cost of warehousing saleable products, etc. (N 99) 5) Research Cost: Cost of development of new product and manufacturing process, improvement of existing products, process and equipment, finding new uses for known products, solving technical problems arising in manufacture and application of products, etc. (N 92, M 96, N 98, N 00) 6) Development Cost: The cost of the process which begins with the implementation of the decision to produce a new improved product, or to employ a new or improved method and ends with commencement of formal production of that product or by that method, i.e. cost incurred for commercialization / implementation of research findings. (N 92, M 96, N 98, N 00) 7) Pre Production Cost: The part of Development Cost incurred in making a trial production run prior to formal production. (N 00) 8) Conversion Cost: The total of Direct Wages, Direct Expenses and Production Overhead, Cost of converting Raw Materials to the finished stage or converting a material from one stage of production to the other. (M 03) Special Note as regards Distribution Costs: Primary Packaging Cost is included in Production Cost. Secondary Packaging Cost is Distribution Cost. In exceptional cases, e.g. in case of Heavy Industries Equipment supply, installation cost at delivery site for Heavy Equipments which involves assembling of parts, testing, etc is included in Production Cost but not Distribution Cost. For example, Installation Cost of a Gas Turbine at Plant Site is included in the Cost of Production of Gas Turbine. 16. Distinguish between Conversion Cost and Added Value. Particulars Conversion Cost Added Value 1. Meaning It is the cost of converting Raw Materials to the finished stage, or converting a material from one stage of production to the other. It is the change in market value resulting from any alteration in the form, location or availability of a product or service, excluding the cost of bought out materials or services Page 9

10 2. Included Items 3. Excluded Items Direct Wages + Direct Expenses + Production Overheads. It totally excludes Materials and Components Cost, but includes cost resulting from variations in Direct Materials weight or volume. Difference in Sales Value of product or service between two places, two versions, two markets, etc. It excludes only cost of purchased bought out components and services, but includes profit element. 17. Distinguish between Production / Manufacturing A/c & Cost Sheet. Particulars Production / Manufacturing A/c Cost Sheet 1. Basic It is prepared on the basis of double entry system of book keeping. It is only a statement and hence double entry system is not applicable. 2. Purpose The primary objective of The primary objective is decision preparation is Reporting. 3. Parts It has two parts one showing the cost of manufacture and the other part showing Sales and Gross Profit. 4. Analysis Total Cost is shown in aggregate. Product wise or Location wise analysis is not generally given. 5. Quotations This is not useful for preparing tenders or quotations. making. It is a step by step presentation of total cost and shows Prime Cost, Works Cost, Cost of Production, Cost of Goods Sold, Cost of Sales and Profit. Cost Sheet shows costs in a detailed and analytical manner, which facilitates cost comparison. Estimated Cost Sheets can be prepared based on past experience, and useful for submitting quotations. 18. What is a Cost Centre? Discuss the various types of Cost Centres. N 91, N 92, M 95, M 97, N 02, M 08, M 11 1) Cost Centre: It is defined as (a) A location e.g. Chennai Factory, Kolkata Factory, etc. (b) A person e.g. Sales Manager L, M, etc. (c) An item of equipment e.g. Machinery P, Q or Process I, II, etc. Or a group these, for which cost may be ascertained and used for the purpose of Cost Control. 2) Classification : cost Centres can be classified as under (a) Based on Type: Personal Cost Centre It consists of a person or group of persons. (b) Based on Role: Production Cost Centre It is a Cost Centre where Raw Material is processed and converted into Finished Product. Here, both Direct and Indirect Costs are incurred. Examples: Machine Shops, Welding Shops and Assembly Shops, etc. Impersonal Cost Centre It consists of a location or an item equipment (or group of these). Service Cost Centre It is a Cost Centre which serves as an ancillary unit and renders services to a Production Cost Centre. Here, only Indirect Costs are incurred. There are no Direct Costs, as there is no measurable and saleable output. Examples: Power House, Gas Production Plant, Material Service Centres, Plant Maintenance Centres, etc Page 10

11 (c) Based on Activity: Operation Cost Centre It consists of machines and / or persons, carrying out similar operations. All machines / operators performing the same operation are brought together under a Cost Centre, the purpose being ascertainment of cost of each operation irrespective of its location inside the factory. Process Cost Centre It consists of machines and / or persons, engaged on a specific process or a continuous sequence of operations. Cost is analysed and related to a series of operations in sequence. Generally, these constitute a single location, as in Oil Refineries and other process industries. 19. What is a Responsibility Centre? What are its types? Distinguish between Profit Centre and Investment Centres. 1. Meaning: It is an activity centre of a business organization entrusted with a special task. It is a unit of function of a business organization headed by an executive responsible for its performance. 2. Types of Responsibility Centres: Particulars Cost Centres Revenue Centres Profit Centres Investment Centres (a) Meaning A centre for which a standard amount of cost is predetermined and used for control. (b) Primary Cost Reduction Responsibilit & Cost y Control. (c) Performance Standard Cost Evaluation Less: Actual Cost (d) Other Points Control of cost is subject to 1. Time 2. Location 3. Product A centre devoted to raising revenue (no responsibility for production). Generation of sale Revenue. Budgeted Revenue Less: Actual Revenue Also responsible for some expenses related with marketing of products. 20. Define a Cost Unit. Give suitable illustrations. A centre whose performance is measured in terms of income earned and cost incurred (profit earning). Profit Earning. Budgeted Profits Less: Actual Profits It may mean that one division sells its output to another division within the firm. (Inter divisional transfer pricing.) A centre responsible for earning profits and also for asset utilization. Earning Return on Investments. Budgeted ROI Less: Actual ROI ROCE or ROI (Return on Capital Employed or Return on Investment) may be considered for evaluation. 1) Cost Unit is a unit of production, service or time or combination of these, in relation to which costs may be ascertained or expressed. It should be one with which expenditure can be most readily associated. 2) Cost Unit is a form of measurement of volume of production or service. This unit is generally adopted on the basis of convenience and practice in the Industry concerned Page 11

12 3) Cost Units differ from one business to the other. They are usually units of physical measurement, e.g. number, weight, area, volume, time, length and value. [Refer Question 33 for illustrations of Cost Units.] 21. Define a Cost object. Give suitable illustrations. 1. Cost object is anything for which a separate measurement of cost is desired. 2. Cost object is defined as any unit of Cost Accounting selected with a view to accumulating all cost under that unit. 3. Cost objects may be a product, a service, a project, a customer, a brand category, an activity, a programmed, a division or department, a group of Plant and Machinery, a group of employees or a combination of several units. 22. Write short notes on the various methods of costing. Businesses vary in their nature and in the type of products or services they produce. Hence, different methods of cost ascertainment are used in different businesses. Costing methods to be employed are determined based on (a) the method of production and (b) the unit of cost used. The various methods of costing are METHODS OF COSTING For Goods For Services- Operating Costing Specialized Production Standardised Production Job Batch Contract Single / Unit Process / Joint Costing Costing Costing /Output Operation and By- Costing Costing Product Costing Work is undertaken on receiving a customer s order / assignment. Output under a Job consists of similar units, it is not feasible to ascertain cost per unit. Execution of work is distributed over two or more financial years. Product(s) is produced from single process. One product is produced from a series of sequential processes. Many products are produced from many sequential & parallel processes. Multiple Costing: It represents a combination of two or more methods of costing given above. For example, if a Company manufactures Cars including its components, the component parts will be costed by Batch Costing System, but the cost of assembling the Car will be computed by the Single or Output Costing method. The whole system of costing is known as Multiple Costing. The following table summarizes the various methods of costing applied in different industries- Nature of Output Method Cost Ascertainment Examples of Industries A. Based on customer specifications: - Single Unit Job Costing For each order / job / Automobile Workshops, - No. of similar units Batch costing assignment. For each batch / lot of units produced. Interior Decoration, etc. Pharmaceuticals, Printing Press i.e. visiting cards, invitations, etc Page 12

13 - Execution of works B. Similar units of single product, from: - Single Process (N 95) - Series of Processes C. Multiple varieties activities processes D. Rendering Services of and Contract Costing For each contract. Roads, Brickworks, Colliery, Paint Manufacturing, etc. Unit or Output or Single Costing Process or Operation Costing Multiple Costing Operating Costing For the entire activity, but averaged for the output. For each process or operation. Combination of any of the methods listed above. For every type of service (no identifiable tangible cost unit). Quarries, Brickworks, Colliery, Paint Manufacturing, etc. Oil Refining, Breweries, etc. Production of TVs, Computers etc, Automobile Assembly. Transport, Hotels, Cinema, Banks, Hospitals, Professional Institutions, etc. 23. List the Method of Costing and Cost Unit applicable for the following industries. Industry Method of Costing Unit of Cost 1. Interior Decoration Job Per Job 2. Advertising Job Per Job 3. Toy Making Batch Per Batch 4. Pharmaceuticals Batch / Unit Per Unit / Box 5. Ship Building Contract Per Ship 6. Bridge Construction Contract Per Contract 7. Cement Unit Per Tonne or Per Bag 8. Coal Single / Unit Per Tonne 9. Brick Works Single / Unit Per 1,000 Bricks 10. Steel Process Per Tonne 11. Oil Refining Process Per Tonne 12. Soap Process Per Unit 13. Sugar Company having own Process Per Tonne or Per Quintal sugarcane fields 14. Hospital / Nursing Home Operating Per Patient-Day or Room-Day 15. Road Transport Operating Per Tonne-Km / Passenger- Km 16. Radio Multiple Per Unit or Per-Batch 17. Bicycles Multiple Per Unit or Per Batch 18. Furniture Multiple Per Unit 24. List the reports provided by Cost Accounting Department for decision-making purpose. The following is an illustrative list of reports and statements provided by the Cost Accounting Department for the use of managers for decision-making purpose- 1. General (a) Cost Sheets setting out the total cost, analyzed into various elements of cost, giving comparative figures for various periods and / or various departments. (b) Reconciliation of actual profit earned with estimated or budgeted profit. (c) Report of Capital Expenditure, R & D Expenditure etc. compared with budgets Page 13

14 2. Materials (a) Materials Consumption Statements, showing total quantity of materials issued for production, materials actually used in production and wastage. (b) Total cost of abnormally spoiled work in the factory and abnormal losses in the store. (c) Total cost of inventory carried of Raw Materials, Work-In- Process and Finished Stock, the number of months for which stocks would be sufficient (on the basis of average consumption). 3. Labour (a) Labour Utilization Statements providing details about the total number of hours paid for, standard hours for the output produced, idle time-hours, cost and causes thereof. (b) Labour Turnover, cost of recruitment and training of new employees. (c) Labour Overtime Payment Statement and the causes thereof. 4. Overheads (a) Overheads actually incurred compared with budgets. (b) Overheads actually charged to production and the difference between the amount actually incurred (Actual Overheads) and the amount charged (Absorbed Overheads). 5. Sales (a) Actual Sales compared with budgets. (b) Statement of reasons for difference between Budgeted & Actual Sales, viz. Price, Quantity, Mix, etc. 25. Discuss briefly the role of the Cost Accountant in a manufacturing Firm. The cost Accountant performs the following functions in a manufacturing organization 1. Accounting and MIS: The Cost Accountant establishes the Cost Accounting Department in the Firm. He ascertains the information requirements of Managers at different levels in the organizational hierarchy. He defines the system to account for costs and to transmit relevant cost information on a timely basis to all Managers. 2. Costing Manual: The Cost Accountant develops the Cost Accounting Manual. The manual specifies the functions of the Cost Accounting Department. It also provides the format of various documents, vouchers, forms and reports for compilation, accounting and dissemination of cost information. 3. Cost Ascertainment: Cost of products, services, departments etc. are ascertained by effective implementation of the Cost Accounting System. The Cost Accountant supervises the operation of the accounting system and is thus responsible for cost ascertainment. 4. Cost Reports: The Cost Accountant is responsible for preparation of various cost reports. These reports assist Managers in reviewing their own performance and in identifying critical areas where control measures should be taken to avoid cost escalation. 5. Cost Comparison: The Cost Accountant provides cost comparison information which is useful for decision making. Some bases of comparison may be- (a) Standard Costs with Actual Costs, (b) Budget and Actual activity levels, (c) Financial and Costing Profits, etc. 6. Cost Analysis: The Cost Accountant analyses costs based on information available internally and externally. Such analysis is useful for decisions such as acceptance of additional orders, quotations for new products and orders, make or buy of components, sub-contractor own make, etc. 7. Cost Control: The Cost Accountant suggests techniques for cost reduction and cost control. He may also supervise the implementation of the cost control techniques Page 14

15 26. What are the advantages / objectives of a Cost Accounting System? A Factory manufactures only one product in one quality and size. Its owner states that he does not need a cost accounting system. State your arguments to convince him the need to introduce a cost accounting system. Discuss briefly how synergetic effect helps Cost Reduction. The primary advantages of a Cost Accounting System are 1. Profit Measurement and Analysis: Costs should be accurately ascertained and matched with revenues to measure profits of a Firm. Further, Cost Accounting is useful for identifying the exact causes for decrease or increase in the profit / loss of the business. 2. Cost Reduction: The application of cost reduction techniques like Value Analysis, Value Engineering and Operations Research techniques helps in achieving economy in operations. Continuous efforts are taken by the Firm, to find new and improved methods for reducing costs. 3. Cost Comparison and Cost Control: Cost comparison helps in cost control. Such a comparison may be made from period to period by using the figures in respect of the same firm or of several units in any industry by employing uniform costing and inter-firm comparison methods. 4. Identification of losses and inefficiencies: A good Cost Accounting System helps in identifying unprofitable activities, losses or inefficiencies in any form, so that appropriate actions are taken. The use of Standard Costing and Variance Analysis techniques points out the deviations from pre-determined level and thus demands suitable action to eliminate its recurrence. Also, the cost of idle capacity can be easily worked out, when a concern is not working to full capacity. 5. Price Determination: Cost Accounting is very useful for price fixation. It serves as guide to test the adequacy or selling prices. The price determined is used for preparing estimates or submitting tenders. 6. Financial Decision-Making: Managers can obtain relevant information from the Cost Accounting System, that help in making decisions involving financial considerations, viz. whether to purchase or manufacture a given component, whether to accept orders below cost, which machine to purchase when a number of choices are available, etc. 7. Dispute and Issue-solving: A good cost accounting system provides cost figures for the use of Government, Wage Tribunals and other bodies for dealing and solving issues like price fixation, price control, tariff protection, wage level fixation, etc. 27. List the essential features of a good Cost Accounting System. To be successful, a good Cost Accounting System should possess the following essential features- 1. Simple and easy to operate: The system should be tailor-made, practical, simple and capable of meeting the requirements of a business concern. 2. Accuracy of data: The data to be used by the Cost Accounting System should be accurate. Otherwise it may distort the output of the system. 3. Relevance of data: The System should handle and report relevant data for use of managers for decision making. It should not sacrifice its utility by introducing meticulous and unnecessary details. 4. Management s Role: The Top Management should have a faith in the Costing System and should also provide a helping hand for its development and success. 5. Participative Role of Executives: Necessary co-operation and participation of executives from various departments of the concern is essential for developing a good system of Cost Accounting. 6. Cost-effective: The cost of installing and operating the system should justify the results. The benefits from the system should exceed the amount to be spent on it Page 15

16 7. Smooth implementation: The system should be effectively implemented. A carefully phased programme should be prepared by using network analysis for the introduction of the system. 28. What are the essential factors for installing a Cost Accounting System? What are the areas of preliminary enquiry before a cost Accounting System is installed? Before setting up a system of cost accounting, the under mentioned factors should be studied- 1. Objective: The objective of the system, e.g. whether it is being introduced for fixing prices or for insisting a system of cost control. 2. Scope and Extent of Coverage: The areas of operation of business where the Management s action will be most beneficial. The system of costing in each case should be designed to highlight, in significant areas, factors considered important for improving the efficiency of operations in that area. 3. Organizational Set-up: The general organization of the business, to find out the manner in which the system of cost control could be introduced, without altering or extending the organizational set-up significantly. 4. Technical aspects: The technical aspects of the Firm, like methods and techniques of production used, extent of services rendered to Manufacturing Departments by other Service Departments, standards of production efficiency. 5. Psycho-social aspects: The attitude and behaviour of people in the organization, the manner in which the benefits of introducing Cost Accounting could be explained to various persons in the concern, especially those in charge of production department and an awareness created for the necessity of promptitude, frequency and regularity in collection of cost data. 6. Impact of expansion: The manner in which Cost and Financial accounts could be interlocked into a single integral accounting system and in which results of separate sets of accounts, cost and financial, could be reconciled by means of control accounts. 7. Information requirements: The maximum amount of information that would be sufficient and how the same should be secured without much clerical labour, degree of accuracy of data collected, responsibility for verification of data etc. 29. You have been asked to install a Costing System in a manufacturing business. What practical difficulties, apart from technical costing problems, would you expect to meet and how would you propose to overcome them? Apart from technical costing problems, there are other practical difficulties which arise during installation of a costing system. Some difficulties and the ways to overcome them are as under- Problem Description of Problem Remedial Measure 1. Lack of Support from Top Management 2. Resistance from Accounting Staff Top Management may not fully support the costing system. Line Managers may view the costing procedures as interference in their work or additional work. Also Managers may not view it seriously if top management does not endorse the system. Existing accounting staff may feel that they would lose their importance. Hence, they may resist the system as they may be unsure of their position in the Firm. Before installation, the top management should be made cost conscious. They must be made aware of the need for operating a costing system and their full support and cooperation to the costing system should be obtained. Staff must be made to understand that the costing system is only supplementary and not a substitute to the financial accounting system. Participative approaches and positive confidence-building measures should be used Page 16

17 3. Lack of cooperation at operating levels 4. Shortage of Trained Staff 5. Costs of operating the system The successful operation of the costing system depends upon the active participation of staff like foremen, supervisors, timekeepers, stores officials etc. These staff may not immediately provide basic activity data in various documents and reports. Sufficient staff may not be available to perform specialized functions like Cost ascertainment, analysis and control, which calls for technical knowledge, adequate knowledge support & training. The costing system involves initial installation cost and regular operating cost. Use of new forms and documents may lead to duplication of efforts and frustration among the employees. Some reports may provide unnecessary and redundant data. The Cost Accountant should educate the staff on the importance of the data to be provided from their department. They should be made to understand that providing data is not additional work but only part of their routine work. Attitudinal problems, if any, should be set right first. The personnel department should recruit adequate staff possessing the requisite skills. Shortage of staff may be overcome by devising and implementing a good overall personnel policy. The costing system should be implemented only when the benefits exceed costs thereof. Also, forms, procedures and documents should be designed so as to effectively capture the required information without much difficulty. Reports should provide timely, adequate and reliable information. 30. What items are generally included in a good Uniform Costing Manual? Uniform Costing Manual is a written document in the form of a booklet or bulletin, containing the principles methods and procedures for the ascertainment and control of cost in uniform costing. It provides guidelines to participating Firms to organize their cost accounting systems on a uniform basis. Its contents include- 1. Statement of objectives, Purposes and Scope of the system, advantages and extent of cooperation necessary. 2. General principles of accounting, nature of coding, terminology to be followed, classification & description of accounts. 3. Details of Stock, Labour, OH methods of cost allocation and procedures of cost control are contained. 4. Essential cost data and various ratios to be computed for cost collection and procedures and efficiency in the operation of the participating units. 5. Mode, format and time for presenting cost data and reports and to the Management. 6. Guidelines on the treatment of depreciation, interest on capital, waste, scrap, by-products, etc. 31. Write short noted on Direct Expenses. 1. Direct Expenses or Chargeable Expenses: These are expenses other than materials and labour which can be allocated directly to jobs, products, processes, cost centers or cost units. Direct Expenses are cost other than material and wages which are incurred for a specific product or saleable services Page 17