Introduction to Cost Accounting. Samir K Mahajan

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1 Introduction to Cost Accounting Samir K Mahajan

2 MEANING OF COST, COSTING AND COS ACCOUNTING Cost is amount of resources given up in exchange for some goods and services. The resources given up are expressed in the form of money or money s equivalent in monetary units. Costing is the technique and processes for ascertaining cost. These techniques consists of the rules or principles which govern the procedure of ascertaining cost of output. Cost accounting is a specialised branch of accounting which involves classifying, recording, analysing, standardising, comparing, reporting and recommending. Cost accounting is concerned with o Ascertaining the cost o Controlling the cost o Reducing the cost

3 DIFFERENCE BETWEEN COST ACCOUNTING and FINANCIAL ACCOUNTING Cost Accounting is a branch of accounting and has been developed due to limitations of financial accounting. Financial accounting is primarily concerned with record keeping directed towards the preparation of Profit and Loss Account and Balance Sheet. The limitations of Financial Accounting which led to the development of cost accounting are as follows. o Financial accounting aims at finding out results of accounting year in the form of Profit and Loss Account and Balance Sheet. Cost Accounting aims at computing cost of production/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 system for an organization s own management for decision making.

4 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)

5 FUNCTIONAL CLASSIFICATION OF COSTS Production costs: They are the cost of operating a production department in which manual and machine operations are performed directly upon any part of product manufactured. This includes the cost of direct materials, direct labour, direct expenses, primary packing expenses and all overhead expenses pertaining to production. Administration costs: These expenses include all indirect expenses incurred in formulating the policy, directing the 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 distribution functions. Research and development costs: These include the cost of discovering new ideas, processes or products 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 expenses are incurred. There would be trial runs. All such costs are called preproduction costs. They are charged to the cost of future production because they are treated as deferred revenue expenditure. Research and Development Cost: They include cost of discovering new ideas, processes, products by experiments and implementing such results on a commercial basis.

6 CLASSIFICATION ON THE BASIS OF TIME Historical costs: Historical costing or actual costing is a system where costs are ascertained after they are incurred. It is a post-mortem of the costs. Historical costing does 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 the production process is completed. These predetermined costs may further be classified into estimated costs and standard costs o Estimated costs: Costs are estimated before goods are produced. As these are purely estimates, 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, the standard costing technique was introduced. A standard cost is a predetermined calculation of how much costs should be under specific working conditions. It is a technique of cost control. Actual costs are compared with these standard costs. The objective of standard cost is to ascertain the quotation and determination of price policy.

7 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 which can be directly identifiable with cost centres, processes or production units are known as direct costs. Indirect costs: If costs cannot be identifiable with cost centres or cost units, they are termed as indirect costs. Such costs that cannot be easily identifiable with cost centres have to be apportioned on some equitable basis.

8 CLASSIFICATION OF COST BY ELEMENTS or NATURE Elements of costs may be broadly divided into material, labour and other expenses. These elements are further analysed into different sub-elements as shown in the following diagram:

9 cost by elements or nature Material Costs: Commodities or substances from which products are produced are called materials. It may be in a raw or a manufactured state. They may be further divided into direct and indirect. Material costs include o Direct materials: Direct materials are those materials which enter into and form part of the finished product. e.g., wood in furniture, chemicals in drugs, leather in shoes. etc. Direct materials include: All components purchased or produced All materials passing from one process to another All manufactures specially purchased or requisitioned for a particular process or job or order All primary packing materials o Indirect materials: Materials which cannot be traced as part of the finished product are known as indirect materials. Indirect Material Cost is used for ancillary purposes of the business. Consumable stores such as Fuel, lubricating oil, grease, cotton etc. (for maintenance of plant and machinery) Tools of small value for general use Printing and stationery materials Stores of small value used

10 cost by elements or nature Labour Costs : This is the cost, incurred in the form of remuneration paid to the employees or labours of the organisation. The workforce required to convert material into finished product is called labour. It can be direct or indirect. Labour costs can also be classified into direct labour and indirect labour. o Direct labour: When employees are employed directly in making the product (manufacturing process) and their work can be easily identified in the process of conversion of raw materials into finished goods, such labour is called direct labour. The cost incurred on direct labour is called direct wages. These costs are easily identified with the individual cost centre Example: Wages paid to the driver of a bus in a transport service. o Indirect labour: Indirect Labour Cost is the cost incurred on those employees who do not directly take part in the manufacturing process. These costs ancillary to production is known as indirect labour. The cost incurred on indirect labour is called indirect wages. These costs may not be traced to specific units of output or costs centres. Example: wages of store keepers, director s salary, salary of foreman, time keepers, supervisors etc.

11 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 are directly charged to cost centres and does not include direct material cost and direct labour cost. Example: cost of special pattern, drawing or layout; secret formula, hire charges of machinery, tools or equipment, consultancy fees to a specific job. Generally, direct expenses form a small part of total cost. o Indirect expenses: Expenses which cannot be charged to cost centres directly and which are neither indirect material cost nor indirect wages cost are treated as indirect expenses. Indirect Examples: Rent, rates, taxes, power, insurance, depreciation, lighting, telephone expenses, insurance

12 OVERHEADS : Overheads include the cost of indirect material, indirect labour and indirect expenses. These cannot be associated directly with specific products. Overheads may be classified into : o Production or manufacturing or factory overhead: Production or factory overhead is the aggregate of indirect material cost (lubricants, cotton waste, hand tools, works stationery), indirect wages (gate-keeper s salary, time-keeper s salary, production 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 (office lighting, office rents, insurance) incurred in general administration and office.

13 o Selling and Distribution overhead: Such expenses are generally incurred when the product is in saleable condition. Such overhead is the sum total of indirect material cost (printing and stationary material, packing,) indirect labour (salaries and commission of sales man, sales manager salaries), and indirect expenses (advertising, transportation, insurance, rent, go-down expenses,) rates and taxes for finished goods, incurred in creating and stimulating demand for a firm s products and securing orders and for delivering/dispatching products and making them available to customers.

14 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. Such costs are charged on manufacturing process either directly as material and labour costs or indirectly as overheads. Examples of products costs are raw material, labour, factory depreciation, fuel and packaging costs. 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 be assigned to cost goods manufactured. Period costs are thus expensed in the period in which they are incurred. 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 and administrative costs.

15 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 the current budget year, irrespective of variations in the volume of activity. Such costs are fixed for a given period over a relevant range of output, on the assumption that technology and methods of manufacturing remain unchanged. Example: Rent, lumpsum taxes, insurance, depreciation, 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 the production increases to 20,000 CDs, the total fixed cost remains the same i.e., Rs. 1,00,000 only. But the average fixed cost per unit will come down from (Rs. 1,00,000 10,000) Rs. 10 to (Rs. 1,00,000 20,000) Rs. 5 per unit.


17 Variable Cost or marginal costs or engineered costs : Variable costs vary directly and proportionally with the output. The total variable costs change corresponding to the levels of output but variable cost per unit is constant. Example: Materials used to manufacture a product, wages of workers in a manufacturing process. To illustrate, let direct material cost to produce one unit of a product be Rs. 25. The existing volume of production is 10,000 units per annum, then the existing direct material cost is 10,000 units Rs. 25 = Rs. 2,50,000. In case, if the production increases to 20,000 units, the direct material cost would be Rs ,000 units = Rs. 5,00,000. This shows that the direct material cost per unit remains constant but total material cost rises with an increase in activity level.

18 Semi-Variable Costs: Semi-variable costs consist of features of both fixed and variable costs. Due to the fixed part of the element, they do not change in direct proportion to output. Due to the variable part of the element, they tend to change with volume. Semi-variable costs change in the same direction of output but not in the same proportion. Example: electricity charges, stationery, telephone expenses. To illustrate, telephone expenses is a semivariable cost. Annual rental is Rs For every call used the charge per call is Re. 1. Here the annual rental is the fixed part of the element remains unchanged whereas the call made forms the variable element. It varies as per usage.

19 METHOD/ TECHNIQUES OF COSTING For ascertaining cost and managerial decision making, following techniques of costing are usually used: Uniform Costing: The practice in which common methods of costing for different undertakings inthe same industry are used is known as uniform costing. Historical Costing: In this technique, ascertainment of cost is done after they have been incurred but the utility of this technique is limited. Direct Costing: The practice of charging all direct costs to operations, processes or products while leaving all indirect costs to be written off against profits in which they arise are called as direct costing. Absorption Costing: In this all costs, both variable and fixed are charged to production, operations or processes.

20 Method/TECHNIQUES OF COSTING contd Marginal Costing: The method of ascertaining marginal cost by differentiating between fixed and variable costs. This technique is used to ascertain effect of changes in volume or type of output over the profits. Standard /Budget Costing: The preparation of standard costs and applying them to measure the variations from actual cost and analysing the causes of variations with a view to maintain maximum efficiency in production is known as standard costing. Activity Based Costing: ABC is a system that focuses on activities as fundamental cost objects and utilizes the cost of these activities as building blocks or compiling the costs of other cost objects.