B.Com (Hons) II Year Graduate Course Paper IX : Cost Accounting Contents: Unit 1 Unit 2 Unit 3 Lesson 1: Cost Accounting: An Overview Lesson 2: Cost Concepts and Classification Lesson 3: Accounting for Material Cost Lesson 4: Pricing & Materials Lesson 5: Labour Cost Lesson 6 Time-Keeping and Time Booking Editor K.B. Gupta School of Open Learning University of Delhi 5, Cavalry Lane, Delhi-110007
Session 2007-08 Copies School of Open Learning Published by The Executive Director, School of Open Learning, 5 Cavalry Lane, University of Delhi, Delhi-110007. Laser typeset at Computer Centre, School of Open Learning. Printed at
UNIT 1 LESSON 1 COST ACCOUNTING: AN OVERVIEW Manisha Verma HansRaj College University of Delhi "A business can be hardly successful over the long-run without effective procedures for treating costs and revenues - Peter F. Drucker in Managing the Next Society LEARNING OBJECTIVES After studying this chapter, you should be able to understand 1.1 Meaning of Costing and Cost Accounting 1.2 Objectives of Cost Accounting 1.3 Limitations of Financial Accounting 1.4 Relationship with Financial Accounting 1.5 Differences between Financial Accounting and Cost Accounting 1.6 Advantages of Cost Accounting 1.7 Objections to Cost Accounting 1.8 Costing Methods and Techniques 1.9 Installation of Cost Accounting System 1.10 Practical Difficulties in Installation 1.11 Essentials of a Good System Cost accounting has grown into an exciting discipline. Now it is a recognized feature of modern business life. It s also the foundation of a firm's internal information system. Management is seeing costing as the instrument of productivity, profitability, and efficiency. Its users of information are no longer simply factory enterprises. Today, it is universally employed and equally touches merchandising and service organizations. Over the years, cost accounting as a body of principle and practice has matured into cost management systems with focus on customer satisfaction and maintaining competitive position. 1.1 Meaning of Costing and Cost Accounting The primary purpose of accounting is to provide financial information relating to an economic/business activity. It is concerned with measuring, recording, and reporting financial information by the management to plan and control the activities of a business as 1
well as by others who provide funds or who have various interests in the operations of an entity. The accounting system that provides the information to measure product costs and performance, and control the operations of a firm is called cost accounting. The Chartered Institute of Management Accountants (CIMA), London has defined costing as, "the techniques and processes of ascertaining costs. Wheldon has defined costing as, "the proper allocation of expenditure and involves the collection of costs for every order, job, process, service or unit." Thus, costing simply means cost finding by any process or technique. It consists of principles and rules which are used for determining: (a) (b) The cost of manufacturing a product, e.g., motor car, furniture, chemical, steel, paper, etc., and The cost of providing a service, e.g., electricity, transport, education, etc. The terms `costing' and `cost accounting' are often used interchangeably. Cost accounting is a formal system of accounting for costs in the books of account by means of which costs of products and services are ascertained and controlled. An authoritative definition of cost accounting has been given by CIMA, London as follows: "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 purposes of managerial decision making." Cost accountancy is thus the science, art and practice of a cost accountant. It is a science in the sense that it is a body of systematic knowledge which a cost accountant should possess for the proper discharge of his duties and responsibilities. It is an art as it requires the ability and skill on the part of a cost accountant in applying the principles of cost accountancy to various managerial problems like price fixation, cost control, etc. Practice refers to constant efforts on the part of cost accountant in the field of cost accountancy. Theoretical knowledge alone would not enable a cost accountant to deal with the various intricacies involved. He should, thus, have sufficient practical training, and exposure to real life costing dilemmas. 1.2 Objectives of Cost Accounting The main objectives of cost accounting are as follows: 1. Ascertainment of cost: The primary objective of cost accounting is to determine the cost of product manufactured or service rendered i.e. both aggregate cost and unit product costs. For cost ascertainment, various methods are employed in different industries like job costing, process costing, operating costing etc. 2. Cost control: Cost accounting aims at improving profitability by controlling and reducing costs. For this purpose, various specialized techniques like standard costing, budgetary control, inventory control, value analysis, etc., are used. This objective of cost control and cost reduction is becoming increasingly important in the present scenario because of growing competition in the business world. 2
3. Guide for managerial decision making : Cost data provide guidelines for various managerial decisions like make or buy, keep or replace, accept or reject, continue or drop a product. 4. Determination of selling price: Cost accounting provides cost information on the basis of which selling prices of products or services may be fixed. FINANCIAL ACCOUNTING AND COST ACCOUNTING Financial accounting aims at presenting a true and fair view of the overall results of transactions and events which are recorded in the books of accounts in terms of money, and in accordance with established principles, accounting standards and legal requirements. The financial statements, comprising the income statement, position statement as well as the funds flow statement reveal the overall performance and position of the business entity. Such reporting is hawed on a post mortem examination of past events. Although management has some interest in the information contained in these statements, the information is of little practical significance from the point of view of planning, control and decision-making. Cost accounting was thus evolved to overcome the limitations of financial accounting. 1.3 Limitations of Financial Accounting (a) In spite of its popularity, financial accounting suffers from the following limitations: Historical in Nature: Financial accounting is essentially historical in nature. It records transactions and events which have already occurred. As such, the financial statements prepared and presented at the end of the accounting period, report on past events as a part of stewardship function of management. Although, the information is historically important, it does not provide the management with day-to-day information for evaluating operational efficiency. (b) (c) (d) (e) (f)) Overall Performance: Financial accounting discloses and reports profitability or otherwise of the business as a whole. Since it does not classify accounts on the basis of departments or segments, products, processes and sales territories, it fails to provide information about costs and profit of these sub-divisions of the organisation. No Objective Classification: In financial accounting, accounts are classified under two major groups, viz. personal and impersonal. Such a primary classification made subjectively, is of little use to management to ascertain costs by products, jobs and processes. Distinction between Direct and Indirect Expenses: In the case of financial accounting, expenses are not classified into direct and indirect, fixed and variable, controllable and uncontrollable, and assigned to departments, jobs or products. As such, controllable items of expenses cannot be distinguished from uncontrollable ones for purposes of cost control and cost reduction. Material Losses: There being no material control system operating under financial accounting, there is no safeguard against material losses consequent upon wastage, pilferage, deterioration and obsolescence of materials. Labour Cost Control: In the case of financial accounting, there is no means of comparing 3
(g) (h) (i) (j) (k) (l) (m) the time clocked with the time booked since workers are paid on the basis of hours worked. Consequently, losses resulting from idle time, evasion of work and loitering cannot be controlled. Further, labour time is not recorded job-wise. Hence, there is no means of judging the efficient utilization of labour time and no incentive systems based upon results can be introduced. Idle Facilities: Financial accounting does not reveal losses due to idle plant and equipment. Such losses can neither be analyzed nor controlled. No Cost Comparison: Financial accounting does not provide data for comparison of costs of' two periods, two firms, two jobs, departments or processes. As such, it is not possible to arrive at conclusions regarding the profitability or otherwise of different products, jobs, departments, processes or sales territories. Distortion of Trading Results: In financial accounting, the values of closing inventories are estimated for the purpose of income statement and balance sheet. If the values are not stated accurately, matching of costs with revenues cannot be done properly. Consequently, trading results become distorted to the extent of variation in values. Only Monetary Information: Financial accounting records contain information relating to transactions and events of a business entity capable of being expressed in terms of money. There is no place in these records for non monetary information such as quantity of materials and quality of labour, etc. Fixation of Product Price: Financial accounting records do not furnish the required information regarding quantity and costs to enable management to fix the price of products, jobs and processes or services rendered. Financial accounting also fails to explain the reason why there is rise or fall in cost of production. Inventory Levels cannot be fixed: Financial accounting fails to supply the necessary information to management for fixation of stock levels such as maximum level, minimum level, ordering level, etc. In the absence of fixation of such levels, investment in inventories cannot be optimized. Lack of Data for Decision-making: Decision-making is one of the basic functions of management of any organisation. However, financial accounting fails to furnish the required data for such decisions as introduction of a product line, discontinuance of production of a product or a department, whether to make or buy, equipment replacement, suitable product-mix, etc. 1.4 Relationship with Financial Accounting Cost accounting is a branch of accounting in much the same way as financial accounting. In fact, financial accounting provides the data base for cost accounting. Necessary information relating to costs is obtained from financial accounting records. As such, cost accounting and financial accounting are complementary to each other. The similarities between the two branches of accounting are: i) Both cost and financial accounting are the branches of accounting. ii) Both are concerned with recording and reporting accounting information. 4
iii) iv) Both the sets of accounts use the same basic documents for recording transactions and events. Both record transactions and events on the basis of double entry. v) Both the sets of accounts record information in monetary terms although cost accounting records contain additional information. vi) vii) viii) ix) Each of these branches is mutually helpful to the other. While financial accounting provides basic information for writing up cost records, cost accounting assists financial accounting in inventory valuation thereby facilitating the preparation of financial statements. Both the sets of accounting records furnish the required information to interested parties. Each of these branches facilitates performance appraisal in its own way. Both the sets of accounts are a means of control. 1.5 Differences between the Two In spite of the above points of similarity between financial and cost accounting, the two branches of accounting differ from each other in the following respects (i) (ii) Purpose: Financial accounting records disclose profitability or otherwise, i.e., trading results as well as the financial position of a business. The chief purpose of cost accounting is to provide detailed cost information to management. Nature: Financial accounting is historical in nature. The information provided by the records is in respect of only monetary transactions and events which have already occurred and about which nothing can be done. Cost accounting, on the other hand, focuses not only with past transactions but of the future ones also. (iii) Legality: Financial accounting is legally necessary, especially in the case of companies. Even in the case of other forms of business, financial accounting has almost become mandatory by virtue of the application of other enactments much as the Income Tax Act and Sales Tax Act. Cost accounting is not legally necessary except for certain specified industries. (iv) (v) (vi) Reporting: Financial accounting serves the interest of people belonging to different groups outside the organization such as shareholders, creditors, potential investors, workers, taxation authorities, financial analyst, government, trade unions. Therefore this branch of accounting accomplishes only external reporting of financial information. Cost accounting, however, serves the needs of management and thus accomplishes internal reporting. Periodicity: Financial accounting reports are prepared on annual basis while cost accounting reports are prepared on weekly, monthly, quarterly even daily basis depending on the needs of management. Analysis of profit:. Financial accounts reveal the profit or loss of business as a whole for a particular period. Cost accounts show the detailed cost and profit data for each product line, department, division, section, process. 5
(vii) (viii) (ix) (x) Focus: In Financial accounting focus is on recording, classifying and summarizing the financial transactions.in cost accounting the focus is on cost ascertainment and cost control. Format of presenting information: Financial accounting has a single uniform format of presenting information, i.e., Profit and Loss Account, Balance Sheet and Cash flow statement Cost accounting has varied forms of presenting cost information which are tailored to meet the needs of management and thus lacks a uniform format. Analysis of cost: In financial accounting, no distinction is made between direct and indirect costs, fixed and variable costs and controllable and uncontrollable costs. In cost accounting, costs are distinguished according to their identification with the cost units (direct and indirect), according to variability (fixed and variable), and according to responsibility (controllable and uncontrollable costs). Use of standards: In financial accounting there are no predetermined standards of cost and performance to evaluate the efficiency of operations as regards the use of material, labour and overhead facilities. Cost accounting makes the use of standard costs against which actual costs are compared, variances are calculated and analyzed into their causes that corrective action may be taken. 1.6 Advantages of Cost Accounting Cost accounting provides information that is useful to management in planning, control and decision-making. The main advantages of cost accounting are listed below: 1. It reveals unprofitable activities, losses, and inefficiencies such as wastage of material in the form of spoilage, excessive scrap, and idle time of labour and idleness of plant facilities. Management can take steps to check these wastes and losses. 2. It helps the management in fixation of prices. Accurate cost data can be used as a guide for preparation of quotations and submission of tenders. 3. It provides suitable data and information which helps the management in taking decisions such as make or buy, shut-down or continue selection of most profitable product-mix, acceptance or rejection of a special order, introduction of a new product, etc. 4. Detailed costs of materials, labour and overheads reveal actual and potential sources of cost saving and reduction. 5. Maintenance of time and job records for workers reveals losses incurred due to idle time. Such records assist in taking steps to minimize those losses. 6. Centralization of purchasing is facilitated by the use of cost accounting. This results in economical purchases. 7. A perpetual inventory system which facilitates continuous stock-taking helps in the preparation of interim profit and loss account. 8. Cost accounting lays the basis of standard costing and budgetary control systems. These two techniques help the management in cost control. Variance analysis and comparison of actual performance with budget estimates indicates areas where economies can be achieved. 6
9. A system of cost accounting provides an independent and reliable check on the accuracy of financial accounts. A reconciliation is made of the profit as shown by cost accounts with that shown by financial accounts. 10. Installation of uniform costing enables management to make inter-firm comparisons. 1.7 Objections against Cost Accounting There are objections raised against the introduction of cost accounting. (i) (ii) (iii) It is expensive. A cost accounting system involves recording, classification, analysis, allocation and apportionment of costs and absorption of overheads which require considerable amount of clerical work. It leads to increase in workload. The results shown by the cost accounts differ materially from those shown by the financial accounts. Preparation of reconciliation statements frequently is necessary to verify their accuracy. This leads to unnecessary increase in work load. It is unnecessary. Introduction of costing system itself does not control costs or contribute to operating efficiency of the concern. It gives management information with which to control costs. If the management is alert and efficient, it can control costs without the aid of this system. This is, therefore, unnecessary. The above arguments are untenable. The basic aim of cost accounting is minimizing costs by avoiding wastes at all stages therefore it, it will be wrong to call it expensive, infact it is a profitable investment. Differences between results shown by cost accounts and financial accounts arise on account of over and under-absorption of overheads, methods of material pricing used and treatment of other incomes. An integrated system of accounts can help in elimination of these differences. In this age of competition and globalization costing is not unnecessary, but must for each manufacturer because he must know the exact cost not only of each article made but also of each process involved in its production so that he may be in a position to avoid waste and minimise its cost. It is possible only when proper costing records are maintained. Hence, it is wrong to say that it is unnecessary. 1.8 Costing Methods and Techniques Methods: The methods of costing refer to the processes employed in the ascertainment of costs. Several methods have been designed to suit the needs of different industries.the methods of costing to be applied in a particular concern depends upon the type and nature of manufacturing activity.. 1 Job Costing is that form of specific order costing under which each job is treated as a cost unit and costs are accumulated and ascertained separately for each job. It is applied in those industries where the goods are manufactured against specific orders as per customer s specifications e.g. printing press, repair shop, interior decoration, painting. 2. Contract Costing is that form of specific order costing under which each contract is treated as a cost unit and costs are accumulated and ascertained separately for each contract e.g. construction of building, roads, bridges or other construction work.. 3. Batch Costing is that form of specific order costing under which each batch is treated as a cost unit and costs are accumulated and ascertained separately for each batch.it is applied 7
in those industries where the similar articles are produced in definite batches e.g. readymade garments, toys manufacturing industries, tyres and tubes, spare parts and components, pharmaceutical industries. 4. Process Costing is a method of costing under which all costs are accumulated for each stage of production and the cost per unit of product is ascertained at each stage of production. It is applied in those industries where manufacturing activity is carried on continuously by means of two or more processes and output of one process becomes the input of the following process till completion. e.g. paper industries, chemical industries, textile industries, sugar industries. 5. Unit /Single /Output Costing is applied in those industries where only one product or a few grades of the same product are produced and production involves only a single process or operation and production is uniform and continuous and units of output are identical e.g. cement industry, steel industry, floor mills industry, bricks making industry. 6. Operating /Service Costing it is used to ascertain the cost of providing services incase of those undertakings which render services and are not engaged in the manufacture of tangible products e.g. road transport, railways, airlines, hotels, hospitals, electricity, cinemas. 7. Multiple /Composite Costing It involves the application of two or more methods of costing in respect of same product. It is used in industries where number of components are separately produced and then assembled in a final product e.g. bicycle, motor cycle, scooter, T.V., air conditioners, cars, refrigerators. Techniques: The techniques of costing are not alternatives to the methods of costing. These are the different ways of analyzing and presenting costs for the purpose of controlling costs or making managerial decisions irrespective of method of costing being used. Some of the popular techniques of costing are as follows: 1. Standard costing: This is a very valuable technique of controlling cost. In this technique, standard cost is pre-determined as target of performance, and actual performance is measured against the standard. The difference between standard and actual costs is analyzed to know the reasons for the difference so that corrective actions may be taken. 2. Budgetary control: A budget is an expression of a firm's business plan in financial form. Budgetary control is a technique applied to the control of total expenditure on materials, wages and overheads by comparing actual performance with the budgeted performance. Thus, in addition to its use in planning, the budget is a control and coordination of business operations. 3. Marginal costing: In this technique, separation of costs into fixed and variable is of special interest and importance. This is so because marginal costing regards only variable costs as the cost of the products. Fixed cost is treated as period cost and no attempt is made to allocate or apportion these cost to cost centres or cost units. It is transferred to costing profit and loss account of period. This technique is used to study the effect on profit of changes in volume of output. 4. Total absorption costing: It is a traditional method of costing whereby total costs (fixed and variable) are charged to products. This is in complete contrast to marginal costing 8
where only variable costs are charged to products. 5. Uniform costing: It is the practice of using the same costing principles or practices by a number of firms in the same industry. It helps in inter firm comparisons, fixation of price, cost reduction and in seeking tax relief or protection from government. 1.9 Installation of Cost Accounting All cost accounting systems reflect the same principles and purposes, although their application may vary with circumstances out of necessity. Accordingly, the cost accounting system proposed to be installed should be designed to suit the nature of the business. Further, the system should be simple, and the expenses of operating it should be commensurate with the expected benefits. The preliminary considerations governing the design and installation of a cost accounting system are: (a) (b) (c) (d) (e) (f) (g) Nature of Business: The system sought to be designed and introduced, should suit the nature of business. Accordingly, it is necessary to be thoroughly acquainted with the technical aspects and the methods of production. If the business engaged in is the production of goods, it should further be seen whether it produces a single product on a mass scale, or a multi-product concern producing more than one product, or a jobbing type of business, a process type or an assembly unit. Nature of Organisation: It is equally necessary to study the layout, nature and size of the organisation. Since the system to be designed should suit the organisation, the existing types of authority relationship, the number of layers and the extent of authority and responsibility should also be studied. Methods and Procedures: The methods of manufacture and the procedures existing for purchase, receipt, storage and issue of materials, the methods of wage payment, computation and payment of wages and of arriving at overheads also deserve careful study. Technical Aspects: Although the cost accountant is not a technical expert, it is necessary for him to get acquainted with the nature of product, the methods and stages of production, the operations involved, varieties produced and such other technical aspects of the business. Since production efficiency depends upon effective production control, it is equally necessary to know the degree of control exercised over production. Management's Expectations and Policies: The cost accounting system to be designed also depends upon management policy and their expectations from the system. If, for instance, the management's objective of installing a costing system is only to ascertain the cost of each product, the cost accounting system should be simple enough to achieve that objective. Simplicity: The system to be introduced should be simple and easy to operate. The operating personnel should be capable of understanding the procedures laid down for working the system efficiently. Co-operation and Support of Personnel: No system of cost accounting, however carefully designed, can be worked successfully without enlisting the co-operation and support of the personnel involved in the cost accounting process. As such, the 9
(h) (i) (J) (k) (l) (m) system should not be thrust upon them. They should be consulted, their views and suggestions considered, and they should be made cost conscious and drawn into the cost accounting process. Standardization of Forms: Accumulation of cost information necessarily involves the maintenance of detailed cost records. Since this entails considerable clerical work, the staff may resent it. It is, therefore, necessary to reduce clerical work to the minimum. Printed forms should be used and they should be standardized as regards size and contents with instructions printed. Accuracy of Data: It is also necessary to determine the degree of accuracy of data to be supplied by the cost accounting system. Prompt Reporting: Since a cost accounting system is mainly intended for internal reporting of cost information, cost data should be made available promptly and regularly. It is also necessary that the information supplied should be clear, nontechnical and unambiguous. There should be no duplication in reporting the same information. Flexibility: The costing system should be flexible and capable of adaptation to changing circumstances. It requires periodical scrutiny and change to avoid the danger of becoming obsolete owing to changes and developments in the business. Reconciliation: Where cost records are maintained independently of financial records, arrangements should be made for regular reconciliation of the trading result as revealed by both the set of books. Cost: It is equally necessary that the cost of installing a system of cost accounting should be commensurate with the benefits of installation. In other words, the benefits should not outweigh the cost of installation and operation of the costing system. 1.10 Practical Difficulties in Installation Apart from technical problems, the practical difficulties which may arise in connection with the introduction of a cost accounting system are the following: (a) (b) Lack of Support from Management: In many cases, the costing system is thrust on the managerial personnel, without consulting them and without explaining the benefits of the system. It may also happen that the system introduced may not be supported by the top management, probably because of the expenditure involved. In either case, the system introduced arouses fear and suspicion in the minds of line managers. Consequently, they view the system as interference in their work, and are likely to resist the same. The difficulty may be got over by explaining the benefits accruing from the system to all those who would be involved in the cost accounting process and instilling in their minds a sense of co-operation.they should be made cost conscious by being drawn into the process of designing and installation. Resistance from the Accounting Staff: The accounting staff may offer resistance to the introduction of cost accounting on the ground that their work would increase, or that it is interference in their routine work of accounting. Their resistance may also be due to their feeling of losing importance with the introduction of cost accounting. Even this difficulty may easily be overcome by explaining to them the need for cost accounting 10
(c) (d) (e) and assuring, at the same time that their position would not, in any way, be affected. They should be made to feel that it is absolutely necessary to supplement their accounting work with cost accounting and that the system would neither increase their work nor bring about unemployment, but on the contrary, the system would create more employment opportunities. Non-co-operation of Operating Personnel: The foremen, supervisory staff and operating personnel may also offer resistance to the system due to ignorance and suspicion. As a result, they may not supply the necessary data for the successful working of the cost accounting system. To overcome this difficulty, it is necessary to properly educate them. They should be made aware of the benefits accruing from the system, and should be made cost conscious by winning their confidence. Shortage of Trained Staff: At the time of introduction of a suitable system of cost accounting, the concern may experience non-availability or shortage of trained staff to handle the, work involved in operating it. This difficulty need not be an excuse for non-introduction of the system designed. It is necessary to train the existing staff and introduce the system rather slowly, instead of thrusting a complete system upon them irrespective of whether or not they are ready to accept and handle the system. Cost of Installation: The use of standardized forms necessary for recording and reporting involves additional expenditure which the concern may not afford.the design of a system and the details of the methods to be employed will vary widely according to the nature of each concern. Accordingly, the system should be designed to suit the concern, and the obtainable results should justify the cost of additional staff and records involved. Cost-benefit analysis should be made to justify the costs involved. 1.11 Essentials of a Good System A suitably designed and an easily workable system of cost accounting should reflect the following features: 1. The system designed should be appropriate to the organisation structure and methods of production. 2. It should be capable of achieving the objectives and goals set by the management. 3. The system should be simple enough to be understood by the operating personnel. 4. It should be flexible so as to permit easy adaptability to changed conditions of business. 5. The reports and statements produced by the system should contain the relevant information for the intended purpose. 6. The reports and statements produced should be timely, accurate and effective. 11
QUESTIONS 1. Limitations of financial accounting have made the management realize the importance of cost accounting Comment. 2. What is cost accounting? Discuss briefly its objectives and advantages? 3. State the main differences between cost accounting and financial accounting? 4. You have been asked to install a costing system in a manufacturing business. What practical difficulties would you expect and how do you propose to overcome them? 5. Cost accounting system is neither unnecessary nor expensive rather it is a profitable investment Comment. 6. What method of costing would you adopt for the following industries? Give reasons 1. Ship building 2. Toy making 3. Oil refinery 4. Sugar 5. Road transport company 12
LESSON 2 COST CONCEPTS AND CLASSIFICATION Manisha Varma Hans Raj College University of Delhi LEARNING OBJECTIVES After studying this chapter, you should be able to understand 2.1 Costs vs. Expense and Loss 2.2 Cost Classifications 2.3 Elements of Cost 2.4 Items Excluded From Cost Accounts 2.5 Cost Sheet 2.6 Questions 2.1 Costs vs. Expense and Loss The term `cost' does not have a definite meaning and its scope is extremely broad and general. It is, therefore, not easy to define or explain this term without leaving any doubt concerning its meaning. Cost accountants, economists and others develop the concept of cost according to their needs because one complete description of `cost' to suit all situations is not possible. According to the Oxford Dictionary, cost means "the price paid for something." Some other definitions of cost are given below: According to CIMA, London Cost is the amount of expenditure (actual or notional) incurred or attributable to a given thing. According to WM Harper "A cost is the value of economic resources used as a result of producing or doing the things coasted." According to ICWA of India "Cost is a measurement, in monetary terms, of the amount of resources used for the purpose of production of goods or rendering of services". Often the terms `cost' and `expense' are used interchangeably. But cost 'should be distinguished from expense and loss. Expense is defined as "an expired cost resulting from a productive usage of an asset." It is that cost which has been applied against revenue of a particular accounting period in accordance with the principle of matching costs to revenue. In other words, an expense is that portion of the revenue earning potential of an asset which has been consumed in the 13
generation of revenue. Unexpired or unconsumed part of the cost is recorded as an asset in the balance sheet. Such an unexpired cost is converted into an expense when it expires while helping to earn revenue. For example: when a plant is purchased, depreciation on plant (expired cost) is charged to profit and loss account as an expense and cost of plant remaining after providing depreciation (unexpired cost) is shown as an asset in the balance sheet. Every year, depreciation on plant representing expense is debited to profit and loss account and depreciated value representing unexpired cost is shown in the balance sheet. Pre-paid insurance is also an example of unexpired cost which is shown in the balance sheet as an asset. Loss is defined as "reduction in, a firm's equity other than from withdrawals of capital for which no compensating value has been received." A loss is an expired cost resulting from the decline in the service potential of an asset that generated no benefit to the firm. Obsolescence or destruction of stock by fire are examples of loss. 2.2 Cost Classifications Classification is the process of grouping costs according to their common characteristics. It is a systematic placement of like items together according to their common features. The principal bases on which costs are classified are: 1. Variability (behavioral classification) 2 Functional areas (functional classification) 3. Responsibility (controllable and uncontrollable costs) 4: Traceability/identifiably (direct and indirect costs) 5. The accounting period charged to revenue (product costs and period costs) 6. Decision-making (relevant and irrelevant costs). Behavioral Classification The basis of classification, the behaviour pattern of costs considers how the costs respond, i.e. change with a given change in the volume of production. While some costs vary with the change in the quantity of output, others do not. Accordingly, there are three categories of costs: fixed, variable and semi-variable. Fixed costs: These are unaffected by variations in the volume of activity. The total fixed costs remain constant over a relevant range of output, while the fixed cost per unit varies with the output. Fixed costs have no particular relation to the volume of activity. These are incurred irrespective of production and sales. These are usually time based. Some typical examples are rent, insurance, taxes and managerial salaries. Variable cost: These are the costs which vary in direct proportion to changes in volume. They increase or decrease in the same proportion in which the output increases or decreases. The total amount of variable costs tends to change in respect to changes in production volume, but the variable cost per unit stays at the same level for a considerable period of time. The examples of such costs are direct material, direct labour, small tools, commission of salesmen, power. 14
Semi-variable costs: Also known as `mixed costs'. These costs include both a fixed and a variable component, i.e. these are partly fixed and partly variable. A semi-variable cost often has a fixed element below which it will not fall at any level of output. The variable element in semi-variable costs changes either at a constant rate or in lumps. For example, introduction of an additional shift in the factory will require additional supervisors and certain costs will increase by steps. In the case of a telephone connection, there is a minimum rent and beyond a specified number of calls, the charges very according to the number of calls made. In fact, there is no definite pattern of behaviour of semi variable costs. The examples of such costs are supervision, maintenance and repairs, telephone expenses, light and power, depreciation. Functional Classification Costs classified according to managerial functions are accumulated according to the activity performed. The costs of a typical organization may be divided into manufacturing, marketing, administrative and financing groups. Manufacturing cost: These are related to the production of an item. These are the sum of direct materials, direct labour and factory overhead. In other words, these include all the costs incurred in the factory up to that stage when the goods are ready for dispatch. Examples are: salaries of factory manager, supervisors and foremen, rent, rates and insurance of the factory, power and fuel used in the factory, depreciation, maintenance and repairs of building, plant, machinery tools, etc. Administrative costs: These include all expenditures incurred in formulating the plans, directing the organization and controlling the operations. A major portion of these costs are policy costs which are of fixed nature and, therefore, uncontrollable. These include salaries paid to management and clerical staff, rent, rates and insurance of general offices, their lighting, heating and air-conditioning, depreciation of office buildings, furniture, machinery, etc. Selling and distribution costs: Selling Cost: These are incurred to create and stimulate demand and to secure orders. These include salaries, commission and traveling expenses of salesmen and technical representatives and sales managers, advertising, catalogues, price lists, bad debts and collection charges, cost of market research, etc. Distribution Cost: These are.the costs incurred in moving the goods from the point of production to the point of consumption. These include: warehouse expenses, carriage outwards, depreciation and upkeep of delivery vans, wages of packers, van drivers, etc. Financing costs: These are costs incurred for raising and using capital, e.g. interest on loans and debentures, commission or brokerage on issue of shares and debentures, discount on the issue of shares and debentures, etc. Controllability Classification Costs are also classified in terms of responsibility over them. Responsibility carries the authority of the manager to influence costs-increase or decrease their amount. As such, there are two groups: Controllable and uncontrollable. Controllable Costs. Costs are said to be controllable when the amount of the cost incurred can be influenced by the action of a specified member (manager or supervisor) of an undertaking. 15
Uncontrollable Costs. Costs which cannot be influenced by the action of a specified member (manager or supervisor) of an undertaking are known as uncontrollable costs. The distinction between controllable and uncontrollable costs depends upon a point of reference. An item of cost may be uncontrollable at one level of management but the same item may be controllable at another level of management. Almost all costs are controllable at some level of management. Segregation of costs into controllable and uncontrollable categories will help the management in fixing responsibilities of different executives for unfavourable cost variances. An executive should be held responsible only for those costs which are under his control. Manufacturing Classification Costs are also classified as to when they are charged against revenue. The basis as the period benefited by the particular cost. This is essential in matching expenses against revenues in the relevant period. Such a grouping helps management in income measurement for the preparation of financial statements. Here, two categories are product costs and period costs. Product Costs. These are the costs directly identified with the product. These are the cost of goods produced and kept ready for sale. They are direct materials, direct labour, variable factory overheads. These costs provide no benefit till the product is sold, and are, therefore, inventoried. When the products are sold, the total product costs are recorded as an expense, and is called cost of goods sold. It is matched against revenue for the period in which products are sold. Period Costs. These are not directly related to the product and, therefore, not inventoried. If the period costs benefit only one accounting period, it is called revenue expenditure. If they benefit two or more accounting periods, they are treated as assets till they are charged as expenditure for the relevant years. Normally, expense of fixed nature like depreciation of assets, insurance premium, rent and rates are treated as fixed costs. These costs represent non-operating items and are related to passage of time and not to the production and sales of the period. In a manufacturing organisation all manufacturing costs are regarded as product costs and non-manufacturing costs are regarded as period cost. In retailing and wholesaling organisations goods are purchased for resale without changing their basic form. The cost of goods purchased is regarded as product cost and all other costs such as administration and selling and distribution are considered to be period costs. Identification / Traceability Classification. Costs are classified as direct and indirect costs on the basis of their identification with particular jobs, products or processes. Direct Cost: It is a cost which can be directly identified with a product, process or department. Materials used and labour employed in manufacturing an article or in a particular process of production, are common examples of direct costs. Indirect Costs: These costs are not traceable to any particular product, process or department, but are common to different products, processes or departments. Factory manager's salary, factory rent, depreciation of machinery, etc., are typical examples of indirect costs. The distinction between direct and indirect costs depends upon whether or not the cost can be identified with the activity or other relevant unit. A cost such as the plant superintendent's salary can be readily identified with the plant and hence is a direct cost of the plant. However, it is 16
an indirect cost of any department within the plant or of any line of product manufactured. Thus the nature of business and cost unit chosen will determine which are direct and which are indirect costs Direct costs are allocated whereas indirect costs are apportioned to different jobs, products or services on a reasonable basis. Decision-making Classification For managerial decision-making, costs are -sub-divided under: (i) Relevant costs (ii) Irrelevant costs. and Relevant costs: These are costs which are relevant for decision-making (for the future) such as differential or incremental costs, opportunity costs, out-of-pocket costs, etc. Differential Costs: Management is expected to make decisions and in doing so compares alternatives. In making a decision, management compares the costs of the alternatives. The costs that remain the same in any case can be disregarded but the difference in cost between alternatives is relevant to decision-making. A difference in cost between one course of action and another is differential cost. If a decision results in an increased cost, the differential cost may be called incremental cost. If the cost is decreased, the differential cost may be referred to as a decremental cost. A decision in favour of an alternative is taken only when, the incremental revenue between two levels of output is greater than differential cost of those levels of activity. This differential cost is the difference in net costs and benefits between two or more alternative courses of action. If the selection of an alternative involves changes in variable costs only, marginal cost and differential costs are the same. However, a decision may involve changes in fixed costs also. Opportunity Costs: In choosing between alternative management has to select the best alternative but in doing so, has to give up the returns that could have been derived from the rejected alternatives. The sacrifice of a return or benefit from a rejected alternative is known as the opportunity cost of the alternative accepted. Opportunity cost are not entered in the accounting records, yet they are used in decision-making. Often management is confronted with alternatives, each having its advantages. Out-of-Pocket Costs: An out-of-pocket cost signifies the relevant cash expenditure which is involved in a particular situation. Manangement decisions are directly affected by such costs. Thus, an out-of-pocket cost is the present or future cash expenditure connected with a certain decision which will change according to the nature of the decision made. For example, if it is proposed to replace the company's delivery trucks by an arrangement to deliver goods through public carriers, the depreciated value of the truck is irrelevant (being a sunk cost) to decide upon the proposal. But, the cost of fuel, driver's salary and maintenance expenditure involved in using the truck should be relevant costs in deciding whether the delivery system should be change. These are out-of-pocket costs. Irrelevant costs: These are those which are not pertinent to a decision. These are the costs that will not be changed by a decision. Because irrelevant costs will not be affected, they may be ignored in decision-making process. An example of irrelevant cost is that of sunk cost. 17
Sunk Cost: It is a cost incurred as a result of decision made in the past which cannot be reversed or altered by any decision in the future. Sunk costs are irrelevant for decision-making. The written down values of assets previously purchased are sunk costs. Let us suppose the management of a company is considering the desirability of replacing an existing machine by a new one. Suppose, an old machine originally costs Rs. 20,000 and it has been depreciated to the extent of Rs. 15000 so far. If it is scrapped (no value being realisable on sale) there will be an accounting loss of Rs. 5000. It would be wrong to recognise this loss as a cost for deciding upon the proposed replacement. The book value of the existing machine is really a sunk cost and the decision to replace or not to replace the machine will not make any difference to its undepreciated value. It is irrelevant to the question of replacing the existing machine. The difference in income which will result from the installation of new machine and expected return on capital investment should be the deciding factor. Other Cost Concepts Shut down cost: These are the costs which will still be incurred although a plant is shut down temporarily, e.g. rent, rates, depreciation, maintenance of plant, etc. Research cost: It is the cost of searching for new or improved products, new application of materials or new or improved methods of production. Development cost: It is the cost of the process which begins with the implementation of the decisions to produce a new/improved product. It ends with the commencement of production of that product or method. Thus, it is the cost of commercial exploitation of successful research. Development cost of new products is treated as an item of deferred expenditure to be spread over a number of years. It is charged to product costs when production is fully established. Joint cost: These are the costs incurred up to the point in a given process where individual products can be identified. Whenever two or more products are produced out of the same basic raw material or process, the cost of material purchased and processing are called joint costs. Such costs have to be apportioned to various products on some basis. 2.3 Elements of Cost A cost is composed of three elements, i.e., material, labour and expense. Each of these elements may be direct or indirect. Material Cost: According to CIMA, London, material cost is "the cost of commodities supplied to an undertaking. Material cost includes cost of procurement, freight inwards, taxes, insurance, etc., directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks, refund on account of modvat, sales tax, etc., are deducted in determining the cost of material. Materials may be direct or indirect. Direct materials: Direct material cost is that which can be conveniently identified with and allocated to cost units. Direct materials generally become a part of the finished product. For example, cotton used in a textile, clay in bricks, leather in shoes, steel in machines, cloth in garments, timber in furniture. Indirect materials: These are those materials which cannot be conveniently identified with individual cost units. These are minor in importance, such as (i) small 18