Basic cost concepts

Basic Cost ConceptsBy

Virtual CFO Team

RVK Business Advisory Services Pvt Ltd www.virtualcfo.co.in

INDEXS No Particulars

1 Introduction

2 Advantages of Cost Accounting

3 Financial Accounting vs Cost Accounting

4 Project Feasibility Study

5 Classification of Costs

6 Concept of Contribution

7 Concept of Break Even Point

8 Product Pricing

9 Product Pricing Strategies

10 Return on Investment


Introduction

Cost

• The amount of expenditure incurred on or attributable to a specific thing or activity

Costing

• The technique and process of ascertaining the cost

Cost Accounting

• The Process of Accounting for Cost which begins with recording and ends with reporting

Cost Accountancy

• The application of costing, cost accounting principles, methods and techniques.


Advantages of Cost

Accounting

Cost Determin

ationSelling Price

Determination

Product Profitability

Analysis

Decision Making/

BudgetingCost Control

Cost Reduction

Statutory Compliance


Financial Accounting vs Cost Accounting

Financial Accounting Cost Accounting

Provides information about

financial performance

Provided information about

ascertainment of cost

Interprets transactions in terms of

Money

Interprets costs in terms of material,

labour and overhead

Records historical dataMakes use both historical/ pre-

determined cost

Users are stakeholdersInformation is used by internal

management

Shows profit/ Loss for the yearProvides details of cost and profit of

each product, process, job etc

Usually prepared on yearly basis Reports prepared as and when required

A set format is used No set of Formats


Financial Feasibility


Financial feasibility

• Study of detailed financial analysisbased on certain assumptions,workings and calculations such as

– Projection for price of the product,Cost of various resources, capacityutilization

– Finance Mix with regard to cost offunds and repayment schedules

– Calculation of parameters such asInterest coverage ratio, Net Presentvalue, IRR.


Classification of Cost


By Nature or Element

Material

• Cost of materials used for the manufacture of a product or order

• Eg: Cloth for making a dress

Labour

• Expenditure borne by employers in order to employ workers.

• Eg: Remuneration, bonuses, ex gratia, training, perquisites etc

Overhead

• Expenses other than Material and Labour


By Controllability

Controllable Costs

• costs which can be influenced by the action of a specified member of an undertaking.

• The specific member can control the cost associated with the activity allocated to him

Uncontrollable Cost

• Costs which cannot be influenced by the action of a specified member of an undertaking.

• Eg: Costs of the administration department allocated to production division who cannot control administrative costs.


By FunctionProduction Cost

• Cost incurred for the sequence of operations which begins with supplyingmaterials, labour & Overhead and ends with primary packing of the product

Administrative Cost

• The cost of formulating the policy, directing the organization and controllingthe operations of an undertaking

Selling & Distribution Cost

• The cost seeking to create and stimulate demand (sometimes termed‘marketing’) and of securing orders as well as the cost of distribution

Research & Development Cost

• The cost of researching for new or improved products, new applications ofmaterials, or improved methods.


By Relation

Direct Cost

• Expenses which are directly traceable to product

• Eg: Material, Direct Labour

Indirect Cost

• Expenses which are not traceable to the product

• Eg: Administrative Cost


By Normality

Normal Cost

• Costs Normally incurred at a given level of output

Abnormal Cost

• Costs Not Normally incurred at a given level of output

• Eg: Machine Break down, FireRVK Business Advisory Services Pvt Ltd www.virtualcfo.co.in

Accounting for Normal & Abnormal Loss

Normal Loss

• Unavoidable Losses

• Considered in product Cost

• Eg: Evaporation of Chemical

Abnormal Loss

• Loss which occurs for abnormal reasons

• Not considered in product cost

• Eg: Spoilage of chemical


By Variability

Variable Cost

Fixed Cost

Semi-Variable Cost

Step Cost


Variable Cost

These costs tend to vary with thevolume of output. Any increase inthe volume of production results inan increase in the variable cost andvice versa.

Example: cost of material, cost oflabour etc.


Fixed CostThe cost which does not vary but

remains constant within a given

period of time and range of activity

in spite of the fluctuations in

production.

Example: rent, insurance of factory

buildings etc. remain the same for

different levels of production.


Semi Variable CostThese costs does not vary proportionatelybut simultaneously cannot remainstationery. It can also be called as semi-fixed cost.

Eg:

1. A Chef may prepare pizzas per day.However if this limit crosses, another chefwill be required irrespective of thenumber of additions.

2. Telephone operators charge aminimum fee per month along withadditional charges as per usage


Step CostsFixed cost can be further classified as follows:

Committed fixed costs: unavoidable in theshort term.

Eg: Rent, Salaries etc,

Discretionary fixed costs :

Set at a fixed amount for specific time periodsby management. This is avoidable at thediscretion.

Eg: Research and development costs,advertisement & market research expenses


Scenario:A Shirt manufacturer starts a business and incurs following Costs

Sl. No Particulars Amount

Initial Investment

1 Cost of the Machine Rs. 25,00,000

2 Expected Life of Machine 4 years

Intervening Costs:

1 Material Cost Rs. 200 per shirt

2 Labour Cost Rs. 200 per shirt

3 Rent Rs. 3,00,000 p.a

4 Admin & manager Cost Rs. 4,00,000 p.a

5 Interest Cost Rs. 3,00,000 p.a

6 Depreciation Rs. 6,25,000 p.a

7 Other Overhead Rs. 1,75,000 p.a

8 Selling Cost per Shirt Rs. 1000


Segregation of the costs based on their variability:

Sl. No Particulars Amount Type

1 Material Cost per Shirt Rs. 200 per Shirt Variable

2 Labour Rs. 200 per Shirt Variable

3 Rent Rs. 3,00,000 p.a Fixed

4 Admin & Managerial Cost Rs. 4,00,000 p.a Fixed

5 Interest Rs. 3,00,000 p.a Fixed

6 Depreciation Rs. 6,25,000 p.a Fixed

7 Other Overhead Rs. 1,75,000 p.a Fixed


Contribution• Excess of Sales revenue over variable cost

– Total Contribution = Total Sales revenue – Total Variable Cost

– Contribution per Unit = Sales price per unit – Variable cost per Unit

• Contribution for the illustrated scenario:

Particulars Amount (Rs.)

Selling Cost Per Shirt 1000

Less: Variable CostMaterial Cost 200

Labour 200

Total Variable Cost per shirt 400

Contribution for sale of one shirt 600


Break Even Point• It is the point at which there is neither a profit nor a loss to

the entity

• No Profit/ No Loss situation

• Volume of Operations at which total sales turnover is just equal to total cost.

• Formula:

– Total Fixed Cost / Contribution per Unit


Break Even Point• For the illustrated scenario:

Particulars Amount (Rs.)

Total Fixed Cost:

Rent 3,00,000

Admin & Managerial Cost 4,00,000

Interest 3,00,000

Depreciation 6,25,000

Other Overheads 1,75,000

Total Fixed Cost 18,00,000

Contribution per Cake 600

Break Even Point (in no of shirts) 3000

Conclusion: After selling the 3000th shirt in the year, entity reaches to no profit/ no loss situation


Break Even Point

• Demonstration:

Particulars Sales of 2500 shirtsSales of 3000

shirts

Sales of 3500

shirts

Total Sales (Sale Qty * Rs. 1000) 25,00,000 30,00,000 35,00,000

Less: Variable Cost

Material Cost (Sales Qty * Rs. 200) 5,00,000 6,00,000 7,00,000

Labour Cost (Sales Qty * Rs. 200) 5,00,000 6,00,000 7,00,000

Total Variable Cost 10,00,000 12,00,000 14,00,000

Contribution 15,00,000 18,00,000 21,00,000

Total Fixed Cost 18,00,000 18,00,000 18,00,000

Profit/ (Loss) -3,00,000 Nil 3,00,000


Pricing under Different Market Structures

Pure Competition

No Pricing policy of its own

for entity

Has to accept Prevalent

Market price

Continue to sell till variable cost

= Sales

Monopoly

Entities can have Pricing

policy of its own

Can Influence the price


Methods of Pricing the Finished Goods

Pricing of Finished Goods

Variable Cost

Pricing

Cost plus

Pricing

Rate of return Pricing

Competitive

Pricing


Variable Cost / Incremental Pricing

• This pricing model is followed after absorbing all fixed costs

• Only Variable costs are considered in pricing decisions

• Any sale price more than variable cost is accepted


Scenario:Let us take a scenario shirt manufacture presently selling 5000 shirts p.a.at Rs. 1,000 per shirt and If he receives order for further 1000 shirts at Rs.600 per shirt, whether he should accept?

ParticularsAt present

level

With the new

order

Sales Turnover 50,00,000 50,00,000

Turnover for New order - 6,00,000

Total Sales Turnover 50,00,000 56,00,000

Less: Variable Cost

Material Cost 10,00,000 12,00,000

Labour 10,00,000 12,00,000

Total Variable Cost 20,00,000 24,00,000

Contribution 30,00,000 32,00,000

Less: Fixed Cost 18,00,000 18,00,000

Profit 12,00,000 14,00,000

Conclusion:As the Profit of the entity increases, the order should be accepted. After absorbing all the fixed costs, any offer for sale price more than variable cost will be accepted


• Cost + Desired Profit

Cost plus Pricing

• Investment + Desired return on investment

Rate of return Pricing

• Submitting bids/ tenders

Competitive Pricing


Pricing Strategies

• Based on Customer

• Based on Product

• Based on Place

• Based on Time

• Skimming

• Penetrating

Geographical

Pricing

Price Discounts

Market Entry

Price Discrimin

ation


Market Entry Strategies

Skimming

• Charging High Price at Introduction

• Eg: Mobile phones

Penetrating

• Charging Low Price at introduction

• Eg: Ola Cabs


Price Discrimination StrategiesBased on Customer

• Same product at different rates to different customers

Based on product

• Slightly Different product charged st very high rate

• No Cost-price relationship

Based on Place

• Price charged based on place

• Eg: Movie Theatre

Based on Time

• Price charged based on time

• Eg: Off-season sales


Return on Investment

Net Present Value

Pay Back Period

IRR


Net Present Value• Difference between Present Value of Cash inflows and the present

value of Cash outflows• If the shirt manufacturer borrows initial investment of Rs. 25,00,000 at the interest rate of

15% p.a and estimates each year sales at 5000 shirts then NPV is calculated as follows:

Period ProfitAdd:

DepreciationCash Inflows

Discounting

factor at 15% p.a

Present

Value

Year 1 12,00,000 6,25,000 18,25,000 0.87 15,86,957

Year 2 12,00,000 6,25,000 18,25,000 0.76 13,79,962

Year 3 12,00,000 6,25,000 18,25,000 0.66 11,99,967

Year 4 12,00,000 6,25,000 18,25,000 0.57 10,43,450

Total Cash Inflows 52,10,336

Initial Investment 25,00,000

Net Present Value 27,10,336

Conclusion: As the NPV of the Project is positive, project is accepted


Internal Rate of Return (IRR)• Rate at which Value of Cash inflows equal to the investment. This is the actual return given by

the project.

• In the case of shirt manufacturer, Present value of cash flows discounted at 60% equals theinitial investment. So, IRR of this project is 60%.

• Implications of IRR

Scenario Decision

If IRR > Cost of Capital Accept the Project

If IRR <= Cost of Capital Reject the Project


Pay Back Period• Period by which initial investment in a project gets recovered.• In the present case of shirt manufacturer, the initial investment of Rs. 25 lakhs will be

recovered in 1 year 10 months. So Payback period is 1 year 10 months.

• Implications of Payback Period

Scenario Decision

If Payback Period >= Project

Duration Reject the Project

If Payback Period < Project

Duration Accept the Project


Sales is SanityProfit is VanityCost is CalamityCash is Rich


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Basic cost concepts

Business

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