Introduction to Cost Accounting

Samir K Mahajan

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 money ormoney’s equivalent in monetary units.

Costing is the technique and processes for ascertaining cost. These techniques consists of the rules or principles whichgovern the procedure of ascertaining cost or 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 costo Controlling the costo Reducing the cost

DIFFERENCE BETWEEN COST ACCOUNTING and FINANCIAL ACCOUNTING

Cost Accounting is a branch of accounting and has been developed due to limitations of financial accounting. Financialaccounting is primarily concerned with record keeping directed towards the preparation of Profit and Loss Account andBalance Sheet. The limitations of Financial Accounting which led to the development of cost accounting are asfollows.

o Financial accounting aims at finding out results of accounting year in the form of Profit and Loss Account and BalanceSheet. Cost Accounting aims at computing cost of production/service in a scientific manner and facilitate cost controland cost reduction.

o Financial accounting reports the results and position of business to government, creditors, investors, and externalparties. Cost Accounting is an internal reporting system for an organization’s own management for decision making.

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 in the same industry areused is known as uniform costing.

Historical Costing: In this technique, ascertainment of cost is done after they have been incurred but the utility of thistechnique is limited.

Direct Costing: The practice of charging all direct costs to operations, processes or products leaving all indirect costs tobe written off against profit’s 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.

Marginal Costing: The method of ascertaining marginal cost by differentiating between fixed and variable costs. Thistechnique is used to ascertain effect of changes in volume or type of output over the profits.

Standard Costing: The preparation of standard costs and applying them to measure the variations from actual cost andanalysing the causes of variations with a view to maintain maximum efficiency in production is known as standardcosting.

Activity Based Costing: ABC is a system that focuses on activities as fundamental cost objects and utilizes the cost ofthese activities as building blocks or compiling the costs of other cost objects.

SOME CLASSIFICATION OF COST

Costs may be classified on different bases. They can be classified as follows:1.By time (historical, predetermined)2.By traceability (direct, indirect)3.By nature of elements (material, labour, overhead)4.By association (product or period)5.By changes in activities or volume (fixed, variable, semi-variable)6.By function (manufacturing, administration, selling, research and development)

CLASSIFICATION ON THE BASIS OF TIME

Historical costs: Historical costing or actual costing is a system where costs are ascertained after they are incurred. Itis 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: Due to these disadvantages and limitations of historical costing, the standard costing technique wasintroduced. A standard cost is a predetermined calculation of how much costs should be under specific workingconditions. It is a technique of cost control. Actual costs are compared with these standard costs. The objective ofstandard cost is to ascertain the quotation and determination of price policy. The other names for standard costs are,budgeted costs, projected costs, model costs, measured costs, specification costs etc.

CLASSIFICATION BY TRACEABILITY

Traceable cost can be easily identified with a product or job or process. By traceability costs may be direct or indirect.

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. These terms should be understood properly, as the same will be applied in case of materials, labour and wages.

CLASSIFICATION OF COST BY ELEMENTS or NATURE

Elements of costs may be broadly divided into material, labour and expenses. These elements are further analysed intodifferent elements as shown in the following diagram:

Material Costs: Commodities or substances from which products are produced are called materials. It may be in araw or a manufactured state. They may be further divided into direct and indirect. Material costs include

cost by elements or nature

o Direct materials: Direct materials are those materialswhich enter into and form part of the finished product.e.g., wood in furniture, chemicals in drugs, leather inshoes. etc. Direct materials include:

All specially purchased or requisitioned for aparticular process or job or order

All components—purchased or produced All materials passing from one process to another All primary packing materials

o Indirect materials: Materials which cannot be tracedas part of the finished product are known asindirect materials. Indirect Material Cost is used forancillary purposes of the business. Fuel, lubricating oil, grease etc. (for

maintenance of plant and machinery) Tools of small value for general use Consumable stores Printing and stationery materials Stores of small value used

Labour Costs : This is the cost, incurred in the form of remuneration paid to the employees or labours of theorganisation. The workforce required to convert material into finished product is called labour. It can be direct orindirect. Labour costs can also be classified into direct labour and indirect labour.

o Direct labour: When employees are employed directlyin making the product (manufacturing process) andtheir work can be easily identified in the process ofconversion of raw materials into finished goods, suchlabour is called direct labour. The cost incurred ondirect labour is called direct wages. These costs areeasily identified with the individual cost centreExample: Wages paid to the driver of a bus in atransport service.

o Indirect labour: Indirect Labour Cost is the costincurred on those employees who do not directlytake part in the manufacturing process. These costsancillary to production is known as indirect labour.The cost incurred on indirect labour is called indirectwages. These costs may not be traced to specificunits of output or costs centres. Example: wages ofstore keepers, director’s salary, salary of foreman,time keepers, supervisors etc.

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 charge toproduction directly and does not include directmaterial 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 aspecific job. Generally, direct expenses form asmall part of total cost.

o Indirect expenses: Expenses which cannot becharged to production directly and which areneither indirect material cost nor indirect wagescost are treated as indirect expenses. IndirectExamples: Rent, rates, taxes, power, insurance,depreciation, lighting, telephone expenses,insurance

cost by elements or nature

OVERHEADS : Overheads include the cost of indirect material, indirect labour and indirect expenses. These cannot beassociated directly with specific products. Overheads may be classified into :

o Production or manufacturing orfactory overhead: Production orfactory overhead is the aggregate ofindirect material cost (lubricants,cotton waste, hand tools, worksstationery) , indirect wages (gate-keeper’s salary, time-keeper’s salary,manager’s salary) and indirectexpenses (factory rent, factoryinsurance factory lighting) incurred inrespect of manufacturing activity.

o Administration overhead: Suchcost includes indirect materials(rooms, storage, dusters, printingand stationary materials), indirectlabour (office accountant,Directors’ remuneration, officemanager, clerks), indirect expenses(lighting, rents insurance) incurredin general administration andoffice.

o Selling and Distribution overhead:Such overhead is the sum total ofindirect material cost((printing andstationary material, packing, ratesand taxes for finished goods), indirectlabour (salaries and commission ofsales man, sales manager salaries),and indirect expenses(advertising,transportation, insurance, rent , go-down expenses) incurred in creatingand stimulating demand for a firm’sproducts and securing orders and fordelivering/dispatching products andmaking them available to customers.Such expenses are generally incurredwhen the product is in saleablecondition.

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 areincurred on manufacturing process either directly as material and labour costs or indirectly as overheads. Examples ofproducts costs are raw material, labour, factory depreciation, fuel and packaging costs. Product costs are furtherclassified into direct material, direct labour and factory overhead.

Period Costs: Period costs are not incurred on the manufacturing process and therefore these cannot be assigned tocost goods manufactured. Period costs are thus expensed in the period in which they are incurred. Example of periodcosts are advertising, sales commissions, office supplies, office depreciation, legal and research and developmentcosts. Period costs may be further classified into selling costs and administrative costs.

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, irrespectiveof variations in the volume of activity. Such costs are fixed for a given period over a relevant range of output, on theassumption that technology and methods of manufacturing remain unchanged. Example: Rent, rates, taxes,insurance, management salary etc

To illustrate, a factory manufacturing CDs incurs a fixed cost of Rs. 1,00,000 per annum (which includes rent, depreciationof plant and machinery, insurance of all fixed assets, salaries of staff). The existing volume of production is 10,000 CDs perannum. If the production increases to 20,000 CDs, the total fixed cost remains the same i.e., Rs. 1,00,000 only. But theaverage 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.

Variable Cost or marginal costs or engineered costs: Variable costs vary directly and proportionallywith the output. The total variable costs changecorresponding to the levels of output but variablecost per unit is constant. Example: Materials usedto manufacture a product, wages of workers in amanufacturing process.

To illustrate, let direct material cost to produce oneunit of a product be Rs. 25. The existing volume ofproduction is 10,000 units per annum, then theexisting direct material cost is 10,000 units × Rs. 25 =Rs. 2,50,000. In case, if the production increases to20,000 units, the direct material cost would be Rs. 25 ×20,000 units = Rs. 5,00,000. This shows that the directmaterial cost per unit remains constant but totalmaterial cost rises with an increase in activity level.

Semi-Variable Costs: Semi-variable costsconsist of features of both fixed and variablecosts. Due to the fixed part of the element,they do not change in direct proportion tooutput. Due to the variable part of theelement, they tend to change with volume.Semi-variable costs change in the samedirection of output but not in the sameproportion. Example: electricity charges,stationery, telephone expenses.

To illustrate, telephone expenses is a semi-variable cost. Annual rental is Rs.1000. Forevery call used the charge per call is Re. 1.Here the annual rental is the fixed part of theelement—remains unchanged—whereas thecall made forms the variable element. It variesas per usage.

FUNCTIONAL CLASSIFICATION OF COSTS

Production costs: They are the cost of operating a production department in which manual and machine operationsare performed directly upon any part of product manufactured. This includes the cost of direct materials, directlabour, 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 theorganization 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 researchand 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 areincurred. There would be trial runs. All such costs are called preproduction costs. They are charged to the cost offuture production because they are treated as deferred revenue expenditure.

Research and Development Cost: They include cost of discovering new ideas, processes, products by experimetnsand implementing such results on a commercial basis.