Introduction to Cost Accounting

Cost Accounting Module IV

Basic Concepts
CIMA, London defines cost as the amount of expenditure (actual or notional) incurred on, or attributable to a specified thing or activity Cost has different denotations hence prefixed with nature of cost. Hence it is necessary to specify the exact meaning of cost.

Basic Concepts
Cost classification Grouping the costs according to their characteristics. Cost Analysis It is a break up of the aggregate costs into relevant types for managerial i.e. decision making / controlling or accounting purpose. Costing systems in the organisations

Objectives of Cost Accounting

Ascertainment of Costs; Determination of Selling Price; Cost control; Cost Reduction; Presentation of Cost data; Ascertainment of profit of each activity; Assisting management in decision making

Costing and Cost Accounting

Costing is the techniques and processes of ascertaining costs. CIMA, London defines Cost Accounting as the establishment of budgets, standard costs and actual costs of operations, processes, activities or products and the analysis of variances, profitability or social use of funds

Importance of Cost Accounting

Useful to Management in the trade depression; in price fixation; making estimates; optimum utilisation of resources; eliminating wastages, scraps and losses; enhancing efficiency; Inventory control and many more ways

Some basic definitions:

Cost Centre: A cost centre is a location, person or item of equipment, in respect of which costs may be ascertained and related to cost units for control purposes. e. g. production department, service department, foreman, Customer, vehicles, a group of machines, etc. Cost Unit: A cost unit is a unit of production, service or time in relation to which costs may be ascertained or expressed. e.g. Kilowatt-hour, Tonne-kilometre, etc. Cost allocation: It is the allotment of whole items of costs to cost centres or cost units. Cost apportionment: It is the allotment of proportions of items of costs to cost centres or cost units.

COST CLASSIFICATION:
Costs can be classified in a number of ways. The more important classifications are as under:

Direct and Indirect costs:

A cost that can be economically and conveniently traced to a cost centre, i.e. that can be allocated to a cost centre is a direct cost of that cost centre, e. g. cost of wood in manufacture of windows. The cost which is apportioned to different cost centres on some suitable basis is an indirect cost for each of those cost centres. e.g. cost of electricity consumed for manufacture of windows.

Functional classification
Classification according to the purpose for which they are incurred: e.g. Production cost Administration cost Selling cost Distribution cost Research and Development cost

Classification according to variability: Fixed costs and Variable costs:

Fixed costs are costs which tend to be unaffected by variations in volume of output.
These are generally costs related to creation of capacity e.g. depreciation, or contractual costs e. g. rent, salary of managers, insurance of factory buildings, etc. Variable costs are costs which tend to vary directly with volume of output. e.g. direct materials, direct wages, direct expenses and variable overheads

Degree of association with the product

On this basis, costs are classified into product costs and period costs.
Product costs: These are the costs which are to be included in the valuation of inventories. These would typically include all direct costs and appropriate manufacturing and administrative overheads necessarily incurred for bringing the inventory into its present state and condition. Parts of administrative overheads not related to manufacturing activity and selling and distribution overheads are treated not as product costs, but as period costs. e.g. depreciation on manufacturing machinery, other manufacturing overheads, etc. Period costs: These are indirect costs which are charged off as expenses in the period in which they are incurred. They are not associated with the products manufactured during the relevant period. e.g. interest on loans, audit fees, selling and distribution overheads, etc.

Controllability of costs:
Controllable costs: These can be influenced by the action of a given member, e.g. direct materials, wages or expenses are generally controllable by the shop level management.

Uncontrollable costs: These can not be influenced by the action of a given member of the hierarchy. e.g. share of tool-room expenses apportioned to a machine shop is not controllable at the level of the machine shop foreman. Costs not controllable by an individual, may be controllable at a higher level in the hierarchy. Costs, which are uncontrollable in the short term, generally become controllable in the long term.

Normality of costs:
Normal costs: A cost which is normally incurred at a given level of output in the conditions in which that level of output is normally attained. Abnormal costs: A cost which is not normally incurred at a given level of output under normal conditions.

Relevant and Irrelevant costs:

Relevant costs are those costs which are relevant for decision-making, e.g. marginal costs, opportunity costs, differential costs etc. (explained later) Irrelevant costs are those costs which have no bearing on the decision to be made, e.g. sunk costs, committed costs, etc.

Classification according to elements of cost:

Overview: Direct materials

Direct wages
Direct expenses

Prime cost

Indirect materials
Indirect wages Indirect expenses Administration overhead Selling & Distribution Overhead Production overhead

FORMAT OF COST SHEET Particulars of Cost Opening Stock of Raw Materials Add: Purchase of Raw Materials Less: Closing Stock of Raw Materials Raw Materials Consumption Direct Labour Direct Expenses Prime Cost Factory Overheads Add: Opening Work-in- Progress Less: Closing Work-in- Progress Less: Sale of By-Products or Scrap Factory Cost Administration Overheads Cost of Production Add: Opening Stock of Finished Goods Less: Closing Stock of Finished Goods Cost of Goods Sold Selling and Distribution Overhead Cost of Sales Profit Sales Amount (Rs.) Per Unit (Rs.)

Elements of cost:
Direct materials cost: This is the cost of materials which can be economically or conveniently identified with and allocated to cost centres or cost units, e.g. main raw materials, primary packing materials, etc.

Direct wages cost: These are wages which can be easily allocated to cost centres, e.g. wages of workers who are directly involved in the manufacturing operations.

Direct expenses: These are expenses which can be directly Identified with the job, order or process, e.g. cost of special designs or drawings, cost of hiring special tools for a job.

Elements of cost: (Contd.)

Production or factory overhead:
Indirect material: Material that can not be easily traced in the finished product, e.g. consumable stores such as lubricants, cotton waste, grease, oil, etc.

Indirect wages: Wages that are not charged directly, e. g. maintenance labour, internal transport, watch and ward, etc.

Indirect expenses: Indirect costs other than material or labour, e.g. factory rent, rates, insurance, depreciation of machinery, etc.

Elements of cost: (Contd.)

Administrative overheads: Includes all indirect costs incurred in the direction, control and administration of an undertaking, e.g. printing and stationery, office salaries, rent, lighting, cleaning of general office, legal charges, audit fees, etc.

Selling and distribution overhead: Includes all indirect costs incurred in promoting sales, retaining custom, and dispatching, e.g. mailing literature, catalogues, remuneration of sales staff, indirect packing material, wages of packers, carriage outward, etc.

Some costs which are relevant for decision-making

Marginal cost: This is the total variable cost. It varies directly with production. Differential cost:: It is the change in costs due to change in the level of activity or pattern or method of production. In case of increase, they are incremental costs, and in case of decrease they are called decremental costs. Opportunity costs: It is the benefit or contribution foregone due to not availing the other alternative. This cost is relevant where alternatives are available. Out-of-pocket costs: These entail current or near future outlays for the decision at hand.

Some costs which are relevant for decisionmaking (contd.)

Replacement costs: It is the cost of replacement at current market price of an asset or material that is being replaced or revalued.

Imputed costs: These are notional costs which are relevant e.g. where alternative capital investments are being evaluated, it is necessary to consider the imputed interest on capital.

Some costs which are irrelevant for decision-making:

Sunk cost: It is cost which is already incurred or sunk in the past, e.g. book value of assets which are to be scrapped.

Committed cost: A cost which has been already committed by the management is not relevant for decision making.

Absorbed fixed cost: Fixed costs which are already absorbed in the cost of production at the normal rate are not relevant for decision-making

Case Studies
A machine purchased for Rs. 3,00,000 having its book value of Rs. 1,50,000 is required to be scrapped. The likely selling price is Rs. 1,35,000. Find out irrelevant cost.

Case Studies
The company is planning for automation of plant. In case of automation, following data is available; Particulars Present Automation Cost Material Cost 10.00 10.00 Labour Cost 5.00 3.50 Fixed Cost 1,00,000 1,20,000

Case Studies
The following particulars are available; Particulars Q1 Q- 2 No. of Units Produced 10,000 9,000 Production Cost 80,000 72,000

Case Studies
X Ltd. has furnished the data as; Expected sales are 50,000 units, Variable cost is Rs. 250 per unit, Fixed cost is Rs. 150 per unit and selling price is Rs. 500 per unit. The company has received an order for additional 10,000 units from a customer only if selling price is Rs. 375 per unit. Should this order be accepted?

Case Studies
X Ltd. is into trading business and it has chain of 25 retail stores; The data is; Annual Sales Rs. 425000, Operating Cost Rs. 382000 and Building ownership cost Rs. 20000. The company can lease the building for Rs. 48000 per annum. Decide whether to continue operations or lease the building? Approach i) Comparative, ii) Incremental relevant cost iii) Opportunity cost approach