Lesson – 5.1 Cost Accounting
5.1.1 Introduction
Accounting can no longer be considered a mere language of
business. The need for maintaining the financial chastity of business
operations, ensuring the reliability of recorded experience resulting from
these operations and conducting a frank appraisal of such experiences
has made accounting a prime activity along with such other activities as
marketing, production and finance. Accounting may be broadly classified
into two categories – accounting which is meant to serve all parties
external to the operating responsibility of the firms and the accounting,
which is designed to serve internal parties to take care of the operational
needs of the firm. The first category, which is conventionally referred to
as “financial accounting”, looks to the interest of those who have primarily
a financial stake in the organisation’s affairs – creditors, investors,
employees etc. On the other hand, the second category of accounting is
primarily concerned with providing information relating to the conduct
of the various aspects of a business like cost or profit associated with some
portions of business operations to the internal parties viz., management.
This category of accounting is divided into “management accounting” and
“cost accounting”. This section deals with cost accounting.
5.1.2
understand the different dimensions of cost accounting.
distinguish cost accounting from financial accounting.
appreciate the utility of cost accounting.
apply the various bases of classification of costs.
prepare a cost sheet or tender or quotations.
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5.1.3 Contents
5.1.3.1 Meaning Of Cost Accounting
5.1.3.2 Distinction Between Financial Accounting And Cost
Accounting
5.1.3.3 Utility Of Cost Accounting
5.1.3.4 Distinction Between Costing And Cost Accounting
5.1.3.5 Classification Of Cost
5.1.3.6 Cost Sheet
5.1.3.7 Illustrations
5.1.3.8 Summary
5.1.3.9 Key Words
5.1.3.10 Self Assessment Questions
5.1.3.11 Key To Self Assessment Questions
5.1.3.12 Case Analysis
5.1.3.13 Books For Further Reading
5.1.3.1 Meaning Of Cost Accounting
Cost accounting developed as an advanced phase of accounting
science and is trying to make up the deficiencies of financial accounts. It
is essentially a creation of the twentieth century. Cost accounting accounts
for the costs of a product, a service or an operation. It is concerned with
actual costs incurred and the estimation of future costs. Cost accounting is
a conscious and rational procedure used by accountants for accumulating
costs and relating such costs to specific products or departments for
effective management action. Cost accounting through its marginal
costing technique helps the management in profit planning and through
its another technique i.e. Standard costing facilitates cost control. In short,
cost accounting is a management information system which analyses
past, present and future data to provide the basis for managerial decision
making.
5.1.3.2 Distinction Between Financial Accounting And
Cost Accounting
Though there is much common ground between financial accounting
and cost accounting and though in fact cost accounting is an outgrowth of
financial accounting yet the emphasis differs. Firstly financial accounting
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is more attached with reporting the results of business to persons other
than internal management – government, creditors, investors, researchers,
etc. Cost accounting is an internal reporting system for an organisation’s
own management for decision making. Secondly financial accounting data
is historical in nature and its periodicity of reporting is much wider. Cost
accounting is more concerned with short-term planning and its reporting
period much lesser than financial accounting. It not only deals with historic
data but also is futuristic in approach. Thirdly, in financial accounting the
major emphasis in cost classification is based on the type of transaction e.g.
Salaries, repairs, insurance, stores, etc. But in cost accounting the major
emphasis is on functions, activities, products, processes and on internal
planning and control and information needs of the organisation.
5.1.3.3 Utility Of Cost Accounting
A properly installed cost accounting system will help the
management in the following ways:
- the analysis of profitability of individual products, services or jobs.
- the analysis of profitability of different departments or operations.
- it locates differences between actual results and expected results.
- it will assist in setting the prices so as to cover costs and generate an
acceptable level of profit.
- cost accounting data generally serves as a base to which the tools and
techniques of management accounting can be applied to make it more
purposeful and management oriented.
- the effect on profits of increase or decrease in output or shutdown of a
product line or department can be analysed by adoption of efficient cost
accounting system.
5.1.3.4 Distinction Between Costing And Cost Accounting
Costing is the technique and process of ascertaining costs. It tries
to find out the cost of doing something, i.e., the cost of manufacturing an
article, rendering a service, or performing a function. Cost accounting
is a broader term, in that it tries to determine the costs through a formal
system of accounting (unlike costing which can be performed even through
informal means). Stated precisely, cost accounting is a formal mechanism
by means of which costs of products and services are ascertained and
controlled. The institute of cost and management accountants, u.k. define
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cost accounting as: the application of accounting and costing principles,
methods and techniques in the ascertainment of costs and the analysis
of savings and/or excesses as compared with previous experience or with
standards. It, thus, includes three things:
Ֆ Cost Ascertainment: finding out the specific and precise total and
unit costs of products and services.
Ֆ Cost Presentation: reporting cost data to various levels of management
with a view to facilitate decision making.
Ֆ Cost Control: this consists of estimating costs for production and
activities for the future, and keeping them within proper limits.
Budgets and standards are employed for this purpose.
Cost accounting also aims at cost reduction, i.e., achieving a
permanent and real reduction in cost by improving the standards. Cost
accountancy is a comprehensive term that implies the àpplication of
costing and cost accounting principles, methods and techniques to the
science, art and practice of cost control’. It seeks to control costs and
ascertain the profitability of business operations.
5.1.3.5 Classification Of Cost
In the process of cost accounting, costs are arranged and rearranged
in various classifications. The term `classification’ refers to the process of
Grouping costs according to their common characteristics. The different
bases of cost classification are:
1. By nature or elements (materials, labour and overheads)
2. By time (historical, pre-determined)
3. By traceability to the product (direct, indirect)
4. By association with the product (product, period)
5. By changes in activity or volume (fixed, variable, semi-variable)
6. By function (manufacturing, administrative, selling, research
and development, pre-production)
7. By relationship with the accounting period (capital, revenue)
8. By controllability (controllable, non-controllable)
9. By analytical/decision-making purpose (opportunity, sunk,
differential, joint, common, imputed, out-of-pocket, marginal,
uniform, replacement)
10. By other reasons (conversion, traceable, normal, avoidable,
unavoidable, total)
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1. Elements Of Cost
The elements of costs are the essential part of the cost. There are
broadly three elements of cost, as explained below:
(A) Material
The substance from which the produce is made is called material.
It can be direct as well as indirect.
I) Direct Material: it refers to those materials which become an integral
part of the final product and can be easily traceable to specific physical
units. Direct materials, thus, include:
1. All materials specifically purchased for a particular job or process.
2. Components purchased or produced.
3. Primary packing materials (e.g., carton, wrapping, card-board
boxes etc.).
4. Material passing from one process to another.
Ii) Indirect Material: all materials which are used for purpose ancillary
to the business and which cannot conveniently be assigned to specific
physical units are known as ìndirect materials’. Oil, grease, consumable
stores, printing and stationery material etc. Are a few examples of indirect
materials.
(b) Labour
In order to convert materials into finished products, human effort is
required. Such human effort is known as labour. Labour can be direct as
well as indirect.
I) Direct Labour:
It is defined as the wages paid to workers who are engaged in the
production process and whose time can be conveniently and economically
traceable to specific physical units. When a concern does not produce but
instead renders a service, the term direct labour or wages refers to the cost
of wages paid to those who directly carry out the service, e.g., wages paid
to driver, conductor etc. Of a bus in transport service.
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Ii) Indirect Labour:
Labour employed for the purpose of carrying out tasks
Incidental to goods produced or services provided is called indirect labour
or indirect wages. In short, wages which cannot be directly identified with a
job, process or operation, are generally treated as indirect wages. Examples
of indirect labour are: wages of store-keepers, foremen, supervisors,
inspectors, internal transport men etc.
(C) Expenses
Expenses may be direct or indirect.
I) Direct Expenses:
These are expenses which can be directly, conveniently and wholly
identifiable with a job, process or operation. Direct expenses are also
known as chargeable expenses or productive expenses. Examples of such
expenses are: cost of special layout, design or drawings, hire of special
machinery required for a particular contract, maintenance cost of special
tools needed for a contract job, etc.
Ii) Indirect Expenses:
Expenses which cannot be charged to production directly and which
are neither indirect materials nor indirect wages are known as indirect
expenses. Examples are rent, rates and taxes, insurance, depreciation,
repairs and maintenance, power, lighting and heating etc.
The above elements of cost may be shown by means of a chart:
Element of cost
materials
labour expenses
Direct
indirect direct
indirect direct
indirect
1. Overheads
The term overheads includes, indirect material, indirect labour and
indirect expenses, explained in the preceding paragraphs. Overheads may
be incurred in the factory, office or selling and distribution departments/
divisions in an undertaking. Thus overheads may be of three types: factory
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overheads, office and administrative overheads and selling and distribution
overheads. This classification of overheads may be shown thus:
Classification Of Overheads
Overheads
Factory office selling and distribution
Indirect indirect indirect indirect indirect indirect indirect indirect indir
Material labour exp mat lab. Exp. Mat. Lab exp
2. Cost Classification By Time
On the basis of the time of computing costs, they can be classified
Into historical and pre-determined costs.
I) Historical Costs:
These costs are computed after they are incurred. Such costs are
available only after the production of a particular thing is over.
Ii) Pre-Determined Costs:
These costs are computed in advance of production on the basis of
a specification of all factors influencing cost. Such costs may be:
1.
Estimated costs: estimated costs are based on a lot of guess
work. They try to ascertain what the costs will be based on certain factors.
They are less accurate as only past experience is taken into account
primarily, while computing them.
2.
Standard costs: standard costs is a pre-determined cost
based on a technical estimate for material, labour and other expenses for a
selected period of time and for a prescribed set of working conditions. It is
more scientific in nature and the object is to find out what the costs should
be.
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3. Cost Classification By Traceability
As explained previously, costs which can be easily traceable
to a product are called direct costs. Indirect costs cannot be traced to a
product or activity. They are common to several products (e.g., salary of
a factory manager, supervisor etc.) And they have to be apportioned to
different products on some suitable basis. Indirect costs are also called
òverheads’.
4. Cost Classification By Association With Product
Costs can also be classified (on the basis of their association with
products) as product costs and period costs.
1.Product Costs: product costs are traceable to the product and
include direct material, direct labour and manufacturing overheads. In
other words, product cost is equivalent to factory cost.
2.Period Costs: period costs are charged to the period in which
they are incurred and are treated as expenses. They are incurred on the
basis of time, e.g., rent, salaries, insurance etc. They cannot be directly
assigned to a product, as they are incurred for several products at a time
(generally).
5. Cost Classification By Activity/Volume
Costs are also classified into fixed, variable and semi-variable on
the basis of variability of cost in the volume of production.
1. Fixed Cost:
Fixed cost is a cost which tends to be unaffected by variations in
volume of output. Fixed cost mainly depends on the passage of time and
does not vary directly with the volume of output. It is also called period
cost, e.g., rent, insurance, depreciation of buildings etc. It must be noted
here that fixed costs remain fixed upto a certain level only. These costs
may also vary after a certain production level.
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2. Semi-Variable Cost:
These costs are partly fixed and partly variable. Because of the
variable element, they fluctuate with volume and because of the fixed
element, they do not change in direct proportion to output. Semi-variable
or semi-fixed costs change in the same direction as that of the output but
not in the same proportion. For example, the expenditure on maintenance
is to a great extent fixed if the output does not change significantly. Where,
however, the production rises beyond a certain limit, further expenditure
on maintenance will be necessary although the increase in the expenditure
will not be in proportion to the rise in output. Other examples in this
regard are: depreciation, telephone rent, repairs etc.
3. Variable Cost:
Cost which tends to vary directly with volume of outputs is called
`variable cost’. It is a direct cost. It includes direct material, direct labour,
direct expenses etc. It should be noted here that the variable cost per unit
is constant but the total cost changes corresponding to the levels of output.
It is always expressed in terms of units, not in terms of time.
6. Cost Classification By Function
On the basis of the functions carried out in a manufacturing concern,
Costs can be classified into four categories:
1.Manufacturing/Production Cost: it is the cost of operating the
manufacturing division of an enterprise. It is defined as the cost of the
sequence of operations which begin with supplying materials, services and
ends with the primary packing of the product.
2Administrative/Office Cost: it is the cost of formulating the policy,
directing the organisation and controlling the operations of an undertaking,
which is not directly related to production, selling, distribution, research
or development. Administration cost, thus, includes all office expenses:
remuneration paid to managers, directors, legal expenses, depreciation of
office premises etc.
3.Selling Cost: selling cost is the cost of seeking to create and
stimulate demand e.g., advertisements, show room expenses, sales
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promotion expenses, discounts to distributors, free repair and servicing
expenses, etc.
4.Distribution Cost: it is the cost of the sequence of operations
which begins with making the packed product, available for despatch
and ends with making the reconditioned returned empty package, if any,
available for re-use. Thus, distribution cost includes all those expenses
concerned with despatching and delivering finished products to customers,
e.g., warehouse rent, depreciation of delivery vehicles, special packing,
loading expenses, carriage outward, salaries of despatch clerks, repairing
of empties for re-use, etc.
5. Research And Development Cost: it is the cost of discovering
new ideas, processes, products by experiment and implementing such
results on a commercial basis.
6.Pre-Production Cost: expenses incurred before a factory is started
and expenses involved in introducing a new product are preproduction
costs. They are treated as deferred revenue expenditure and charged to the
cost of future production on some suitable basis.
7. Cost Classification By Relationship With Accounting Period
On the basis of controllability, costs can be classified as controllable or
uncontrollable.
1.Controllable Cost: a cost which can be influenced by the action
of a specified member of an undertaking is a controllable cost, e.g., direct
materials, direct labour etc.
2.Uncontrollable Cost: a cost which cannot be influenced by the
action of a specified member of an undertaking is an uncontrollable cost,
e.g., rent, rates, taxes, salary, insurance etc.
The term controllable cost is often used in relation to variable
cost and the term uncontrollable cost in relation to fixed cost. It should
be noted here that a controllable cost can be controlled by a person at a
given organisation level only. Sometimes two or more individuals may be
involved in controlling such a cost.
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8. Cost Classification By Decision-Making Purpose
Costs may be classified on the basis of decision-making purposes
for which they are put to use, in the following ways:
1.Opportunity Cost: it is the value of the benefit sacrificed in
favour of choosing a particular alternative or action. It is the cost of the
best alternative foregone. If an owned building, for example, is proposed
to be used for a new project, the likely revenue which the building could
fetch, when rented out, is the opportunity cost which should be considered
while evaluating the profitability of the project.
2.Sunk Cost: a cost which was incurred or sunk in the past and
is not relevant for decision-making is a sunk cost. It is only historical in
nature and is irrelevant for decision-making. It may also be defined as the
difference between the purchase price of an asset and its salvage value.
3.Differential Cost: the difference in total costs between two
alternatives is called as differential cost. In case the choice of an alternative
results in increase in total cost, such increase in costs is called ìncremental
cost’. If the choice results in decrease in total costs, the resulting decrease is
known as decremental cost.
4.Joint Cost: whenever two or more products are produced out of
one and the same raw material or process, the cost of material purchased
and the processing are called joint costs. Technically speaking, joint cost
is that cost which is common to the processing of joint products or by-
products upto the point of split-off or separation.
5.Common Cost: common cost is a cost which is incurred for more
than one product, job territory or any other specific costing object. It
cannot be treated to individual products and, hence, apportioned on some
suitable basis.
6.Imputed Cost: this type of cost is neither spent nor recorded
in the books of account. These costs are not actually incurred (hence
known as hypothetical or notional costs) but are considered while making
a decision. For example, in accounting, interest and rent are recognized
only as expenditure when they are actually paid. But in costing, they are
charged on a notional basis while ascertaining the cost of a product.
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7.Out-Of-Pocket Cost: it is the cost which involves current or
future expenditure outlay, based on managerial decisions. For example
a company has its own trucks for transporting goods from one place to
another. It seeks to replace these by employing public carriers of goods.
While making this decision, management can ignore depreciation, but not
the out-of-pocket costs in the present situation, i.e., fuel, salary to drivers
and maintenance paid in cash.
8.Marginal Cost: it is the aggregate of variable costs, i.e., prime cost
plus variable overheads.
9.Replacement Cost: it is the cost of replacing a material or asset in
the current market.
5.1.3.6 Cost Sheet
Cost sheet is a statement presenting the items entering into cost
of products or services. It shows the total cost components by stages and
cost per unit of output during a