Introduction to Cost Accounting

 

Introduction to

Cost Accounting

 

What is Cost

It is the actual or notional expenditure incurred on, or attributable to, a given process, product or service. It is a measure of resources that have been or must be sacrificed for a cost objective. A cost objective is something for which a separate cost determination is required to accomplish the overall costing objective. The cost objective can be a cost unit [A cost unit refers to one unit of the product manufactured or one unit of the service provided (or combination of these) in terms of which different elements of cost can be ascertained in order to calculate cost per unit of such product or service.] or a cost centre [A cost centre is a location, person or item of equipment (or group of persons or group of equipment) in terms of which different elements of cost can be ascertained and used for the purpose of calculating cost per unit of each product or service or for the purpose of cost control.] In short, cost represents the resources that have been or must be sacrificed to attain a particular objective.

 

What is Costing

It is the technique and process of ascertaining cost. It is the technique consisting of principles and rules which govern the procedure of ascertaining cost of products and services. The technique of costing mainly involves:

1)      Collecting expenditure;

2)      Recording and classifying the expenditure according to the elements of cost; and

3)      Allocation and apportionment of the expenditure to the process, operation, product or service.

 

What is Cost Accounting

It is the process of accounting for cost. This process begins with recording of income and expenditure and ends with preparation of statistical data. It can be referred to as the formal mechanism by means of which cost of products or services are ascertained and controlled. It has also been referred to as art of determining cost.

 

Cost accounting is also defined as the “process of accounting for cost from the point at which expenditure is incurred or committed to the establishment of its ultimate relationship with cost centres and cost units.” Broadly speaking, cost accounting covers the activities like preparation and analysis of statistical data with respect to different cost elements and their behaviour, application of cost control methods and ascertainment of profitability of the work carried out or planned.

 

The primary objectives of cost accounting:

(a)     Ascertaining per unit cost of various products and services,

(b)     Determining profit or loss for various products and services,

(c)     Valuation of inventory,

(d)     Controlling costs of all production, administration, selling and distribution activities, and

(e)     Stimulating cost-consciousness among all the employees including workers.

 

Advantages of cost accounting

1.             It helps in optimum utilisation of men, material and machine.

2.             It identifies the areas requiring corrective actions.

3.             It helps management in formulation of policies.

4.             It presents a tailor-made solution for the problems in the different functional areas of operation.

5.             It helps management in making decisions by use of techniques like marginal costing, etc.

6.             It provides useful data for final accounts by giving cost of closing stock of raw materials, work-in-progress and finished products.

7.             It provides a data-base for reference by Government, Wage Tribunals, Trade Unions, etc.

8.             It helps in formation of cost centres and responsibility centres to exercise control.

9.             It helps to face increasing difficulties in determining prices and improving efficiency.

10.      It facilitates use of specialised techniques like cost reduction, value analysis, operations research, management by exception, etc.

11.      It threads its way through every phase of business and to a large extent influences the make-up of the entire enterprise – its products, its markets and its methods of operation.

12.      It focuses attention on the profitability of each product and service unlike financial accounting, which presents profitability for company as a whole.

 

Limitations of cost accounting

1.             It is not an exact science and involves inherent element of judgement.

2.             Cost collected for one purpose may not be suitable for another purpose, because cost varies with purpose.

3.             Cost accounting presents the basis for taking the best decisions, but it does not give outright the solution of the problems.

4.             Most of the cost accounting techniques are based on some pre-assumed notions.

5.             Common costs are apportioned among different products mostly arbitrarily.

6.             Different views are held by different cost accountants about the items to be included in cost.

 

Classification of costs

Element-wise classification:

1.  Material cost – Direct materials and indirect materials

Direct materials are those materials which can be identified or readily traced with the products or production departments. Direct materials include:

1)            Materials specifically required for a process, a job order or a production order;

2)            Materials transferred from one process to another process;

3)            Requisition charges such as carriage inwards, freight inwards, import duties, octroi duties, insurance on incoming materials, etc.; and

4)            Primary packing materials.

 

Indirect materials are the materials of minor importance. These materials are not directly traceable to finished products. Examples of indirect materials are oil, grease, and cleaning materials for janitors (i.e. caretakers).

 

2.  Labour cost – Direct labour and indirect labour

Direct labour cost is that portion of wages or salaries which can be identified with and charged to a single cost unit. Labour cost will be classified as direct cost when:

(i)            There is a direct relationship between the labour cost and the product or process,

(ii)         The labour cost may be measured in the light of this relationship, and

(iii)       The labour cost is sufficiently material in amount.

 

Indirect labour costs are costs which are not identifiable with the production of specific goods or services. These labour costs are usually incurred in connection with production activities. Indirect labour costs consist of labour costs incurred in service departments such as purchasing, engineering and time-keeping. Labour costs of certain workers in the production departments will also come in the category of indirect labour like labour costs of foremen, material expediters and clerical assistants. The auxiliary labour for store-room, factory office and maintenance department will also be categorised as indirect labour. While direct labour forms part of prime cost, indirect labour cost becomes part of overhead.

 

3.  Overhead cost – Sum of all indirect costs including indirect material and indirect labour

A direct cost is a cost which can be easily identified with respect to a cost centre or cost unit or which can be conveniently allocated to different cost centres or cost units. Direct material and direct labour cost are categorised as direct costs.

 

An indirect cost is a cost which cannot be easily identified with respect to any cost centre or cost unit or which cannot be conveniently allocated to any of the different cost centres or cost units. All costs other than direct material cost and direct labour cost are categorised as indirect costs.

 

Operation-wise classification:

1.  Production cost

It represents prime cost plus absorbed production overhead. Prime cost is the aggregate of direct material cost and direct labour cost. Production overhead is the aggregate of all indirect costs necessary to be incurred to carry the production activities. Examples of production overhead are: remuneration of works manager, depreciation / insurance premium with respect to plant, machinery and building used for production purpose, lighting of production shop, power consumed in carrying out production activities, etc.

 

2.  Administration cost

It represents all indirect costs necessary to be incurred to carry out the function of administration. Examples of administration cost are: remuneration paid or payable to the staff of accounts department, purchase department and personnel department, all expenses pertaining to the corporate office, depreciation/insurance premium with respect to assets used in the office for official purpose, lighting of office premises, etc.

 

3.  Selling cost

It represents all indirect costs necessary to be incurred to carry out the function of selling. Examples of selling cost are: remuneration paid or payable to the staff of sales department, advertisement expenses, sales promotion expenses, salesmen’s commission, market research expenses, etc.

 

4.  Distribution cost

It represents all indirect costs necessary to be incurred to carry out the function of distribution of products. Examples of distribution cost are: remuneration paid or payable to the delivery personnel, delivery van maintenance expenses, depreciation/insurance premium with respect to the delivery van, etc.

 

Behaviour-wise classification:

1.  Fixed cost

2.  Variable cost

3.  Semi-variable/Semi-fixed cost

 

Fixed Costs:

Fixed cost is the cost which has to be incurred for a period, and which, within the installed capacity level tends to remain unaffected by the fluctuations in the levels of activity. In other words, fixed costs are the costs that remain unchanged in the short run regardless of changes in the levels of activity within the installed capacity level. Examples of fixed costs are depreciation of plant and machinery, rent of factory premises, insurance premiums on fixed assets, salaries and remuneration of staff, remuneration of directors, interest on loans, etc.

 

Variable Costs:

Variable cost is that part of total cost, which changes directly in proportion with volume. Total variable cost changes with change in volume of output. Increase in output will lead to increase in total variable cost and decrease in output will lead to reduction in total variable cost. However, variable cost per unit of production remains the same irrespective of increase or decrease in volume of production. Variable cost per unit is arrived at by dividing total variable cost by total units produced. Examples of variable costs are direct material cost, direct labour cost, direct expenses, etc.

 

Semi-variable Costs:

Semi-variable cost is that part of total cost, which is partly fixed and partly variable in nature. Semi-variable costs may remain fixed within a certain activity level, but once that level is exceeded, they vary without having direct relationship with volume changes. Semi-variable costs do not fluctuate in direct proportion to volume. For the purpose of marginal costing system, semi-variable costs must be segregated into fixed and variable costs. Examples: telephone bills, electricity bills, etc.