Cost Accounting

Chapter Module-1 - Introduction to Cost Accounting

Definition

Cost: - Generally cost refers to all expenses incurred in producing a

product or rendering service. But, from the cost accounting point of
view “Cost is a normal sacrifice of resources in the creation of product
or services”.

Costing: - Costing is defined as “the technique and process of

ascertaining cost of a given thing”.
According to CIMA it is defined as “the establishment of budgets,
standard, costs and actual costs of operations, processes, activities or
products and the analysis of variances, profitability or the social use of
funds”.

Cost Accounting: - Cost accounting is defined as “the process of

accounting for cost from the point at which expense is incurred or
committed to the establishment of its ultimate relationship with cost
centers and cost units.
The institute of Cost and Works Accountant ICWA defines “Cost
accounting is the technique and process of ascertainment of cost. Cost
accounting is the process of accounting for cost, which, begins with
recording of expenses or the basis on which they are calculated and
end with preparation of statistical data.

Cost Accountancy: - Cost accountancy is used to describe the

principles, conventions, techniques and systems which are employed
in a business to plan and control the utilization of its resources.
It is defined as “the application of costing and cost accounting
principles, methods and techniques to the science, art and practice of
cost control and the ascertainment of profitability. It includes the
presentation of information derived there-from for the purpose of
marginal decision making”.

Cost Centre: - Cost centre is defined as “a place or location or

machine or person or thing for which cost can be ascertained”. It is
the segment of activity or area of responsibility for which costs are
accumulated”.
Cost Unit: - Cost unit is defined as “a unit of a product or service or
combination of them in relation to which costs are ascertained or
expressed”.
Objectives of Cost Accounting: - The main objectives or purposes
of Cost accounting are as follows:

1. Ascertainment of Cost: - It enables the Management to ascertain

the cost of product, job, contract, services etc. The cost is calculated,
by aggregating expenses subject to certain concepts and conventions.

2. Analysis of Cost: - Total cost is broken down into several

constituent parts according to some basis for eg. Material labour
expenses. The detail information about these parts helps to know the
significance of each in the total cost.

3. Cost control: - The object is to minimize the cost of manufacturing,

comparison of actual cost with standards, reveals the discrepancies,
variances. If the variances are adverse the management enters into
investigation so as to adopt corrective action immediately.

4. Reduction of cost: - Reduction of cost refers to the permanent

reduction in the cost of a product or service without impairing the
quality and without affecting the purpose for which it is intended to be
used. Due to an instance competition in the market, the management
has little scope to vary the sales price. In such situation, it becomes
necessary to look into the activities that reduce the cost component.

5. Fixation of selling price: - Cost accounting provides cost

information on the basis of which selling prices of products or services
may be fixed. In periods of depression cost accounting guides in
deciding the extent to which the selling prices will be reduced to meet
the special situation.

6. Guide to business policy: - Cost accounting aims at serving the

needs of management in conducting the business with more efficiency.
Cost data provides guidelines for various managerial decisions, like
make or buy, selling below cost, utilization of idle plant capacity,
introduction of a new product etc.

Functions of Cost accounting

In order to pursue the objectives cost accounting is expected to
perform the following functions.

1. Cost book keeping: - It is a process of recording the relevant

transactions to facilitate ascertainment of cost various accounts are
maintained according to the principles of cost accounting.

2. Cost Analysis: - This is the function of establishing the relationship

between the cost and the various determinants of cost. It involves the
determination whether a cost is direct cost or indirect cost, normal cost
or abnormal cost etc. It serves costing objective.

3. Cost control: - This is the function of establishing relationship

between what should happen and what has happened. Cost accounting
facilitates preparation of standard cost and their comparison with
actual cost and the analysis of variances to their causes and remedial
measures.

4. Cost Comparison: - This is the function of comparing cost of

alternative prospects, proposals, plans and actions. This comparison
helps to take the right decision at crucial point of time.

5. Quotations: - Another important function of cost accounting is to

measure or scientifically estimate the cost of a job or work order to
quote the price. Getting the order depends on the appropriate
quotations, lower price may fetch more order and higher price may
fetch less order.

6. Cost Planning: - This is the function of planning involved in

accounting for cost every cost segment or element should be properly
planned and incurred accordingly. The overall planning of the
organization should flow down to the level of incidence of cost in order
to achieve the goal.

7. Cost Budgeting: - This is the function of facilitating to formulate

the cost budgets; the budget sets the overall limit of expenses and the
cost information guides to be within the set frame works.

Advantages of Cost accounting:

Following are the advantages of Cost Accounting:

1. Action against Unprofitable activities:-

It reveals unprofitable activities, inefficiencies such as wastage of
materials and wastage of resources, inadequate utilization etc. The
management is able to concentrate on profitable jobs and consider
change or closure of the unprofitable jobs.

2. Facilitates Decision Making: It provides necessary data along

with information to the management to take decision on any matter
relating to the business.

3. Assists in fixing prices: - The various types of cost accounting are

much helpful in fixing the cost and selling price of a product.

4. Improve Efficiency:-
Through the standard cost and budgetary control remedial action can
be chosen in order to improve the efficiency and implement new
principles.

5. Facilitates Cost Control: - It facilitates cost control possible by

comparisons, product wise, department wise or firm wise.

6. Establishes Standard Cost: - It enables the managers to find out

the cost of each job and to know what it should have cost. It indicates
where the losses and wastes occur before the work is finished.

7. Inventory Control: - It enables the management to have an

effective system and check on all materials and stores.

8. Prevents Fraud: - An effective costing system prevents frauds and

manipulation and supplies cost data to the management.

9. Tool of Management Control: - It provides systematic and

comparative reports to the management and in turn corrective
measures can be applied immediately.

10. Measuring Rods: - It records the performance of different groups

of workers, plant, and machinery etc for measuring their comparative
efficiency.

11. Future prospects: - The cost accountant not only provides the
present trend but future prospects also.

12. Budgeting: - As cost accounting reveals actual cost, estimated

cost and standard cost of products, preparation of budget is easy.

Disadvantages or limitations Cost accounting

1.) In cost accounting many judgments are biased and depend on the
individual discretion.
2.) It is based on various assumptions leading to wrong conclusions in
some cases.
3.) It is expensive and can be adopted only in big companies and not
suitable for small concerns.
4.) It lacks uniformity in application.
5.) Post apportionment may be arbitrary.
6.) Different types of costs are required for different purposes.
7.) Determination of standards is subject to fluctuations leading to
suspicion.
Financial Accounting versus Cost Accounting
.

FEATURES FINANCIAL ACCOUNTING COST ACCOUNTING

1. Distinction Transactions are recorded for a Transactions are identified
Period/Amoun definite period with cost units
t
2. Coverage It covers transactions of the It covers only a part of the
of whole firm pertaining to transactions namely
transactions business- complete manufacturing, sales service
etc - partial
3. Purpose It prepares to show the final It aims to guide the
results during a particular management for proper
period to owners, outsiders etc planning, control and
decision making
4. Efficiency The overall results of the It analyzes the profitability
business can be revealed by p and un-profitability of each
& l account but results of each department so that
dept. cannot be known as such corrective measures can be
corrective measures cannot be taken.
taken.
5.Material It does not tell us the It provides a system of good
control inefficiencies of material inventory control through a
handling as the figures are prescribed procedure for
available in aggregate purchases, storage issues
etc.
6. Transaction It deals with external It deals with internal
transactions transactions
7. Dealings It deals with actual facts and It deals partly with actual
figures facts & figures & partly with
estimate
8.Classificatio It makes no distinction It makes clear distinction
n between controllable and between controllable &
uncontrollable or fixed and uncontrollable or fixed &
variable costs variable cost. The cost can
be reduced to the minimum.
9. Stock It is valued at cost price or It is valued at cost
market price whichever less is.
10.Relative It does not reveal the relative It provides information of all
efficiency efficiencies of workers, plant, operations and can compare
machineries etc. with standard cost &
deviations can be analyzed
for corrective actions.
11.Legal They are kept as required by These accounts are
requirements Co’s Act, I.T. Act etc generally kept to meet the
requirements of the
Management
Methods of Costing

Following are the important methods of costing:

1. Job Costing: It is defined by ICMA London as “that form of specific

order, costing, which applies where work is undertaken to customer’s
special requirements.”
It means and applied to an industry, which produces a definite article
against individual orders from customers. This is a system of costing
where the items of cost are traced for specific jobs or orders. This type
of costing is suitable to printing press, repair shops, furniture
manufacture etc.

2. Contract Costing: The method of contract costing is applied where

the job is big and of longer duration. For each individual contract
separate accounts are kept and costs are ascertained. It applies to the
concerns like construction of roads, bridges, buildings etc.

3. Batch Costing: A batch may represent a number of small orders

partly in batches through the factory. The unit of cost is a batch or a
group of identical products. The total cost of a batch is ascertained and
the same is divided, by the number of units in the batch, so as to know
the cost per unit.

4. Multiple Costing: It means combination of two or more of the

above methods. This system of costing is adopted in manufacturing
concerns where a variety of parts are produced separately and later
assembled into a final product. It is also known as composite costing.
One system of costing cannot be applied due to the fact each
component differs from the other in respect of material in
manufacturing process.

5. Process Costing: It applies to industries where production is

carried on through different stages (process) before becoming a
finished product. The output of each process becomes the input of the
next process. Finished products are obtained at the end of each
process. The method of ascertaining the cost of each such processes
and the cost per unit at each process is known as process costing.

6. Single Output or Unit Costing: Under the method production is

continuous and units are identical. By preparing a cost sheet the cost
per unit is arrived at by dividing the total cost by the total number of
units produced.

7. Operating Costing: This method is used by those industries, which

render services instead of producing goods. This system is adopted
where expenses are incurred for provision of services. For eg.
Transport companies, Electricity co’s, Railways etc.
8. Departmental Costing: It is a method of cost finding adopted to
ascertain the cost of operating a department or a cost center
separately.

Techniques of costing

1. Historical Costing: It refers to the ascertainment of cost after they

have been incurred. For example the expenditure on building, which is
still in use?

2. Standard Costing: Standard cost is predetermined cost. The costs

are determined in advance of production. Standard performance is said
in terms of cost and actual costs are compared with the standards.

3. Uniform Costing: It is a system of costing which are adopted by

the undertaking for all its products. This system enables inter-firm
comparisons.

4. Marginal Costing: This system of costing differentiates between

fixed cost and variable cost, Under this system the cost is ascertained
for producing excess of a unit of a commodity. The cost that is saved
by decreasing the production by one unit is called marginal cost.

Cost Classification

There are various ways of classifying cost, each classification serves a

different purpose. Important classifications are given below.

1.) Functional Classification: On this basis costs are classified into

the following groups.

a.) Manufacturing Cost: Also named production cost or factory cost.

This is the cost of the sequence of operation, which begins with
supplying material, labour and services and ends with the completion
of production. Examples of Manufacturing Cost are materials, wages,
power, lighting etc.

b.) Administration Cost: This is the general administration cost and

includes all expenditure incurred in formulating the policy, directing
the organization and controlling the operations of an undertaking
which is not directly related to production and selling and distribution
functions.
Examples: Office rent, postage, legal expenses, audit fees, directors
remuneration.
c.) Selling and Distribution Cost: Selling cost is the cost of seeking
to create and stimulating demand and of securing orders.
Examples:- Advertising, Salaries & Commission of Sales men,
Showroom expenses etc.

Distribution cost is the cost of sequence of operation, which begins

with making the packed products available for dispatch, and ends with
and ends with making the reconditioned returned empty package for
reuse.
Examples; Carriage outwards, Packing cost, Operating cost of delivery
vans, Wearhousing etc.

2.) Classification according to variability or cost behaviour:-

a.) Fixed Cost: These costs remain fixed in total and do not increase
or decrease when the volume of production increases or decreases. Ex;
Rent, Managerial salaries etc.

b.) Variable cost: These costs fluctuate in proportion to the volume of

production. In other words when volume of output increases total
variable cost also increase and vice versa. But the variable cost per
unit remains fixed.
Ex. Direct material cost, Direct wages, Power etc.

c.) Semi- Variable Cost or Semi Fixed Cost: There are certain items
of cost which are partly fixed and partly variable, these are termed as
semi fixed or semi variable cost.
Ex. In case of telephone expenses, there is a minimum rent and after a
specified number of calls, charges are according o the number of
additional calls made.
Thus telephone costs are semi fixed. Other examples :- Depreciation,
Indirect labour, repairs and maintenance etc.

3.) Classification of Cost into Direct and Indirect

Direct Cost:- Direct costs are those which are incurred for and may
be conveniently identified with a particular product, process or
department. Cost of raw materials used and labour employed in the
manufacture of a product are common examples of direct cost.

Indirect Cost: Indirect costs are general cost and are incurred for the
general benefit of a number of cost units, processes or departments.
These costs cannot be conveniently identified with a particular cost
unit or cost center. Depreciation of machinery, lighting, insurance,
materials used in repairs etc. are common examples of indirect cost.
4.) Classification according to Controllability.

a.) Controllable Costs: These are the costs, which may be directly
regulated at a given level of management authority. Variable costs are
generally controllable by departmental heads.
Examples; Cost of raw materials may be controlled by purchasing in
large quantities.

b.) Uncontrollable Costs: These are those costs which cannot be

influenced by the action of a specified member of an enterprise Fixed
costs are generally uncontrollable.
Examples; It is very difficult to control cost like factory, rent,
managerial salary etc.

Other classification

1.) Conversion Cost: The cost, which, is incurred to convert the raw
material into finished product is called conversion cost.

2.) Opportunity Cost: This is the benefit foregone for having selected
one alternative use against another for eg; the benefit lost for not
having selected a project, which gives an income of Rs.10, 000/- as
against a product selected which gives an income of Rs.12, 000/-.

3.) Imputed Cost: [Hypothetical Cost]: This type of cost is neither

spent nor recorded in the books of account For ex. Interest on capital,
Rent on freehold
Premises etc; are notional costs. These types of costs are not actually
incurred but are to be considered in making decision but in costing
they are charged while ascertaining the cost of a product.

4.) Replacement Cost: It is a cost of replacing a material or product

in current market.

5.) Sunk Cost: A cost which was incurred or sunk in the past and is not
relevant to the particular decision, making, is a sunk cost. For ex.:- the
expenditure on building which is abundant.

6.) Out of Pocket Cost : The cost which involves the cash outflow due
to a particular management decision is called out of pocket cost for ex.
Depreciation

7.) Shut down Cost: It refers to the cost which continue to occur even
after the shutting down of the plant or temporary stoppage of
production activities such as salary of workmen, Rent, Depreciation
etc.

Cost Sheet: A cost sheet is a statement showing the detail of various

elements of cost in the manufacture of a product. It is defined as a
document, which provide for the assembly of the
detailed cost of a cost center or cost unit.
A cost sheet provides the split up of cost as prime cost, works cost,
cost of production, cost of goods sold and sales. A cost sheet will
reveal the cost per unit and well as total cost

Elements of Cost: The following chart shows the various elements of

cost.

Total Cost

Material Labour Expenses

Direct Indirect Direct Indirect Direct

Indirect

Prime Cost Overhead

Overhead

Factory OH AdminveOH Selling&Distribn.

OH

Direct Material + D. Labour + D. Expenses = Prime cost

Prime Cost + Factory OH = Factory Cost
Factory Cost + Administrative OH = Cost of production
Cost of prodn + Selling & Distrn. Exp. = Cost of sales
Cost of Sales + Profit = Sales

In the books of …..

Cost sheet for the period of …..
 Particulars Amoun Amoun
t t
Opening stock of Raw-material Xxxxx
Add: Purchase of Raw-material Xxxxx
Less: Closing stock of Raw-material Xxxxx
Raw-materials consumed Xxxxxx
Add: Direct Wages Xxxxxx
Add: Direct Expenses Xxxxxx
Prime Cost Xxxxxx
Add: Factory Overhead Xxxxxx
Xxxxxx
Add: Opening stock of Work-in-progress Xxxxxx
Less: Closing stock of Work-in-progress Xxxxxx
Works Cost/Factory cost Xxxxxx
Add: Office and Administration overhead Xxxxxx
Cost of Production Xxxxxx
Add: Opening Stock of Finished goods Xxxxxx
Less: Closing stock of finished goods Xxxxxx
Cost of goods sold Xxxxxx
Add: Selling and distribution overhead Xxxxxx
Cost of Sales Xxxxxx
Profit/Loss Xxxxxx
Sales Xxxxxx
 The cost is composed of three elements- Materials, labour and
expenses. Each of these elements can be direct and indirect that
is direct material and indirect material, direct labour and indirect
labour, direct expenses and indirect expenses.

Direct Material: Direct Materials are those materials, which can be

conveniently identified with and allocated to cost units. Direct
materials generally become a part of the finished product. Ex. Leather
in shoe making, cloth in garments, timber in furniture.

Direct Labour: Direct labour cost consists of wages paid to workers

directly engaged in converting raw materials into finished products.
These wages can be conveniently identified with a particular product,
job or process. Wages paid to a machine operator is a case of direct
wages.

Direct Expenses: These expenses are also known as chargeable

expenses, include all direct cost other than direct material and direct
labour that are specially incurred for a particular product or process.
Ex. Cost of special moulds & patterns, Royalties, higher charges of
plant for a particular job etc are direct expenses.

Prime Cost: The aggregate of direct material cost direct labour cost
and direct expenses is termed as prime cost.

Overheads: Overhead is the total of all indirect expenses. It is defined

as “ the aggregate of indirect material, indirect labour, and indirect
expenses. Overhead is also known as on cost, supplementary cost,
burden etc.
OH thus consists of three elements namely:- Indirect material, Indirect
labour, and Indirect expenses.

Indirect Material: They are those materials which cannot be

identified with individual cost unit. These are generally minor in
importance.
Ex. Coal, Lubricating oil, Sand paper, soap etc.

Indirect Labour: It is of general character and cannot be conveniently

identified with a particular cost unit. Indirect labour is not directly
engaged in production but only indirectly assists in production
operations. Ex. Peon, Watchman Supervisor etc.

Indirect Expenses: All indirect costs other than indirect materials and
indirect labour cost are termed as indirect expenses. These cannot be
directly identified with a particular job, process, or work order and are
common to cost units and cost centers. Ex. Rent & rates, Insurance,
depreciation, Power, Cartage, Advertising etc.
Overheads are classified into production overhead, administration OH,
& Selling and Distribution OH.

Production OH:- It includes all indirect costs which are connected

with the manufacture of a product. It is also known as Manufacturing
OH or Work OH.
Ex. Factory rent, Coal, Depreciation of plant, power, grease, oil,
lubricants etc.

Office or Administrative OH: These are the OH’s incurred in the

General management and administration of the enterprise. Ex. Office
rent, Office lighting, Audit fees, Ofice printing & stationery.

Selling and Distribution OH: Selling Oh’s are incurred in promoting

sales and securing orders. Ex. Advertisement expenses, Salaries of
salesmen, Showroom expenses.
Distribution Overhead include all expenditure incurred from the time
the product is complete and put in storage for despatch until it reaches
customers.
Ex. Upkeep and running cost of delivery vans, packing cost,
wearhousing cost, carriage outwards etc.

Installation of a Costing System

Cost accounting is an independent system, many advantages are

derived to the
organization from the system. In the wake of computer invention the
scope of the system is enlarged. Certain expenses are incurred to
install this system. The advantages of this system would outweigh the
expenses to be incurred, in the long run. Not only the big firms even
the small firms can develop this system in a simple and small way.
Proper care should be taken to see that the system is installed
properly. Otherwise it may become a burden to the company. The
extent of the requirement & complexity of the system depends on the
objectives of the management. It must not only meet the internal
needs but also the external needs such as legal requirements,
Government and the industry.

The installation of the costing system requires the following steps to be

taken:

1. Preliminary investigations should be made relating to the

technical aspects of business.
2. The organizational structure of the business should be studied to
ascertain the scope of authority of each executive.
3. The methods of purchase, storage, and issue of materials should
be examined and modified as per the requirements.
4. The existing methods of remunerating labour should be
examined.
5. Forms and accounting records should be so designed so as to
involve minimum clerical labour and expenditure.
6. The size and layout of the factory should be studied.
7. The system should be effective in cost control and cost
reduction.
8. Costing system should be simple and easy to operate.
9. The installation and operation of the system should be
economical.
10. The system should be improved gradually.