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Meaning & Significance of Costing

(a) Meaning of Costing
Collection & analysis of relevant cost data for interpretation & presentation to
management for decision making & control.
It is a set of procedures used in refining raw data into useful information for:
- Managerial decision making
- Ascertaining products/services cost
- Ascertaining products/services profitability

(b) Significance of Costing

Company having proper cost accounting system helps management in following
ways:
 Profitability analysis of individual Jobs, Products & Services can be done. By this
analysis management can take decision of discounting unprofitable lines.
 Analysis of cost behavior of various items of expenditure helps to make future
estimates of cost with reasonable accuracy.
 It locates difference between actual results & expected results. This is useful for
managerial control.
 For setting prices of different products & for designing pricing policy costing data is
very much useful.
 Useful for assessing effect of decrease in output or of shutdown on profitability.
 Useful for initiating actions for efficient use of available resources.
 Performance of managers can be judged on basis of cost saving & cost reduction by
them. Costing data is very much useful for this.
 Costing data is useful for knowing effect of
-- Improvement of productivity
-- Modernization of plant
-- New management techniques on costs & profits of company.
 By using technique of Activity Based Costing (ABC) unprofitable & non value added
activities can be corrected or eliminated.
 It is essential for management to assess the effect of various strategies on cost of final
products/services. This is readily and continuously provided by costing department.

Important Aspects of Cost

a) Cost
Resource sacrificed or forgone to achieve specific objective. It is measured in monetary
terms. It is an amount paid to acquire goods or services. An actual cost is the cost incurred
(historical cost) as distinguished from budgeted (or forecasted) cost

b) Cost Object

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 To guide their decisions, managers want to know how much a particular thing such as
product, machine, service or process costs. This is called cost object. It is an activity or
operation in which resources like material, labour etc. are consumed. Cost may pertain to
more than one cost objects simultaneously e.g. material cost may be a part of product cost
as well as production department cost.

c) Cost Unit
It is a unit of product, service or combination of them in relation to which costs are
ascertained or expressed.
Selection of cost unit depends on:
 Nature of business
 M.I.S.
 Requirements of costing system.
Exs. Of cost unit are:
Industry Cost unit
Automobile No.
Biscuit Kg.
Chemicals Lit/Kg/Ton
Textile Meters

Cost Components

(I) Prime Cost

It is total of Materials, Labour & Expenses directly related to production. They are
called as direct material, direct labour, direct expenses respectively.

Prime Cost = (Direct Material) + (Direct Labour) + Direct Expenses)

(a) Direct Material
Material which directly goes into and forms part of the product is direct material . e.g.
sugar used in Cadbury chocolates. It includes all materials consumed in process of
manufacture up to its primary packing. It consists of raw materials, bought outs &
primary packing material.

Direct Material = (Raw material)+(Bought outs)+(Primary Packing material)

(i) Raw material is the material on which processing is carried out in the factory
e.g. steel sheets used to manufacture Indica car.
(ii) Bought outs are the components & parts readily bought from outside & are
fitted in the product e.g. bought outs for Tata Motors Ltd. include A.C.
(iii) Primary Packing Material is the packing material required for presenting
product to customer e.g. wrapper used by Parles biscuits.

(b) Direct Labour

It includes all remuneration & other benefits paid to workmen who are directly
involved in manufacturing of a product

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 (c) Direct Expenses
Expenses incurred specifically for a particular product e.g. cost of drawings &
Designs for Maruti 800 is added to cost of Maruti 800 & for Alto is added to cost of
Alto

Direct Expenses = Expenses for particular job, product or process

(II) Overheads
It is total of Material, Labour & Expenses not directly related to production

Overheads = (Indirect Material) + (Indirect Labour) + (Indirect Expenses)

(a) Indirect Material

The material which is not present in product but is required to accelerate rate of
production e.g. machine oil, coolants, welding rods etc.

Indirect Material = Total expenses on all indirect material

(b) Indirect Labour

Salaries & benefits given to employees who are not involved in the Process of
production but these employees are required to accelerate the rate of production
e.g. supervisors, executives, security guards.
(c) Indirect Expenses
These expenses are not directly related to a particular product, process, or job.
They are common expenses for all the products. e.g. electricity, telephone,
computer, traveling etc.

Cost Classification
a) Element wise
Costs can be collected under 3 main elements viz Material, Labour, Expenses.When these
costs can be identified easily with cost unit, operation or cost centre they are called direct or
traceable costs. When these costs cannot be allocated but can be apportioned to cost centers
or cost units they are called overheads.

There are three main elements of costs

i) Materials
a) Direct Materials
b) Indirect Materials
ii) Labour
a) Direct labour
b) Indirect labour
iii) Expenses
a) Direct expenses
b) Indirect expenses
Direct Material + Direct Labour + Direct Expenses = Prime Cost
Indirect Material + Indirect Labour + Indirect Expenses = Overhead

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b) Function wise
1) Production Cost: Includes all direct labour, direct material direct expenses &
manufacturing overheads. All costs starting with supply of material till production of
finished goods are included in this cost. Production manager controls this cost.
2) Administration cost: is incurred for carrying the administration functions of organization
3) Selling & Distribution Cost: All the costs related to distribution, marketing, sales & after
sales services of company’s product are included in these costs.
4) Research & Development cost include all cost searching new products & processe and
improving existing products & processes.
c) Behaviour wise
1) Variable costs: are those costs which tend to vary in accordance with level of activity
within relevant range of activity & within given period of time. There is linear
relationship between volume and variable costs. They are constant per unit.
Egs: Direct material cost, direct labour cost, transport, sales commission, fuel etc.
2) Fixed Costs : are those costs which are unaffected by changes in level of activity during
given period of time. They remain constant in total regardless of changes in output & for
certain period of time.
Ex: Depreciation, interest on term loans, insurance, property taxes.
3) Semi variable costs: They are neither perfectly variable nor absolutely fixed in relation to
changes in volume. They change in same direction as volume but not indirect proportion.
Ex: Telephone, Electricity, Maintenance cost.

d) Control wise
1) Controllable costs are those which can be controlled by specific action of a particular
member of organization e.g. sales & marketing expenses can be controlled by marketing
manager of a company.
2) Uncontrollable costs are those which cannot be controlled by action of a particular
manager.
e.g. depreciation & interest cost are uncontrollable by action of any particular manager.
These costs are generally incurred by actions of top management.

e) Normality wise
1) Normal costs are those incurred in normal course of business e.g. normal losses or
wastages. These costs must be considered while calculating cost of a product, process or
service.
2) Abnormal costs are those costs which do not incur in normal course of business. e.g.
abnormal wastages. These costs are deleted from costing of a product, process or service.

f) Decision wise
1) Opportunity Costs

It is the value of a benefit sacrificed in favour of an alternative course of action. It represents

income foregone by rejecting alternatives. They are therefore not incorporated into formal
accounting system because they do not incorporate cash receipts or cash outflows. Opportunity

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 costs are very much relevant while examining alternative proposals or projects. Every manager is
trying to use limited resources available to him. If resources are applied to alternative B instead
of A then opportunity cost is the potential benefits foregone from alternative A. The concept is
useful to the management in decision making among alternatives.

2) Imputed or Notional costs

It is hypothetical or notional. It does not involve any cash outlay. It is computed
only for decision making. It is used for evaluating performance of profit centers where
managers are having responsibility of managing revenues & expenses in their respective
centers. Eg.: interest on funds internally generated, payment for which is not actually
made.

3) Sunk Cost
It is historical cost incurred in past. It is sunk in the past. It is not relevant in particular
decision making. Eg: While considering replacement of a plant, depreciated book value of
old asset is irrelevant as amount is sunk cost.

iv) Relevant Cost

It is relevant for specific purpose or situation. It is anticipated, future cost which
differs among different alternatives under consideration. Eg. many times fixed costs are
irrelevant in decision making.

Cost Sheet

Detailed statement showing actual cost of products, job order, contract etc.

Significance :
a) It shows total cost of product & average cost per unit
b) Different elements of total cost are highlighted
c) Useful for cost control
d) Locates inefficient areas & products
e) Useful for controlling wastages
f) It is a basis for preparing budgets & tenders
g) Selling prices of products can be fixed on the basis of cost shown by cost sheet.
h) Shows stocks of each product.
i) Useful for fixing responsibilities of diff. managers.

Format of Cost Sheet

Op. Stock ( Raw material)
+ Purchases ( Incl. fright I/W)
- Clo. Stock (Raw material)
= Materials Consumed (a)
Direct Labour (b)

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 Direct Expenses (c)

Prime Cost (a+b+c)

+ Factory overheads (net of scrap)

+ Op. Stock (WIP)
- Clo. Stock (WIP)
-
= Factory or Works Cost

+ Administration overheads

= Cost of Production of Goods Produced

+ Op. stock of finished goods

- Clo. Stock of finished goods

= Cost of Prodn. of goods Sold

+ Selling & Distribution. Overheads

= Cost of Sales

+ Profit

= Sales (Net of taxes)

Items not included in Cost Sheet

1) Interest paid to owners on capital
2) Legal expenses related to loan
3) Commission on share/debenture issue
4) Any penalty, damages payable
5) Loss on sale of fixed assets or investments
6) Income tax paid
7) Transfer of funds to any reserves
8) Goodwill amount paid or written off
9) Preliminary expenses
10) Discount on debentures
11) Charitable donations not related to business
12) Any capital expenditure
13) Any abnormal loss
14) Over/under valuation of stock
15) Any expense not related to particular product.

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 Notes:

j) Material consumed = Opening stock + Purchases – Closing stock

Q.1) Calculate Prime Cost

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Q.2) Calculate Prime Cost

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Q3 ) Calculate Works Cost

Opening Stock of RM- Rs 40000

Purchases- Rs 100,000
Carriage Inward Rs 10000
Direct Wages- Rs 60000
Opening Stock of WIP Rs 25000

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Q.4) Calculate Cost sheet

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Solution:

Q5)

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 10% on cost of materials. Factory overhead 50% of wages.
 10% of the casting was rejected and a sum of 6,000 was realised on sale as scrap.
 10% of finished products was found to be defective and the defective products were
rectified at an additional expenditure which is equivalent to 20% of proportionate direct
wages.
 The total output was 10,000 tonnes during the year.
 Ascertain the manufacturing cost per tonne.

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HOMEWORK-

Ques.1) From the following figures extracted from the books of Shree Engineering Ltd
for the year ended 31/3/2009
Direct material 80,000 Direct wages 40,000
Indirect wages 10,000 Direct expenses 12,000
Electric power 1,000 Depreciation of office building 1,000
Depreciation of plant & 2,000 Directors fees 2,000
Mach
Oil and waste 2,00 Lubricants 300
Consumable stores 1000 Bad debts 2,000

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 Postage and telegraph 500 Lighting- factory – 1000
Office – 400
Carriage outward 300 Office printing and stationary 500
Storekeepers wages 1200 General selling expenses 2000
Travelling expenses 1000 Telephone charges 800
Rent – factory- 2000 Managers salary 3000
Office – 1000
General factory expenses 500

Ques. 2) Prepare cost sheet from the following

Raw material consumed Rs. 160000
Direct wages Rs. 80000
Factory overheads Rs. 16000
Selling overhead 12,000
Units produced 4000 and units sold 3600
Office overheads 10% of factory costs
Selling price Rs. 100 per unit

Ques. 3) The books and records of the Anand Manufacturing company presents the following
data for the month of August, 2009
Direct labour cost Rs. 16,000 (160% of factory overhead)
Cost of goods sold Rs. 56,000
August 1st 31st August
Raw materials 8000 8600
WIP 8000 12000
Finished goods 14000 18000
Selling expenses: Rs. 3400
General and administration expenses: Rs. 2600
Sales for the month : 75000
You are required to prepare a statement showing cost of goods manufactured and sold
and profit earned.

Ques. 4) Following particulars are available n respect of cost structure for the product XYZ
for the quarter ended on 31st December, 2009
Rs.
Opening stock of raw materials 15,000
Purchases of raw materials 75,000
Freight & insurance on materials 6,000
Carriage inwards on materials 4,000
Return of material to suppliers 5,000
Closing stock of materials 20,000
Normal loss of materials 2,000
Accidental loss of materials 6,000
Productive wages paid 52,000
Wages outstanding 4,000
Factory Expenses 20,000

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Office & Adm. Exp 32,000
Office Rent 4,000
Office Exp. Prepaid 2,000
Selling expense 20,000
Distribution Expenses 5,000
The selling price is fixed by profit of 20% on selling price. Prepare a cost sheet.

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