ASSIGNMENT

UNIT 2: Cost Concepts

1. “Cost accounting is a tool of managerial planning and control”. Explain the
statement.
Answer:
Cost accounting may be regarded as “a specialised branch of accounting which involves classification,
accumulation, assignment and control of costs. ”The Costing terminology of C.I.M.A. 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 the social use of funds. ”Cost
accounting is different from costing in the sense that the former provides only the basis and information
for ascertainment of costs. Once the information is made available, costing can be
carried out arithmetically by means of memorandum statements or by method of integral
Accounting.

Cost accounting is the process of collecting information about the costs incurred by a company’s
activities, assigning selected costs to products and services and other cost objects, and evaluating the
efficiency of cost usage. It is mostly concerned with developing an understanding of where a company
earns and loses money, and providing input into decisions to generate profits in the future.
Here critically examine the need and importance of cost accounting with reference to the inadequacies of
financial accounting.
(a) Costing helps in periods of trade depression and trade competition –
In periods of trade depression the business cannot afford to have leakages which pass unchecked. The
management should know where economies may be sought, waste eliminated and efficiency increased.
The business has to wage a wax for its survival. The management should know the actual cost of their
products before embarking on any scheme of reducing the prices of giving tenders. Adequate costing
facilitates this.
(b) Aids in price fixation –
Though economic law & supply and demand and activities of the competitors, to a great extent, determine
the price of the article, the cost to the producer does play an important part. The producer can take
necessary guidance from his costing records.
(c) Helps in estimate –
Adequate costing records provide a reliable basis upon which tenders and estimates may be prepared.
The chances of losing a contract on account of overrating or losing in the execution of a contract due to
underrating can be minimized. Thus, “ascertained costs provide a measure for estimates, a guide to
policy, and control over current production”.
(d) Helps in channeling production on right lines –
Costing makes possible for the management to distinguish between profitable and non-profitable activities
profit can be maximized by concentrating on profitable operations and eliminating non-profitable ones.
(e) Wastages are eliminated –
As it is possible to know the cost of the article at every stage, it becomes possible to chock various forms
of waste, such as time, expenses etc. or in the use of the machine, equipment, and tools.
(f) Costing makes comparison possible –
If the costing records are regularly kept, comparative cost data for different periods and various volumes
of production will be available. It will help the management in forming future lines of action.
(g) Provides data for periodical profit and loss accounts –
Adequate costing records supply to the management such data as may be necessary for the preparation
of profit and loss account and balance sheet, at such intervals as may be desired by the management.
It also explains in detail the sources of profit or loss revealed by the financial accounts thus helps in the
presentation of better information before the management.
(h) Aids in determining and enhancing efficiency –
Losses due to wastage of material, the idle time of workers, poor supervision etc., will be disclosed if the
various operations involved in manufacturing a product are studied by a cost accountant. The efficiency
can be measured and .costs controlled and through it, various devices can be framed to increase
efficiency.
(i) Helps in inventory control –
Costing furnishes control which management requires in respect of stock. of materials, work-in-progress
and finished goods. (This has been explained in detail under the chapter “Material’s”)
(j) Helps in cost reduction –
Costs can be reduced in the long run when alternatives are tried. This is particularly important in the
present day context of global competition cost accounting has assumed special significance beyond cost
control this way.
(k) Assists in increasing productivity –
The productivity of material and labor is required to be increased to have growth and more profitability in
the organization costing renders great assistance in measuring productivity and suggesting ways to
improve it.

2. Classify cost on the basis of nature of elements.

Answer:

Cost is the amount of expenditure incurred on a given thing and to ascertain the cost of a given thing. A
‘cost’ is the sum of three groups or components – the purchase or transfer price of materials, the cost of
the hire of labour and the value of other disbursements made or expenditure incurred in achieving the
desired product or result. Thus, the total cost is the sum of materials, wages and overheads (i.e. all
other expenses).
By grouping the elements of cost, the following divisions of cost are obtained:

Prime Cost = Direct materials + Direct labour + Direct expenses

Factory cost = Prime cost + Factory over heads
Cost of production = Factory cost + Administrative overheads
Cost of sales = cost of production + selling and distribution overhead.

a. Material:
Direct material is the material which becomes a major part of the finished product and can be easily
traceable to the units. Includes materials specifically purchased for a particular job/process, material
acquired and latter requisitioned from stores, components purchased or produced, primary packing
materials and material passing from one process to another. Indirect material is that which is used for
purposes ancillary to production and which can be conveniently assigned to specific physical units is
termed as indirect materials. Examples, oil, grease, consumable stores, printing and stationary material
etc.
b. Labour:
Direct labour is the wages paid to workers who are engaged in the production process whose time can
be conveniently and economically traceable to units of products. Wages paid to compositors in a
printing press, to workers in the foundry in cast iron works, etc. are few examples of direct labour.
Indirect labour is the labour employed for the purpose of carrying tasks incidental to goods or services
provided. It cannot be practically traced to specific units of output. Wages of store-keepers, foreman,
time-keepers, supervisors, inspectors, etc. are few examples of indirect labour.
c. Expenses:
Direct expenses are incurred on a specific cost unit and identifiable with the cost unit. Examples are
cost of special layout, design or drawings, hiring of a particular tool or equipment for a job; fees paid to
consultants in connection with a job, etc. Indirect expenses cannot be directly, conveniently and wholly
allocated to cost centre or cost units. Examples are rent, rates and taxes, insurance, power, lighting and
heating, depreciation etc. Overheads It is the aggregate of indirect material costs, indirect labour costs
and indirect expenses.

Classification by Nature
This is the analytical classification of costs. Let us divide as per their natures. So basically there are
three broad categories as per this classification, namely Labor Cost, Materials Cost and Expenses.
These heads make it easier to classify the costs in a cost sheet. They help ascertain the total cost and
determine the cost of the work-in-progress.

Material Costs: Material costs are the costs of any materials we use in the production of goods. We
divide these costs further. For example, let’s divide material costs into raw material costs, spare parts,
costs of packaging material etc.
Labor Costs: Labor costs consists of the salary and wages paid to permanent and temporary
employees in the pursuit of the manufacturing of the goods
Expenses: All other expenses associated with making and selling the goods or services.

Classification by nature

The total cost of making a product or providing a service consists of the following:
(a) Cost of materials
(b) Cost of the wages and salaries (labour costs)
(c) Cost of other expenses
(i) Rent and rates
(ii) Electricity and gas bills
(iii) Depreciation
 Direct costs and indirect costs
A direct cost is a cost that can be traced in full to the product, service, or department that is being
costed.
An indirect cost (or overhead) is a cost that is incurred in the course of making a product, providing a
service or running a department, but which cannot be traced directly and in full to the product, service or
department.
Materials, labour costs and other expenses can be classified as either direct costs or indirect costs
 Direct material costs are the costs of materials that are known to have been used in making and
selling a product (or even providing a service). Example
 Materials = Direct materials + Indirect materials
+ + +
Labour = Direct labour + Indirect labour
+ + +
Expenses = Direct expenses + Indirect expenses
TotalCost = Direct cost + Overhead

 Direct labour costs are the specific costs of the workforce used to make a product or provide a
service. Direct labour costs are established by measuring the time taken for a job, or the time
taken in ‘direct production work’
 Other direct expenses are those expenses that have been incurred in full as a direct
consequence of making a product, or providing a service, or running a department.
Examples of indirect costs include supervisors’ wages, cleaning materials and buildings insurance

Analysis of total cost

Full cost of sales
In costing a small product made by a manufacturing organisation, direct costs are usually restricted to
some of the production costs. A commonly found build-up of costs is therefore as follows.

Production costs
Direct materials A
Direct wages B
Direct expenses C
Prime cost A+B+C
Production overheads D
Full factory cost A+B+C+D
Administration costs E
Selling and distribution costs F
Full cost of sales A+B+C+D+E+F

Production overhead
Production (or factory) overhead includes all indirect material costs, indirect wages and indirect
expenses incurred in the factory from receipt of the order until its completion.
Production overhead includes the following.
 Indirect materials which cannot be traced in the finished product. Consumable stores, e.g.
material used in negligible amounts
 Indirect wages, meaning all wages not charged directly to a product. Wages of non-productive
personnel in the production department, e.g. foremen
 Indirect expenses (other than material and labour) not charged directly to production.
(i) Rent, rates and insurance of a factory
(ii) Depreciation, fuel, power, maintenance of plant, machinery and buildings

Administration overhead
Administration overhead is all indirect material costs, wages and expenses incurred in the direction,
control and administration of an undertaking.
Examples of administration overhead are as follows.
 Depreciation of office buildings and equipment.
  Office salaries, including salaries of directors, secretaries and accountants.
 Rent, rates, insurance, lighting, cleaning, telephone charges and so on.

Selling overhead
Selling overhead is all indirect materials costs, wages and expenses incurred in promoting sales and
retaining customers.
Examples of selling overhead are as follows.
 Printing and stationery, such as catalogues and price lists.
 Salaries and commission of salesmen, representatives and sales department staff.
 Advertising and sales promotion, market research.
 Rent, rates and insurance of sales offices and showrooms, bad debts and so on

Distribution overhead
Distribution overhead is all indirect material costs, wages and expenses incurred in making the packed
product ready for dispatch and delivering it to the customer.
Examples of distribution overhead are as follows.
 Cost of packing cases.
 Wages of packers, drivers and despatch clerks.
 Insurance charges, rent, rates, depreciation of warehouses and so on.

3. Classify cost on the basis of functions.

Answer:
On the basis of functions
Depending on different managerial activities and involvement in the operation of a business, we have
these types of costs.
a. Production cost: Total cost incurred from the production. It is the cost of operating the
manufacturing division of an undertaking. It includes the cost of direct materials, direct labour, direct
expenses, packing (primary) cost and all overhead expenses relating to production.
b. Administration cost: Cost incurred for formulating policy, directing the organization, the controlling
the operation of a firm, which is not related to R&D, production and selling function.
c. Selling cost: The expenditure related in seeking of demand and stimulating the demand.
d. Distribution cost: The cost related to packing of product available for dispatch and the cost incurred
for the returned empty containers if any. It includes expenditure incurred intransporting articles to central
or local storage.

Production or Manufacturing Costs

All the costs relating to the production of goods or services, whether direct or indirect, variable or fixed,
are included in the production cost. We can classify production costs into direct and indirect production
costs.
Example of Direct Production Costs (also known as direct manufacturing costs)
 Direct Raw Material
 Direct Labor
 Other Direct Expenses such as job work charges relating to a particular product, etc.
Examples of Indirect Production Costs (also known as Production or Manufacturing Overheads)
 Salaries of Supervisors, Production Heads, Technical and Planning Staff, etc
 Quality control costs
  Other labor-related expenses
 Quality control
 Store expenses
 Depreciation of plant and machinery
 Repair and maintenance of factory building and plant & machinery
 Security expenses for the unit
 Labour welfare expenses like canteen expenses
 Insurance, etc.
In summary, we can say that all the costs that a firm incurs for producing goods are part of production or
manufacturing costs. This is a critical cost classification. Most companies have a bigger chunk of total
costs incurred here. Therefore, companies invest a lot of their time and energy to streamline these
costs. They have a direct role to play in the sustainability of the company.

Administration Costs
These costs are incurred in connection with the general management of the business. These usually
are indirect costs and are also known as administrative overheads. Examples of such costs can be the
following:
 Salaries of staff in general management
 Office-related expenses such as rent, rates, taxes, telephone, stationery, etc.
 Charges levied by the bank.
 Audit and legal fees
 Office-related depreciation etc.
This includes all those costs that are not related to product manufacturing but are unavoidable for the
organization’s overall administration. These costs support the primary activity of production. Most
organizations wish to keep these costs as low as possible. It is because the managers cannot link them
directly to the profits of the company. For example, the contribution of an accountant towards the
earnings of a particular year is challenging to judge.
Marketing or Selling Costs
Selling costs include all kinds of expenses incurred for achieving sales of the products and services.
These are also considered indirect expenses are, known as selling overheads. Examples of such costs
are as follows:
 Salaries of selling staff
 Commission, conveyance, discount, etc
 Product market research
 Royalty, etc
This function gets a lot of focus from management. This is a crucial function because if there are no
sales, all other activities or functions are useless. Streamlining the selling function has fast and visible
fruits for the management. For example, a slight change in the commission structure of the selling task
force could lead to a lot of additional sales. Additional sales have a lot of advantages like control in
stock levels, better capacity utilization, lower fixed costs per unit, etc.

Distribution Costs
Distribution costs include all kinds of expenses are incurred for distributing the products from their point
of production to their customers. Examples of distribution costs are as follows:
 Transportation costs
 Warehouse rents
 Commission to Distribution channel etc
This classification of cost is vital for customer satisfaction. A sound distribution system ensures timely
and safe delivery of goods, reduces wastage in transportation, etc. Many businesses run through
distribution channels. From selecting the distribution channel to deciding the commission structure
comes under the purview of distribution management. Streamlining these costs could make the product
cheaper for the customer. There are various strategies companies follow to optimize such costs.

Research and Development Costs

Costs under these heads are the costs comprising development costs of new products, improvement-
related expenses, etc. These are not unavoidable costs. A company may wish not to spend even a
penny on such costs. But, this would be a mistake. With current products and production lines, a
company can sustain itself in the short run. With the technology change and consumer choices, it is
crucial to innovate new products and continually streamline existing ones. Most companies try and
allocate a budget for these costs every year.

Customer Service
These days after-sales service is a primary key supporting the marketing or selling function of the
organization. We can notice that the consumer now requires not only a tension-free purchase but also
its utilization. For example, servicing AC, Washing Machines, etc. Most importantly, the customers are
ready to pay more for products of companies who have proved better customer service after selling the
product also.
 4. Write a short note on opportunity cost.
Answer:
Opportunity cost is a concept in Economics that is defined as those values or benefits that are lost by a
business, business owners or organisations when they choose one option or an alternative option over
another option, in the course of making business decisions.
In simple words, it can be said as the value that is lost when a business is choosing between two or
more alternatives. From an investor perspective, opportunity cost will always mean that the investment
choices made will be carrying immediate loss or gain in the future.
Opportunity costs can be viewed as a trade off. Trade offs happen in decision making when one option
is chosen over another option. Opportunity costs sums up the total cost for that trade off.
For example, a certain kind of bamboo can be used to produce both paper and furniture. If the business
takes a decision to consider using bamboo for furniture, then the society has to forego the number of
bamboos that could have been used for manufacturing paper.
Here, the opportunity cost of producing furniture is the number of papers that are foregone.
Aspects of Opportunity Cost
The opportunity cost of a product is the best alternative that was foregone. There cannot be any other
alternative.
How to Calculate Opportunity Costs
Opportunity costs can be calculated using the following formula
Opportunity Cost = Return on investment for an option not chosen – Return on investment for a chosen
option
Limitations of Opportunity Costs
The following are the limitations of opportunity costs:
1. Future returns cannot be predicted accurately using opportunity costs.
2. It is difficult to make quantitative comparison between two available alternatives.

Opportunity cost: It is the value of benefit sacrificed in favour of an alternative course of action.
Opportunity cost is the cost of selecting one course of action and the losing of other opportunities to
carry out that course of action. E.g. The fixed deposit is withdrawn and invested in a project. The
interest on fixed deposit which is sacrificed is the opportunity cost. This cost should be taken into
account while evaluating the profitability of the project. Opportunity costs are not recorded in the books.
It is important in decision making and comparing alternatives.

Opportunity cost represents the potential benefits that a business, an investor, or an individual
consumer misses out on when choosing one alternative over another. While opportunity costs can't be
predicted with total certainty, taking them into consideration can lead to better decision making.
KEY TAKEAWAYS
 Opportunity cost is the forgone benefit that would have been derived from an option other than the
one that was chosen.
 To properly evaluate opportunity costs, the costs and benefits of every option available must be
considered and weighed against the others.
 Considering potential opportunity costs can guide individuals and organizations to more profitable
decision making.
 Opportunity cost is a strictly internal measure used for strategic planning; it is not included in
accounting profit or reflected in external financial reporting.
 Examples of opportunity cost considerations include investing in a new manufacturing plant in Los
 Angeles as opposed to Mexico City, deciding to upgrade company equipment or hire additional
workers, or buying stock A vs. stock B.

Formula for Calculating Opportunity Cost

Opportunity Cost=FO−COwhere:FO=Return on best forgone optionCO=Return on chosen option
Opportunity Cost=FO−COwhere:FO=Return on best forgone optionCO=Return on chosen option
The formula for calculating an opportunity cost is simply the difference between the expected returns of
each option. Consider a company that is faced with the following two mutually exclusive options:
Option A: Invest excess capital in the stock market
Option B: Invest excess capital back into the business for new equipment to increase
production
Assume the expected return on investment (ROI) in the stock market is 10% over the next year, while
the company estimates that the equipment update would generate an 8% return over the same period.
The opportunity cost of choosing the equipment over the stock market is 2% (10% - 8%). In other
words, by investing in the business, the company would forgo the opportunity to earn a higher return—
at least for that first year.

5. Differentiate between direct and indirect cost.

Answer:

Costs may be direct or indirect with respect to a particular division or department.

a. Direct Costs: The direct costs are those which can be easily traceable to a product or costing unit or
cost center or some specific activity, e.g. cost of wood for making furniture. It is also called traceable
cost. Direct cost can be allocated directly to costing unit or cost center.
Definition of Direct Cost
The cost that can be directly attributable to/identified with/ associated with the specific cost center or
cost object like a product, function, activity, project and so on is known as Direct Cost. Based on
elements, the direct costs are classified into the following parts:
 Direct Material: The cost of material that can be allocable to production.
Example: Raw material consumed during production of the unit.
 Direct Labor: Wages to the laborers that can be identified with a cost object.
Example: The term wages include bonus, gratuity, provident fund, perquisites, incentives, etc.
 Direct Expenses: It includes all the other expenses that are directly linked to the production of a
product.
Example: Job processing charges, hire charges for tools and equipment, subcontracting expenses.
When all these three costs are taken together, they are known as Prime Cost.

b. Indirect Costs: The indirect costs are difficult to trace to a single product or it is uneconomic to do
so. They are common to several products, e.g. salary of a factory manager. It is also called common
costs. Indirect costs have to be apportioned to different products, if appropriate measurement
techniques are not available. These may involve some formula or base which may not be totally correct
or exact.

Definition of Indirect Cost

Indirect cost is those costs that cannot be directly assigned to/related to/identified with a particular cost
center or cost object, but they benefit multiple cost objects. It is not possible to calculate them for a
single cost object. However, it needs to be apportioned over various products as well as among the
different departments of the organization. It includes production, office & administration, selling &
distribution costs. The indirect cost is divided into the following categories:
 Indirect Material: Material Cost which cannot be identified with a particular product or project.
Example: Lubricants
 Indirect Labor: Salary to the employees that cannot be allocable to a particular cost object.
Example: Salary to the management team and employees of the accounts department.
 Indirect Expenses: All the expenses other than indirect material and labor are included in this
category.
Example: Interest, Rent, Tax, Duty, etc.

BASIS FOR COMPARISON DIRECT COST INDIRECT COST

Meaning A cost that is easily attributable to a Indirect Cost is defined as the cost
cost object is known as Direct Cost. that cannot be allocated to a
particular cost object.
Benefits Specific projects Multiple projects
Aggregate When all the direct costs are taken Total of all the indirect costs is called
together they are known as prime as overheads or oncost.
costs.
Traceable Yes No
Classification Direct material, direct labor, direct Indirect material, indirect labor,
expenses indirect overheads