ENGINEERING ECONOMICS

AND COSTING

CHAPTER TWO
COSTING
Contents
Cost accounting
Classification of cost
Element of cost
Types of estimation
Method of estimation
Data requirement and sources
Collection cost
Allowance in estimation
Costing methods
Uniform costing

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 Cost Accounting
• The cost accounting consists of two words: Cost and
Accounting.
• Cost means the resources sacrificed for the production
of a commodity and Accounting refers to the financial
information system.
• Cost accounting system can be described as
measurement and reporting of resources used in
monetary terms.
• Cost accounting is the branch of accounting dealing
with the classification, recording, allocation,
summarization and reporting of current and prospective
cost.
Cost accounting is accounting for cost. 3
 Costing And Cost Accounting

• We use costing and cost accounting interchangeably,

But they should not be.
• Costing refers to the technique and process of
ascertaining cost.
• The technique consists of the principles and rules for
the determining the costs of products and services.
• Cost accounting on the other hand, is defined as the
process of accounting for cost from the point at which
expenditure is incurred or committed.

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• It is that specialized branch of accounting
which involves classification, accumulation,
allocation, absorption and control of costs.
• The concept of cost accounting is some bit
wider than costing.
• It includes several subjects like costing, cost,
accounting, cost control, budgetary control,
and cost audit.

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a. Cost ascertainment: Ascertaining the cost of goods produced and
services rendered has been the primary function of cost accounting.
This purpose is some times referred to as product costing or cost
accumulation.
b. Cost Analysis: Cost analysis is one of the important function of
cost accounting, Because cost accounting helps in decision making.
When making decision, we require information about cost, revenue
and other information, So we have to analyze the cost.
c. Cost control: To control the cost, is the primary motive of every
management. Cost information shows the performance of the
organization.
There are two types of cost control method: Standard Costing and
Budgetary Control. Actual costs are compared on the budgeted cost.
This help in controlling the cost.
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 Objectives Of Cost Accounting

1. The cost accounting helps in ascertaining the cost of

production of every units, job, operation process,
department and service.
2. It indicate to management any inefficiency and the
extent of various forms of waste, whether as material,
time, expense or in the use of machine, equipment and
tools.
3. It disclose profitable and unprofitable activities so
that steps can be taken to eliminate or reduce those from
what, little or no profit is obtained or to change the
method of production or incidence of cost in order to
render such activities more profitable.
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 Cont’d
4. It provides actual figures of cost for comparison with
estimates and to assist the management in their price
fixing policy.
5. It present comparative cost data for different periods and
different volumes of production and those by assist the
management in budgetary control.
6. It record and report to the concerned manager how
actual costs compare with standard cost and possible
causes of differences between them.
7. It indicates the exact cause of increase or decrease in
profit or loss shown by the financial accounts.
8. It also provides data for comparison cost within the firm
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also between similar firm.
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 Cost Concepts

• Cost form the subject matter of cost accounting.

• Cost are the resources sacrificed to achieve a specific
objective.
• It is defined as the benefit sacrificed to serve some
benefit.

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 Cost Classification
• Proper classification of cost is necessary for the
clear understanding of the cost.
• Cost can be classified according to their common
characteristics.
1. Behavioral classification
2. Direct and indirect cost
3. Product cost and period cost
4. Relevant and irrelevant cost
5. Real cost
6. Opportunity cost
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 1. Behavioral Classification

• Fixed, Variable, Marginal, and Average Costs

• Fixed costs are constant or unchanging regardless of the

level of output or activity.
• In contrast, variable costs depend on the level of output
or activity.
• A marginal cost is the variable cost for one more unit,
• while the average cost is the total cost divided by the
number of units.
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 Cont’d
• For example, in a production environment fixed
costs, such as those for factory floor space and
equipment, remain the same even though production
quantity, number of employees, and level of work-in-
process may vary.
• Labor costs are classified as a variable cost because
they depend on the number of employees in the
factory.
• Thus fixed costs are level or constant regardless of
output or activity, and variable costs are changing and
related to the level of output or activity.
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• As another example, universities charge full-time
students a fixed cost for 12 to18 hours and a cost per
credit hour for each credit hour over 18.Thus for full-
time students who are taking an overload (> 18 hours),
there is a variable cost that depends on the level of
activity
• This example can also be used to distinguish between
marginal and average costs. A marginal cost is the cost of
one more unit. This will depend on how many credit
hours the student is taking.
• If currently enrolled for 12 to 17 hours, adding one more
is free. The marginal cost of an additional credit hour is
$0.However, if the student is taking 18 or more hours,
then the marginal cost equals the variable cost of one
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 Cont’d
• To illustrate average costs, the fixed and variable
costs need to be specified. Suppose the cost of 12 to
18 hours is $1800 per term and overload credits are
$120/ hour.
• If a student takes 12 hours, the average cost is
$1800/12 = $150 per credit hour. If the student were
to take 18 hours, the average cost decreases to
$1800/18 = $100 per credit hour. If the student
takes 21 hours, the average cost is $102.86 per credit
hour [$1800 + (3 x $120) /21].

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 Cont’d
• Average cost is thus calculated by dividing the total
cost for all units by the total number of units.
Decision makers use average cost to attain an overall
cost picture of the investment on a per unit basis.
• Marginal cost is used to decide whether the
additional unit should be made, purchased, or
enrolled in.
For the full-time student at our example university, the
marginal cost of another credit is $0 or $120 depending
on how many credits the student has already signed up
for.
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 Example-1
• An entrepreneur named Mr. X was considering the
money-making potential of chartering a bus to take
people from his hometown to an event in a larger city.
• Mr. X planned to provide transportation, tickets to the
event, and refreshments on the bus for his customers.
• He gathered data and categorized the predicted
expenses as either fixed or variable.

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 Cont’d

Develop an expression of Mr. X ’s total fixed and total

variable costs for chartering this trip.

Mr. X 's Fixed Costs Mr. X 's Variable Costs

Bus rental 80 Event ticket 12.50 per person
Gas 75 Refreshments 7.50 per person
expense
Other fuels 20
Bus driver 50

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 Solution
• Mr. X 's fixed costs will be incurred regardless of
how many people sign up for the trip (even if only
one person signs up!). These costs include bus
rental, gas and fuel expense, and the cost to hire a
driver:
• Total fixed costs = 80 + 75 + 20 + 50 = 225
• Mr. X 's variable costs depend on how many people
sign up for the charter, which is the level of activity.
Thus for event tickets and refreshments, we would
write
• Total variable cost=12.50+7.50= 20 per person
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• From Example 1 we see how it is possible to calculate
total fixed and total variable costs. Further more, these
values can be combined into a single total cost equation
as follows:
Total cost =Total fixed cost + Total variable cost (1)
• In Example 1, Mr. X developed an overall total cost
equation for his business expenses.
• Now he wants to evaluate the potential to make money
from this chartered bus trip.
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 Solution
• We use Equation 1 to find Mr. X ’s total cost
equation:
Total cost= total fixed cost +total variable cost
= $225 + ($20)(number of people on the
trip)
where number of people on the trip =X. Thus,
Total cost = 225 + 20x
• Using this relationship, Mr. X can calculate the total
cost for any number of people up to the capacity of
the bus. What he lacks is a revenue equation to offset
his costs.
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• Mr. X 's total revenue from this trip can be expressed as:
Total revenue=(Charter ticket price)(Number of people
on the trip) = (Ticket price) (x)
• Mr. X believes that he could attract 30 people at a charter
ticket price of $35. Thus
Total profit = (Total revenue) - (Total costs) = (35x) -
(225 + 20x)= 15x - 225
• At x=30,
• Total profit = 35 x 30 - (225 + 20 x 30) = $225
• So, if 30 people take the charter, Mr. X will net a profit
of $225. This is somewhat simplistic analysis ignores
the value of Mr. X 's time-he would have to "pay
himself" out of his $225 profit.
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 Cont’d
• In Examples 1 and 2 Mr. X developed total cost and
total revenue equations to describe the charter bus
proposal. These equations can be used to create what
is called a profit-loss breakeven chart.
• Both the costs and revenues associated with various
levels of output (activity) are placed on the same set
of x-y axes.
• This allows one to illustrate a breakeven point (in
terms of costs and revenue) and regions of profit and
loss for some business activity. These terms can be
defined as follows.
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Figure Profit-loss breakeven chart for Examples.

Total cost = Total revenue

$225 + 20x = 35x
x = 15 people

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 Cont’d
• Breakeven point: The level of business activity at
which the total costs to provide the product, good, or
service are equal to the revenue (or savings)
generated by providing the service. This is the level at
which one "just breaks even."
• Profit region: The output level of the variable x
greater than the breakeven point, where total revenue
is greater than total costs.
• Loss region: The output level of the variable x less
than the breakeven point, where total costs are greater
than total revenue.

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 Cont’d

• Notice in Figure that the breakeven point for the

number of persons on the charter trip is 15 people.
For more than 15 people, Mr. X will make a profit. If
fewer than 15 sign up there will be a net loss.
• At the breakeven level the total cost to provide the
charter equals the revenue received from the 15
passengers.
• We can solve for the breakeven point by setting the
total costs and total revenue expressions equal to each
other and solving for the unknown value of x.

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 2. Direct And Indirect Cost

• Direct costs-The expenses incurred on material

and labor which are economically and easily
traceable for a product, service or jobs.
• In the process of manufacturing of production of
articles, materials are purchased, laborers are
employed and the wages are paid to them.
• All of these take an active and direct part in the
manufacture of a particular commodity and hence
are called direct costs.

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 Cont’d
• Indirect costs- The expenses incurred on those
items which are not directly chargeable to
production are known as indirect costs.
• For example salaries of timekeepers, storekeepers
and foremen.
• Also certain expenses incurred for running the
administration or factory manager’s salary, factory
rent, depreciation of machinery are the indirect costs.
• All of these cannot be conveniently allocated to
production and hence are called indirect costs.

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 3. Product Cost And Period Cost

• The costs which are a part of the cost of a product

rather than an expense of the period in which they are
incurred are called as “product costs.”
• In financial statements, such costs are treated as
assets until the goods they are assigned to be sold.
• They become an expense at that time.
• These costs may be fixed as well as variable, e.g.,
cost of raw materials and direct wages, depreciation
on plant and equipment etc.

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• The costs which are not associated with production
are called period costs. They are treated as an
expense of the period in which they are incurred.
• They may also be fixed as well as variable.
• Such costs include general administration costs,
salaries salesmen and commission, depreciation on
office facilities etc..
• They are charged against the revenue of the
relevant/related period.
 4. Relevant And Irrelevant Cost

• Relevant costs are those which change by managerial

decision.
• Irrelevant costs are those which do not get affected by
the decision.
• For example, if a manufacturer is planning to close
down an unprofitable retail sales shop, this will affect
the wages payable to the workers of a shop.
• This is relevant in this connection since they will
disappear on closing down of a shop.
• But prepaid rent of a shop or unrecovered costs of any
equipment which will have to be scrapped are irrelevant
costs which should be ignored.
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 Element Of Cost
1. Material
The substance from which a product is made. It may be in a
raw or a manufactured state. It can be direct or indirect.
Direct Material
• The material which becomes an integral part of a finished
product
All material or components specifically purchased,
produced or seized from stores
Primary packing material (e.g. carton, wrapping, cardboard,
boxes etc.)
Purchased or partly produced components
• Direct material is also described as process material, prime
cost material, production material, stores material,
constructional material etc.
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Cont’d
Indirect Material
• The material which is used for purposes
ancillary to the business and which cannot be
conveniently assigned to specific physical units
is termed as indirect material.
» Consumable supplies, oil and waste,
printing and stationery material etc
• Indirect material may be used in the factory,
office or the selling and distribution divisions

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 2. Labor

 human effort for the conversion of materials into finished goods

 Direct Labor
• The labor which actively and directly takes part in the
production of a particular item
• described as process labor, productive labor, operating
labor, etc.
 Indirect Labor
• The labor employed for the purpose of carrying out tasks
incidental/related to goods produced or services provided
• storekeepers, foremen, timekeepers, directors’ fees,
salaries of salesmen etc
• Personals in the office or the selling and distribution
divisions
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 3. Expenses

 Direct Expenses
These are the expenses that can be directly, conveniently
and wholly allocated to specific cost centers or cost units
• Rent of some special machinery required for a
particular contract
• Cost of defective work incurred in connection with a
particular job or contract etc.
chargeable expenses.
 Indirect Expenses
– cannot be directly, conveniently and wholly
allocated to cost centers or cost units
– rent, lighting, insurance charges etc.
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 4. Overhead
 Overhead : The term overhead includes indirect material,
indirect labor and indirect expenses
• Factory, where production is done
• Office and administration, where routine as well as
policy matters are decided
• Selling and distribution, where products are sold and
finally dispatched to customers
 For all cases
• Indirect material
• Indirect labor
• Indirect expenses
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 Components of Total Cost
 Prime Cost
– Prime cost consists of costs of direct materials, direct labors and direct
expenses. It is also known as basic, first or flat cost.
 Factory Cost
– prime cost and, works or factory overheads that include costs of
indirect materials, indirect labors and indirect expenses incurred in a
factory
– known as works cost, production or manufacturing cost.
 Office Cost
– sum of office and administration overheads and factory cost
– administration cost or the total cost of production.
 Total Cost
• Selling and distribution overheads are added to the total cost
of production to get total cost or the cost of sales.
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Components of total cost
Direct material
Prime cost or direct cost or
Direct labor
first cost
Direct expenses
Works or factory cost or
Prime cost plus works
production cost or
overheads
manufacturing cost
Works cost plus office and Office cost or total cost of
administration overheads production
Office cost plus selling and
Cost of sales or total cost
distribution
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overheads
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 Cost Sheet
• Document that provides for the assembly of an
estimated detailed cost in respect of cost centers and
cost units
• It analyzes and classifies in a tabular form the
expenses on different items for a particular period
• Additional columns to show the cost of a particular
unit related to each item of expenditure and the total
per unit cost.
• may be prepared on the basis of actual data (historical
cost sheet) or estimated data (estimated cost sheet),
depending on the technique employed and the purpose
to be achieved.
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Table. 2 Following information has been obtained from
the records of a company named left center corporation
for the period from June 1 to June 30, 1998.
Cost of raw materials on June 1,1998 30,000
Purchase of raw materials during the month 450,000
Wages paid 230,000
Factory overheads 92,000
Cost of work in progress on June 1, 1998 12,000
Cost of raw materials on June 30, 1998 15,000
Cost of stock of finished goods on June 1, 1998 60,000

Cost of stock of finished goods on June 30, 1998 55,000

Selling and distribution overheads 20,000
Sales 900,000
Administration overheads 30,000 39
 Cost statement
Components of Total cost Amount Cost components
Opening stock of raw materials 30000 30,000
Add-- purchase 480000 30,000+450,000
Less-- closing stock of raw material 465000 480,000-15,000
Value of raw materials consumed 465000 Direct material cost
Wages 230000 given
Prime cost 695000 465,000+230,000 
Factory overheads 92 000
  787000 695,000+92,000

Add-- opening stock of work in progress 799000 787,000+12,000

Less-- closing stock of work in progress 799000 799,000-000

Factory cost 799000  
Add-- Administration overhead 829000 799,000+30,000
Add--opening stock of finished goods 889000 829,000+60,000
Less-- closing stock of finished goods 834000 889,000-55,000
Cost of production of goods sold 834000  

Add-- selling and distribution overheads 854000 834,000+20,000

Cost of sales 854000  
Sales 900000  
Profit 46000 900,000-854,000
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 Types Of Estimation

• There are three general types of estimates:

1. Rough – order of magnitude, used for high level

planning, inaccurate, range from -30% to +60% of
actual values.
2. Semi-detailed - based on historical records,
reasonably sophisticated and accurate, -15% to
+20% of actual values.
3. Detailed - based on detailed specifications and cost
models, very accurate, within -3% to +5% of actual.

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 Cont’d
• In considering the three types of estimate, it is
important to recognize that each has its unique purpose,
place, and function in a project's life.
• Rough estimates-are used for general feasibility
activities
• Semi-detailed estimates-support budgeting and
preliminary design decisions, and
• Detailed estimates-are used for establishing design
details and contracts.
• As one moves from rough to detailed design, one
moves from less to much more accurate estimates.
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 Method Of Estimation
 The two fundamental approaches are “top-down”
and “bottom-up.”
Top-down
 uses historical data from similar projects.
 It is best used when alternatives are still being
developed and refined.
Bottom-up
 is more detailed and works best when the detail
concerning the desired output (product or service) has
been defined and clarified.

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Results of cost estimating are used for a variety
of purposes.

 Setting selling prices for bidding, or evaluating

contracts.
 Determining if a proposed product can be made and
distributed at a profit.
 Evaluating how much capital can be justified for
changes and improvements.
 Setting benchmarks for productivity improvement
programs.

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 Costing Methods
• Costing methods, refer to the systems of cost finding and
ascertainment.
• There are two basic methods used by manufacturers to assign
costs to their products or services provided:
A. Specific Order Costing: Where work is undertaken to
customer’s special requirements, the method of costing that will
be in operation is job costing (specific order costing).
 This method is used, where expenses are linked to the cost object.
Example, Job Costing, Contract Costing, Batch Costing fall under
specific order costing method.
 Job-order costing allocates costs to products that are identified by
individual units or batches. It is used by a manufacturer who
produces products as individual units or in distinct batches or jobs.

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Example

• David Co. is a small furniture manufacturing business.

They received an order for 10 chairs from a customer.
Total cost for the job was $500. How much was the cost
per chair?
• Job cost record is a document used to accumulate the costs
of a job.

$500 ÷ 10 = $50/chair

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B. Unit Costing (Average Costing):Where standardized
goods result from a sequence of repetitive and more or
less continuous operation or process, then process
costing is used.
 It is more efficient for companies that produce large
quantities of homogenous product in a continuous
process.
 Process costing does not distinguish among
individual units of product.
 Process costing requires one WIP account for each
process but job-costing has one WIP account.
 Process costing can be applied to non manufacturing
and manufacturing activities.
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Cont’d

 This costing method is used where expenses cannot

be linked directly with the cost object and are,
therefore, charged to the department or process.
 The total costs are then averaged over the total units
produced.
Examples of these are Service or Operating Costing,
and Process or Operation Costing.
 Process Costing Example
Laura Foods produces a garlic flavored tomato sauce.
• Production of the sauce requires two major processes:

Chopping Mixing and Canning

• Assume that Laura incurred $20,000 in the Mixing and

Canning process to mix 100,000 pints of tomato sauce.
• What is the Mixing and Canning cost per pint?

$20,000 ÷ 100,000 = $0.20/pint

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Assignment(10%)

The integrated cost estimation approach has three major components

1. Work breakdown structure (WBS)

2. Cost and revenue structure (classification)

3. Estimating techniques (models)

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• Reading Assignment
– Data Requirement And Sources
– Collection cost
– Allowance in estimation
– Uniform Costing
– Cost Sheet
 Data Requirement And Sources
• A variety of sources exist for cost and revenue
estimation.
• Accounting records: good for historical data, but
limited for engineering economic analysis.
• Other sources inside the firm: e.g., sales,
engineering, production, purchasing.
• Sources outside the firm: government data, industry
surveys, trade journals, and personal contacts.
• Research and development: e.g., pilot plant, test
marketing program, surveys.

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 Collection cost

 A collection cost is any cost associated with recovering debt on

which the borrower has defaulted on his obligation to pay.
 Such items as the fees charged by collection agencies and
attorneys are the various costs involved in collection the debt
through legal process.
 Other costs associated with borrowing, such as the cost of
obtaining credit reports of potential borrowers, are related to the
lending decision, not collection, and so are not collection costs.
 Likewise, the routine costs of collecting a debt that is in good
standing- printing payment coupons or issuing receipts as
payments are made are also not considered collection costs.

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 Allowance in estimation

Allowance:- additional resources included in an

estimate to cover the cost of known but undefined
requirements for an activity or work item.
Allowance is a base cost item.

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Material Cost
• Companies using job costing often use a
perpetual system to account for direct materials.
• A materials requisition is used to request
transfer of materials to the production floor.
Example
• Alec Clothing Co. purchased raw materials on
account for $15,000.
• Materials costing $10,000 were requisitioned
for production.
• Of this total, $2,000 was indirect materials.

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Materials Cost Example

Direct materials
Materials Inventory WIP Inventory
15,000 10,000 8,000

Manufacturing Overhead
2,000
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Indirect materials
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 Labor Costs
• Labor costs are accumulated using the payroll
register and time records.
• Labor time records identify the employee, the
amount of time spent, and the cost charged to each
job.
Example
• The company incurred $30,000 of manufacturing
wages for all jobs.
• Assume that $25,000 can be traced directly to the
jobs and $5,000 is for indirect labor.
04/07/2023 Prepared by: Sharmarke A.
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Labor Cost Example

Direct labor
Manufacturing Wages WIP Inventory
30,000 30,000 25,000

Manufacturing Overhead
5,000
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Indirect labor
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 Manufacturing Overhead cost &
Manufacturing Overhead Rate
• Plant equipment depreciation.
• At the beginning of the year, a predetermined
manufacturing overhead application rate is computed.
• This rate is used to apply overhead to all jobs
completed during the year.

Estimated overhead ÷ Estimated base = Rate

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 Allocating Manufacturing Overhead Cost
There are six steps in allocating manufacturing overhead
cost
1. Estimate total overhead for the period.
2. Select an overhead allocation base.
3. Estimate total quantity of the overhead allocation
base.
4. Compute the predetermined overhead rate.
5. Obtain actual quantities of the overhead allocation
base.
6. Allocate manufacturing overhead by multiplying the
predetermined manufacturing overhead rate by the
actual quantity of the allocation base that relates to
each job. 61
Uniform Costing

• Uniform Costing is not a distinct method of costing.

• In fact when several undertakings start using the same

costing principles and practices, they are said to be
following uniform costing.
• The basic idea behind uniform costing is that the different
firms in an industry should adopt a common method of
Costing and apply uniformly the same principles and
techniques for better cost comparison and common good.
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Objectives

1. Facilitates cost control and cost reduction.

2. Fixing of common sales price among the different
units.
3. Improving performance of inefficient units by
adopting uniform principle and practices.
4. Facilitates inter-firm comparison of cost of
production.
5. Establishment of common standard for the operations
of different units.
6. Formulation of common policies, methods and
procedures for the participating units.
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Cont’d
7. Ensures reasonable price to customers and profits
to producers.
8. Facilitates exchange of ideas and sharing
experience to improve the overall performance of
common units.
9. Avoidance of monopolistic trade practice among
member units.
10. To ensures steady demand and supply of
finished goods for participating units

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 End of chapter 2

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