COST ACCOUNTING : Nature and Scope NOTES

COST ACCOUNTING : Nature and Scope NOTES

In the modern business world, the nature and functioning of business organizations have become very complicated. They have to serve the needs of variety of parties who are interested in the functioning of the business. These parties constitute the owners, creditors, employees, government agencies, tax authorities, prospective investors, and last but not the least the management of the business. The business has to serve the needs of these different category of people way of supplying various information from time to time. In order to satisfy the needs of all these group of people a sound organization of accounting system is very essential. In the ancient days the information required those who were interested with a business organization was met practising a system of accounting known as financial accounting system. Financial accounting is mainly concerned with preparation of two important statements, viz., income statement (or profit and loss account) and positional statement (or Balance sheet). This information served the needs of all those who are not directly associated with management of business. Thus financial accounts are concerned with external reporting as it provides information to external authorities. But management of every business organization is interested to know much more than the usual information supplied to outsiders. In order to carry out its functions of planning, decision-making and control, it requires additional cost data. The financial accounts to some extent fails to provide required cost data to management and hence a new system of accounting which could provide internal report to management was conceived of.

  • MEANING AND NATURE OF COST ACCOUNTANCY

Cost accountancy is a wide term. It means and includes 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 therefrom for the purposes of managerial decision making”–C.I.M.A. London.

Cost accountancy is thus the science, art and practice of a cost accountant. It is a science in the sense that it is a body of systematic knowledge which a cost accountant should possess for the proper discharge of his duties and responsibilities. It is an art as it requires the ability and skill on the part of a cost accountant in applying the principles of cost accountancy to various managerial problems like price fixation, cost control, etc. Practice refers to constant efforts on the part of cost accountant in the field of cost accountancy. The theoretical knowledge alone would not enable a cost accountant, to deal with the intricacies, he should have sufficient practical training.

Cost accountancy includes several subjects. These are costing,

cost accounting, cost control and cost audit. These are described below :

Costing : Costing refers to the process of cost finding. It is defined as “the technique and process of ascertaining costs”. It has also been defined as “the classifying, recording and appropriate allocation of expenditure for the determination of costs, the relation of these costs to sales value and the ascertainment of profitability. Thus costing consists of principles and rules which are used for determining : (a) the cost of manufacturing a product like chemical, television, etc. and (b) the cost of providing a service, i.e., electricity, transport, etc.

Cost Accounting : Cost accounting is a system means of which costs of products or services are ascertained and controlled. It is defined as “the application of accounting and costing principles, methods and techniques in the ascertainment of costs and the analysis of savings and/or excesses as compared with previous experience or with standards”.

Thus, whereas costing is simply cost finding, which can be carried out means of memorandum statements, arithmetic process etc., cost accounting denotes the formal accounting mechanism means of which costs are ascertained. In simple words, costing means finding out the cost of something, and cost accounting means costing using double entry book keeping methods as a basis for ascertainment of costs. However, cost accounting and costing are often used interchangeably.

Cost Control : Cost control is the function of keeping costs within prescribed limits. In other words, cost control is compelling actual costs to conform to planned costs. Amongst the various techniques used for cost control, the two most popular are budgetary control and standard costing. These will be discussed in detail in lessons 13 and 14 respectively.

Cost Audit : Cost audit is the specific application of auditing principles and procedures in the fields of cost accounting. It is defined as the verification of cost accounts and a check on the adherence to the cost accounting plan. It has thus two functions – (a) to verify that the cost accounts have been correctly maintained and compiled, and (b) to check that principles laid down have been properly followed.

10.3    SCOPE OF COSTING

Cost accounting is not applicable only to manufacturing concerns. Its applications are in fact much wider. All types of activities, manufacturing and non-manufacturing, in which monetary value is involved, should consider the use of cost accounting. Wholesale and retail businesses, banking and insurance companies, railways, airways, shipping and road transport companies, hotels, hospitals, schools, colleges and universities, all may employ cost accounting techniques to operate efficiently. It is only a matter of recognition the management of the applicability of these concepts and techniques in their own fields of endeavour.

10.4    COST ACCOUNTING VS. FINANCIAL ACCOUNTING

Financial accounting, as pointed out previously, is concerned with recording, classifying and summarizing financial transactions pertaining to an accounting period. The basic objective is to provide a commentary to the shareholders and outside parties on the financial status of an enterprise in the form of a profit and loss account and balance sheet. The profit or loss of business operations is revealed through these statements year after year, observing the statutory requirements of the Companies Act, 1956.

Cost accounting, on the other hand, aims at providing prompt cost data for managerial planning, controlling and decision making. It offers a complete explanation as to how the scarce inputs are put to use in business. The sources of efficiency or inefficiency are revealed through periodic reports. The profit or loss relating to each job, department or product can also be found out easily. The following table 10.1 tries to draw the curtain between financial accounting and cost accounting :

Basis of           Financial Accounting distinction Cost Accounting
Statutory              These accounts have to be prepared Maintenance of these accounts
Requirements     pared according to the legal requirements is voluntary except in certain
of Companies Act and Income Tax Act industries where it has been made obligatory to keep
cost records
under the Companies Act.
Purpose              The main purpose of financial accounting The main purpose of cost
is to prepare profit and loss account  and accounting is to provide detailed
balance sheet for reporting to owners and cost information to management
and outside agencies i.e., external users i.e., internal users.
Analysis of         Financial accounts reveal the profit or Cost accounts show the detailed
cost and               loss of the business as a whole during cost and profit data for each
Profit                   a particular period. It does not show product line, department,
the figures of cost and profit for individual products, departments and processes, etc. process etc.
Periodicity           Profit and Loss Account and Cost reporting is a continuous
of Reporting         Balance Sheet are prepared process and may be daily,
periodically, usually on an annual basis. weekly, monthly, etc.
Control It keeps records of financial It is used as a detailed
aspect transactions and does not attach system of controls. It takes
any importance to control the help of certain special
aspect. techniques like standard costing and budgetary control.
Nature It is concerned with historical records. Cost accounting does not end
The historical nature of financial with what has happened in the
accounting can be easily understood past. It extends to plans and
in the context of the purposes for policies to improve performance
which it was designed. in the future.
Nature of General purpose statements like Profit It generates special purpose
statements and Loss Account and Balance Sheet statements and reports like
prepared are prepared it. Report of Loss of Materials,
Report That is to say that financial accounting Idle Times Report, Variance Report
must produce information that is used by etc. Cost accounting identifies
many classes of people none of whom the user, discusses his problems
have explicitly defined information needs. and needs and provides tailored information.
Classification Financial accounting classifies records Cost accounting records and
of and analyses transactions in subjective classifies expenditure according
Records manner i.e. according to nature of to the purpose for which cost is
expenditure. incurred.

10.5       COST ACCOUNTING Vs MANAGEMENT ACCOUNTING

Cost accounting and management accounting are both internal to an organisation. Both have, more or less, the same objective of assisting management in its planning, decision making etc. It is not worthwhile to distinguish the two inter-related disciplines as two branches of accounting. Consider what experts opine in this regard.

Dobson : Management accounting is so broad and comprehensive that it includes both financial and cost accounting.

C.T. Horngren : Cost accounting is management accounting plus a small part of financial accounting.

It is because of the overlapping nature of the two in many areas, that  everyone talks of cost and management accounting as a single discipline. However, some distinctions can be drawn thus :

Point of distinction Cost accounting Management accounting
Coverage It deals with ascertainment, It is concerned with the
allocation, distribution and impact and effect aspects
accounting aspects of costs of costs.
Position in the Cost accountant is generally Management accountant
hierarchy placed at a lower level of assumes a superior
hierarchy than a management level in the management
accountant. hierarchy.
Approach Narrow, as the focus is Wider, as one may have
primarily on cost data to use certain economic and statistical data along with costing data to assist managerial decision making.
Emphasis It lays emphasis on cost It is used as a decision
ascertainment and cost control. making technique.
Scope The scope of cost accounting It Makes use of other
is limited to important techniques like funds
techniques like variable flow, ratio analysis,
costing, break-even cash flow etc. in
analysis and standard costing. addition to variable costing, break-even analysis and standard costing. This includes financial accounting, tax planning and tax accounting.
Focus It focuses on short It focuses on short
term planning. range and long range
Sophisticated tools not planning and uses
employed for forecasting sophisticated technique
purposes. in the planning and control process.
Orientation It deals with data supplied Futuristic in orientation,
financial accounting, is more predictive in
orientation is not futuristic. nature than cost 

accounting.

Table10.2: Distinction between Cost Accounting and Management Accounting

Evolution 

cost accounting.

The evolution of cost It draws heavily on cost accounting is mainly due to data and other information 

the limitations of financial       derived from cost accounting

accounting.                              It is merely an extension

of the managerial aspects of

Purpose Its main purpose is to report         Its main objective is to current and prospective costs of provide all accounting 

product, service, department, information relevant for use job or process in formulation of policies,

planning, controlling, decision making etc. to ensure maximum profits.

10.6 USEFULNESS OF COST ACCOUNTING TO MANAGERS

The shortcomings inherent in financial accounting have made the management to realise the importance of cost accounting. Whatever may be the type of business, it involves expenditure on labour, materials and other items required for manufacturing and disposing of the product. Moreover, big business requires delegation of responsibility, division of labour and specialisation. Management has to avoid the possibility of waste at each stage. Management has to ensure that no machine remains idle, efficient labour gets due initiative, proper utilisation of by-products is made and costs are properly ascertained. Besides management, creditors and employees are also benefited in numerous ways installation of a good costing system in an industrial organisation. Cost accounting increases the overall productivity of an industrial establishment and, therefore, serves as an important tool in bringing prosperity to the nation. The various advantages derived managements on account of a good costing system can be put as follows :

  1. Useful in periods of depression and competition: During 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 war for its survival. The management should know the actual cost of their products before embarking on any scheme of reducing the prices or giving tenders. Costing system facilitates this.
  2. Helps in pricing decisions : Though economic law of supply and demand and activities of the competitors, to a great extent, determine the price of the article, cost to the producer does play an important part. The producer can  take necessary guidance from his costing records.
  3. Helps in estimates : Adequate costing records provide a reliable basis upon which tenders and estimates may be prepared. The chances of losing a contract on account of over-rating or the loss in the execution of a contract due to under-rating can be minimised. Thus, “ascertained costs provide a measure for estimates, a guide to policy, and a control over current production.
  4. Cost Accounting helps in channelising production on right lines : Costing makes possible for the management to distinguish between profitable and non-profitable activities. Profits can be maximised concentrating or profitable operations and eliminating non-profitable ones.
  5. Helps in reducing wastage :As it is possible to know the cost of the article at every stage, it becomes possible to check various forms of waste, such as of time, expense etc., or in the use of machinery, equipment and tools.
  6. 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.
  7. Provides data for periodical profit and loss accounts : Adequate costing records supply to the management such data as may be necessary for preparation of profit and loss account and balance sheet, at such intervals as may be desired the management. It also explains in detail the sources of profit or loss revealed the financial accounts, thus helps in presentation of better information before the management.
  8. Costing results into increased efficiency : Losses due to wastage of materials, idle time of workers, poor supervision etc. will be disclosed if the various operations involved in manufacturing a product are studied a cost accountant. The efficiency can be measured and costs controlled and through it various devices can be framed to increase the efficiency.
  9. Costing helps in inventory control and cost reduction : Costing furnishes control which management requires in respect of stock of materials, work-in-progress and finished goods. Costs can be reduced in the long-run when alternates are tried. This is particularly important in the present-day content of global competition. Cost accounting has assumed special significance beyond cost control this way.
  10. Helps in increasing productivity : Productivity of material and labour is required to be increased to have growth and more profitability in the organisation. Costing renders great assistance in measuring productivity and suggest ways to improve it.

10.7    METHODS OF COSTING

The basic principles of ascertaining costs are the same in every system of cost accounting. However, the methods of analysing and presenting the cost may vary from industry to industry. The method to be used in collecting and presenting costs will depend upon the nature of production. Basically there are two methods of costing, namely. Job costing and Process costing.

Job costing : Job costing is used where production is not repetitive and is done against orders. The work is usually carried out within the factory. Each job is treated as a distinct unit, and related costs are recorded separately. This type of costing is suitable to printers, machine tool manufacturers, job foundries, furniture manufactures etc. The following methods are commonly associated with job costing :

Batch costing : Where the cost of a group of product is ascertained, it is called ‘batch costing’. In this case a batch of similar products is treated as a job. Costs are collected according to batch order number and the total cost is divided the numbers in a batch to find the unit cost of each product. Batch costing is generally followed in general engineering factories which produce components in convenient batches, biscuit factories, bakeries and pharmaceutical industries.

Contract costing : A contract is a big job and, hence, takes a longer time to complete. For each individual contract, account is kept to record related expenses in a separate manner. It is usually followed concerns involved in construction work e.g. building roads, bridge and buildings etc.

Process Costing : Where an article has to undergo distinct processes before completion, it is often desirable to find out the cost of that article at each process. A separate account for each process is opened and all expenses are charged thereon. The cost of the product at each stage is, thus, accounted for. The output of one process becomes the input to the next process. Hence, the process cost per unit in different processes is added to find out the total cost per unit at the end. Process costing is often found in such industries as chemicals, oil, textiles, plastics, paints, rubber, food processors, flour, glass, cement, mining and meat packing. The following methods are used in process costing :

Output/Unit Costing : This method is followed concerns producing a single article or a few articles which are identical and capable of being expressed in simple, quantitative units. This is used in industries like mines, quarries, oil drilling, cement works, breweries, brick works etc. for example, a tonne of coal in collieries, one thousand  bricks in brick works etc. The object here is to find out the cost per unit of output and the cost of each item of such cost. A cost sheet is prepared for a definite period. The cost per unit is calculated dividing the total expenditure incurred during a given period the number of units produced during the same period.

Operating Costing : This method is applicable where services are rendered rather than goods produced. The procedure is same as in the case of unit costing. The total expenses of the operation are divided the units and cost per unit of service is arrived at. This is followed in transport undertakings, municipalities, hospitals, hotels etc.

Multiple Costing : Some products are so complex that no single system of costing is applicable. Where a concern manufactures a number of components to be assembled into a complete article, no one method would be suitable, as each component differs from the other in respect of materials and the manufacturing process. In such cases, it is necessary to find out the cost of each component and also the final product combining the various methods discussed above. This type of costing is followed to cost such products as radios, aeroplanes, cycles, watches, machine tools, refrigerators, electric motors etc.

Operating Costing : In this method each operation at each stage of production or process is separately identified and costed. The procedure is somewhat similar to the one followed in process costing. Process costing involves the costing of large areas of activity whereas operation costing is confined to every minute operation of each process. This method is followed in industries with a continuous flow of work, producing articles of a standard nature, and which pass through several distinct operations in a sequence to completion. Since this method provides for a minute analysis of cost, it ensures greater accuracy and better control of costs. The costs of each operation per unit and cost per unit upto each stage of operation can be calculated quite easily. This method is in force in industries where toys, leather and engineering goods are manufactured.

Departmental Costing : When costs are ascertained department department, such a method is called ‘departmental costing’. Where the factory is divided into a number of departments, this method is followed. The total cost of each department is ascertained and divided the total units produced in that department in order to obtain the cost per unit. This method is followed departmental stores, publishing houses etc.

10.8    TECHNIQUES OF COSTING

In addition to the different costing methods, various techniques are also used to find the costs. These  techniques may be grouped under the following heads:

Historical Absorption Costing : It is the ascertainment of costs after they have been incurred. It is defined as the practice of charging all costs, both variable and fixed, to operations, process or products. It is also known as traditional costing. Since costs are ascertained after they have been incurred, it does not help in exercising control over costs. However, It is useful in submitting tenders, preparing job estimates etc.

Marginal Costing : It refers to the ascertainment of costs differentiating between fixed costs and variable costs. In this technique fixed costs are not treated as product costs. They are recovered from the contribution (the difference between sales and variable cost of sales). The marginal or variable cost of sales includes direct material, direct wages, direct expenses and variable overhead. This technique helps management in taking important policy decisions such as product pricing in times of competition, whether to make or not, selection of product mix etc.

Differential Costing : Differential cost is the difference in total cost between alternatives evaluated to assist decision making. This technique draws the curtain between variable costs and fixed costs. It takes into consideration fixed costs also (unlike marginal costing) for decision making under certain circumstances. This technique considers all the revenue and cost differences amongst the alternative courses of action to assist management in arriving at an appropriate decision.

Standard Costing : It refers to the ascertainment and use of standard costs and the measurement and analysis of variances. Standard cost is a predetermined cost which is computed in advance of production on the basis of a specification of all factors affecting costs. The standards are fixed for each element of cost. To find out variances, the standard costs are compared with actual costs. The variances are investigated later on and wherever necessary, rectificational steps are initiated promptly. The technique helps in measuring the efficiency of  operations from time to time.

Practical Difficulties in Installing Costing System : Apart from technical costing problems, a cost accountant is confronted with certain practical difficulties in installing a costing system. These are :

  1. Lack of support of management : In order to make the costing system a success, it must have the whole-hearted support of every member of the management. Many a time, the costing system is introduced at the behest of the Managing Director or the Financial Director without the support of functional managers. They view the system as an interference in their work and do not make use of the system.

Before the system is installed, the cost accountant should ensure that the management is fully committed to the costing system. A sense of cost consciousness should be created in their minds explaining them that the system is for their benefit. A cost manual should be prepared and distributed to them giving the details and functions of the system.

  1. Resistance from the accounting staff : The existing accounting staff may not welcome the new system. This may be because they look with suspicion at a system which is not known to them. The co-operation of the employees should be sought convincing them that the system is needed to supplement the financial accounting system and that it is for the betterment of all.
  2. Noncooperation of Working and Supervisory Staff : Correct activity data which is supplied supervisory staff and workers is necessary for a costing system. They may not co-operate and resist the additional paper work arising as a result of the introduction of the system. Such resistance generally arises out of ignorance. Proper education should be given to the staff regarding benefits of the system and the important roles they have to play to make it successful.
  3. Shortage of Trained Staff : In the initial stages, there may be shortage of trained costing staff. The staff should be properly trained so that costing department can run efficiently.
    • CONCEPT OF COST

The scope of term ‘cost’ is extremely broad and general. It is therefore, not easy to define or explain this term without leaving any doubt concerning its meaning. Cost accountants, economists and others develop the concept of cost according to their needs. This concept should, therefore, be studied in relation to its purpose and use. Some of the definitions of ‘cost’ are reproduced below:

Cost is “the amount of expenditure (actual or notional) incurred on or attributable to a given thing”. (C.I.M.A. London). Cost is “an exchange price, a foregoing, a sacrifice made to secure benefit”. (A tentative set of Broad Accounting Principles for Business Enterprises).

Cost should be distinguished from expenses and losses though in practice the terms cost and expenses are sometimes used synonymously. An expense is defined as including “all expired costs which are deductible from revenue”. When a portion of the service potential of an asset is consumed, that portion of its cost is re-classified as an expense.

  • COST CENTRE AND COST UNIT

Cost is ascertained cost centres or cost units or both. The terms are discussed below :

Cost Centre : A cost centre is “a location, person, or item of equipment or group of these for which costs may be ascertained and used for the purpose of control”. Thus, a cost centre refers to a section of the business to which costs can be charged. It may be a location (a department, a sales area), an item of equipment (a machine, a delivery van), a person (a salesman, a machine operator) or a group of these (two automatic machines operated one workman).

A cost centre is primarily of two types :

  • Personal cost centre–which consists of a person or a group of persons.
  • Impersonal cost centre– which consists of a location or an item of equipment or group of these.

From functional point of view, cost centres may be of the following two types:

  • Production cost centre–those cost centres where actual production work takes place. Examples are melting shop, machine shop, welding shop, finishing shop, etc.
  • Service cost centre– those cost centres which are ancillary to and render services to production cost centres. Examples of service cost centres are power house, tool room, stores department, repair shop, canteen, etc. Cost incurred in service cost centres are of indirect type.

Cost accountant sets up cost centres to enable him to ascertain the costs the needs to know. A cost centre is charged with all the costs that relate to it, eg.. if a cost centre is a machine, it will be charged with the costs of power, light, depreciation and its share of rent etc. The purpose of ascertaining the cost of a cost centre is cost control. The person incharge of a cost centre is held responsible for the control of cost of that centre.

The number of cost centres and the size of each vary from one undertaking to another. It all depends upon the expenditure involved and requirements of the management of the purpose of cost control. A large number of cost centres tend to be expensive but having too few cost centres defeat the very purpose of control.

Cost Unit : It has been seen above that cost centres help in ascertaining the costs location, equipment or person. Cost unit is a step further which breaks up the cost into smaller sub-divisions and helps in ascertaining the cost of saleable products or services.

A cost unit is a “unit of product, service or time in relation to which cost may be ascertained or expressed”, (C.I.M.A. London). Cost units are the ‘things’ that the business is set up to provide of which cost is ascertained. For example, in a sugar mill,  the cost per tonne of sugar may be ascertained, in a textile mill the cost per-metre of cloth may be ascertained. Thus a tonne of sugar and ‘metre’ of cloth are cost units. In short, cost unit is unit of measurement of cost.

All sorts of cost units are adopted, the criterion for adoption being the applicability of  particular cost unit to the circumstances under consideration. Broadly, cost unit may be :

  • Units of production, e.g. a metre of cloth, a ream of paper, a tonne of steel, a metre of cable, etc. or
  • Units of service , e.g. passenger miles, cinema seats, consulting hours etc.

A few more examples of cost units in various Industries are given below :

Industry Cost Unit
Bricks 1000 bricks
Cement Tonne
Chemicals Tonne, kilogram, litre, gallon, etc.
Carpets Square foot
Pencils Dozen or gross
Electricity Kilowatt hour (KWH)
Transport Passenger kilometer or tonne kilometre
Printing Press Thousand copies
Cotton or jute Bale
Timber Cubic foot
Mines Tonne
Hotel Room per day
Shoes Pair or dozen pairs

Note :       The cost units and cost centres should be those which are readily understood and accepted all concerned.

10.11 COST CONCEPTS

The clear understanding of various cost concepts is essential for

the study of cost accounting and cost systems. Description of these concepts follows now.

Product and period costs – The product cost is aggregate of costs that are associated with a unit of product. Such costs may or may not include an element of overheads depending upon the type of costing system in force- absorption or direct. Product costs are related to goods produced or purchased for resale and are initially identifiable as part of inventory. These product or inventory costs become expenses in the form of cost of goods sold only when the inventory is sold. Product cost is associated with unit of output. The costs of inputs in forming the product viz., the direct material, direct labour, factory overhead constitute the product costs.

The period cost is a cost that tends to be unaffected changes in level of activity during a given period of time. Period cost is associated with a time period rather than manufacturing activity and these costs are deducted as expenses during the current period without having been previously classified as product costs. Selling and distribution costs are period costs and are deducted from the revenue without their being regarded as part of the inventory cost.

Common and joint costs : The common cost is an indirect cost that is incurred for the general benefit of a number of departments or for the whole enterprise and which is necessary for present and future operations. The joint costs are the cost of either a single process or a series of processes that simultaneously produce two or more products of significant relative sales value.

Short-run and long-run costs : The short-run costs are costs that vary with output when fixed plant and capital equipment remain the same and become relevant when a firm has to decide whether or not to produce more in the immediate future. The long-run-costs are those which vary with output when all input factors including plant and equipment vary and become relevant when the firm has to decide whether to set up a new plant or to expand the existing one.

Past and future cost : The past costs are actual costs incurred in the past and are generally contained in the financial accounts. These costs report past events and the time lag between event and its reporting makes the information out of date and irrelevant for decision-making. These costs will just act as a guide for future course of action.

The future costs are costs expected to be incurred at a later date and are the only costs that matter for managerial decisions because they are subject to management control. Future costs are relevant for managerial decision making in cost control, profit projections, appraisal of capital expenditure, introduction of new products, expansion programmes and pricing etc.

Controllable and non-controllable costs :The concept of responsibility accounting leads directly to the classification of costs as controllable or uncontrollable. The controllable cost is a cost chargeable to a budget or cost centre, which can be influenced the actions of the person in whom control the centre is vested. It is always not possible to predetermine responsibility, because the reason for deviation from expected performance may only become evident later. For example excessive scrap may arise from inadequate supervision or from latent defect in purchased material. The controllable cost is a cost that can be influenced and regulated during a given time span the actions of a particular individual within an organisation.

The controllability of cost depends upon the level of responsibility under consideration. Direct costs are generally controllable the shop level management. The uncontrollable cost is a cost that is beyond the control (i.e. uninfluenced actions) of a given individual during a given period of time.

The distinction between controllable and uncontrollable costs are not very sharp and may be left to individual judgement. Some expenditure which may be uncontrollable on the short-term basis can be controllable on long-term basis, There are certain costs which are really difficult to control due to the following reasons.

  • Physical hazards arising due to flood, fire, strike, lockout etc.
  • Economic risks such as increased competition, change in fashion or model, higher prices of inputs, import restrictions, etc.
  • Political risk like change in Government policy, political unrests, war etc.
  • Technological risk such as change in design, know-how etc.

Replacement and Historical Costs : The Replacement costs and Historical costs are two methods for carrying assets in the balance sheet and establishing the amounts of costs that are used to determine income.

The Replacement cost is a cost at which material identical to that is to be replaced could be purchased at the date of valuation (as distinct from actual cost price at the date of purchase). The replacement cost is a cost of replacing an asset at any given point of time either at present or the future (excluding any element attributable to improvement).

The Historical cost is the actual cost, determined after the event. Historical cost valuation states costs of plant and materials, for example, at the price originally paid for them whereas replacement cost valuation states the costs at prices that would have to be paid currently. Costs reported conventional financial accounts are based on historical valuations. But during periods of changing price level, historical costs may not be correct basis for projecting future costs. Naturally historical costs must be adjusted to reflect current or future price levels.

Out of pocket and Book Costs : The out of pocket cost is a cost that will necessitate a corresponding outflow of cash. The costs involving cash outlay or payment to other parties  are termed as out of pocket costs. Book costs are those which do not require current cash payments. Depreciation, is a notional cost in which no cash transaction is involved. The distinction between out of pocket costs and book costs primarily shows how costs affect the cash position. Out of pocket costs are relevant in some decision making problems such as fluctuation of prices during recession, make or buy decisions etc. Book costs can be converted into out of pocket costs selling the assets and having item on hire. Rent would then replace depreciation and interest.

Imputed and Sunk Costs : The imputed cost is a cost which does not involve actual cash outlay, which are used only for the purpose of decision making and performance evaluation. Imputed cost is a hypothetical cost from the point of view of financial accounting. Interest on capital is common type of imputed cost. No actual payment of interest is made but the basic concept is that, had the funds been invested elsewhere they would have earned interest.

Thus, imputed costs are a type of opportunity costs.

The Sunk costs are those costs that have been invested in a project and which will not be recovered if the project is terminated. The sunk cost is one for which the expenditure has taken place in the past. This cost is not affected a particular decision under consideration. Sunk costs are always results of decisions taken in the past. This cost cannot be changed any decision in future. Investment in plant and machinery as soon as it is installed its cost is sunk cost and is not relevant for decisions. Amortization of past expenses e.g. depreciation is sunk cost. Sunk costs will remain the same irrespective of the alternative selected. Thus, it need not be considered the management in evaluating the alternatives as it is common to all of them. It is important to observe that an unavoidable cost may not be a sunk cost. The Managing Director’s salary is generally unavoidable and also out of pocket but not sunk cost.

Relevant and Irrelevant Costs : The relevant cost is a cost appropriate in aiding to make specific management decisions. Business decisions involve planning for future and consideration of several alternative courses of action. In this process the costs which are affected the decisions are future costs. Such costs are called relevant costs because they are pertinent to the decisions in hand. The cost is  said to be relevant if it helps the manager in taking a right decision in furtherance of the company’s objectives.

Opportunity and Incremental Costs : The opportunity cost is the value of a benefit sacrificed in favour of an alternative course of action. It is the maximum amount that could be obtained at any given point of time if a resource was sold or put to the most valuable alternative use that would be practicable. The opportunity cost of a good or service is measured in terms of revenue which could have been earned employing that good or service in some other alternative uses. Opportunity cost can be defined as the revenue forgone not making the best alternative use. Opportunity cost is the prospective change in cost following the adoption of an alternative machine process, raw materials etc. It is the cost of opportunity lost diversion of an input factor from use to another.

The Incremental cost is the extra cost of taking one course of action rather than another. It is also called as different cost. The incremental cost is the additional cost due to a change in the level of nature of business activity. The change may take several forms e.g., changing the channel of distribution, adding a new machine, replacing a machine a better machine, execution of export order etc. Incremental costs will be different in case of different alternatives. Hence, incremental costs are relevant to the management in the analysis for decision making.

Marginal cost : The marginal cost is the variable cost of one unit of a product or a service i.e., a cost which would be avoided if the unit was not produced or provided. In this context a unit in usually either a single article or a standard measure such as litre or kilogram, but may in certain circumstances be an operation, process or part of an organisation. The marginal cost is the amount at any given volume of output which aggregate costs are changed if the volume of output is increased or decreased one unit. The marginal costing technique is the process of ascertaining marginal costs and of the effects of changes in volume of type of output on profit differentiating between fixed and variable costs.

Notional cost : The notional cost is a hypothetical cost taken into account in a particular situation to represent the benefit enjoyed an entity in respect of which no actual expense is incurred.

10.12 CLASSIFICATION OF COST

The process of grouping costs according to their common characteristics is called classification of cost. It is a systematic placement of like items together according to their common features. The followings are the important ways of classifying costs.

  1. A) Classification According to Functions : This is a traditional classification. A business has to perform a number of functions like manufacturing, administration, selling, distribution and research. Cost may have to be ascertained for each of these functions. On this basis, costs are classified into the following groups :
  • Manufacturing cost : This is the cost of the sequence of operations which begins with supplying materials, labour and services and ends with completion of production.
  • Administration cost : This is general administrative cost and includes all expenditure incurred in formulating the policy, directing the organisation and controlling the operations of an undertaking, which is not directly related to production, selling and distribution, research and development activity or function.
  • Selling and distribution costs : Selling cost is the cost of seeking to create and simulating demand and of securing orders.

Distribution cost is the cost of sequence of operations which

begins with making the packed product available for despatch and ends with making the reconditioned returned empty package for re-use. The various items included in manufacturing administrative, selling and distribution costs are available in Table 10.3

Table 10.3

Functional Classification of Costs

Manufacturing Costs                      Selling Costs

Materials                                        Advertising

Labour                                             Salaries & Commissions of salesmen

Factory rent                                     Showroom expenses

Depreciation                                   Samples

Power & lighting                             Travel expenses

Insurance                                         Distribution Costs

Stores Keeping                                Packing costs

Administration Costs                     Carriage outward

Accounts office expenses                  Warehousing costs

Audit fees                                       Upkeep and running costs of delivery vans

Legal expenses

Office rent

Director’s remuneration

Postage

(iv) Research and development cost : Research cost is the cost of searching new or improved products or methods. It comprises wages and salaries of research staff, payments to outside research organisations, materials used in laboratories and research departments, etc.

After completion of research, the management may decide to produce a new improved product or to employ a new or improved method. Development cost is the cost of the process which begins with the implementation of the decision to produce a new product or to employ a new or improved method and ends with the commencement of formal production of that product or that method.

Pre-production cost is that part of the development cost which is incurred in making in trial production run preliminary to formal production.

  1. B) Classification based on cost behaviour : Depending on the variability behaviour costs can be classified into variable and fixed costs.
  • Variable cost : The variable cost is a cost that tends to vary in accordance with level of activity within the relevant range and within a given period of time. The Prime product costs i.e., direct material, direct labour and direct expenses tend to vary in direct proportion to the level of activity. An increase in the volume means a proportionate increase in the total variable costs and a decrease in volume will lead to a proportionate decline in the total variable costs. There is a linear relationship between volume and variable costs. They are constant per unit.

Variable costs have an explicit physical relationship with a selected measure of activity and exists an optimum cause and effect relationship between the input and output. Therefore variable costs are also known as engineered costs. All variable costs are not engineered costs. Some of the variable components which are termed as discretionary variable costs and such costs will vary with fluctuations in the levels of activity merely because of the policy of the management. The variable element of research and development or advertisement costs, which are discretionary nature may increase with increased activity and management may decide to spend more in periods of increased activity.

  • Fixed cost : The fixed cost is a cost that tends to be unaffected changes in the level of activity during a given period of time. The fixed costs remain constant in the total regardless of changes in volume upto a certain level of output. They are not affected changes in the volume of production. There is an inverse relationship between volume and fixed cost per unit. Fixed costs tend to remain constant for all levels of activity within a certain range. It follows that some fixed costs will continue to be incurred even when the activity comes down to nil. Some fixed costs are liable to change from one period to another. For example salaries bill may go up because of annual increments or due to change in the pay rates and due to pay structure.
  • Semi-variable cost or semi-fixed cost : Many costs fall between these two extremes. They are called as semi-variable cost or semi-fixed costs. They are neither perfectly variable nor absolutely fixed in relation to changes in volume. They change in the same direction as volume but not in direct proportion thereto. An example is found in telephone charges. The rental element is a fixed cost whereas charges for call made are a variable cost. The distinction between fixed and variable cost is important in forecasting the effect of short-run changes in volume upon costs and profits. This distinction has also given rise to the concepts of Marginal Costing, Direct Costing, Flexible Budgeting. Costs which have neither a linear or curvilinear relationship with output but they move in steps with fluctuations in activity levels. These are called stepped up costs. Basically these are fixed costs upto a certain level of activity specified but they change as soon as a new range is reached. Such costs are semi variable in the long-term but fixed in the short-term. Certain variable costs tend to vary during specific  periods for reasons not related to fluctuations in activity level. For example, increased maintenance cost during periods of low production, increased costs on air-conditioning in summer. Costs which fluctuate with volume of production but after certain stage of production has reached the fluctuations in cost is disproportionate. It changes either at a retarded or accelerated rate.
  1. C) Committed and Discretionary costs : It is shown above that costs may be classified into fixed and variable. Fixed costs may be further classified as committed costs and discretionary (or programmed) costs. This classification is based on the degree to which firm is locked into the asset or service that is generating the fixed cost.

Fixed cost is committed if it is incurred in maintaining physical facilities and management set up. Committed costs cannot be avoided in the short run. For example, salary of the managing director may represent a committed cost if, policy, the managing director is not to be released unless the firm is liquidated. Similarly, depreciation of plant and equipment is committed because these facilities cannot be easily changed in the short  run.

Discretionary fixed costs are those which can be avoided management. Such costs are not permanent. Advertising, research and development cost, salaries of low level managers are examples of discretionary costs because these costs may be avoided or reduced in the short run if so desired the managements.

This classification into committed and discretionary costs is important from the point of view of cost control and decision making. D) Financial Costs :

Cash costs : Cash costs are those sacrifices that are reflected in actual cash outflows. Business transactions usually involve both reward (or revenue) and sacrifice (or cost) with the difference between the two being gain (or profit). Thus

Reward-Sacrifice              =        Gain

Revenue – Cost                 =         Profit

Non-cash costs : Non-cash costs are financial sacrifices that do not involve cash outlays at the time when the cost is recognised. These costs are found in deprecation, opportunity costs etc.

(b) Non-Financial costs : Non financial costs are those costs that are not directly traceable through a company’s cash flow. While such costs (e.g., low morale of employees) certainly involve scarifies and they may lead  eventually, in complex ways to a reduced cash flow in the future. They do not represent an immediate cash outlays.

The above cost concepts are based on several factors like controllability, period, situation, input-output relationship, opportunity, urgency, historical, product, etc. The clear understanding of costs concepts will help the management in analysis of costs, reporting, cost control and decision making.

  1. Product Costs and Period Costs : Product costs are those costs which are necessary for prediction and which will not be incurred if there is not production. These consist of direct materials, direct labour and some of the factory overhead. Product costs are ‘absorbed by’ or ‘attached to’ the units produced.

Period costs are those which are not necessary for production and are written off as expenses in the period in which these are incurred. Such cost are incurred for a time period and are charged to Profit and Loss Account of the period, rent, salary of company executives, travel expenses are examples of period costs. These costs are not inventoried i.e. these are not included in the value of closing stocks.

Classification into product and period cost is important from the point of view of profit determination. This is so because product cost is carried forward to the next accounting period as part of the unsold finished stock whereas period cost is written off in the accounting period in which it is incurred.

  1. Classification according to Identifiability with Cost Units : Costs are classified into direct and indirect on the basis of their identiability with cost units or jobs or processes :
  • Direct costs : These are those costs which are incurred for and may be conveniently identified with a particular cost unit, process or department.
  • Indirect costs : These costs cannot be conveniently identified with a particular cost unit, process or department. These are general costs and are incurred for the benefit of a number of cost units or cost centres.

Cost of raw materials used, wages of machine operators are common examples of direct costs. Examples of indirect costs are rent, repairs, depreciation, managerial salaries, coal, lubricating oil, wages of foreman, etc.

Costs are not traced or identified directly to a product for one of the three reasons :

  1. It is impossible to do so e.g., rent of building etc.
  2. It is not convenient or feasible to do so e.g., nails used in furniture, sewing thread, etc.
  3. Management chooses not to do so i.e. many companies classify certain items of cost as indirect because it is customary in the industry to do so e.g., carriage inward etc.

This classification is important from the point of view of accurate ascertainment of cost. Direct costs of  product can be conveniently determined while the indirect costs have to be arbitrarily apportioned to various cost units. For example, in readymade garments, the cost of cloth and wages of tailor are accurately ascertained without any difficulty and are thus direct costs. But the rent of factory, managerial salaries, etc., which are indirect costs, have to be apportioned to various cost units on some arbitrary basis and cannot be accurately ascertained.

  1. G) Classification According to Controllability : The costs can also be classified into controllable and uncontrollable :
  • Controllable costs : These are the costs which may be directly regulated at a given level of management authority. Variable costs are generally controllable department heads. For example, cost of raw material may be controlled purchasing in larger quantities.
  • Uncontrollable costs : These are those costs which cannot be influenced the action of a specified member of an enterprise. Fixed costs are generally uncontrollable. For example, it is very difficult to control costs like factory rent, managerial salaries, etc.

Two important points should be noted regarding this classification. First, controllable costs cannot be distinguished from uncontrollable costs without specifying the level and scope of management authority. In other words, a cost which is uncontrollable at one level of management may be controllable at another level of management. Secondly, in the long-run all costs are controllable.

10.13 COMPONENTS OF TOTAL COST

Prime cost : It consists of direct material, direct labour and direct expenses. It is also known as basic, first or flat cost.

Factory cost : It comprises of prime cost and, in addition, works or factory overheads which include costs of indirect material, indirect labour, and indirect expenses of the factory. The cost is also known as works cost, production or manufacturing cost.

Office Cost : If office and administrative overheads are added to factory cost, office cost is arrived at. This is also termed as administrative cost or the total cost of production.

Total Cost : Selling and distribution overheads are added to the total cost of production to get the total cost or the cost of sales.

10.14 COST SHEET

The components of cost explained above can be presented in the form of a statement. Such a statement of cost giving total cost, cost per unit alongwith different cost components of is termed as a cost sheet.

 

  • SUMMARY

Whatever may be the type of business, it involves expenditure on labour, materials and other items required for manufacturing and disposing of the product. Moreover, big business requires delegation of responsibility, division of labour and specialisation. Management has to avoid the possibility of waste at each stage. Management has to ensure that no machine remains idle, efficient labour gets due initiative, proper utilisation of by-products is made and costs are properly ascertained. Besides management, creditors and employees are also benefited in numerous ways installation of a good costing system in an industrial organisation. Cost accounting increases the overall productivity of an industrial establishment and, therefore, serves as an important tool in bringing prosperity to the nation. The basic principles of ascertaining costs are the same in every system of cost accounting. However, the methods of analysing and presenting the cost may vary from industry to industry. The method to be used in collecting and presenting costs will depend upon the nature of production. Basically there are two methods of costing, namely. Job costing and Process costing. Cost is ascertained cost centres or cost units or both. The components of cost when presented in the form of a statement. Such a statement of cost giving total cost, cost per unit alongwith different cost components of is termed as a cost sheet.

  • KEYWORDS

Cost: The technique and process of ascertaining the cost is defined as costing. Cost accounting: It is that branch of accounting which deals with the classification, recording, allocation, summarisation and reporting of current and prospective costs.

Cost control: It represents the employment of management devices in the performance of any necessary operation so that pre-established objectives may be attained at the lowest possible outlay for goods and services.

Cost unit: A cost unit is a unit of finished product, service or time or combination of these in relation to which cost is ascertained and expressed.

Cost centre: A cost centre refers to a section of a factory for which costs are accumulated separately.

Cost sheet: A cost sheet is a statement which shows the details regarding the total cost of the job or a product.

10.17    SELF ASSESSMENT QUESTIONS

  1. Define costing and discuss briefly its objectives and advantages.
  2. State the differences between Financial Accounting, Cost Accounting and Management Accounting. Explain how financial accounts are inadequate to measure the performance of an industry.
  3. “A good system of costing serves as a means of control over expenditure and helps to secure economy in manufacture” Discuss.
  4. What are the main benefits that may be expected from the installation of costing system in a manufacturing business.
  5. Describe, in brief, the various methods of costing.
  6. Distinguish between ‘Product and period Cost’ 7. Write short note on ‘Cost Centre’ and ‘Cost Unit’
  7. Distinguish between :

(a) controllable costs and uncontrollable costs. (b) Variable cost and direct cost.

  • Cost control and profit control
  • Sunk cost and Out of Pocket cost. (e) Job costing and process costing.

“Costs may be classified in a variety of ways accord to their nature and the information needs of management”. Explain and discuss this statement giving examples of classifications required for different

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