COST ACCOUNTING

 

 Meaning of Cost

Cost refers to the total expenses incurred for the manufacture and sale of a product or for providing a service.

Meaning of Costing

Costing refers to the process of ascertaining the cost of manufacturing an article, rendering a service or performing a function.

Meaning of Cost Accounting

Cost Accounting is the classifying, recording and appropriate allocation of expenditure for the determination of the costs of products or services, and for the presentation of the suitably arranged data for the purposes of control and guidance of management.

Definition of Cost Accounting

According to ICWAI, India, “Cost Accounting is the technique and process of ascertainment of costs. Cost Accounting is the process of accounting for costs, which begins with recording of expenses or the bases on which they are calculated and ends with preparation of statistical data”.

Meaning of Cost Accountancy

The cost accountancy refers to the practice of a cost accountant of using the information derived for the purpose of managerial decision making. It includes costing, cost accounting, cost control, budgetary control and cost audit.

NATURE OF COST ACCOUNTING

1. It is a branch of Knowledge

Cost accounting is an organised body of knowledge having its own principles, concepts and conventions. But the principles and rules vary depending on the industry to which they are applied.

2. It is a Science

Cost accounting is a science because it is a body of systematic knowledge.

3. It is an Art

Cost accounting is an art as it requires the ability and skill of the Cost Accountant. The Cost Accountant has to have skill and ability to apply the principles, methods and techniques of cost accountancy to various management problems.

4. It is a profession

In the recent years, the Cost Accountancy has become a challenging profession. It is evident from the setting up of professional bodies such as Institute of Cost and Works Accountants in India, the Institute of Cost and Management Accountants in UK and the National Association of Accountants in USA and enrolment of large number of students in these institutes to qualify them to practice as professionals.

SCOPE OF COST ACCOUNTING

The terms scope refers to the activities involved in Cost accounting. The following are the activities of cost accounting:

1. Cost Ascertainment

Ascertainment of cost is the primary objective of cost accounting. The cost of a product or a service is ascertained through the methods and techniques of costing depending on the type of industry. It involves the collection, classification, allocation and apportionment of expenses.

2. Cost Control

Cost control is another important objective of cost accounting. Cost control results in the improvement of profitability of a concern. Cost control is exercised at different stages in a factory mainly through budgetary control and standard costing techniques. These techniques reveal the unfavourable deviations in costs. Costs are controlled through remedial actions.

3. Cost Reduction

Reduction of cost should always be achieved without impairing the quality and suitability of intended use of goods or services. It can be achieved through the techniques of budgetary control, standard costing, material control, labour control and overheads control.

COST ANALYSIS - CLASSIFICATION OF COST

The costs can be classified on different bases namely element, functions, variability, controllability, identity, nature and normality.

I. Classification on the basis of Elements

Based on elements of cost, costs are classified into three types. They are as follows:

1. Material Cost

Material cost refers to the cost of commodities used in the production of a product or service. It is divided into direct material cost and indirect material cost. Direct material cost is a cost which is used in the production and becomes constituent element of a product or service. Cost of Cotton used in Cotton textiles and cost of Timber used in Furniture-making are examples for direct material cost. Indirect material cost refers to the material cost other than direct material cost which is used in production but not a constituent element of a product or a service. Consumable stores such as oil and cotton waste are examples of indirect material cost.

2. Labour Cost

Labour cost refers to the amount paid to the workers engaged in the production of a product or a service. It is divided into direct labour cost and indirect labour cost. Direct labour cost refers to the remuneration paid to workers whose skills and efforts are directly applied to a product or service. Wages paid to the workers directly engaged in the ginning, spinning or weaving processes of a textile unit and wages paid to the Carpenters engaged in Wooden Furniture-making are examples for direct labour costs. Indirect labour cost refers to the remuneration paid to those workers who assist or help the expert workers. The wages paid to helpers and assistants in any process are examples of indirect labour cost.

3. Expenses

Costs incurred for production or sale of a product or service other than material cost and labour cost are referred to as expenses. They are divided into direct expenses and indirect expenses. Expenses incurred specifically for a product or a service is known as direct expenses. Expenses other than direct expenses are indirect expenses.

II. Classification on the basis of Functions

Based on the functions performed, the costs are classified into four types. They are as follows:

1. Production Cost

A cost incurred for the production of a product or a service is known as production cost. Material cost, Labour cost and direct and indirect expenses incurred in the factory are examples of production cost.

2. Administration Cost

A cost incurred for general management, secretarial services, accounting services, policy formulation, directing, organising and control of an undertaking is known as administration cost.

3. Selling and Distribution Cost

A cost incurred for securing orders, stimulating demand and facilitating the movement of goods to the buyers is known as selling and distribution cost. Salaries of salesmen, advertising, packing, warehouse charges and freight charges are examples of selling and distribution cost.

4. Research and Development Cost

A cost incurred for searching new products, new application of materials, improved methods and new methods and implementation of the same is referred to as research and development cost.

III. Classification on the basis of Variability

Based on variability, the costs are classified into three types. They are as follows:

1. Fixed Cost

A cost which is unaffected by the change in the volume of output is known as fixed cost. It is also known as period cost. It depends on the passage of time. It does not vary directly with the volume of output. The total amount remains the same but the unit cost varies according to the changes in the level of output. Rent, Insurance, Salaries, Printing and stationery and Depreciation are examples of fixed cost.

2. Variable Cost

A cost that varies in direct proportion to the volume of output is known as variable cost. The unit cost remains the same but the total amount varies according to the changes in the level of output. Direct material cost, direct labour cost and power are examples of variable cost.

3. Semi-variable Cost

A cost that is partially fixed and partially variable is known as semi-variable cost. Both fixed and variable elements are present in this cost. Such cost is fixed upto certain level and after that starts varying according to the output. If you take the telephone charges, it has a fixed annual charge plus variable according to calls. Telephone charges and Depreciation are examples of semi-variable cost.

IV. Classification on the basis of Controllability

Based on controllability, the costs are classified into two types. They are as follows:

1. Controllable Cost

A cost that is influenced by the action of a specified member of an undertaking is known as controllable cost. Every organisation is divided into a number of responsibility centres. A manager is in charge of each of such responsibility centres. When a cost incurred in a responsibility centre can be influenced by the action of the manager, it is referred to as a controllable cost. Direct materials costs and direct labour costs are controllable costs.

2. Uncontrollable Cost

A cost that cannot be influenced by the action of a specified member of an undertaking is known as uncontrollable cost. Every organisation is divided into a number of responsibility centres. A manager is in charge of each of such responsibility centres. When a cost incurred in a responsibility centre cannot be influenced by the action of the manager, it is referred to as uncontrollable cost. Rent, rates, taxes, insurance and salaries are uncontrollable cost.

V. Classification on the basis of Identifiability

Based on identifiability, the costs are classified into two types. They are as follows:

1. Direct Cost

A cost that can be conveniently identifiable and allocable to a cost centre or cost unit is known as direct cost. It can be directly charged to the output or operation.

2. Indirect Cost

A cost that cannot be conveniently identifiable and allocable to a cost centre or cost unit is known as indirect cost. It has to be apportioned to cost units or cost centres on appropriate basis.

VI. Classification on the basis of Period of Benefit

Based on the period of benefit, the costs are classified into two types. They are as follows:

1. Capital Cost

A cost incurred to increase the earning capacity of the business and for future benefit is known as capital cost. Capital cost is normally heavy and invested in fixed assets. Cost of Land and buildings, plant and machinery and equipment are examples of fixed cost.

2. Revenue Cost

A cost incurred to maintain the earning capacity of the business and for current benefit is known as revenue cost. Revenue cost is incurred to carry on the day-to-day operations. Rent, wages, salaries and insurance premium are examples of variable cost.

VII. Classification on the basis of Normality

Based on the normality, the costs are classified into two types. They are as follows:

1. Normal Cost

A cost incurred for attaining the output in the normal conditions which cannot be avoided is known as normal cost. It is also known as unavoidable cost.

2. Abnormal Cost

A cost which is not normally incurred for attaining the output in the normal conditions and can be avoided is known as abnormal cost. These costs can be avoided and controlled through necessary actions. It is also known as avoidable cost.

VIII. Classification on the basis of Relevance to Managerial Decisions

Based on the relevance to managerial decisions, the costs are classified as follows:

1. Marginal Cost

Marginal cost is the total of variable costs. It comprises of prime cost and all variable overheads.

2. Sunk Cost

Sunk cost is a historical cost incurred in the past which is irrecoverable. It is not relevant for decision-making. If a decision to replace a machine is to be made, the book value of it is a sunk cost and has no relevance for the replacement decision.

3. Opportunity Cost

Opportunity cost is the advantage which has been foregone due to not using the facility in the manner originally planned. For example, if an owned building is proposed to be used for a project, the likely rent for the project is the opportunity cost which should be taken into consideration in the evaluation of profitability of the project.

4. Shut-down Cost

A cost that will continue to incur even if the plant is shut-down or the production is temporarily stopped is known as shut-down cost. Rent, rates, maintenance costs and depreciation are examples of shut-down cost.

5. Out of Pocket Cost

It refers to the current or future expenditure involving cash payment. In this case, the management looks at finding out whether the income from a particular project will at least cover the expenditure incurred on that project.

6. Imputed Cost

It refers to a hypothetical cost taken into account to represent a benefit enjoyed by the undertaking in respect of which no actual expense is incurred. It is also known as notional cost. Rent of own building, proprietor’s salary and interest on capital are the examples of imputed cost.

7. Differential Cost

It refers to the change in cost due to change in the level of activity or pattern or method of production. The differential cost may be incremental cost or decremental cost. If the change causes an increase in cost, it is incremental cost. If the change causes a decrease in cost, it is known as decremental cost.

8. Replacement Cost

It refers to the current market price of replacing an asset or material with identical one.

9. Conversion Cost

It refers to the cost incurred for converting the raw materials into finished goods. It is the aggregate of direct wages, direct expenses and indirect expenses.

10. Period Cost

This cost is identified with a particular product or job. It is incurred and paid for a particular period. Rent, rates, taxes and salaries are the examples of period cost. The benefit is usually exhausted with the expiry of certain period.

11. Avoidable Cost

It is a cost that can be eliminated if a particular product or department with which it is directly related is discontinued. For example, salary of clerks employed in department ‘X’ can be eliminated on the discontinuance of department ‘X’.

12. Unavoidable Cost

It is a cost which will not be eliminated with the discontinuation of a product or department. For example, salary of factory manager and factory rent cannot be eliminated on the discontinuance of a product or a department.

INSTALLATION OF A COSTING SYSTEM

While installing a costing system the cost accountant should ensure the following:

(a) Least disturbance to the existing organisation

(b) Gradual introduction of the system

(c) Avoidance of over-elaboration of records

FACTORS TO BE CONSIDERED BEFORE INSTALLATION OF A COSTING SYSTEM

The following factors are to be considered before installing a costing system in any organisation:

1. History of the Firm

History of the firm refers to the duration of existence, position in the industry, rate of growth and the philosophy of the management. History serves as basis for designing the cost accounts in respect of necessity, simplicity and investment involved in it.

2. Nature of Business

The nature of business may be manufacturing, trading or mining. It decides the type and method of costing to be introduced. It may be job costing, process costing, operating costing or unit costing. Also appropriate techniques of control such as standard costing or budgetary control should be introduced.

3. Objectives of Costing System

The objectives the management expects to be achieved from the costing system should be thoroughly understood. The management and personnel should understand the system well to have proper cooperation.

4. Existing Organisational Structure of the Firm

The existing scope of authority and responsibility of each individual in the organisation should be clearly understood. While installing the system, the modifications in the organisational structure should be as minimal as possible.

5. Size of the Firm

Depending on the size of the firm, the decision regarding maintenance of separate set of cost books and financial books or an integrated accounting system can be made.

6. Range of Products

The range of products in terms of size, models, fashions, area of market and competitors must be analysed to determine the method of costing to be applied.

7. Technical Aspects

Technical aspects such as size and layout of the factory, existence of production and service departments, flow of production, capacity of machines, degree of mechanization, existence of laboratories, material handling techniques, inspection and testing of materials and finished goods are to be considered.

8. Method of Selling and Distribution

Regarding selling and distribution the warehousing facilities, transport facilities, market research, promotional measures, terms of sale and procurement of orders from customers are to be considered.

9. Accounting System

The number of financial records, existing forms and registers used in respect of accounting are to be considered.

10. Communication System

A proper system of communication must be drawn to ensure complete and reliable cost information in the aspects of collection, transmission, report-making and reaching the appropriate levels of management.

STEPS INVOLVED IN THE INSTALLATION OF A COSTING SYSTEM

The following steps are involved in the installation of a costing system in a firm:

1. Determining the Objectives to be Achieved

The objectives to be achieved through the costing system have to be finalised. If the objective is just to determine the cost, the costing system can be simple. On the other hand, if the objective is to have information which will help the management to make decisions and exercise control, the costing system will have to be elaborate.

2. Studying the Existing Organisation and Routine

To determine the scope of authority and responsibility each individual in the organisation, the organisation structure is to be anlysed. Only minor changes in the organisational structure can be made for the benefit of the management. The routine activities of the organisation such as methods of dealing with materials, the system of time recording, the methods of computing and paying wages, etc. are to the thoroughly studied.

3. Deciding the Structure of Cost Accounts

Depending on the nature of manufacturing process and the ancillary services, the type of costing andtechnique of costing to control costs to be introducedshould be decided. It should also be decided whether separate set of cost and financial books are to be maintained or an integrated system is to be followed.

4. Determining the Cost Rates

The factory conditions are to be thoroughly studied and determine the classification of costs, grouping of indirect costs, treatment of all kinds of wastages, adoption of methods of pricing the issue of materials, adoption of methods of recovering overheads and calculation of overhead rates.

5. Introducing the System

As the success of the system largely depends on the co-operation of all the personnel, the implications of the system should be explained to them highlighting the benefits that will accrue to each of them and to the organisation as a whole. Then the system should be introduced by stages.

6. Organising the Cost Office

The cost office is to be situated adjacent to the factory and the costing staff must be allowed to have access to the works so that it can present figures with speed and accuracy. The duties of cost office fall into stores accounts, labour accounting, cost accounts, cost control and preparation of special statistical information for management to carry out special investigations and preparation of periodical trading statements.

7. Making the Cost office Directly Responsible to the Top

All the departments should be instructed to co-operate and co-ordinate with the cost office. The costing department should be made to function independently. It should establish smooth working relationship with all the departments. The cost accountant should be made directly responsible to the General Manager or Managing Director.

8. Defining the Authority and Responsibility

The success of the costing department depends on the clarity in the definition of authority and responsibility. Hence, there should not be any ambiguity in anything.

COST UNIT

Meaning of Cost Unit

A cost unit is a unit of product or service or time in relation to which cost may be ascertained. It is a devise used for the purpose of breaking up or separating costs into smaller subdivisions. Examples are per kg., per order, per car, per tonne, per gallon, per square feet, per passenger- kilometer and per tonne-kilometer.

Definition of Cost Unit

The Chartered Institute of Management Accountants, London defines a cost unit as “a unit of product or service in relation to which costs are ascertained”.

COST CENTRE

Meaning of Cost Centre

A cost centre is a section of a factory for which costs are accumulated separately. A cost centre is also called responsibility centre. Various production and service departments are known as cost centres.

Definition of Cost Centre

ICMA Terminology defines cost centre as “A location person or item of equipment (or group of theses) in respect of which costs may be ascertained and related to cost units”.  

PROFIT CENTRE

A profit centre is a segment of a business that is responsible for all activities involved in the production and sales of products and services. It is responsible for both revenues and costs. It is created by the top management for evaluating the performance of a division. It enjoys autonomy in decision-making.