Cost Accounting1 (1)(1)

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COST ACCOUNTING

CHAPTER1

INTRODUCTION TO COST ACCOUNTING

1.1 INTRODUCTION:

After passing your senior secondary examination, if you set up a small manufacturing unit, saymanufacturing of packing boxes, a problem will arise what price of each box you should quote to the

buyer. Many factors are considered while fixing the price of a product/item such as competitorsprice etc. One of the basic factors is the cost of its production. Cost is essential not only to fix pricebut also to ascertain the margin of profit. Knowledge of the cost determination is also necessary tokeep a check on the cost of product/control on wastages, etc. The accounting used to study thevarious aspects of cost is known as cost accounting. In this lesson, you will learn about meaning,importance, limitations etc. of cost accounting.

1.2 MEANING OF COST, COST ACCOUNTANCY AND COSTING

The term cost means the amount of expenses [actual or notional] incurred on or attributable tospecified thing or activity.

As per Institute of cost and work accounts (ICWA) India, Cost is measurement in monetary terms ofthe amount of resources used for the purpose of production of goods or rendering services.To get the results we make efforts. Efforts constitute cost of getting the results. It can be expressed interms of money; it means the amount of expenses incurred on or attributable to some specific thingor activity. The term cost is used in this very form. In reference to production/manufacturing ofgoods and services cost refers to sum total of the value of resources used like raw material and labour

and expenses incurred in producing or manufacturing of given quantity.

COST ACCOUNTANCY

The terminology of cost accountancy published by the Institute of Cost and ManagementAccountants, London defines cost accountancy as the application of costing and cost accounting

principles, methods and techniques to the science, art and practice of cost control and theascertainment of profitability. It includes the presentation of information derived therefrom for themanagerial decision-making.

On analysis of the above definition, the following features of cost accountancy become evident :(a) Cost accountancy is used in the broadest sense when compared to cost accounting andcosting. This is so because cost accountancy is concerned with the formulation of principles,methods and techniques to be applied for ascertaining cost and profit.(b) Having ascertained cost and profit, cost accountancy is concerned with presentation ofinformation to management. To enable management to carry out its functions, reports must be

promptly made available at the right time, to the right person and in a proper from.(c) The information so provided is to serve the purpose of managerial decision making such asintroducing a new line of product, replacement of manual labour by machines, make or buy,decisions, etc.


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COSTING:

Costing includes the techniques and processes of ascertaining costs. The Technique refers toprinciples which are applied for ascertaining costs of products, jobs, processes and services. The`process refers to day to day routine of determining costs within the method of costing adopted by a

business enterprise. Costing involves the classifying, recording and appropriate allocation ofexpenditure for the determination of costs of products or services; the relation of these costs to salesvalue; and the ascertainment of profitability.

1.3 MEANING OF COST ACCOUNTING:

Cost accounting is the process of determining and accumulating the cost of product or activity. It is aprocess of accounting for the incurrence and the control of cost. It also covers classification, analysis,and interpretation of cost. In other words, it is a system of accounting, which provides theinformation about the ascertainment, and control of costs of products, or services. It measures theoperating efficiency of the enterprise. It is an internal aspect of the organisation. Cost Accounting isaccounting for cost aimed at providing cost data, statement and reports for the purpose of managerialdecision making.

The Institute of Cost and Management Accounting, London defines Cost accounting is the process

of accounting from the point at which expenditure is incurred or committed to the establishment ofits ultimate relationship with cost centres and cost units. In the widest usage, it embraces thepreparation of statistical data, application of cost control methods and the ascertainment ofprofitability of activities carried out or planned.

1.4 SCOPE OF COST ACCOUNING:

The terms costing and cost accounting are many times used interchangeably. However, the scopeof cost accounting is broader than that of costing. Following functional activities are included in thescope of cost accounting:

1. Cost book-keeping: It involves maintaining complete record of all costs incurred from theirincurrence to their charge to departments, products and services. Such recording is preferably doneon the basis of doubleentry system.

2. Cost system: Systems and procedures are devised for proper accounting for costs.

3. Cost ascertainment: Ascertaining cost of products, processes, jobs, services, etc., is the importantfunction of cost accounting. Cost ascertainment becomes the basis of managerial decision makingsuch as pricing, planning and control.

4. Cost Analysis: It involves the process of finding out the causal factors of actual costs varying fromthe budgeted costs and fixation of responsibility for cost increases.

5. Cost comparisons: Cost accounting also includes comparisons between cost from alternativecourses of action such as use of technology for production, cost of making different products andactivities, and cost of same product/ service over a period of time.

6. Cost Control: Cost accounting is the utilisation of cost information for exercising control. Itinvolves a detailed examination of each cost in the light of benefit derived from the incurrence of thecost. Thus, we can state that cost is analysed to know whether the current level of costs is satisfactoryin the light of standards set in advance.


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7. Cost Reports: Presentation of cost is the ultimate function of cost accounting. These reports areprimarily for use by the management at different levels. Cost Reports form the basis for planning andcontrol, performance appraisal and managerial decision making.

1.5 OBJECTIVES OF COST ACCOUNTING

There is a relationship among information needs of management, cost accounting objectives, andtechniques and tools used for analysis in cost accounting. Cost accounting has the following mainobjectives to serve:1. Determining selling price,2. Controlling cost3. Providing information for decision-making4. Ascertaining costing profit5. Facilitating preparation of financial and other statements.

1. Determining selling price

The objective of determining the cost of products is of main importance in cost accounting. The totalproduct cost and cost per unit of product are important in deciding selling price of product. Costaccounting provides information regarding the cost to make and sell product or services. Other

factors such as the quality of product, the condition of the market, the area of distribution, thequantity which can be supplied etc., are also to be given consideration by the management beforedeciding the selling price, but the cost of product plays a major role.

2. Controlling costCost accounting helps in attaining aim of controlling cost by using various techniques such asBudgetary Control, Standard costing, and inventory control. Each item of cost [viz. material, labour,and expense] is budgeted at the beginning of the period and actual expenses incurred are comparedwith the budget. This increases the efficiency of the enterprise.

3. Providing information for decision-making

Cost accounting helps the management in providing information for managerial decisions forformulating operative policies. These policies relate to the following matters:(i) Determination of cost-volume-profit relationship.(ii) Make or buy a component(iii) Shut down or continue operation at a loss(iv) Continuing with the existing machinery or replacing them by improved and economicalmachines.

4. Ascertaining costing profit

Cost accounting helps in ascertaining the costing profit or loss of any activity on an objective basisby matching cost with the revenue of the activity.

5. Facilitating preparation of financial and other statementsCost accounting helps to produce statements at short intervals as the management may require. Thefinancial statements are prepared generally once a year or half year to meet the needs of themanagement. In order to operate the business at high efficiency, it is essential for management tohave a review of production, sales and operating results. Cost accounting provides daily, weekly ormonthly statements of units produced, accumulated cost with analysis. Cost accounting system

provides immediate information regarding stock of raw material, semifinished and finished goods.This helps in preparation of financial statements.


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1.6 NEED FOR COST ACCOUNTING

The need for cost accounting arises owing to the following :

[A ]To Overcome the L imi tations of F inancial Accounts

Financial accounting records in an overall manner the results of the operations of a business, usingconventional double entry book-keeping techniques. It suffers from the following limitations :

(i) It provides only past data : Financial accounts provide out of date information to management.But management is interested in current data but not past data as it does not serve any purpose to it.Therefore it has been rightly pointed out that financial accounts provide only a post-mortem analysisof past activities.

(ii)It reveals only over all result of the business : Financial accounts does not provide data for eachand every product, process, department or operation separately. Instead it provides the financialinformation in a summary form for the entire organisation as a whole.

(iii) It is static in nature : Modern business is dynamic but not static. Financial accounts does notincorporate the changes that take place within the business.

(iv) It fails to take into account the impact of price level change : In the modern inflationaryconditions the price level has significant impact over financial statement. Under financial accounts,assets are shown at the actual or historical cost. Consequently depreciation is also charged on actualor historical cost. This under charging of depreciation will distort the profit figure.

(v)Possibility of manipulation of financial accounts : Very often financial accounts are manipulatedat the whims and fancies of management so as to project better image in the minds of prospectiveinvestors. The chief forms of manipulating the financial accounts assume the form of over orundervaluation of inventory, excessive or inadequate provision for depreciation, creation of secretreserves, etc.

(vi) It fails to exercise control over resources : Financial accounts fail to exercise control overmaterials, labour and other expenses incurred in a business enterprise. As a results, avoidablewastages and losses go unchecked under this system of accounts.

(vii)It fails to provide adequate data for price fixation : Financial accounts fail to provide adequatecost data on the basis of which selling price is fixed. In the absence of fixation of prices in advance, itis not possible to supply quotations to the prospective customers. To that extent the income fromsuch sales diminish.

(viii)It fails to provide adequate data for management in carrying out its functions : Management ofevery organisation relies heavily on adequate cost data for formulating policies and in decision-

making process. But financial accountsfails to provide such useful cost data to management.

(ix) It does not provide a basis for cost comparison : Financial accounts does not help in costcomparison over a period of time or between two jobs or two operations. Thus a basis for judging theefficiency of an year with past year or worthfulness of two different jobs or operations cannot beappraised.

(x) It does not make use of control techniques : Financial accounts fail to make use of certainimportant cost control techniques such as budgetary control and standard costing. Thus financialaccounts do not facilitate measuring the efficiency of the business with the help of controltechniques.

(xi) It fails to ascertain break-even point : Financial accounting does not help in ascertaining thebreak-even point, i.e., the sale or output where the revenue equals the cost. Hence, the point of no-profit-no-loss cannot be made out under financial accounts.


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[B ]To Ensure Optimum Uti li sation of Resources

In todays business world, the resources available are very scarce. Hence every business unit muststrive hard to obtain maximum output with the available input. In order to ensure the optimumutilisation of scarce resources, the value of input is measured against the value of output. Thisimplies matching cost per unit of production against the value of output or selling price. But financialaccounts does not provide the information relating to cost per unit of production. Hence the need forcost accounting was felt necessary.

[C]To Achieve Overal l Ef fi ciency of Business

Every businessman will make constant effort to improve his business. In order to formulate suitablepolicy and sound decision, he has to know answers to certain questions such as(a) What is the maximum profit which a business can make?(b) Is the profit earned by it is more or less compared to the earlier years?(c) Which product line is making more profit?(d) Has too much capital is blocked in raw materials?(e) Whether the cost of production has gone up compared to earlier years?(f) Should the selling price requires revision?Cost accounting serves as an useful tool in the hands of management in this direction. By analysingthe cost of production of every unit, it helps management to know the answers to the abovequestions.

1.7 GROWTH AND DEVELOPMENT OF COST ACCOUNTING

The history of cost accounting can be traced back to the fourteenth century. In the course of itsevolution it passed through following stages.

(1) In the first stage of its development, cost accounting was concerned only with the three primecost elements, viz., direct material cost, direct labour cost and direct expenses. For recording thetransactions relating to materials the important documents used were(a) stores ledger,

(b) a material requisition note, and(c)materials received note.To account for labour cost, employee time card and labour cost card were devised by Mr. Metcalfe.Later on a distinction between manufacturing and non-manufacturing cost was made by Mr. Norton.Thus material cost, labour cost and manufacturing cost constituted prime cost.

(2) Secondly, around the turn of the nineteenth century, the importance of nonmanufacturing cost(overheads) was recognised as one of the distinct element of cost. The method of charging non-manufacturing cost to the production cost was devised under this stage.

(3) Thirdly, the techniques of estimation and standards are devised. Instead of using actual cost,

standard costs are used and by comparing with the actual cost the differences are noted, analysed anddisposed off accordingly. This helps in knowing the efficiency of the business undertaking.

(4) Fourthly, cost accounting methods were applied to all types of business undertakings. The costingprinciples and techniques were also extended to important functions of a business.

(5) In modern times the development of electronic data processing has occupied significant stage inthe growth of cost accounting system.

1.8 COST ACCOUNTING IN INDIAN CONTEXT

The application of cost accounting methods in Indian industries was felt from the beginning of thetwentieth century. The following factors have accelerated the system of cost accounting in ourcountry.


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(a) Increased awareness of cost consciousness by Indian industrialists with a view to ascertain costsmore accurately for each product or job.

(b) Growing competition among manufacturers led to fixation of prices at a lower level so as toattract more customers.

(c) Economic policy of government which laid emphasis on planned economy with a view to achievethe targets led to cost reduction programmes by Indian industrialists.

(d) Increased government control over pricing led the Indian manufacturers to give utmostimportance to the installation of cost accounts.

(e) The establishment of National Productivity Council in 1958 and the Statutory Recognition ofInstitute of Cost and Works Accountants of India in 1959 gave further encouragement to install costaccounting system in Indian industries.

1.9 DIFFERENCES BETWEEN COST ACCOUNTANCY, COSTING AND COSTACCOUNTING

Points of

Differences

Cost Accountancy Costing Cost Accounting

1. Scope Cost Accountancy isbroadest in its scope.

It is broader in its

scope.

It is narrow in its

scope.

2. Function It is concerned withformulation of costing

principles, methods,

techniques to be

adopted by the

business.

It is concerned with

ascertainment of cost.

It is concerned with

recording of cost.

3. Periodicity offunctioning

It is starting point. It begings where cost

accountancy ends.

It begin where costing

ends.

4. Personsinvolved

The persons involved

are the experts in thefeild of cost

accountancy such as

management


are cost accountants.


are cost clerks.


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accountants

1.10 COST CONTROL:

According to Kohler, cost control represents the employment of management devices in theperformance of any necessary operation so that pre-established objectives of quality, quantity andtime may be attained at the lowest possible outlay for goods and services.

The terminology published by ICMA, London, defines cost control as The guidance and regulationby executive action of the cost of operating an undertaking. Acccording to this definition, costcontrol aims at guiding the actuals towards the lines of target and regulates the actuals if they deviatefrom the targets. This guidance and regulation is done by the executive who is responsible forcausing the deviation. This process will become clear by enumerating the steps involved in any costcontrol technique.

(a) Fixation of targets in terms of cost and production performance.(b) Ascertaining the actual cost and production performance.(c) Comparison of actuals with the targets.(d) Analysing the variance by causes and the person responsible for it.(e) Taking remedial steps to set right unfavourable variations.

Cost control is exercised through a variety of techniques such as inventory control, quality control,budgetary control, standard costing, etc. The advantages of cost control are as follows :(a) It helps in utilising the resources to the full extent.(b) It helps in reduction of prices which are benefited by customers.(c) It helps in competing successfully in the market.(d) It increases the profit earning capacity of the business.(e) It increases the goodwill of the business.

1.11 RELATIONSHIP BETWEEN FINANCIAL ACCOUNTING AND COST

ACCOUNTING

Cost accounting is very closely-related to financial accounting. Some authorities on the subjectconsider cost accounting to be the branch of financial accounting. But it may be said that costaccounts is complementary to financial accounts, i.e., a subject which is necessary to make financialaccounts whole or complete. Financial accounts and cost accounts are both similar in certainrespects. But in some other respects they differ from one another. These points of similarities anddissimilarities and enumerated below :

Points of Similarities(a) The fundamental principles of double entry is applicable in both the systems of accounts.(b) The invoices and vouchers constitute the common basis for recording transactions under both thesystems of accounts.(c) The results of business are revealed by both the systems of accounts.(d) The causes for losses and wastages of a business are provided by both these systems of accounts.(e) The determination of future business policy is guided by both these systems of accounts.(f) A basis for comparison of expenses is being provided by both the accounting systems.

(g) Accuracy of accounts is maintained under both the systems by means of exercising check overerrors and commissions which might creep in either of accounts.

BASIS OF DI FF ERENCE FINANCIAL ACCOUTING COST ACCOUTING


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1. OBJECTIVE It provide information aboutthe enterprise in a general way

i.e. profitability, assets,

liabilities, owners fund etc.

It provides information for the

guidance of management for

the proper planning,

operation,co-ordination, control

and decision making.

2. FORMS OFACCOUNTS

P & L A/C and B/S are kept as

per the companies Act and

income tax act.

These are kept as per the

requirement of the

management. Recently thecompanies act has made it

obligatory to keep costing

records in some manufacturing

companies.

3. RECORDING These are kept in a subjectivemanner i.e. according to the

nature of the expenditure.

These are kept in objective

manner i.e. according to the

purpose for which costs are

incurred.

4. ITEMS OF COST Items of cost are expressed intotal.

Items of costs are analysed,

classified, apportioned and

allocated in order to calculate

the cost per unit.

5. ANALYSIS OFPROFIT

These reveals to the profit of

the whole business.

It is only a part of financial

accounts. It shows the result of

each operation, process, job or

product so that unprofitable

lines of business can be

eliminated.

6. CONTROL Emphasis on recording only.No importance to control

aspect.

It provides a detailed system of

cost control with help of

standards and budgets.

7. PERIODICITY These are prepared at the endof accounting year.

It is continuous system of

accounting and submits the

cost reports to the management

weekly or monthly and as whendesired.

8. NATURE OFTRANSACTION

1. These relate tocommercial transaction

of business.

2. These are concernedwith transactions

relating to third party.

1. These related tomanufacturing

activities.

2. These are concernedwith internal

transactions.

3. INVENTORYVALUATION

Inventory is valued at cost or

market price whichever is less.

Inventory is valued at cost.


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4. FIGURES These deals with actual figures. These deal partly with actualfigures and partly with

estimates.

1.12 DIFFERENCES BETWEEN COST AND MANAGEMENT ACCOUNTING

The American Accounting Association 1958, committee on management accounting definesmanagement accounting as the application of appropriate techniques and concepts in processing thehistorical and projected economic data of an entity to assist management in establishing a plan forreasonable economic objectives and in the making of rational decisions with a view towardsachieving these objectives. It includes the methods and concepts necessary for effective planning forchoosing among alternative business actions, and for control through the evaluation andinterpretation of performance. Its study involves consideration of ways in which accountinginformation may be accumulated, synthesised, analysed and presented in relation to specific

problems, decisions and day-to-day tasks of business management.

The terminology published by ICMA, London, defines management accounting as the application

of professional knowledge and skill in the preparation and presentation of accounting information insuch a way as to assist management in the formulation of policies and in the planning and control ofthe operation of the undertaking. If we examine the above two definitions of managementaccounting it appears that both the systems of accounts serve the same purpose. However, they differfrom one another in respect of the following :

BASIS OF DI FF ERENCE COST ACCOUTING MANAGEMENT

ACCOUTING

1. Growth of Accounting The history of cost accountingdates back to fourteenth

century

This system of accounting

evolved in the middle of 20th

century. Hence it is of recent

origin where compared to cost

accounting.

2. Object The main objects of costaccounts is to ascertain and

control cost.

.

The main objective of

management accounting is to

provide useful information

to management for decision-making

3. Basis of recording It is based on both present andfuture

transactions for cost

ascertainment.

It is concerned purely with the

transactions relating to future.

4. Scope Cost accounts has narrowscope as it covers matters

relating to ascertainment of

cost

It has a wide scope in as muchas it covers

areas of financial accounts ,


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and control of cost cost accounts, taxation, etc.

5. Observation ofprinciple and format

Cost accounts follow a definite

principle for ascertaining cost

and a format for recording.

It does not follow a definite

principle and format Instead,

the data to be presented

depends up on the need of the

management.

1.13 ADVANTAGES OF COST ACCOUNTING

A good costing system serves the needs of large sections of people. The advantages of costaccounting are discussed below.

Advantages of Cost Accounting to M anagement

1. Fixation of responsibility: Whenever a cost centre is established, it implies establishing a kind of

relationship between superior and subordinates. Thus responsibilities are fixed on every individualwho is concerned with incurrence of cost.

2. Measures economic performance: By applying cost control techniques such as budgetary controland standard costing it helps in assisting the performance of business.

3. Fixation of price: By providing cost data it helps management to fix the selling price in advance.Hence, quotations can be supplied to prospective customers to secure orders.

4. Aids in decision-making: It helps management in making suitable decisions such as make or buy,replace manual labour by machines, shut down or continue operations based on cost reports.

5. Helps in the preparation of interim final accounts: By the process of continuous stock taking itenables to know the value of closing stock of materials at any time. This facilitates preparation offinal accounts wherever desired.

6. Helps in minimising wastages and losses: Cost accounting system enables to locate the lossesrelating to materials, idle time and under utilisation of plant and machinery.

7. Facilitates comparison: It facilitates cost comparison in respect of jobs, process, and departmentsand also between two periods. This reveals the efficiency or otherwise of each job process ordepartment.

8. Assists in increasing profitability: Costing reports provide information about profitable orunprofitable areas of operation. The management can discontinue that product line or that departmentwhich are responsible for incurring losses. Thereby only profitable line of activities alone areretained.

9. Reconciliation with financial accounts: A well maintained cost accounting system facilitatesreconciliation with financial accounts to check the arithmetical accuracy of both the systems.

10. It guides future production policy: Cost data help management in determining futureproduction policy. Any expansion or contraction of production for the future is based on past costdata.


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Advantages to Employees

1. Cost accounting system enables employees to earn better wages through overtime wages andincentive systems of wage payment.2. By providing better facilities it ensures job security to employees.3. Employees benefit by merit rating techniques which is conducted by scientific process.

Advantages to Creditors

1. It increases the confidence of creditors in the capital employed in the business.2. The frequent preparation of reports and statements help in knowing solvency position of the

business.

Advantages to the Government

1. It helps government in formulating policies regarding export, import, taxation, price controlmeasures, wage fixation, etc.2. It helps in assessing excise duty, sales tax and income tax of the business.3. Costing information helps in preparing national plans.

Advantages to Society

1. Cost reduction and cost control programmes go to minimise cost of production of goods andservices. A portion of the reduced cost of production is shared by customers by paying less price forgoods and services.2. It offers employment opportunities in the cost accounting department in the capacity of costaccountants and cost clerks.

1.14 LIMITATIONS OF COST ACCOUNTING

1. It is expensive : The system of cost accounting involves additional expenditure to be incurred ininstalling and maintaining it. However, before installing it, care must be taken to ensure that the

benefits derived is more than the investment made on this system of accounting.

2. The system is more complex : As the cost accounting system involve number of steps inascertaining cost such as collection and classification of expenses, allocation and apportionment ofexpenses, it is considered to be complicated system of accounts. Moreover the system makes use ofseveral documents and forms in preparing the reports. This will tend to delay in the preparation ofaccounts.

3. Inapplicability of same costing method and technique : All business enterprises cannot makeuse of a single method and technique of costing. It all depends upon the nature of business and typeof product manufactured by it. If a wrong technique and method is used, it misleads the results of

business.

4. Not suitable for small scale units : A cost accounting system is applicable only to a large-sizedbusiness but not to a small-sized one. Hence, there is limitation to its application to all types ofbusiness.

5. Lack of accuracy : The accuracy of cost accounts get distorted owing to the use of notional costsuch as standard cost, estimated cost, etc.

6. It lacks social accounting : Cost accounting fails to take into account the social obligation of thebusiness. In other words, social accounting is outside the purview of cost accounts.


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1.17 SELF ASSESSMENT:

Q.1. Define the term cost, costing and cost accountancy.

Q.2. Define cost accounting and bring out the differences between cost accounts and Financialaccounts.

Q.3. Mention two objects of cost accounting.

Q.4. Mention two limitations of costing.

Q.5. Cost accounting has become an essential tool of modern management. Comment

Q.6. Define costing. How does it differ from financial accounting? Explain its importance underpresent CircumstancesQ.7. Define costing. Discuss briefly the objectives and advantages of costing

Q.8. State the advantages of costing. How it aids the management and what objections are raisedagainst cost accounts?

Q.9. Differentiate between costing, cost accounting and cost accountancy.

Q.10. State how cost accounting helps business to maintain the business smoothly.


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CHAPTER2

COST ACCOUTS AND COST ACCOUTING SYSTEM

2.1 PURPOSES OR OBJECTS OF COST ACCOUNTS

Costing serves number of purposes among which the following are considered to be most important.

1. Ascertainment of cost : This was considered to be the primary objective of cost accounting in theinitial stages of its development. However, in modern times this has assumed the secondary objectiveof cost accounting. Cost ascertainment involves the collection and classification of expenses at thefirst instance. Those items of expenses which are capable of charging directly to the productsmanufactured are allocated. Then the other expenses which are not capable of direct allocation areapportioned on some suitable basis. Thus the cost of production of goods manufactured is

ascertained. In this process, cost accounts involves maintenance of different books to record variouselements of cost. Cost of production is ascertained by using any of the costing technique such ashistorical costing, marginal costing, etc.

2. Cost control : At one time cost control was considered as secondary objective of cost accounts.But in modern times it constitutes the primary purpose because of its utmost importance in all

business undertakings. Cost control is exercised at different stages in a factory, viz., acquisition ofmaterials, recruiting and deployment of labour force, during the production process and so on. Assuch we have material cost control, labour cost control, production control, quality control and so on.However, control over cost is exercised through the techniques of budgetary control and standardcosting. The control techniques enable the management in knowing the operating efficiency of a

business.

3. Determination of selling price : Every business organisation aims at maximising profit. Totalcost of production constitutes the basis on which selling price is fixed by adding a margin of profit.Cost accounting furnishes both the total cost of production as well as cost incurred at each and everystage of production. No doubt other factors are taken into consideration before fixing price such asmarket conditions the area of distribution, volume of sales, etc. But cost plays the dominating role in

price fixation.

4. Frequent preparation of accounts and other reports : The management of every businessconstantly rely upon the reports on cost data in order to know the level of efficiency relating to

purchase, production, sales and operating results. Financial accounts provide information only at theend of the year because closing stock value is available only at the end of the year. But cost accounts

provide the value of closing stock at frequent intervals by adopting a continuous stock verificationsystem. Using the value of closing stock it is possible to prepare final accounts and know theoperating results of the business.


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5. To provide a basis for operating policy : Cost data to a great extent helps in formulating the

policies of a business and in decision-making. As every alternative decisions involve investment ofcapital outlay, costs play an important role in decision-making. Therefore availability of cost data is amust for all levels of management. Some of the decisions which are based on cost are(a) make or buy decision,(b) manufacturing by mechanisation or automation,(c) whether to close or continue operations in spite of losses.

2.2 FUNCTIONS OF COST ACCOUNTANT

The functions of cost accountant may be enumerated under the following :

Traditional Functions

The traditional functions comprise of the routine functions of cost accountant. Such functions are asfollows :(a) To establish various cost centres in the organisation.(b) To ascertain the cost of every product, job or process both in terms of total and per unit of

product.(c) To design suitable system for defining responsibilities and controlling cost.(d) To provide necessary data to enable management in fixing the price.(e) To prepare reports on wastages of material, loss of labour time, idle capacity of machines so as toimprove profitability of business.(f) To implement cost control techniques such as budgetary control and standard costing.(g) To prepare cost schedules to assist management in making decisions and in formulating policies.(h) To design suitable forms for organising an effective system of reporting which ensures provisionof adequate cost data to all levels of management.(i) To assist management in the valuation of closing stock of raw materials and work-in-progress sothat too much of capital is not locked up in unnecessary inventories.

(j) To prepare periodical cost statements and profit and loss account.

Modern Functions

In recent times the functions of a cost accountant are not only confined to ascertain and control costbut extend far beyond these functions. This is on account of the additional responsibilities arisingfrom the various branches of accounting, works organisation, office management and administration,methods of statistical analysis, systems analysis, O and M studies, modern principles of management,use of computers, etc. These modern functions are as follows :(i) Supervising the functions of mechanised accounting.(ii) Organisation of internal audit in the field of accounting.(iii) To work in close co-ordination with various departmental managers so as to implement cost

reduction programmes and methods of improvement.(iv) To undertake cost audit programmes as per the directives issued by the government and the

provisions of the Indian Companies Act of 1956.

As regards the role of cost accountant in an industry, in has been beautifully summarised by Mr.Wilmot in his article on the cost accountants place in management. According to him, the role ofcost accountant is that of a historian, news agent, and prophet. As historian he must bemeticulously accurate, i.e., while supplying cost information to management he has to furnish ingreater detail with carefulness and exactness. As news agent, he must be up-do-date, selective and

provide full cost information to the needy person. As a prophet he must combine knowledge andexperience with foresight and courage.

2.3 INSTALLATION OF COST ACCOUNTING SYSTEM


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At the outset it is to be understood that a common cost accounting system cannot be installed for alltypes of business undertakings. The cost accounting system depends upon the nature of business andthe product manufactured. Before a suitable system of cost accounting is installed it is necessary toundertake a preliminary investigation so as to know the feasibility of installing cost accountingsystem to such business. While introducing a system of cost accounts it should be borne in mind thatcost accounting system must suit the business. There should not be any attempt to make the businesssuit the system. One more consideration that is of practical importance is that the benefits derivedfrom cost accounting system must be more than the investment made on it. This means the systemmust be simple and it must lead to savings through the control of materials, labour and overheads

when compared to expenses incurred in maintaining it. For the successful functioning of the costingsystem, the following conditions are essential :

(a) There must be an efficient system of material control.(b) A sound and well designed method of wage payment must be set up.(c) The existence of sound basis for collection of all indirect expenses and a basis for itsapportionment to various production departments.(d) The integration of cost and financial accounts to facilitate reconciliation of profit as shown bythese two systems of accounts.(e) The use of printed forms so as to facilitate quick compilation of cost reports.(f) The duties and responsibilities of cost accountant must be made clear.

2.4.FACTORS TO BE CONSIDERED BEFORE INSTALLING A COST ACCOUNTING

SYSTEM

The following factors are to be considered before installing a cost accounting system :

1. History of business unit : The history of a business unit implies the duration of its existence,position in the industry, the rate of growth, policy and philosophy of management and the like. Thehistory of business unit serves as the basis for designing the cost accounts in respect of necessity,simplicity, and investment involved in installing cost accounts.

2. Nature of the industry : The nature of business such as manufacturing, mining, trading, etc.determines the costing techniques to be applied. Similarly, the type of product manufactured alsodetermine the method of costing that is to be employed. In other words, there is no all purposetechnique and method of costing that can be applied universally.

3. Product range : The range of products manufactured and sold also determine the method ofcosting to be selected. Accordingly range of products must be analysed in terms of size, models,fashions, area of market, competitors and whether the products are made to customers specificationor for stocking and selling.

4. Technical considerations : Technical considerations that influence the installation of costaccounts are as follows :(a) Size and layout of the factory(b) The existence of production and service departments(c) Flow of production(d) Capacity of machines and degree of mechanisation(e) Existence of laboratories(f) Internal transport and material handling equipments(g) Production control techniques(h) Inspection and testing of materials and finished goods.

5. Organisational factors : The problem of installing cost accounting is somewhat difficult in caseof an existing business when compared to new business. However, the existing set up of theorganisation should be least disturbed should the need arise. In order to fix up responsibility to the


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executives it may be necessary to group the departments. The organisational factors to be consideredare : (a) size and the type of organisation such as line, line and staff, functional and committeeorganisation, (b) the levels of management, viz., top level, middle level and bottom levelmanagement, (c) extent of delegation and responsibility, (d) extent of centralisation anddecentralisation, (e) extent of departmentation, (f) availability of modern office equipments, and (g)number of managerial and supervisory staff.

6. Selling and distribution method : The chief factors to be considered with regard to distributionprocess are the warehousing facilities, external transport, market research and other promotional

measures, terms of sale and procurement of orders from customers.

7. Accounting aspects : The factors to be considered in respect of accounting are : (a) number offinancial records, (b) existing forms, (c) registers used, and (d) number of copies required.

8. Area of control to be exercised : The areas where cost control is to be exercised is to beidentified so that each manager may take action relevant to his activities. If material control occupiessignificant area of control, it must be given topmost priority for exercising control over materials.

9. Reporting : The cost accounting system to be installed must ensure frequency and promptitude inreporting cost data to all levels of management. It must also to be pointed out that duplication ofreporting is to be avoided. Further, only those information which are relevant for the management ina particular context alone should be reported.

10. Uniformity : The practice of adopting uniform costing facilitates inter-firm comparison amongvarious firms belonging to the same industry. Further it also has the benefit of adopting commoncosting practice if a holding company has number of subsidiaries.

11. Use of electronic data processing : In modern days it has become a common practice to useelectronic data processing equipments and computers. In this situation it is essential to ensure that theequipment meets the needs of the system but not the other way round.

12. Practical considerations : The cost accounting system to be installed must be flexible inoperation and must be capable of adaptation to changing conditions. The system must be periodicallyscrutinised so as to make necessary changes owing to development in business.

2.5 PRACTICAL DIFFICULTIES IN INSTALLING COST ACCOUNTING

In addition to the above problems, a cost accountant will encounter the following practicaldifficulties at the time of installation of cost accounting system :

1. Lack of support from management : Wherever costing system is installed. It is essential to seek

the support of various departmental managers. Very often the managers show hostile attitude towardsthe costing system. They feel that this system will interfere in their routine work and probably as ameans of checking their efficiency. Under such circumstances it is better to convince them about theutility of costing system for the business as a whole.

2. Resistance by existing accounting staff : Very often the existing accounting staff resist theinstallation of the cost accounting system on two grounds. Firstly, they feel that the new system ofaccounting might lead to excess work. Secondly, they are afraid of their job security. But thisdifficulty may be overcome by encouraging them about the usefulness of cost accounting as asupplement to financial accounts and the generation of more employment opportunities from theinstallation of cost accounting system.

3. Non-cooperation from middle and bottom level management : At times the middle and bottomlevel managers such as foremen, supervisors and inspectors also fail to extend their wholehearted


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cooperation fearing additional work which may be entrusted to them. This problem may be overcomeby suggesting them about the simplicity of the system and the existence of a separate cost accountingdepartment to look after costing matters. However, they may be required to provide necessary reportsconcerning their area of activity so as to enable functioning of cost accounting departmentefficiently.

4. Lack of trained staff : This was no doubt a problem in olden days. Today this problem isovercome, thanks to the establishment of The Institute of Cost and Works Accountant of India in ourcountry which offers professional course in costing and also offers training facilities through various

companies to the candidates undergoing the course. In spite of this facility, it is somewhat difficult toget the competent and experienced staff at the time of installation. This problem can be overcome by

paying attractive salaries to the cost accountants.

5. Heavy expenses in installing and maintaining the system : The setting up of a separate costingdepartment with staff often poses a problem. In addition to installation, the operating expenses in theform of printing and stationery, heating and lighting, depreciation and insurance, rent and rates are to

be incurred. However, as was mentioned earlier, the system of cost accounting must be a usefulinvestment, i.e., benefits derived from it must be more than the investment made on it. If this is not

possible, for the time being the system must be discarded.

2.6 REQUISITES OR ESSENTIALS OF COST ACCOUNTING SYSTEM

The following are the essentials of an ideal cost accounting system :

1. Accuracy : The system of cost accounting must provide for accuracy in terms of both costascertainment and presentation. Otherwise it will prove to be misleading.

2. Simplicity : Cost accounting system involves detailed analysis of cost. To avoid complications inthe procedure of cost ascertainment an elaborate system of costing should be avoided and every care

must be taken to keep it as simple as possible.

3. Elasticity : The cost accounting system should be capable of adopting itself to the changingsituations of business. It must be capable of expansion or contraction depending upon the needs ofthe business.

4. Economy : The costs of operating costing system must be less. It must result in increased benefitwhen compared to the expenditure incurred in installing it.

5. Comparability : The records to be maintained must facilitate comparison over a period of time.The past records must serve as a basis to guide the future.

6. Promptness : An ideal costing system is one which provides cost data in an analytical form to themanagement. So all the departments of a factory must analyse and record the relevant items of cost

promptly in order to furnish cost information on a regular basis to various levels of management.This helps in checking up the progress of the business on a regular basis. results frequently, it isdesirable to prepare accounts periodically. Constant comparison of actual result with standard resultenables to spot out areas of inefficiency. This can be set right by taking remedial measures.

8. Reconciliation with financial accounts : The system of cost accounts must be capable ofreconciling with financial accounts so as to check accuracy of both the system of accounts.

9. Uniformity : The various forms and documents used under costing system must be uniform insize and quality of paper. Printed forms must be used to avoid delay in the preparation of reports.This also reduces the burden of clerical staff. Forms of different colours can be used to distinguishdifferent documents.


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10. Equity : The basis of apportioning indirect expenses to products, departments or jobs must befair and equitable.

2.7 ORGANISATION OF COST ACCOUNTING DEPARTMENT

The organisation of cost accounting department depends upon the size of the concern. Whatever maybe the structure of cost accounting department in a factory, it is established to serve the followingpurposes : (i) To compile cost data in order to meet the statutory requirement wherever applicable,(ii) To provide necessary cost data to management to carry out its functions efficiently, and (iii) Toensure efficiency and economy in thefunctioning of cost accounting department. To achieve the above purposes cost accountingdepartment usually performs the following functions :

(1) Designing and installation of appropriate method of costing.(2) Accumulation of cost data by process, department and product.(3) Analysis of such cost by elements of cost.(4) Estimation of cost of production.

(5) Reporting of cost information to all levels of management.(6) Advising management in relation to investment based on cost information.

In a small and medium-sized concern, the cost accounting department may be set up as a section offinancial accounting system. The cost accountant who is incharge of cost accounting department may

be authorised to report to the chief accountant. In large-sized concern, a separate cost accountingdepartment is established under the supervision of a full-fledged cost accountant. The costaccounting department is equipped with sufficient staff each to look after different facets of costaccounting function. While important functions such as budgeting, cost analysis, etc. are performed

by cost accountant, cost recording, cost reporting and such other functions are performed by costclerks.

The cost accounting department may be organised either on the principle of centralisation ordecentralisation. Under centralised system, the functions of cost accounting departments relating toall firms belonging to same industry is performed at a common central place. The extent ofcentralisation of cost accounting department depends upon the following factors :(a) The philosophy of management regarding divisional responsibility.(b) The ready availability of cost data from each firm.(c) Size of the firm.(d) The area of operations of every firm.(e) The economy involved in centralisation process

Advantages of Centrali sed Cost Accounting Department1. It facilitates full utilisation of services of costing staff.2. It permits mechanisation of accounting which is not possible under decentralisation system.3. It reduces paper work and economise stationery costs.4. It facilitates prompt reporting.

Under decentralisation systema separate cost accounting department is set up for each and everyfirm under the supervision of a competent cost accountant. Th is system has certain advantages.

(a) It tends to increase the initiative of the cost accountants of every firm as the responsibility tocontrol lies in their hands.(b) It eliminates duplication of recording and reporting.(c) It increases the speed of functioning of cost accounting department.

2.8 RELATIONSHIP OF COST DEPARTMENT TO OTHER DEPARTMENTS


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1. Cost accounting department and production department : It can well be said that productiondepartment and cost department are interwoven together as the former cannot function efficientlywithout the existence of the latter. The production process is concerned with the utilisation ofmaterials, money and human resources. The cost department helps in estimating the material cost,labour cost and other expenses for manufacturing a product. It also helps in controlling these costs soas to minimise the cost or production. In fact, the main objective of cost accounting system is toreduce the cost of production of goods or services manufactured and rendered by business units. Theother areas where cost accounting department is helpful in manufacturing process are :

(a) Engineering department which is concerned with designing a product,(b) Research and development department which is concerned with development of a new product,(c) Production planning and control department which ensures completion of production within thetime schedule, and(d) Quality control section, which ensures quality of products.

All these departments heavily rely on cost accounting department because costs to be incurred inthese departments have a direct impact over the functioning of these departments.

2. Cost accounting department and personnel department : The personnel department which isconcerned with proper recruitment, selection, training, time-keeping, fixation of wage rate and

preparation of payroll, will work with close co-ordination of cost department. Each and everyfunction performed by personnel department is again influenced by additional cost to be incurred onsuch function as for example promotion of employeesleads to incurrence of additional wages.

3. Cost accounting department and finance department : The finance department is concernedwith receiving and disbursement of cash. The allocation of investments on fixed and working capitalentirely depends upon the cost reports submitted to it by the cost department. Judicious utilisation ofavailable capital is possible only when priority is given for more important areas of investment. This

is facilitated by furnishing prompt report by cost department.

4. Cost accounting department and purchase department : In majority of firms purchase of rawmaterials at right quantity, of right quality, from right supplier, at a right time not only ensures readysupply but also at a reasonably low price. Any purchase of substandard quality of materials will leadto dissatisfaction among customers and consequently it leads to loss of orders. Further, purchase ofmaterials at high rate will increase the cost of production tremendously. Delay in getting supplies ofmaterials lead to delay in executing customers orders. In these respects cost accounting departmentcan assist purchase department to ensure efficient purchasing. Cost department also help in reducing(a) waste of materials, (b) the risk from theft, and (c) excessive investment in inventories.

5. Cost accounting department and marketing department : Marketing department relies on costinformation in order to(a) estimate future product cost for fixing the selling price,(b) in knowing the expenses incurred in marketing the products so that if the amountexceeds the target, control measures can be taken to reduce such expenses,(c) to consider alternative selling methods and promotional measures, and(d) to make further investment in warehousing and distribution process.

Cost department provides all such information as is required by the marketing department for itsefficient functioning.

6. Cost accounting department and financial accounting department : The existence of cost

accounting department makes the financial accounting department a complete organisation byfurnishing additional cost data to the chief accountant. Cost department enable financial accountsdepartment in carrying out the latters function furnishing necessary data in respect of the following : (a) Supply of material cost, labour cost and expenses to facilitate preparation of manufacturingaccount.


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(b) Provision of the value of closing stock frequently to facilitate the preparation of interim finalaccounts.(c) Assist financial accounting department in matters relating to taxation, insurance and in solvinglegal matters.(d) Enables financial accounting department to settle the bills by duly approving them.(e) Helps financial accounting department in budgeting.

2.9 CRITICISMS OR OBJECTIONS LEVELLED AGAINST COST ACCOUNTS

Despite several benefits offered by cost accounts, critics have levelled the following criticismsagainst it :

1. Cost accounting is merely a system of estimates and probabilities : Though the main purposeof cost accounting is to ascertain the cost of production with a reasonable degree of accuracy, yetabsolute accuracy is not possible owing to the two reasons.(a) Indirect expenditures are absorbed on the basis of predetermined rates instead of actual rates, and(b) The material cost and labour cost is inflated so as to cover the normal loss and wastage ofmaterials and normal idle time of workers.

2. Cost accounting is unnecessary in such business enterprises which make large profit : It is

argued that industries which earn large amount of profit need not have a system of cost accounting.This statement is absolutely wrong. Earning of more profit by industry does not necessarily meanthat its cost of production is lowest and there is no scope for further reduction in the cost. Profitrepresents the difference between the selling price and the cost of a product. Profit earned by a

business may be high because of increased priceprevailing in the market. Two or more than twoproducts manufactured by business may earn profit for one line of product and loss by other. Theprofit earned by one product may outweigh the loss suffered by other product thus resulting inoverall profit. So it is wrong t judge the efficiency of the business on the basis of overall profitabilityof the business. Ifnecessary steps are taken to reduce or eliminate losses suffered by a second line

product,the industry would earn more amount of profit. It is in this context that a system of costing is felt.

3. It is unnecessary : This criticism is levelled owing to lack of understanding of the objectives andadvantages of costing. In the present-day competitive world, every manufacturer must know the costof production for each article so that he can fix selling price on a reliable and reasonable basis.Further he can also compare his selling price thus fixed with the price prevailing in the market. Costascertainment involves application of certain principles and techniques. Having ascertained the cost,control techniques are used to keep the costs under check and thereby increase the profit. Thus it can

be said that cost accounting is necessary in most of the concerns.

4. It is expensive : This criticism is true as long as the benefits derived from this system is notcommensurate with the investment made on it. But by carefully designing the system so as to suit the

business, the criticism can be nullified.

5. Competition governs price and hence there is no need for costing system : Some criticscontend that in these days of competition prices are determined by the forces of demand and supplyas against fixation of selling price by adding a desired margin of profit on the cost price. Thisargument is incorrect. Even in this situation cost accounts disclose the margin of profit that is earned

by comparing the market price and cost of production. It impresses upon management the need toreduce cost by increasing the volume of production or by elimination of losses and wastages if any. Ifthe cost price tend to be higher than the market price, it is desirable to abandon such product line and

pay attention to profitable line of products.


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6. There is no need for costing where production efficiency is high : The statement is misleadingas without a yardstick to measure the efficiency it is not possible to appraise the efficiency of a

business. Cost accounting system offers number of techniques such as standard costing, budgetarycontrol, inter-firm comparison and so on. The cost of production can also be compared between two

periods of time to know whether business is currently running efficiently when compared to previousyear. In case of inefficient operation remedial measures can be taken to improve the business.

7. Other objections : Some other objections that are raised against the installation of cost accounting

system are follows :

(a) It is a mere matter of forms and rulings : Often it is argued that the cost accounting systemdegenerates into a matter of mere forms and rulings. This is not the defect of cost accounting system

but the way in which the system is maintained. No doubt different forms are necessary under costingsystem but they must be simplified and altered to meet the changing condition.

(b)Failure in many cases : The system of cost accounting is often condemned as defective inasmuchas it has failed to produce the desired result. The defect does not lie in the costing system but forsome other reasons such as indifferent attitude of the management, lack of adequate facilities, non-cooperations or opposition from employees. These defects can be overcome by reversing the abovetrend.

(c) For want of necessity : It is contended by some that costing is of recent origin and that itsapplication was not felf in the past. Though it was not used earlier, still many industries prospered.So it is felt by some critics that the installation of costing involves unnecessary expenditure.However it is to be remembered that todays business functions in a competitive conditions and everymanufacturer must know the actual cost of production in order to reduce the selling price. Manyindustrial failures in the past may be attributed to the lack of knowledge on the part of managementrelating to the actual cost of production thereby selling product below cost.

2.10 SELF ASSESSMENT

Q.1. Define Cost Accounts and its importance.


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Q.2 What are the pre-requisites required to install a cost accounting system in a business.Q.3. Define the Cost accounting system?Q.4. A Good system of costing must place the same emphasise on cost control as on costascertainment. Comment on this statement.Q.5. Cost accounting is a system of foresight like pre-natal care, but financial accounting is just a

post-mortem examination. Critically examine this statement.Q.6 Cost accounting has become an essential tool of management. Mention the steps to be takenwhile installing cost accounting system in a manufacturing concern.Q.7. Cost accounting has become an essential tool of modern management. CommentQ.8. An efficient system of costing is essential factor for industrial control under modern conditionsof business and as such may be regarded as an important part in the efforts of any management tosecurebusiness stabilityElaborate.Q.9. A good costing system is an involvable aid to management. Discuss.Q.10. How cost accounting is superior over financial accounting? Explain the techniques of costingand their application and suitability.

CHAPTER- 3BASIC COST CONCEPT

3.1 Concept of Cost

Cost accounting is concerned with cost and therefore is necessary to understand the meaning of termcost in a proper perspective.

In general, cost means the amount of expenditure (actual or notional) incurred on, or attributable to agiven thing.

However, the term cost cannot be exactly defined. Its interpretation depends upon the followingfactors:


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1. The nature of business or industry2. The context in which it is usedIn a business where selling and distribution expenses are quite nominal the cost of an article may becalculated without considering the selling and distribution overheads. At the same time, in a businesswhere the nature of a product requires heavy selling and distribution expenses, the calculation of costwithout taking into account the selling and distribution expenses may prove very costly to a business.The cost may be factory cost, office cost, cost of sales and even an item of expense. For example,

prime cost includes expenditure on direct materials, direct labor and direct expenses. Money spent on

materials is termed as cost of materials just like money spent on labor is called cost of labor and soon. Thus, the use of term cost without understanding the circumstances can be misleading.

Different costs are found for different purposes. The work-in-progress is valued at factory cost whilestock of finished goods is valued at office cost. Numerous other examples can be given to show thatthe term cost does not mean the same thing under all circumstances and for all purposes. Manyitems of cost of production are handled in an optional manner which may give different costs for thesame product or job without going against the accepted principles of cost accounting. Depreciation isone of such items. Its amount varies in accordance with the method of depreciation being used.However, endeavor should be, as far as possible, to obtain an accurate cost of a product or service.

3.2 Cost Unit and Cost Center

The technique of costing involves the following:

1. Collection and classification of expenditure according to cost elements2. Allocation and apportionment of the expenditure to the cost centers or cost units or bothCost Unit

While preparing cost accounts, it becomes necessary to select a unit with which expenditure may be

identified. The quantity upon which cost can be conveniently allocated is known as a unit of cost orcost unit. The Chartered Institute of Management Accountants, London defines a unit of cost as aunit of quantity of product, service or time in relation to which costs may be ascertained orexpressed.

Unit selected should be unambiguous, simple and commonly used. Following are the examples ofunits of cost:

(i) Brick works per 1000 bricks made

(ii) Collieries per ton of coal raised

(iii) Textile mills per yard or per lb. of cloth manufactured or yarn spun(iv) Electrical companies per unit of electricity generated

(v) Transport companies per passenger km.

(vi) Steel mills per ton of steel made

Cost Center

According to the Chartered Institute of Management Accountants, London, cost center means alocation, person or item of equipment (or group of these) for which costs may be ascertained andused for the purpose of cost control. Thus, cost center refers to one of the convenient units into

which the whole factory or an organization has been appropriately divided for costing purposes. Eachsuch unit consists of a department, a sub-department or an item or equipment or machinery and a

person or a group of persons. Sometimes, closely associated departments are combined together andconsidered as one unit for costing purposes. For example, in a laundry, activities such as collecting,


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sorting, marking and washing of clothes are performed. Each activity may be considered as aseparate cost center and all costs relating to a particular cost centre may be found out separately.

Cost centres may be classified as follows:

1. Productive, unproductive and mixed cost centres2. Personal and impersonal cost centres3. Operation and process cost centresProductive cost centres are those which are actually engaged in making products. Service orunproductive cost centres do not make the products but act as the essential aids for the productivecentres. The examples of such service centres are as follows:

1. Administration department2. Repairs and maintenance department3. Stores and drawing office departmentMixed costs centres are those which are engaged sometimes on productive and other times on serviceworks. For example, a tool shop serves as a productive cost center when it manufactures dies and jigs

to be charged to specific jobs or orders but serves as servicing cost center when it does repairs for thefactory.

Impersonal cost center is one which consists of a department, a plant or an item of equipmentwhereas a personal cost center consists of a person or a group of persons. In case a cost centerconsists of those machines or persons which carry out the same operation, it is termed as operationcost center. If a cost center consists of a continuous sequence of operations, it is called process costcenter.

In case of an operation cost center, cost is analyzed and related to a series of operations in sequencesuch as in chemical industries, oil refineries and other process industries. The objective of such an

analysis is to ascertain the cost of each operation irrespective of its location inside the factory.

3.3 Cost Estimation and Cost Ascertainment

Cost estimation is the process of pre-determining the cost of a certain product job or order. Such pre-determination may be required for several purposes. Some of the purposes are as follows:

1. Budgeting2. Measurement of performance efficiency3. Preparation of financial statements (valuation of stocks etc.)4. Make or buy decisions5. Fixation of the sale prices of productsCost ascertainment is the process of determining costs on the basis of actual data. Hence, thecomputation of historical cost is cost ascertainment while the computation of future costs is costestimation.

Both cost estimation and cost ascertainment are interrelated and are of immense use to themanagement. In case a concern has a sound costing system, the ascertained costs will greatly help themanagement in the process of estimation of rational accurate costs which are necessary for a varietyof purposes stated above. Moreover, the ascertained cost may be compared with the pre-determined


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costs on a continuing basis and proper and timely steps be taken for controlling costs and maximizingprofits.

3.4 Cost Allocation and Cost Apportionment

Cost allocation and cost apportionment are the two procedures which describe the identification andallotment of costs to cost centers or cost units. Cost allocation refers to the allotment of all the itemsof cost to cost centers or cost units whereas cost apportionment refers to the allotment of proportionsof items of cost to cost centers or cost units Thus, the former involves the process of charging directexpenditure to cost centers or cost units whereas the latter involves the process of charging indirectexpenditure to cost centers or cost units.

For example, the cost of labor engaged in a service department can be charged wholly and directlybut the canteen expenses of the factory cannot be charged directly and wholly. Its proportionate sharewill have to be found out. Charging of costs in the former case will be termed as allocation of costswhereas in the latter, it will be termed as apportionment of costs.

3.5 Cost Reduction and Cost Control

Cost reduction and cost control are two different concepts. Cost control is achieving the cost target asits objective whereas cost reduction is directed to explore the possibilities of improving the targets.Thus, cost control ends when targets are achieved whereas cost reduction has no visible end. It is acontinuous process. The difference between the two can be summarized as follows:

1. Cost control aims at maintaining the costs in accordance with established standardswhereas cost reduction is concerned with reducing costs. It changes all standards andendeavors to improve them continuously.

2. Cost control seeks to attain the lowest possible cost under existing conditions whereascost reduction does not recognize any condition as permanent since a change willresult in lowering the cost.

3. In case of cost control, emphasis is on past and present. In case of cost reduction,emphasis is on the present and future.

4. Cost control is a preventive function whereas cost reduction is a correlative function.It operates even when an efficient cost control system exists.

3.6 Elements of cost

Cost of production/manufacturing consists of various expenses incurred on

production/manufacturing of goods or services. These are the elements of cost which can be dividedinto three groups : Material, Labour andExpenses.

Elements of cost

Material Labour Expenses

Material

To produce or manufacture material is required. For example to manufacture shirts cloth is requiredand to produce flour wheat is required. All material which becomes an integral part of finished


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product and which can be conveniently assigned to specific physical unit is termed as DirectMaterial. It is also described as raw material, process material, primematerial, production material, stores material, etc. The substance from which the product is made isknown as material. It may be in a raw or manufactured state. Material is classified into twocategories:

_ Direct Material_ Indirect Material

_Di rect materi al

Direct Material is that material which can be easily identified and related with specific product, job,and process. Timber is a raw material for making furniture, cloth for making garments, sugarcane formaking sugar, and Gold/ silver for making jewellery, etc are some examples of direct material.

_I ndir ect materi al

Indirect Material is that material which cannot be easily and conveniently identified and related witha particular product, job, process, and activity. Consumable stores, oil and waste, printing andstationery etc, are some examples of indirect material. Indirect materials are used in the factory, theoffice, or the selling and distribution department

LabourLabour is the main factor of production. For conversion of raw material into finished goods, humanresource is needed, and such human resource is termed as labour. Labour cost is the main element ofcost in a product or service. Labour can be classified into two categories:

_ Direct Labour, and_ Indirect labour

_Di rect labour

Labour which takes active and direct part in the production of a commodity. Direct labour is thatlabour which can be easily identified and related with specific product, job, process, and activity.Direct labour cost is easily traceable to specific products. Direct labour costs are specially andconveniently traceable to specific products. Direct labour varies directly with the volume of output.Direct labour is also known as process labour, productive labour, operating labour, direct wages,manufacturing wages, etc. Cost of wages paid to carpenter for making furniture, cost of a tailor in

producing readymade garments, cost of washer in dry cleaning unit are some examples of directlabour.

_I ndirect labourIndirect labour is that labour which can not be easily identified and related with specific product, job,

process, and activity. It includes all labour not directly engaged in converting raw material intofinished product. It may or may not vary directly with the volume of output. Labour employed for the

purpose of carrying out tasks incidental to goods or services provided is indirect labour. Indirectlabour is used in the factory, the office, or the selling and distribution department. Wages of store-keepers, time-keepers, salary of works manager, salary of salesmen, etc, are all examples of indirectlabour cost.

Expenses

All cost incurred in the production of finished goods other than material cost and labour cost aretermed as expenses. Expenses are classified into two categories:Direct expenses, andIndirect expenses (An item of overheads)

Direct expenses


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These are expenses which are directly, easily, and wholly allocated to specific cost center or costunits. All direct cost other than direct material and direct labour are termed as direct expenses. Directexpenses are also termed as chargeable expenses. Some examples of the direct expenses are hire ofspecial machinery, cost of special designs, moulds or patterns, feed paid to architects, surveyors andother consultants, inward carriage and freight charges on special material, Cost of patents androyalties.

I ndi rect expenses

These expenses cannot be directly, easily, and wholly allocated to specific cost center or cost units.All indirect costs other than indirect material and indirect labour are termed as indirect expenses.

Thus,

Indirect Expenses = Indirect costIndirect materialIndirect labour.

Indirect expenses are treated as part of overheads. Rent, rates and taxes of building, repair, insuranceand depreciation on fixed assets, etc, are some examples of indirect expenses.

OVERHEADS : MEANING

The term overhead has a wider meaning than the term indirect expenses. Overheads include the costof indirect material, indirect labour and indirect expenses. This is the aggregate sum of indirectmaterial, indirect labour and indirect expenses.

Overhead = Indirect material + Indirect labour + Indirect expenses

Overheads are classified into following three categories:_ Factory/works/ production overheads_ Office and administrative overheads_ Selling and distribution overheads

_Factory/works overheadsAll indirect costs incurred in the factory for production of goods is termed as factory/worksoverheads. Such costs are concerned with the running of the factory or plant. These include indirectmaterial, indirect labour and indirect expenses incurred in the factory. Some examples are as follows:

Indirect materials:(i) Grease, oil, lubricants, cotton waste etc.(ii) Small tools, brushes for sweeping, sundry supplies etc.(iii) Cost of threads, gum, nails, etc.(iv) Consumable stores(v) Factory printing and stationery

Indirect wages

(i) Salary of factory manager, foremen, supervisors, clerks etc.(ii) Salary of storekeeper(iii) Salary and fee of factory directors and technical directors

1. Cost center means a location, person, or item of equipment or group

of these for which costs may be ascertained and used for the purposeof cost control.2. Cost object is anything for which a separate measurement of cost isdesired. It may be a product, service, project, or a customer.


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(iv) Contribution to ESI, PF., Leave pay etc. of factory employee.

Indirect expenses

1. Rent of factory buildings and land(ii) Insurance of factory building, plant, and machinery(iii) Municipal taxes of factory building(iv) Depreciation of factory building, plant and machinery, and their repairs and maintenance charges(v) Power and fuel used in factory(vi) Factory telephone expenses.

_Off ice and admini strative overheadsThese expenses are related to the management and administration of the business. They are incurredfor the direction and control of an undertaking. These represent the aggregate of the cost of indirectmaterial, indirect labour, and indirect expenses incurred by the office and administration departmentof an organisation. Some examples are as follows: Office printing and stationery, Cost of brushes,dusters etc. for cleaning office building and equipments, Postage and stamps. Salary of officemanager, clerks, and other employees, Salary of administrative directors, Salaries of legal adviser,Salaries of cost accountants and financial accountants, Salary of computer operator. Rent, insurance,rates and taxes of office building, Office lighting, heating and cleaning, Depreciation and repair of

office building, furniture, and Equipment etc., Legal charges, Bank charges, Trade subscriptions,Telephone charges, Audit fee etc.

_Sell ing and distr ibu tion overheadsSelling and distribution overheads are incurred for the marketing of a commodity, for securing orderfor the articles, dispatching goods sold or for making efforts to find and retain customers. Theseexpenses represent the aggregate of indirect material, indirect labour, and indirect expenses incurred

by the selling and distribution department of the organisation. These overheads have two aspects (i)

procuring orders (ii) executing the order. Based upon this concept the selling and distributions arestudied separately.

I . Sell ing overheads

Indirect costs incurred in relation to the procurement of sale orders are termed as selling overheads.Some of the examples of selling overheads are as follows:

Indirect material(i) Catalogues, price list(ii) Printing and stationery(iii) Postage and stamps

(iv) cost of sample

Indirect wages(i) Salaries of sales managers, clerks and other employees(ii) Salaries and commission of salesmen and technical representatives(iii) Fees of sales directors

Indirect expenses(i) Advertising(ii) Bad debts(iii) Rent and insurance of showroom(iv) Legal charges incurred for recovery of debts(v) Travelling and entertainment expenses(vi) Expenses of sending samples(vii) Market research expenses.


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I I . Distri bution overheads

Indirect costs incurred in relation to the execution of the sales order is termed as distributionoverheads. Some of the examples of distribution overheads are as follows:

Indirect material(i) Cost of packing material(ii) oil, grease, spare parts etc. for maintaining delivery vans

Indirect wages

(i) Salaries of godown employees(ii) Wages of drivers of delivery vans(iii) Wages of packers and dispatch staff.

Indirect expenses(i) Packing expenses(ii) Godown rent, insurance, depreciation, and repair etc.(iii) Freight carriage outwards and other transport charges.(iv) Running expenses of delivery vans, repair, and depreciation.(v) Insurance in transit etc.

3.7 Classification of Cost

Cost may be classified into different categories depending upon the purpose of classification. Someof the important categories in which the costs are classified are as follows:

1. Fixed, Variable and Semi-Variable Costs

The cost which varies directly in proportion with every increase or decrease in the volume of outputor production is known as variable cost. Some of its examples are as follows:

1. Wages of laborers2. Cost of direct material3. PowerThe cost which does not vary but remains constant within a given period of time and a range of

activity inspite of the fluctuations in production is known as fixed cost. Some of its examples are asfollows:

1. Rent or rates2. Insurance charges3. Management salaryThe cost which does not vary proportionately but simultaneously does not remain stationary at alltimes is known as semi-variable cost. It can also be named as semi-fixed cost. Some of its examplesare as follows:

1. Depreciation2. RepairsFixed costs are sometimes referred to as period costs and variable costs as direct costs in systemof direct costing. Fixed costs can be further classified into:


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1. Committed fixed costs2. Discretionary fixed costsCommitted fixed costs consist largely of those fixed costs that arise from the possession of plant,equipment and a basic organization structure. For example, once a building is erected and a plant isinstalled, nothing much can be done to reduce the costs such as depreciation, property taxes,insurance and salaries of the key personnel etc. without impairing an organizations competence tomeet the long-term goals.

Discretionary fixed costs are those which are set at fixed amount for specific time periods by themanagement in budgeting process. These costs directly reflect the top management policies and haveno particular relationship with volume of output. These costs can, therefore, be reduced or entirelyeliminated as demanded by the circumstances. Examples of such costs are research and developmentcosts, advertising and sales promotion costs, donations, management consulting fees etc. These costsare also termed as managed or programmed costs.

In some circumstances, variable costs are classified into the following:

1. Discretionary cost2. Engineered costThe term discretionary costs is generally linked with the class of fixed cost. However, in thecircumstances where management has predetermined that the organization would spend a certain

percentage of its sales for the items like research, donations, sales promotion etc., discretionary costswill be of a variable character.

Engineered variable costs are those variable costs which are directly related to the production or saleslevel. These costs exist in those circumstances where specific relationship exists between input andoutput. For example, in an automobile

industry there may be exact specifications as one radiator, two fan belts, one battery etc. would be

required for one car. In a case where more than one car is to be produced, various inputs will have tobe increased in the direct proportion of the output.

Thus, an increase in discretionary variable costs is due to the authorization of management whereasan increase in engineered variable costs is due to the volume of output or sales.

2. Product Costs and Period Costs

The costs which are a part of the cost of a product rather than an expense of the period in which theyare incurred are called as product costs. They are included in inventory values. In financialstatements, such costs are treated as assets until the goods they are assigned to are sold. They becomean expense at that time. These costs may be fixed as well as variable, e.g., cost of raw materials anddirect wages, depreciation on plant and equipment etc.

The costs which are not associated with production are called period costs. They are treated as anexpense of the period in which they are incurred. They may also be fixed as well as variable. Suchcosts include general administration costs, salaries salesmen and commission, depreciation on officefacilities etc. They are charged against the revenue of the relevant period. Differences betweenopinions exist regarding whether certain costs should be considered as product or period costs. Someaccountants feel that fixed manufacturing costs are more closely related to the passage of time than tothe manufacturing of a product. Thus, according to them variable manufacturing costs are product

costs whereas fixed manufacturing and other costs are period costs. However, their view does notseem to have been yet widely accepted.

3. Direct and Indirect Costs


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The expenses incurred on material and labor which are economically and easily traceable for aproduct, service or job are considered a

Cost Accounting1 (1)(1)

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