Published On:Saturday 17 December 2011
Posted by Muhammad Atif Saeed
Basic Cost Concepts
In order to determine and take a dispassionate view about what lies beneath the surface of accounting figures, a financial analyst has to make use of different management accounting techniques. Cost techniques have a precedence over the other techniques since accounting treatment of cost is often both complex and financially significant. For example, if a firm proposes to increase its output by 10%, is it reasonable to expect total cost to increase by less than 10%, exactly 10% or more than 10%? Such questions are concerned with the cost behavior, i.e. the way costs change with the levels of activity. The answers to these questions are very much pertinent for a management accountant or a financial analyst since they are basic for a firm’s projections and profits which ultimately become the basis of all financial decisions. It is, therefore, necessary for a financial analyst to have a reasonably good working knowledge about the basic cost concepts and patterns of cost behavior. All these come within the ambit of cost accounting.
Meaning of Cost Accounting
Previously, cost accounting was merely considered to be a technique for the ascertainment of costs of products or services on the basis of historical data. In course of time, due to competitive nature of the market, it was realized that ascertaining of cost is not so important as controlling costs. Hence, cost accounting started to be considered more as a technique for cost control as compared to cost ascertainment. Due to the technological developments in all fields, cost reduction has also come within the ambit of cost accounting. Cost accounting is, thus, concerned with recording, classifying and summarizing costs for determination of costs of products or services, planning, controlling and reducing such costs and furnishing of information to management for decision making.
According to Charles T. Horngren, cost accounting is a quantitative method that accumulates, classifies, summarizes and interprets information for the following three major purposes:
- Operational planning and control
- Special decisions
- Product decisions
According to the Chartered Institute of Management Accountants, London, cost accounting is the process of accounting for costs from the point at which its expenditure is incurred or committed to the establishment of the ultimate relationship with cost units. In its widest sense, it embraces the preparation of statistical data, the application of cost control methods and the ascertainment of the profitability of the activities carried out or planned.
Cost accounting, thus, provides various information to management for all sorts of decisions. It serves multiple purposes on account of which it is generally indistinguishable from management accounting or so-called internal accounting. Wilmot has summarized the nature of cost accounting as “the analyzing, recording, standardizing, forecasting, comparing, reporting and recommending” and the role of a cost accountant as “a historian, news agent and prophet.” As a historian, he should be meticulously accurate and sedulously impartial. As a news agent, he should be up to date, selective and pithy. As a prophet, he should combine knowledge and experience with foresight and courage.
Objectives of Cost Accounting
The main objectives of cost accounting can be summarized as follows:
- Determining Selling Price Business enterprises run on a profit-making basis. It is, thus, necessary that revenue should be greater than expenditure incurred in producing goods and services from which the revenue is to be derived. Cost accounting provides various information regarding the cost to make and sell such products or services. Of course, many other factors such as the condition of market, the area of distribution, the quantity which can be supplied etc. are also given due consideration by management before deciding upon the price but the cost plays a dominating role.
- Determining and Controlling Efficiency Cost accounting involves a study of various operations used in manufacturing a product or providing a service. The study facilitates measuring the efficiency of an organization as a whole or department-wise as well as devising means of increasing efficiency.
Cost accounting also uses a number of methods, e.g., budgetary control, standard costing etc. for controlling costs. Each item viz. materials, labor and expenses is budgeted at the commencement of a period and actual expenses incurred are compared with budget. This greatly increases the operating efficiency of an enterprise.
- Facilitating Preparation of Financial and Other Statements The third objective of cost accounting is to produce statements whenever is required by management. The financial statements are prepared under financial accounting generally once a year or half-year and are spaced too far with respect to time to meet the needs of management. In order to operate a business at a high level of efficiency, it is essential for management to have a frequent review of production, sales and operating results. Cost accounting provides daily, weekly or monthly volumes of units produced and accumulated costs with appropriate analysis. A developed cost accounting system provides immediate information regarding stock of raw materials, work-in-progress and finished goods. This helps in speedy preparation of financial statements.
- Providing Basis for Operating Policy Cost accounting helps management to formulate operating policies. These policies may relate to any of the following matters:
- Determination of a cost-volume-profit relationship
- Shutting down or operating at a loss
- Making for or buying from outside suppliers
- Continuing with the existing plant and machinery or replacing them by improved and economic ones
Concept of Cost
Cost accounting is concerned with cost and therefore is necessary to understand the meaning of term cost in a proper perspective.
In general, cost means the amount of expenditure (actual or notional) incurred on, or attributable to a given thing.
However, the term cost cannot be exactly defined. Its interpretation depends upon the following factors:
- The nature of business or industry
- The context in which it is used
In a business where selling and distribution expenses are quite nominal the cost of an article may be calculated without considering the selling and distribution overheads. At the same time, in a business where the nature of a product requires heavy selling and distribution expenses, the calculation of cost without 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 so on. 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 while stock of finished goods is valued at office cost. Numerous other examples can be given to show that the term “cost” does not mean the same thing under all circumstances and for all purposes. Many items of cost of production are handled in an optional manner which may give different costs for the same product or job without going against the accepted principles of cost accounting. Depreciation is one 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.
Elements of Cost
Following are the three broad elements of cost:
- Material The substance from which a product is made is known as material. It may be in a raw or a manufactured state. It can be direct as well as indirect.
- Direct Material The material which becomes an integral part of a finished product and which can be conveniently assigned to specific physical unit is termed as direct material. Following are some of the examples of direct material:
- All material or components specifically purchased, produced or requisitioned from stores
- Primary packing material (e.g., carton, wrapping, cardboard, boxes etc.)
- Purchased or partly produced components
- Indirect Material The material which is used for purposes ancillary to the business and which cannot be conveniently assigned to specific physical units is termed as indirect material. Consumable stores, oil and waste, printing and stationery material etc. are some of the examples of indirect material.
Indirect material may be used in the factory, office or the selling and distribution divisions.
- Direct Material The material which becomes an integral part of a finished product and which can be conveniently assigned to specific physical unit is termed as direct material. Following are some of the examples of direct material:
- Labor For conversion of materials into finished goods, human effort is needed and such human effort is called labor. Labor can be direct as well as indirect.
- Direct Labor The labor which actively and directly takes part in the production of a particular commodity is called direct labor. Direct labor costs are, therefore, specifically and conveniently traceable to specific products.
Direct labor can also be described as process labor, productive labor, operating labor, etc.
- Indirect Labor The labor employed for the purpose of carrying out tasks incidental to goods produced or services provided, is indirect labor. Such labor does not alter the construction, composition or condition of the product. It cannot be practically traced to specific units of output. Wages of storekeepers, foremen, timekeepers, directors’ fees, salaries of salesmen etc, are examples of indirect labor costs.
Indirect labor may relate to the factory, the office or the selling and distribution divisions.
- Direct Labor The labor which actively and directly takes part in the production of a particular commodity is called direct labor. Direct labor costs are, therefore, specifically and conveniently traceable to specific products.
- Expenses Expenses may be direct or indirect.
- Direct Expenses These are the expenses that can be directly, conveniently and wholly allocated to specific cost centers or cost units. Examples of such expenses are as follows:
- Hire of some special machinery required for a particular contract
- Cost of defective work incurred in connection with a particular job or contract etc.
- Indirect Expenses These are the expenses that cannot be directly, conveniently and wholly allocated to cost centers or cost units. Examples of such expenses are rent, lighting, insurance charges etc.
- Direct Expenses These are the expenses that can be directly, conveniently and wholly allocated to specific cost centers or cost units. Examples of such expenses are as follows:
- Overhead The term overhead includes indirect material, indirect labor and indirect expenses. Thus, all indirect costs are overheads.
A manufacturing organization can broadly be divided into the following three divisions:
- Factory or works, where production is done
- Office and administration, where routine as well as policy matters are decided
- Selling and distribution, where products are sold and finally dispatched to customers
- Factory Overheads They include the following things:
- Indirect material used in a factory such as lubricants, oil, consumable stores etc.
- Indirect labor such as gatekeeper, timekeeper, works manager’s salary etc.
- Indirect expenses such as factory rent, factory insurance, factory lighting etc.
- Office and Administration Overheads They include the following things:
- Indirect materials used in an office such as printing and stationery material, brooms and dusters etc.
- Indirect labor such as salaries payable to office manager, office accountant, clerks, etc.
- Indirect expenses such as rent, insurance, lighting of the office
- Selling and Distribution Overheads They include the following things:
- Indirect materials used such as packing material, printing and stationery material etc.
- Indirect labor such as salaries of salesmen and sales manager etc.
- Indirect expenses such as rent, insurance, advertising expenses etc.
- Direct material
- Direct labor
- Direct expenses
- Overheads
- Factory overheads
- Selling and distribution overheads
- Office and administration overheads
- Indirect material
- Indirect labor
- Indirect expenses
- Indirect material
- Indirect labor
- Indirect expenses
- Indirect material
- Indirect labor
- Indirect expenses
Components of Total Cost
- Prime Cost Prime cost consists of costs of direct materials, direct labors and direct expenses. It is also known as basic, first or flat cost.
- Factory Cost Factory cost comprises prime cost and, in addition, works or factory overheads that include costs of indirect materials, indirect labors and indirect expenses incurred in a factory. It is also known as works cost, production or manufacturing cost.
- Office Cost Office cost is the sum of office and administration overheads and factory cost. This is also termed as administration cost or the total cost of production.
- Total Cost Selling and distribution overheads are added to the total cost of production to get total cost or the cost of sales.
Various components of total cost can be depicted with the help of the table below:
| Components of total cost | |
| Direct material Direct labor Direct expenses | Prime cost or direct cost or first cost |
| Prime cost plus works overheads | Works or factory cost or production cost or manufacturing cost |
| Works cost plus office and administration overheads | Office cost or total cost of production |
| Office cost plus selling and distribution overheads | Cost of sales or total cost |
Cost Sheet
Cost sheet is a document that provides for the assembly of an estimated detailed cost in respect of cost centers and cost units. It analyzes and classifies in a tabular form the expenses on different items for a particular period. Additional columns may also be provided to show the cost of a particular unit pertaining to each item of expenditure and the total per unit cost.
Cost sheet may be prepared on the basis of actual data (historical cost sheet) or on the basis of estimated data (estimated cost sheet), depending on the technique employed and the purpose to be achieved.
The techniques of preparing a cost sheet can be understood with the help of the following examples.
Example 1
Following information has been obtained from the records of left center corporation for the period from June 1 to June 30, 1998.
| Cost of raw materials on June 1,1998 | 30,000 |
| Purchase of raw materials during the month | 4,50,000 |
| Wages paid | 2,30,000 |
| Factory overheads | 92,000 |
| Cost of work in progress on June 1, 1998 | 12,000 |
| Cost of raw materials on June 30, 1998 | 15,000 |
| Cost of stock of finished goods on June 1, 1998 | 60,000 |
| Cost of stock of finished goods on June 30, 1998 | 55,000 |
| Selling and distribution overheads | 20,000 |
| Sales | 9,00,000 |
| Administration overheads | 30,000 |
Prepare a statement of cost.
Solution
Statement of cost of production of goods manufactured for the period ending on June 30, 1998.
| Opening stock of raw materials Add-- purchase | 30,000 4,50,000 ------------ 4,80,000 15,000 | |
| Less-- closing stock of raw material Value of raw materials consumed Wages Prime cost Factory overheads Add-- opening stock of work in progress Less-- closing stock of work in progress Factory cost Add-- Administration overhead Cost of production of goods manufactured Add--opening stock of finished goods | 4,65,000 2,30,000 6,59,000 92,000 7,87,000 12,000 7,99,000 --- 7,99,000 30,000 8,29,000 60,000 8,89,000 | |
| Less-- closing stock of finished goods Cost of production of goods sold Add-- selling and distribution overheads Cost of sales Profit Sales | 55,000 8,34,000 20,000 8,54,000 46,000 9,00,000 |
Example 2
From the following information, prepare a cost sheet showing the total cost per ton for the period ended on December 31, 1998.
| Raw materials Productive wages Direct expenses Unproductive wages Factory rent and taxes Factory lighting Factory heating Motive power Haulage Director’s fees (works) Directors fees (office) Factory cleaning Sundry office expenses Expenses Factory stationery Office stationery Loose tools written off | 33,000 35,000 3,000 10,500 2,200 1,500 4,400 3,000 1,000 2,000 500 200 800 750 900 600 | Rent and taxes (office) Water supply Factory insurance Office insurance Legal expenses Rent of warehouse Depreciation-- Plant and machinery Office building Delivery vans Bad debt Advertising Sales department salaries Up keeping of delivery vans Bank charges Commission on sales | 500 1,200 1,100 500 400 300 2,000 1,000 200 100 300 1,500 700 50 1,500 |
The total output for the period has been 10000 tons.
Solution
| Raw materials Production wages Direct expenses Prime cost Add--works overheads: Unproductive wages Factory rent and taxes Factory lighting Factory heating | $. 33,000 35,000 3,000 10,500 7,500 2,200 1,500 4,400 | 71,000 |
| Motive power Haulage Directors’ fees (works) Factory cleaning Estimating expenses Factory stationery Loses tools written off Water supply Factory insurance Depreciation of plant and machinery Works cost Add-- office overhead Directors’ fees (office) Sundry office expenses Office stationery Rent and taxes (office) Office insurance Legal expenses Depreciation of office building Bank charges Office cost Add-- selling and distribution overheads Rent of warehouse Depreciation on delivery vans Bad debts Advertising Sales department salaries Commission on sales Upkeep of delivery vans Total cost Cost per ton $. 1,18,200/10,000 = $. 11.82 | 3,000 1,000 500 800 750 600 1,200 1,100 2,000 2,000 200 900 500 500 400 1,000 50 300 200 100 300 1,500 1,500 700 | 37,050 1,08,050 5,550 1,13,600 4,600 1,18,200 |
Classification of Cost
Cost may be classified into different categories depending upon the purpose of classification. Some of 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 output or production is known as variable cost. Some of its examples are as follows:
- Wages of laborers
- Cost of direct material
- Power
The 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 as follows:
- Rent or rates
- Insurance charges
- Management salary
The cost which does not vary proportionately but simultaneously does not remain stationary at all times is known as semi-variable cost. It can also be named as semi-fixed cost. Some of its examples are as follows:
- Depreciation
- Repairs
Fixed costs are sometimes referred to as “period costs” and variable costs as “direct costs” in system of direct costing. Fixed costs can be further classified into:
- Committed fixed costs
- Discretionary fixed costs
Committed 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 is installed, 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 organization’s competence to meet the long-term goals.Discretionary fixed costs are those which are set at fixed amount for specific time periods by the management in budgeting process. These costs directly reflect the top management policies and have no particular relationship with volume of output. These costs can, therefore, be reduced or entirely eliminated as demanded by the circumstances. Examples of such costs are research and development costs, advertising and sales promotion costs, donations, management consulting fees etc. These costs are also termed as managed or programmed costs.
In some circumstances, variable costs are classified into the following:
- Discretionary cost
- Engineered cost
The term discretionary costs is generally linked with the class of fixed cost. However, in the circumstances 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 costs will be of a variable character. Engineered variable costs are those variable costs which are directly related to the production or sales level. These costs exist in those circumstances where specific relationship exists between input and output. 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 to be increased in the direct proportion of the output.
Thus, an increase in discretionary variable costs is due to the authorization of management whereas an 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 they are incurred are called as “product costs.” They are included in inventory values. In financial statements, such costs are treated as assets until the goods they are assigned to are sold. They become an expense at that time. These costs may be fixed as well as variable, e.g., cost of raw materials and direct wages, depreciation on plant and equipment etc.
The costs which are not associated with production are called period costs. They are treated as an expense of the period in which they are incurred. They may also be fixed as well as variable. Such costs include general administration costs, salaries salesmen and commission, depreciation on office facilities etc. They are charged against the revenue of the relevant period. Differences between opinions exist regarding whether certain costs should be considered as product or period costs. Some accountants feel that fixed manufacturing costs are more closely related to the passage of time than to the 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 not seem to have been yet widely accepted.
3. Direct and Indirect Costs
The expenses incurred on material and labor which are economically and easily traceable for a product, service or job are considered as direct costs. In the process of manufacturing of production of articles, materials are purchased, laborers are employed and the wages are paid to them. Certain other expenses are also incurred directly. All of these take an active and direct part in the manufacture of a particular commodity and hence are called direct costs.
The expenses incurred on those items which are not directly chargeable to production are known as indirect costs. For example, salaries of timekeepers, storekeepers and foremen. Also certain expenses incurred for running the administration are the indirect costs. All of these cannot be conveniently allocated to production and hence are called indirect costs.
4. Decision-Making Costs and Accounting Costs
Decision-making costs are special purpose costs that are applicable only in the situation in which they are compiled. They have no universal application. They need not tie into routine-financial accounts. They do not and should not conform the accounting rules. Accounting costs are compiled primarily from financial statements. They have to be altered before they can be used for decision-making. Moreover, they are historical costs
and show what has happened under an existing set of circumstances. Decision-making costs are future costs. They represent what is expected to happen under an assumed set of conditions. For example, accounting costs may show the cost of a product when the operations are manual whereas decision-making cost might be calculated to show the costs when the operations are mechanized.
5. Relevant and Irrelevant Costs
Relevant costs are those which change by managerial decision. Irrelevant costs are those which do not get affected by the decision. For example, if a manufacturer is planning to close down an unprofitable retail sales shop, this will affect the wages payable to the workers of a shop. This is relevant in this connection since they will disappear on closing down of a shop. But prepaid rent of a shop or unrecovered costs of any equipment which will have to be scrapped are irrelevant costs which should be ignored.
6. Shutdown and Sunk Costs
A manufacturer or an organization may have to suspend its operations for a period on account of some temporary difficulties, e.g., shortage of raw material, non-availability of requisite labor etc. During this period, though no work is done yet certain fixed costs, such as rent and insurance of buildings, depreciation, maintenance etc., for the entire plant will have to be incurred. Such costs of the idle plant are known as shutdown costs.
Sunk costs are historical or past costs. These are the costs which have been created by a decision that was made in the past and cannot be changed by any decision that will be made in the future. Investments in plant and machinery, buildings etc. are prime examples of such costs. Since sunk costs cannot be altered by decisions made at the later stage, they are irrelevant for decision-making.
An individual may regret for purchasing or constructing an asset but this action could not be avoided by taking any subsequent action. Of course, an asset can be sold and the cost of the asset will be matched against the proceeds from sale of the asset for the purpose of determining gain or loss. The person may decide to continue to own the asset. In this case, the cost of asset will be matched against the revenue realized over its effective life. However, he/she cannot avoid the cost which has already been incurred by him/her for the acquisition of the asset. It is, as a matter of fact, sunk cost for all present and future decisions.
Example
Jolly Ltd. purchased a machine for $. 30,000. The machine has an operating life of five yea$ without any scrap value. Soon after making the purchase, management feels that the machine should not have been purchased since it is not yielding the operating advantage originally contemplated. It is expected to result in savings in operating costs of $. 18,000 over a period of five years. The machine can be sold immediately for $. 22,000.
To take the decision whether the machine should be sold or be used, the relevant amounts to be compared are $. 18,000 in cost savings over five yea$ and $. 22,000 that can be realized in case it is immediately disposed. $. 30,000 invested in the asset is not relevant since it is same in both the cases. The amount is the sunk cost. Jolly Ltd., therefore, sold
