unit 1: Introduction to cost accounting

Unit 1 is about introducing cost accounting as a subject of study.

A reader is supposed to go through and (as a result is expected to know) following topics or points:

1. What is Cost Accounting? Why did come into existence as a separate field of study?

2.Scope of Cost Accounting or What do we do in Cost Accounting/Functions performed by cost accounting/Objectives

3.A distinction between Financial Accounting, Cost Accounting and Management Accounting.

4. A brief understanding (meaning) of the term Cost, Costing, Cost Accounting and Cost Accountancy.

5.Limitations of Financial Accounting (which led to the development of Cost Accounting) and Advantages and Limitations of Cost Accounting

6. Cost Centre, Cost Object and Cost Unit

7. Techniques of Cost Accounting

8. Methods of Cost Accounting

9 Classification of Cost

1.

What were the factors that led to the growth of cost accounting as a separate branch of study ?

(i)                 Limitations placed on the financial accounting viz. financial accounting prepared information mainly for outsiders and that too in aggregates without enough or pertinent analysis to enable the management to support decision making process.

(ii)              Rising costs of production and provision of services forced management to study costs and its components in order to control costs

(iii)            Rapid industrial development and mechanization on one hand and high human resource costs on the other

(iv)             Growing competition forced producers and suppliers to operate at reduced sales price.

(v)               Rising inflation and government/public pressure

(vi)             Increased governmental and statutory requirements

The result of above factors was that sales price could not be increased with controlling and reducing costs remaining only alternative to continue and prevail.Thus, in order to circumvent and counter above factors cost accounting emerged as a separate field of study and practice.

2.

Scope and objectives of Cost Accounting or its Functions:

(i) Cost Ascertainment

(ii) Cost Control

(iii) Cost Reduction

(iv) Setting of Selling price

(v) Facilitates inventory valuation

(vi) Establishing standard cost and budgetary control techniques  

(vii) Helping point out inefficiencies in the form of wastages

(viii) Establishing cost volume profit relationships and using techniques of marginal costing and differential costing to facilitate decision making.

(ix) Providing specialized reports and information to government regulatory bodies, workers and industry unions

(x) Cost Audit

3.

Point of difference Financial Accounting Cost Accounting

Point of difference	Financial Accounting	Cost Accounting
Objective of information	It provides the information about the business in a general way. i.e Profit and Loss Account , Balance Sheet of the business to owners and other outside stakeholders.	a) It provides information to the management for proper planning, operation, control and decision making.
Approach to information processing	b) It classifies, records and analyses the transac­tions in a subjective manner, i.e according to the nature of expense.	b) It records the expenditure in an objective manner, i.e according to the purpose for which the costs are incurred.
Emphasis on control	c) It lays emphasis on recording aspect without attaching any importance to control.	c) it provides a detailed system of control for materials, labour and overhead costs with the help of standard costing and budgetary control.
Periodicity of results	d) It reports operating results and financial position usually at the end of the year.	d) It gives information through cost reports to management as and when desired.
Whole business accounting or related to object	e) Financial Accounts are accounts of the whole business. They are independent in nature.	e) Cost Accounting is only a part of the financial accounts and discloses profit or loss of each product, job or service.
Exclusivity or scope of information	f) Financial Accounts records all the commercial transactions of the business and include all expenses i.e Manufacturing, Office, Selling etc.	f) Cost Accounting relates to transactions connected with Manufacturing of goods and services, means expenses which enter into production.
Internal or External transactions	g) Financial Accounts are concerned with external transactions i.e transactions between business concern and third party.	g) Cost Accounts are concerned with internal transactions, which do not involve any cash payment or receipt.
Monetary Transactions only	h) Only transactions which can be measured in monetary terms are recorded.	h) Non-Monetary information like No of Units / Hours etc are used.
Role of estimates	i) Financial Accounting deals with actual figures and facts only.	i) Cost Accounting deals with partly facts and figures and partly estimates / standards.
Focus on efficiencies and capacities	j) Financial Accounting do not provide information on efficiencies of various workers / Plant & Machinery.	j) Cost Accounts provide valuable information on the efficiencies of employees and Plant & Machinery.
Valuation of stock	k) Stocks are valued at Cost or Market price whichever is lower.	k) Stocks are valued at Cost only.
Positive or normative science	l) Financial Accounting is a positive science as it is subject to legal rigidity with regarding to preparation of financial statements.	l) Cost Accounting is not only positive science but also normative because it includes techniques of budgetary control and standard costing.
Voluntary or Statutory	m) These accounts are kept in such away to meet the requirements of Companies Act as per Sec 209 (1) (a) to (c)& Income Tax Act Sec 44AA.	m) Generally Cost Accounts are kept voluntarily to meet the requirements of the management, only in some industries Cost Accounting

4.

Cost represent expending or consumption or extinguishment or deterioration or diminution of a valuable resource in the course of production of any good or provision of any service. 

Costing is defined as the technique and process of ascertaining costs

It is a formal exercise to ascertain total expenditure incurred in manufacture of products and providing of services. It involves analysis of expenditure into various elements and components of total cost

Cost Accounting may be defined as “Accounting for costs classification and analysis of expenditure as will enable the total cost of any particular unit of production to be ascertained with reasonable degree of accuracy and at the same time to disclose exactly how such total cost is constituted”

Cost Accountancy is defined as ‘the application of Costing and Cost Accounting principles, methods and techniques to the science, art and practice of cost control and the ascertainment of profitability’

5. Limitations of Financial Accounting

Limitations of financial accounting arise as such viewing financial accounting from the perspective of cost accounting and as such all the points used to distinguish between the two can be used while discussing this topic. Additionally all the limitations of accounting like different bases of valuation of assets, provisioning approaches, difference in accounting policies and assumptions, different methods of calculating depreciation etc. can also be safely cited.

Limitations and Advantages of Cost Accounting:

Advantages of Cost Accounting:

(i)             Cost Accounting reveals the exact cause of losses or areas which are responsible for low profit or losses by way of wastages and inefficiencies

(ii)           Cost Accounting provides data and statistics of various elements of cost, or function wise cost etc to provide an in-depth analysis of cost. This facilitates Managerial decision making.

(iii)         Supports Cost Audit

(iv)          Act as a tool of Cost Control

(v)           Provide the basis of Cost Reduction

(vi)          Helps in pricing of products and services

(vii)        Government agencies and authorities, workers and other interested stake holders can get ready and accurate data for various purposes.

(viii)      Helps management in identifying and create feasible cost centers which in turn supports fixation of responsibility and authority of individuals

(ix)          Valuation of inventory is facilitated as a result of good costing system and recording for example use of perpetual inventory system.

(x)           Helps management in introducing tools and techniques of Marginal costing, Standard costing and Budgetary Control.

Limitations:

Limitation creep in because of practical difficulties of real life and in-borne human fallacies. Main Limitations are:

(i)             Appropriation and Allocation of joint costs

(ii)           Segregation of costs among cost centers

(iii)         Material issue pricing

(iv)          Labour Methods

(v)           Conflict with Financial Accounting

(vi)          Fixed and Variable costs are not truly fixed and variable in real life.

(vii)        Costly and resource consuming.

6. Cost Centre, Cost Object and Cost Unit

A very important step in the process of cost ascertainment. This is just like entity concept used in financial accounting. It establishes necessary clarity that costing exercise is being done on whose behalf or for whom or whom whose reference point. This helps in identification of relevant costs and distinguishing costs which are directly related or related indirectly to that 'who, whom or whose' i.e cost centre or cost object or cost unit.

Thus, more formally cost centre is the reference point with respect to which cost ascertainment exercise is carried out. It may be a division, department, section...even an individual like a supervisor etc. Cost centre may be personal, impersonal

Any unit of Cost Accounting selected with a view to accumulating all cost under that unit. The unit may be a product, a service, division, department, section, a group of plant and machinery, a group of

employees or a combination of several units

It is the center of study and analysis:

Ø    f    or which specific objective or activity is assigned  

Ø             Only expenses which are related or relevant to the objective or activity of the cost center are thus linked to the cost center. As a result even common expenses are required to be apportioned for ascertaining costs i.e. total expenses incurred with respect to the cost center.

Ø              Why concept of cost centre developed? Cost center provides a very logical basis of analyzing performance of various activity centers which collectively go on to make the organization or entity. The result of the analysis help to identify the weak areas i.e. centers and corrective action can be taken effectively.  For understanding, it is like identifying and separately studying the bodies under various functional areas say bones, skin, eyes, ear, nose, throat, kidney, liver, stomach, heart, brain and the like.

A very practical and common approach is to identify various revenue generating units or activities as cost centers in order to have a clear idea about the costs and expenses involved in carrying out them. If this is achieved then management can compare the costs with associated revenues or with other such cost centers within or outside the organization.

     Cost Object : anything for which a separate measurement of cost may be desired or is undertaken. Say the management is interested in knowing the cost of a particular thing, then that thing ( in relation to which all related costs shall be accumulated) is known as Cost Object. It is thus that concept under both cost center and cost object is same, only perceivable difference is that cost center is more close to a section of a business organization. Example: radiology department may be thought of a cost center while X-ray machine or X-ray report may be thought of as a Cost Object. For all practical purposes cost center and cost object have insignificant difference.

      Cost Unit: A unit of cost is a unit of quantity of product, service or time in relation to which costs may be ascertained or expressed. It simply denotes the level of activity, volume of measurement of production or services. A cost unit is generally set to be a practically known, accepted and physical quantity like units representing numbers, weight, length, volume, time etc.

  A cost unit can be a simple cost unit like per meter, kg etc. as well as a composite unit for eg. Patient-day, Tonne-Km etc.

               Common examples are:

Industry	product Cost unit basis
Automobile	Numbers
Brick	Per thousand bricks
Cement, Fertilizers	No. of Bags, Per Tonne
Chemicals	Liter, Gallon, Kilogram
Hospital/Medical Care	Per patient or Per Bed or patient-day
Transport Services	Per Passenger-Km or Tonne-Km
Power/Electricity	Watts/ MW
Shoes	No. of pairs
Electricity	Kilowatt-Hr or KWH or MWH
Timber	Cubic Foot
Gas	Cubic Foot or Metre
College/University/School	Student or Teacher
Brewery or refinery	Barrel or Gallon or Ltr.
Hotels	Per Room or Room-days
Tiles, Marble, Carpet, Vinyl Flooring etc	Square Ft.
Cotton /Jute/Cement	Bale/Bundle/Cement

   Classification or classes or categories of costs: Costs are sorted and classified for the purpose of analysis to help in decision making. Normally Costs should be classified on the basis of their nature or on the basis of purpose or objective in hand. There can be n number of ways in which costs can be classified and an extreme case represents the whim and fancy of the Cost Controller, CEO or owner.

However the objective in hand, the constraints of the given situation and practicality are the main criteria adopted in choosing a particular pattern of classification of costs.

Some common criteria include :

(i)      On the basis of nature or elements : (i) Material, (ii) Labour (iii)Expenses

(ii)    On the basis of relation to Cost Center : (i) Direct Costs and (ii) Indirect Costs

(iii)   On the basis of variability : (i) Fixed  (ii) Variable and (iii) Semi Variable

(iv)    On the basis of functions: (i) Production or Manufacturing Costs (ii) Administrative Costs (iii) Selling Cost (iv) Distribution Costs (v) Research & Development Costs

(v)     On the basis of Controllability: (i) Controllable Costs and (ii) Non Controllable Costs

(vi)       On the basis of Normalcy: (i) Normal Costs and (ii) Abnormal Costs

(vii)      For the purpose of Decision making : (i) Opportunity Cost (ii) Sunk Cost (iii) Marginal Cost (iv) Replacement Cost (v) Notional or Imputed Cost (vi) Normal/Abnormal Cost (vii) Controllable Cost and Non-Controllable Costs and (vii) Relevant Cost

(viii)     On the basis of activity (i.e. operation or process): (i) Batch Cost (ii) Process Cost (iii) Operation Cost (iv) Operating Cost (v) Contract Cost (vi) Joint Cost

(ix)              Classification on the basis of Timing: (i) Historical Costs (ii) Pre-determined Cost (Budgeted Costs) (iii) Standard Cost

13.   Concept of Direct and Indirect Costs:  This is a cost concept as well as a basis of classification of costs.

 Aim of any business or commercial organization is to create value i.e. generate revenue. To generate revenue, organizations undertake either production of goods or provision of services. These are the main revenue generating activity of such organizations or entities i.e. for which they exist.  To carry out such production or service providing activities, certain resources in the form of material, labour and expenses are used. These are collectively referred to as costs.

Here a very important distinction is made, certain costs are considered are cardinal, essential and compulsory so much so that the main activity (of production or rendering of service) cannot be thought of or is impossible to take place if these costs are not incurred. Such costs are collectively termed as DIRECT COSTS.

As a corollary, all other remaining costs are Indirect Costs. In other words, all costs which are not direct costs and which are required for providing necessary support to the main function or activity (of production or rendering of service). They supplement the main process and organization as a whole so that the overall functioning of the organization is efficient, effective, safe and controlled. Still they do not take part in the main activity (of production or rendering of service).

Apart from above there are certain instances where items of insignificant value or proportion are not included in Direct Costs may be because of practicality.

Note: This does not imply that indirect costs i.e. costs are irrelevant and shall not become the part of total costs for carrying out the main activity (of production or rendering of service).

14.   Classification of Costs on the basis of elements/components/nature:

(a)    Material Costs: Cost of all material items – natural or synthetic, finished or semi-finished which goes into the making of the final product and which is meant for sale is known as Material Cost. Even cost of bringing such items to the place of processing or manufacturing, any further cost incurred for rendering it fit for use in production process or in service process.

Following are generally included in cost of material:

(i)    Purchase price of raw material

(ii)   All other ingredients and support material required during production or process

(iii     Ordering Costs, Freight, Carriage inward, loading-unloading, insurance, Normal loss during transport and handling

(iv)  Any toll, taxes, duties imposed on the procurement and purchase

(v)    While Trade Discounts, rebates, Modvat, Centvat credits etc. are deducted from above costs.

(b)   Labour Costs:  It represent use of human resources towards accomplishment of various activities.   This generally includes salaries, wages, remuneration etc paid to employees whether permanent or temporary. Other employee costs like PF contribution, Gratuity, Bonus, encashment of earned leave, normal idle time, perquisites and fringe benefits and  compensations of various types are also covered under Labour Costs. 

(c)    Expenses (other than Material and Labour): There are certain expenses which fall neither under the category of material nor labour, yet they are incurred for the successful accomplishment of the activities relating to production or provision of the service generating revenue. Examples include rent and insurance of any machine used in the manufacturing process, professional fees paid to engineers or other experts for designs, modules and special dies, Power and fuel used by manufacturing facility, Royalty and Usage charges paid to the owner of knowhow, patent etc. This is quite common in case of electronics and automobile industry.

Remember that sum total of (a) Direct Material (b) Direct Labour and (c) Direct Expenses is referred to as PRIME COSTS. Theoretically (as well as practically to a major extent), Prime Cost varies directly with the level of production or activity, hence Prime Cost is variable in nature.

It can be said that all Prime Costs are Variable Costs and also that Prime Costs are a subset of Variable Costs.

15.   On the basis of relation with cost center and/or cost unit, costs can be classified as Direct Costs and Indirect Costs.

15.1 Direct Costs: All costs which bear direct relationship with cost center or cost unit are termed as Direct Costs. What is direct relationship here? By Direct Relationship it is thought of as such costs i.e. material, labour and expenses which are the main ingredient in the production or provision of service. To say it differently without such costs the cost center or cost unit i.e. production or output or provision of service is impossible and beyond imagination. For example without wheat flour production of bread cannot take place. Likewise without requisite implants, knee replacement surgery cannot take place. In above cases wheat flour and knee implant are examples of direct costs. Again salary of operator at bakery and Surgeon doing their respective activities are examples of Direct Labour. Similarly power and fuel and electricity used in the bakery and operation theatre are examples of Direct Expenses.

Remember that sum total all direct costs is also known as PRIME COSTS

15.2 Indirect Costs:

Just in contrast to Direct Costs, these costs are such costs which have no direct relationship or bearing with the main process or activity (cost center or cost unit). These costs do not participate directly in the main activity of the cost center i.e. production or rendering of service.

For example let us think of the salary as well as the role of the security guard or gardener or even the CEO who otherwise is responsible for the entire affairs of the entity. Similarly the cost of stationery, travelling expenses of directors, legal expenses to advocates, advertisements, telephone and courier,  Bank charges,  interest on term loan for acquiring infrastructure facilities, auditors fees etc are some common examples of Indirect Expenses.

This is just asking a simple question: What if such material or labour or other expense was not incurred or incurred randomly that too only when necessitated? If the answer is Ok, the cost under question can be curtailed or deferred without having any immediate impact on the main process or activity of the cost center or cost unit, it can be thought of as an Indirect Cost.

Indirect Costs are collectively and more commonly known as OVERHEADS.

16.               Classification of Costs on the basis of functions/Departments

(a)    Production/Manufacturing/Factory Costs : refers to all the costs, whether direct or indirect incurred in the production activity.

(i) Direct Production costs include Direct Material costs, Direct Labour Costs and Direct Expenses

(ii)  Indirect Production Costs are also known as Production Overheads and examples include

Repair and Maintenance of factory building, Depreciation on factory building and machinery, salary of security staff, salary of manager, technical staff, planning staff, labour benefit schemes, first aid and dispensary,  canteen and Tiffin facilities, quality control and inspection, waste treatment and pollution control measures, creche etc.

(b)   Administrative Costs: These are costs incurred in general and overall management of the organization or entity. These costs facilitate and provide necessary support to the main activity. Examples include : Salaries of administrative and accounts staff,  general office expenses like travelling & conveyance,  rent, municipal taxes, lighting and electricity, telephone, printing &  stationery, postage & courier, depreciation-repair & maintenance of office building, bank interest & charges, audit fees, legal expenses, staff welfare expenses, refreshment, computer repair & maintenance.

(c)    Selling Costs : Costs incurred in the selling function of products and/or services. Examples include:

(i)     Salary, commission and travelling expenses of salesmen or sales personnel

(ii)    Advertisement and publicity

(iii)   Costs relating to credit sales/debtors i.e. bad debts, carrying costs, realization costs.

(iv)     Market survey, market research costs.

(v)     Royalty on sales (fixed amount)

(vi)    Brochures, samples, demonstrations, promotions, workshops, customizations etc

(vii)  After sales service.

(d)   Distribution Costs: These are the costs incurred in sending and making available the goods and services to the customer or consumer. They include all handling and carrying costs till the goods are ready for sale and are actually sold to the consumers. Examples include

(i)       Warehousing Costs including rent, insurance etc of warehouse.

(ii)     Loading Un-loading costs 

(iii)   Delivery costs i.e. transportation and handling costs

(iv)    Secondary packaging i.e. packing into bags, cartons, containers, envelopes etc for safe transport and handling is covered under distribution costs.

(v)   Sometimes minor assembly and installation costs are also included in the distribution costs e.g. Set Top Boxes in case of satellite TV transmission devices, Furniture etc.

(e)   Research & Development Costs: These are common to industries like electronics, drugs and pharmaceuticals, automobiles etc. These costs are necessary to continuously upgrade and improve the products and services as per the changing times, needs and requirements of the customers. This is also necessary to remain in lead in competition. All costs towards material, labour and expenses incurred for carrying out research and development are accumulated under category

  

16.   Classification of Costs for Decision Making or Strategic Management:

Management or owners have to engage themselves many times in strategic decision making, which involves questions like (i) Make or buy a component (outsource) (ii) Own or Lease a vehicle or machinery (iii) Discontinue a segment or line of goods or service (iv) Replacement Decisions and the like. 

To deal with such situations costs are viewed in many ways, some more common categories of such costs are as follows: 

(i)      Imputed or Notional Costs: Again as the name suggests, these costs are assumed to have incurred while they may not be actually paid or incurred. This include salary of owners, interest on own capital or funds, rent on owner’s building. Interest on profit earned and reinvested in business also falls under same category. Imputed costs are also known as Hypothetical Costs. 

  

(ii)     Sunk Costs: Sunk costs are those costs which have already been incurred in the past and cannot be monitored or controlled in present. In other words they do not influence present or future decisions.  Also, they cannot be recovered in future whatever decision is taken.  As a result they have zero impact on the present decision to be made. These costs are historical in nature. For example if a machinery is to be extended or repaired say at a cost of Rs.20 Lacs then its original cost of acquisition for Rs.40 Lacs or previously spent Rs.10 Lacs on its repairs and maintenance has no relevance in deciding whether to make further extension or repair of Rs.20 Lac. In this example, acquisition cost of Rs.40 Lac and previous repair of Rs.10 Lac are SUNK costs.

  

(iii)   Relevant and Irrelevant Costs: Relevant Costs are those costs which have a direct bearing or influence on the decision to be taken. For example if we have to start a hospital, then costs in the form of necessary approvals and sanctions from various authorities like development authority, Fire department, Pollution department etc. are relevant costs as they will be incurred as a result of this decision and will not be incurred if the decision to start the hospital is not taken i.e. dropped.



Again if a machine is decided to be sold, then its written down valued is important or relevant in this decision. However written down value of this machine is not important or relevant if the machine is to be replaced. In case of replacement decision, the scrap value of the machine expected to be realized is relevant.



Again if I am deciding to use my own scooter or to take a tempo to travel to University, then tempo fare and cost of petrol used by scooter are relevant costs, while insurance costs of scooter are irrelevant. Scooter insurance has to be paid in any case.



Thus costs which are either cause or effect of a decision are relevant costs for that decision and costs which do not feature this relationship with the decision are irrelevant costs with reference to that decision.

  

(iv) Period Costs and Product Costs: Costs which relate to the product and service are product costs. Thus costs which are incurred in the production or manufacture of product or provision of service. Thus these include all direct material, direct labour, direct expenses plus factory overheads.

On the other hand costs which are related to the period or efflux of time are period costs. These are not necessary for the manufacture and provision of services. They keep on incurring even when there is zero production.  Rent, Yearly Rates and Taxes like house tax and water tax, Insurance, fixed salary of managers are examples of Period Costs.

   

(v) Marginal Cost: Costs which result from change of activity level i.e. either decrease or increase in one unit of production or service. This is a very important concept in managerial decision making. Normally marginal cost is affected as a result of presence of variable costs i.e. it results from the movement in variable costs as a result of increase or decrease in output or service level by one unit.

  

(vi) Incremental and Decremental Costs : The amount by which aggregate costs  increase over present level of costs is known as incremental costs while the amount by which aggregate costs decrease in comparison to present level of aggregate costs, is known as Decremental costs. This facilitates management in focusing on key areas by identifying and analyzing the relevant costs having a direct influence over the decision.

  

(vii) Opportunity Costs: Economic resources, be it men, machine, money or material are scarce and have alternative uses. If they are used for one purpose, it has to be borne in mind that they can also be used for other revenue generating activities as well. Alternative revenue foregone by using it for another activity is known as opportunity cost of that resource. This follows thus that resources should be channelized towards that alternative which is bringing in highest value or revenue among alternatives.

  

(viii) Normal and Abnormal costs: Normal Costs are costs incurred in the routine course of activity.  These costs are found or experienced or accepted to be normal. In other words, many times the level of these costs is based on industry averages or is accepted by the management as usual or normal in the ordinary course of activity.  Such costs are included under any costing exercise and are not charged to Profit & Loss Account. Examples include normal spoilage or weight loss or evaporation in handling of fuel oils.

 

Abnormal costs are incurred abruptly and have no relationship with the nature of activity or the normal level of activity. All accidental outlays and expenditure are referred to as abnormal. They occur as a result of carelessness or act of God, and are most of the time either preventable or are manageable. They are not allowed to become the part of costing and instead, charged to Profit & Loss Account. Examples include loss on account of Fire, mishandling, theft etc.



  

(ix) Controllable and non-controllable costs : As is clear from the name, those costs which can be influenced i.e. increased or reduced as a result of management action are Controllable costs. Similarly costs which cannot be controlled or influenced by the action or decision of management are known as Non-controllable costs.

Example of  Non-Controllable costs are rental or royalty of a machine or process, minimum house tax and water tax, salary of higher management, legal fees, idle time, switch over time, recruitment and training costs.

Examples of controllable costs are procurement costs, storage costs, Attrition costs, repair & maintenance costs, all direct and variable costs.

     

(x) Historical costs and Pre-determined costs: Historical costs are those costs which are already incurred and known with precision. They are thus actual costs. In other words their figures or value is known for actual and no process of estimation is involved. Pre-determined costs have to be estimated in advance i.e. before the actual production or service process is executed. These are generally based on past experiences or comparable costs taken from similar establishment and processes. They are important for forecasting, budgeting and planning.

  

(xi)   Differential (or Incremental costs) : Differential cost may be defined as the difference in total costs arising as a result of choosing other alternative course of action as compared to previous or existing option. It is arrived at by subtracting total cost under one alternative from total costs under other alternative. Further if there is increase in cost we call it incremental costs and if there is decrease in total costs we call it Decremental costs. The alternative courses of action are commonly found in situations of make or buy, own or lease, change in product mix etc. 

  

(xii) Replacement costs: This is the cost of replacing an existing asset with an identical asset in future or in present. It is a common experience that prices of commodities keep on changing with the passage of time. Generally they increase but sometimes the decrease also. So historical cost of an item may be different from the present or future cost at which it may be replaced. While taking the decision to replace an asset, it is logical to disregard its historical cost and take into consideration cost of replacement.

  

(xiii)  Out-of-pocket costs (aka explicit costs): These are those costs which require actual outflow or extinguishment of funds and existing resources like wages, cost of material, salaries etc. They may be either fixed or variable but they have to be incurred in real. On the contrary, costs which do not require consumption or outflow of existing resources are hidden or implicit costs. Common example of implicit cost is depreciation.

  

(xiv)  Future Costs: Historical costs are not important to managers as nothing can change what has occurred in past. All costs that are to be incurred in future are relevant for decision making.

         

(xv) Conversion Costs: Conversion costs represent all human efforts and factory required to convert raw material into finished products. In other words conversion costs = factory costs – direct material costs. 

Explicit Costs and Implicit Costs:

Explicit Costs:

(i)    This is also known as out of pocket cost

(ii)   This cost necessitates cash payment

(iii)  These costs should be payable in cash immediately. For example, bill for electricity consumed, salary of employees, rent, taxes and the like.

(iv)  These costs will affect the income.

Implicit Costs:

(i)    This cost does not necessitate cash payment.

(ii)   This cost is not payable in cash. For example, depreciation on any fixed asset is a cost. But it need not be paid in cash in present period.

(iii)  As this cost is also shown in books of account, though not payable in cash, this will also affect the net worth of the enterprise.

Imputed Costs:

Imputed Costs do not involve actual cash outlay.

They can only be estimated from similar situation as they are not actually incurred

They are not recorded in books but a factor needs to be recognized in making comparison, performance evaluation etc.

As an example: Interest on owned i.e. invested funds, rental value of company owned building, salaries of owner-directors of sole proprietorship firms.

Product Costs and Period Costs:

Product Costs:

(i)     Costs included in inventory values are called product costs

(ii)    In manufacturing organizations, raw materials costs and costs incurred in the conversion of raw materials into finished products are called product cost or inventoriable cost.

(iii)   For Trading organizations, the cost of goods purchased, and expenses incurred in bringing them to their existing location and in saleable condition are product costs.

(iv)   Product cost is a full factory cost.

(v)   This is shown in the balance sheet till they are sold off

(vi)   Product costs are included in thecost of the product. It will not affect the income till it is sold

Period Costs:

(i)    Period costs are costs that are charged against the revenue of a period of time in which they are incurred.

(ii)    Period costs like rent and salaries are incurred on the basis of time.

(iii)   Period costs include selling distribution costs and administration costs.

(iv)  These costs are charged to Profit & Loss Account.

Techniques of Cost Accounting:

a.       Uniform Costing: The practice in which common methods of costing for different undertakings in the same industry are used is known as uniform costing.

b.      Historical Costing: In this technique, ascertainment of cost is done after they have been incurred but the utility of this technique is limited.

c.       Direct Costing: The practice of charging all direct costs to operations, processes or products leaving all indirect costs to be written off against profit’s in which they arise are called as direct costing.

d.      Absorption Costing: In this all costs, both variable and fixed are charged to production, operations or processes.

e.      Marginal Costing: The method of ascertaining marginal cost by differentiating between fixed and variable costs. This technique is used to ascertain effect of changes in volume or type of output over the profits under various levels of activity.

f.        Standard Costing: The preparation of standard costs and applying them to measure the variations from actual cost and analyzing the causes of variations with a view to maintain maximum efficiency in production is known as standard costing.

g.       Activity Based Costing: ABC is a system that focuses on activities as fundamental cost objects and utilizes the cost of these activities as building blocks or compiling the costs of other cost objects.

(2)    Methods of Costing

The methods of costing are as follows:

a.       Job Costing: In this system the cost of each job is ascertained separately. It is suitable in all cases where work is undertaken on receiving a customer’s order. Like a printing press, motor work shop etc. Examples of industries where this method is suitable: House building, painting, designer garments, furniture building, ERP development and implementation, commissioning of specialized industrial plants and facilities.

b.      Batch Costing: It is considered as the extension of job costing. It represents a number of small orders passed through the factory in batch. Each batch here is treated as a separate unit of cost. Examples of industries where this method is preferred: Pharma industries, automobile components and spare parts, surgical consumables etc.

c.       Contract Costing: It is suitable for the firms which are engaged in the work of construction of bridges, roads, buildings etc.

d.      Single or Output Costing: It is used in the business where a single standard production process is used on a continuous basis to produce homogeneous units and it is desired to find the cost per unit of production. Here the distinctive feature is uniformity in output units i.e. each unit is identical on all criteria including costs charged to it. Example include Cement bags, consumer goods, pantry items, personal care and hygiene items like shaving razors, bathing soap etc.

e.      Process Costing: It is a method of costing used to ascertain the cost of a product which may passes through various processes before completion in such a way that output of first process becomes the output of second process. Industries to which this costing method is recommended include petroleum refineries, metallurgical industry, sugar industry, breweries, tanneries, distilleries etc.

f.        Operating Costing: The cost of providing a service is known as operating cost and the methods to ascertain the cost of such services is known as operating costing.

g.       Multiple Costing: In multiple costing, a combination of two or more methods of costing is used in conjunction to determine the cost of final product. This method is used by the industries where different components are separately manufactured and subsequently assembled into the finished product. For e.g.: Motor car, Television, Ships etc.

Main summary points (must-know points):

·         Cost Accounting is a specialized branch of accounting, which is concerned with the techniques and processes of ascertaining costs of products and services.

·         The emergence of cost accounting is due to limitations of financial accounting to meet the informational needs of the management in the wake of continuously rising competition.

·         Cost Accounting is a applicable to manufacturing and non-manufacturing activities in which monetary value is involved.

·         Several methods of ascertainment of costs have been devised according to the nature of operations of different industries.

·         The main objectives of cost accounting include: (Ascertainment of costs (ii) Cost control & reduction (iii) Determination of selling price, and supporting managerial decision making.

·         Cost is defined as a measurement, in monetary terms, of the amount of resources used for the purpose of production of goods or rendering of services.

·         Cost object may be defined as anything for which a separate measurement of cost may be desired, like a car, melting process in a steel mill, taxi service, etc.

·         Cost centre is a section of the organization, like a person, equipment, a department etc., for which costs may be ascertained and used for the purpose of control.

·           Cost unit is a unit of product like a tonne of sugar or service like hotel room per day in relation to which costs are ascertained.

·         Cost Accounting is a specialized branch of accounting, which is concerned with the techniques and processes of ascertaining costs of products and services.

·    The emergence of cost accounting is due to limitations of financial accounting to meet the informational needs of the management in the wake of continuously rising competition.

·     Cost Accounting is a applicable to manufacturing and non-manufacturing activities in which monetary value is involved.

·         Several methods of ascertainment of costs have been devised according to the nature of operations of different industries.

·         The main objectives of cost accounting include: (Ascertainment of costs (ii) Cost control & reduction (iii) Determination of selling price, and supporting managerial decision making.

·         Cost is defined as a measurement, in monetary terms, of the amount of resources used for the purpose of production of goods or rendering of services.

·         Cost object may be defined as anything for which a separate measurement of cost may be desired, like a car, melting process in a steel mill, taxi service, etc.

·         Cost centre is a section of the organization, like a person, equipment, a department etc., for which costs may be ascertained and used for the purpose of control.

·         Cost unit is a unit of product like a tonne of sugar or service like hotel room per day in relation to which costs are ascertained.

·      Direct costs are incurred for and conveniently identified with a particular cost unit, process or department, like cost or raw materials.

·         Indirect costs are common costs for the benefit of a number of cost units, processes or department, like depreciation of furniture and fittings or building rent.

·         Fixed costs remain constant in ‘total’ amount over a specific range of activity for a specified period of time, i.e., those, which do not increase or decrease when the volume of production changes, like building rent.

·         Variable costs are the costs which vary ion direct proportion to the volume of output. In other words, when volume of output increases, total variable cost also increases and vice-versa.

·         Semi variable costs are partly fixed and partly variable.

·         Controllable costs are the costs which may be directly regulated at a given level of management authority, whereas non-controllable costs are the costs which cannot be influenced by the action of management.

·         In management decision making, only those costs are relevant costs which are future costs and which differ under each alternative. Irrelevant costs are those that will not be affected by a managerial decision.

·         There are three elements or components of cost – (i) material (ii) labour (iii) other expenses

·         The aggregate of direct material cost, direct labour cost and direct expenses is called prime cost and aggregate of indirect material cost, indirect labour is termed as overheads. 

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