Unit 1: Concept of Cost: Introduction (12 hours): Meaning of Cost accounting—

Comparison between financial accounts an cost accounts—Objectives and functions of cost

accounting—Cost concepts and classification of costs—cost unit—cost centre—elements of
cost—preparation of cost sheet (excluding Tender and Quotations), Advantages and
limitations of cost accounting.

Introduction:
The present days have been witnessing sweeping changes in the industrial activities.

With the onset of LPG, radical shift has taken place in the market driven economy of most of

the countries in the world. The world today is dominated by innovation and research oriented

activities. Technology has become the forerunner of the changes taking place in the world.

With all these developments, it is becoming very difficult for the management to manage the

affairs of the organisations. Unless and until they are able to scan the financial statements to

know profitability or otherwise of the enterprise, no decisions can be taken. In this respect,

the traditional financial management need to be augmented with other accounting branches so

that adequate information can be shared to the management in taking the decisions.

Cost accounting in the recent years emerged as a branch of financial accounting. It

helps the management in controlling the cost of production and thereby reducing to the

minimum so that profits can be maximised. So, to understand the emergence of cost

accounting, we need to look into the limitations of financial accounting in general.

Limitations of Financial Accounting:

1. Collective information: Financial accounting supplies the information regarding profit or

loss of the business as a whole by preparing the profit and loss account at the end of the year.

But in cost accounting the cost information is maintained unit wise, product wise, process

wise and job wise, so that effectively the cost can be controlled.

2. Historical in Nature: Financial accounts are prepared at the end of the accounting year

only after all the expenditure has been incurred and nothing is possible to control. In cost

accounting weekly, monthly, quarterly, and even on a daily basis statements are prepared.
3. Materials and Supplies are not effectively controlled: In financial accounting no

device is available to control effectively the materials purchases, stored and likely to be used

by the production department of the company. On the other hand, in cost accounting

effective material control known as Inventory Control Techniques are applied to keep a check

on the usage of materials.

4. Expenses are not classified systematically: The expenses of the business are not

classified on scientific basis such as direct and indirect, controllable and uncontrollable, fixed

and variable, etc.

5. Fails in Cost control and cost reduction: The financial accounting does not help in any

way in controlling the cost and thereby reducing it over a period of time. Thus, profitability

of the business is adversely affected.

6. Fails to provide cost information in price fixation: It is very difficult to fix the price of

the product or service in the absence of accurate information about the cost of the product.

But in cost accounting in marginal costing technique, selling price fixation will be done

efficiently.

7. No information about labour cost: In financial accounting no information is available

about the labour remuneration, incentives, bonus etc.

8. Fails to provide information for comparative appraisal of the performance: The

financial accounting does not provide financial information for comparative analysis of the

performance of the business units.

Cost, Costing, Cost Accounting and Cost Accountancy

These terms are often used interchangeably. However, there is clear distinction

between these terms in accounting language.

Cost: It means a price or value expressed in terms of money. It means cost of preparing a

product. It is the amount of expenditure incurred on a given thing or rendering service.

According to W.M.Harper, “ A cost is the value of economic resources used as a result of

producing or doing the thing costed’.

I.C.M.A. London defines, Cost as “the amount of expenditure incurred on a attributable to

a given thing”.

Types of Costs or Cost Concepts:

1. Historical Cost: These are collected after they have been incurred.

2. Future Cost: The costs which are expected to be incurred in future.

3. Replacement Cost: The cost replacing the current product or market.

4. Standard Cost: It is a predetermined cost based on each element of cost viz., material,

labour and overhead.

5. Estimated Cost: It is approximate assessment of the cost to be incurred.

6. Product Cost: The costs which can be directly charged to the product.

7. Production Cost: The prime cost plus absorbed production overhead is called production

cost.

8. Direct Cost: The costs which can be identified with a specific product, process etc.

9. Prime Cost: The aggregate of direct material cost, direct labour cost and direct expenses

is called prime cost.

10. Indirect Cost: The cost which cannot be identified to a particular product or process.

11. Fixed Cost or period cost: The cost which does not change in total for a given period of

time with any fluctuation in the production or output.

12. Variable Cost: The cost which changes in accordance with the level of activity or

output.
13. Opportunity Cost: The value of the benefit sacrificed in favour of an alternative course

of action is called opportunity cost.

14. Controllable Cost: The costs which can be controllable are called controllable costs.

15. Uncontrollable Cost: The costs which cannot be controlled by the management are

called Uncontrollable cost.

16. Imputed Cost or notional cost: The costs which are not actually incurred but considered

in cost accounts are called notional cost e.g., notional depreciation, notional interest

on own capital, etc.

17. Joint Costs or Common Costs: Joint costs are those incurred in the manufacturing of a

product wherein two or more than two products are manufactured simultaneously.

18. Sunk Cost: These are the past costs which are not taken into consideration in the decision

making process.

19. Conversion Cost: The cost incurred for converting the raw material into finished

product is called conversion costs, e.g., direct labour, direct expenses and factory

overhead.

20. Relevant Cost: The costs which are appropriate to a specific management decision is

called relevant cost.

21. Shut down Cost: The cost incurred due to shut down of the plant temporarily.

22. Out of pocket Cost: The cost which involves in the outflow of cash due to a particular

management decision.

23. Marginal Cost: It is cost of one extra unit of product or service.

24. Committed Cost: It is a fixed cost which occurs on account of decisions of prior period.

25. Avoidable Cost: It is the specific cost of an activity of business which can be avoided.
COSTING

According to I.C.M.A. London, Costing is the “technique and process of ascertaining

the costs”. Techniques are related to principles and rules governing the ascertainment of cost

of product or services. It involves two basic steps:

a. Collection and classifications of expenses according to the elements of costs.

b. Allocation and apportionment of expenditure to cost centres and cost units.

For example, Marginal Costing, Standard Costing, Budgetary Control, etc.

As a process, costing is concerned with method or procedure of ascertaining the costs.

For example, Job Costing, Batch Costing, Process Costing, Operating Costing, etc.

Thus, Wheldon has rightly defined costing as “classifying, recording and appropriate

allocation of expenditure for the ascertainment of costs of products or services”.

COST ACCOUNTING

H.J.Wheldon, Cost Accounting is the “classifying, recording and appropriate allocation of

expenditure for the determination of costs of products or services, the relation of these costs

to Sales values and the ascertainment of profitability”.

ICMA London defines cost accounting as “process of accounting for cost from the point at

which expenditure is incurred or committed to the establishment of its ultimate relationship

with cost centres and cost units. In its widest usage, it embraces the preparation of statistical

data, the application of cost control methods and ascertainment of profitability of activities

carried out or planned”.

Thus, cost accounting is a science, an art and a practice of cost ascertainment, cost

presentation and cost control.

Nature of Cost Accounting: The nature of cost accounting can be identified with the

following:

1. It is a special branch of knowledge consisting of its own principles and conventions.

2. It is an art.
3. It is a science.
4. It is a profession.
5. It is a part of Accounting, in other words, extension of financial accounting.
6. It provides cost information.
Scope of Cost Accounting: It covers the following aspects,

1. Ascertainment of cost
2. Technique and process of costing.
3. Cost control.
4. Cost Audit
5. Budgetary Control.

COST ACCOUNTANCY

It is a widest of all terms and it includes cost, costing and cost accounting, cost audit

and cost control.

ICMA London defined cost accountancy as “the application of costing and cost accounting

principles, methods and techniques to the science, art and practice of cost control and

ascertainment of profitability as well as the presentation of information for the purpose of

managerial decision making”.

Objectives of Cost Accounting:

1. Ascertaining and analysing cost and income.

2. Inventory valuation and insisting on cost control.

3. Matching cost and revenues.

4. Securing operating efficiency through cost control.

Functions of Cost Accounting

In order to realise the objectives of the cost accounting, it has to undertake the

following functions in an enterprise.

1. Recording. 2. Cost Analysis. 3. Cost Control. 4. Cost comparison. 5. Quotation and

Tenders. 6. Cost planning. 7. Cost budgeting. 8. Reporting. 9. Decision-making.

Advantages of Cost Accounting

To the management:

1. It discloses the profitability of activities.

2. It helps in cost control.
3. It helps in inventory control.
4. It aids in formulating policies.
5. It helps in decision making.
6. It guides in fixing selling price.
7. It discloses the idle capacity.
To the Workers:

1. It rewards the efficient workers.

2. It helps for fixing the standard or efficiency.
3. It helps in job security.
To the Government:

1. It helps in formulating the economic policies.

2. It helps in assessment of excise duty and income tax, import and export policies.
3. It provides cost data which is used as a base in fixing wages, price control, subsidy, etc.
4. It provides information for evaluation the public sector undertakings.
To the Society:

1. The society will get better quality product or service at reasonable price.
2. It helps in controlling the inflation in the economy.
3. It instils confidence in the public that the companies are fair and reasonable.
4. The creditors and banks are benefitted in the form of evaluation of financial position and
creditworthiness of the business.
Disadvantages or Limitations of Cost Accounting:
1. Absence of readymade system of cost accounting.
2. No uniform procedure of treating the cost concepts.
3. No use of the cost data if the management does not take the decision.
4. It may or may not be exact cost.
5. Lack of accuracy.
6. It is quite expensive.
7. It is not an exact science.
8. It fails to provide right information at the right time.
9. Notional costs are not properly treated and considered.
10. The system is more complex.
11. It lacks social accounting.
12. Not suitable for small firms.
Objections against Cost Accounting:
1. It is unnecessary.
2. It is expensive.
3. It is not universally applied.
Distinction between Financial Accounting and Cost Accounting
Basis Financial Accounting Cost Accounting
1. Purpose To prepare P&L A/c and B/S To provide cost information.
2.Statutory Compulsory as per the Companies Voluntary on the part of
requirement Act and Income Tax Act companies.
3. Nature Historical Estimation
4.Cost No cost classification Costs are classified
classification systematically.
5. Profit Ascertained as a whole Ascertained product or process
wise.
6. Reporting Periodically at the end of the year. Continuous process.
7. Applicability Usually for all business entities. Only for manufacturing units.
8. Controllability Greater control on cash and financial Greater control on material,
position labour, overheads.
9. Principles Adhered to GAAP Costing principles.
10. Valuation of Cost or market price whichever is At cost price only.
Stock less
11. Party Outsiders Management
12. Compliance As per the Companies Act As per the requirement of
management.
Systems of Costing

In costing different ways are adopted for charging costs to the product or service or a

job viz., Historical Costing, Standard Costing, Estimated Costing, and Continuous Costing.

Methods of Costing

In order ascertain the cost , different methods are adopted viz., Job Costing which

may be either Contract Costing or Batch Costing, Process Costing which includes Output

Costing, Operation Costing, Operating Costing, Composite Costing.

Techniques of Costing

To control the cost and to use the information for managerial decision making

process, the following techniques of costing are adopted viz., Marginal Costing, Standard

Costing, Absorption Costing, Uniform Costing, Budgetary Control.

Steps in installation of Cost Accounting System

1. Nature of Organisation

2. Co-operation and support of personnel

3. Simplicity

4. Maintenance of Records

5. Standardisation

Practical difficulties in installation of Cost Accounting System

1. No support from top management.

2. Opposition from the existing accounting staff.

3. Non co-operation from the workers and supervisory staff.

4. Shortage of trained staff.

COST CENTRE

A cost centre is defined as “a location, person or item of equipment for which costs

may be ascertained and used for the purpose of cost control”. ICMA London. There are three

types of cost centres viz., Production Cost Centre, Service Cost Centre and Mixed Cost

Centre.

Production Cost Centres are engaged in production of goods, eg., machine shops, Welding

Shops, etc.

Service Cost Centres are subsidiary to production costs and render service only. Indirect

expenses are incurred in these centres. E.g., Stores, Internal transport, Labour bureaus,

canteen recreation clubs, General Offices, Accounts Section, Cash Counter, etc.

Mixed Cost Centres are those which are engaged in both the production and service e.g.,

carpentry shop manufacturing furniture and as well as repair work.

COST UNIT

A Cost unit is unit of product or service or time in relation to which costs may be

ascertained and expressed. For example, Cost per tonne of steel, passenger kilometre, Cost

per machine hour, kilowatt hour, etc., There are two types of cost units (1) Single and (2)

Composite. In single cost unit, single unit of costs are used viz., per tonne, per meter, per

km. Whereas in Composite cost unit, two or more simple cost units are used viz., per

passenger km, per tonne km, etc.

CLASSIFICATION OF COSTS OR ELEMENTS OF COST

Elements of cost mean the essential parts or components of goods or services or jobs.

It is a part of total cost and includes the main item of expenditure incurred for production of

goods or services. Cost classification is the process of grouping costs according to their

common features or characteristics.

Objectives of Classification:

1. It helps the management in cost control and cost reduction.

2. It helps in calculation of cost of production.

3. It helps for valuation of work in progress.

4. It helps in fixation of selling price.

5. It helps in planning and budgeting the cost.

Methods or Basis of Classification of Cost:

1. Elements: Material Cost, Labour Cost, and Expenses.

2. Functions: Production Cost, Administrative Cost, Selling and Distribution Cost.

3. Behaviour or Nature: Fixed Costs, Variable Costs, and Semi-variable Cost.

4. Time: Historical Cost and Predicted Cost.

5. Controllability: Controllable Cost and Uncontrollable Cost.

6. Averaging : Total Cost and Unit Cost.

7. Traceability: Direct Cost and Indirect Cost.

8. Relevance to Decision Making: Relevant Cost, Imputed Cost , Junk Cost, Replacement

Cost, Sunk Cost, Shut down cost, Out of pocket cost, Marginal Cos, Differential Cost,

etc.
A. Element-wise Classification of Cost:

According to elements, costs are classified into three types viz., Material Cost, Labour

Cost and Expenses.

Material Cost: The cost of materials supplied to an undertaking are called material cost.

There are two types of material costs viz., Direct Material Cost and Indirect Material Cost.

Direct Materials: Direct materials are those materials which can enter into and form part of

the finished product. In other words, are those which can be conveniently identified and

allocated to cost units, e.g., Timber in furniture, Leather in Shoe, Clay in bricks, Cloth in

garments, etc.

Indirect Materials: Indirect materials are those materials which cannot be conveniently

identified with cost units, e.g., Nails used in furniture, Thread used in garments, Nuts and

bolts, Lubricating oil, Gum, etc.

Labour Cost: These are costs of remuneration, such as wages, salaries, commissions, bonus,

etc., of the employees of an undertaking. Labour costs may be either Direct Wages or

Indirect Wages.

Direct Wages: Wages paid to labourers who are directly engaged in converting raw

materials into finished products. It is also called Direct Labour, Productive Labour, Operating

Labour.

e.g., Tailor, Shoe maker, Carpenter, Weaver, etc.

Indirect Wages: Wages paid to labourers or workers who are not directly engaged in

converting raw materials into finished products. But they help in the production process

indirectly. E.g., Watchman, Inspector, Cleaner, Peon, Clerk, Supervisor, Time Keepers, etc.

Expenses: The expenses means the cost of services provided to an undertaking and the

notional cost of the use of owned assets. In other words, costs other than material and labour

are expenses. These expenses may be either Direct or Indirect.

Direct Expenses: Direct Expenses are those expenses which can be specifically incurred in

connection with a cost unit, e.g., Carriage inwards, octroi, freight, customs duty, import duty,

excise duty royalty paid, cost of moulds, expenses incurred for defective work, fees paid to

surveyors or architects.

Indirect Expenses: Indirect Expenses are those expenses which cannot be directly identified

with a particular job, e.g., Rent, Power, Lighting, Insurance, Carriage outwards, Advertising.

B. Function-wise Classification of Cost:

Costs are classified on the basis of functions into four viz., Production Cost,

Administration Cost, Selling Cost and Distribution Cost.

Production Cost or Manufacturing Cost or Works Cost or Factory Cost: are those costs

which begins with supplying of raw materials , labour and services and ends with the

completion of production, e.g., indirect materials, indirect labour, indirect expenses, etc.

Administration Costs: are those consists of all expenses incurred in the direction, control

and administration of an undertaking, salaries of staff, directors fees, bank charges, printing

and stationery, rent, rates, audit fees, legal charges, etc.

Selling Costs: are hose expenditures incurred for sales and stimulating demand and for

securing orders for the product, e.g., salaries and commission of salesmen, show room

expenses, samples, free fits, travelling expenses, advertising, etc.,

Distribution Costs: are those expenditure incurred for distributing the goods from the place

of production to the place of consumption, e.g., packaging, carriage outwards, warehousing,

loading, despatch expenses, etc.

C. Behaviour-wise Classification of Costs:

Costs are classified based on their behaviour or nature in relation to output or sales.

These are Variable Costs, Fixed Costs and Semi-variable or Semi-fixed Costs.
Variable Costs: are those costs which vary in direct proportion to the output or sales .

However, the variable cost per unit will remain same but in aggregate increases with the

increase in the output or sale and vice versa, e.g., direct material, direct wages, direct

expenses.

Fixed Costs: are those costs which remain fixed irrespective of the output or sales. In total

or aggregate, fixed cost remain same, however fixed cost per unit vary inversely with the

increase or decrease in the output or sales, i.e., fixed cost per unit increases with decrease in

output and decreases with the increase in the output, e.g., rent, rates, salary or works

manager, depreciation of building, interest on capital, insurance, etc.

Semi-variable Costs: are those costs which partly fixed and partly variable, e.g., Telephone

expenses, salary of supervisors, etc.,

COST SHEET

Cost sheet is a document which provides the information about estimated detailed cost

in respect of a cost centre or cost unit. It is going to summarise the cost of manufacturing a

particular product with details of costs classified, viz., prime costs, works cost, cost of

production, cost of goods sold, cost of sales, sales, profit, etc.

Purposes of Cost Sheet:

1. It gives the break-up of total cost by elements wise.

2. It discloses the total cost and cost per unit also.

3. It helps in cost comparison.

4. It helps in preparation of tenders and quotations.

5. It helps in fixing selling price.

6. It helps in ascertaining profits or loss.

Specimen copy of Cost Sheet:

In the books of XXX Co., Ltd.,

Cost Sheet for the period .....................
Output:..............in units
Particulars Total Cost per
Cost unit
Direct Materials:
Opening Stock of Materials Xxx
Add: Purchases during the year Xxx
Carriage inwards Xxx
Octroi, excise, customs duty xxx
Less: Closing Stock of Materials Xxx
Materials lost or transferred xxx
Materials Consumed xxx xx

Direct Wages or Direct Labour xxx

Direct Expenses or Chargeable expenses xxx
A. PRIME COST(Direct Cost) xxxxx xx
Add : Factory Overheads or Works Overheads or Works on xxx
Cost
Less: Sale of Scrap xx xxx
Manufacturing Cost xxxx
Add: Opening Work-in-progress xxx
Total goods processed during the period xxxx
Less: Closing Work-in-progress xxx
B. WORKS COST xxxxx xx
Add: Office & Administration Overheads xxxx
C. COST OF PRODUCTION xxxxx xx
Add: Opening Stock of Finished Goods xxx
Less: Closing Stock of Finished Goods xxx
D. COST OF GOODS SOLD OR AVAILABLE FOR xxxx
SALE
Add: Selling & Distribution Overheads xxx
E. COST OF SALES xxxx xx
Add: Profit/Loss xxx xx
F. SALES xxxx xx

Note: (i)While preparing the cost sheet financial items (income and expenses) are not
considered.
(ii)The sum of direct labour costs, direct expenses and factory overhead represents
conversion costs.
Accounting Treatment of Stocks: There are three types of stocks, viz., Stock of raw

materials, stock of work in progress and stock of finished goods.

Stock of Raw Materials:

Opening Stock of Raw Materials xxx

Add: Purchases during the year xxx
xxx
Less: Closing Stock of Raw Materials xxx
Cost of Raw Materials Consumed xxx

Stock of Work-in-Progress:

Prime Cost xxx

Add: Factory Oveheads or Works on Cost xxx
Manufacturing Cost xxx
Add: Opening Stock of Work-in-Progress xxx
Total Goods processed during the year xxx
Less: Closing Stock of Work-in-Progress xxx
Factory or Works Cost xxx

Stock of Finished Goods:

Cost of Production xxx

Add: Opening Stock of Finished Goods xxx
xxx
Less: Closing Stock of Finished Goods xxx
Cost of Goods Sold or Cost of goods available for sale xxx