Concepts

COST ASCERTAINMENT - ELEMENTS OF COST:

Material Costs: (i) Procurement of Materials, (ii) Inventory Management and Control, (iii) Inventory
Accounting & Valuation (iv) Physical Verification, treatment of losses (v) Scrap, spoilage,
defectives and wastage.

Employee Costs: (i) Time keeping, Time booking and payroll, (ii) Labour Turnover, Overtime and
idle time (iii) Principles and methods of remuneration and incentive schemes (iv) Employee cost
reporting and measurement of efficiency.

Direct Expenses

Overheads: (i) Collection, classification and apportionment and allocation of overheads (ii)
Absorption and treatment of over or under absorption of overheads (iii) Reporting of overhead costs
Cost Allocation
When items of cost are identifiable directly with some products or departments such costs are charged
to such cost centres. This process is known as cost allocation. Wages paid to workers of service
department can be allocated to the particular department. Indirect materials used by a particular
department can also be allocated to the department. Cost allocation calls for two basic factors - (i)
Concerned department/product should have caused the cost to be incurred, and (ii) exact amount of
cost should be computable.

Cost Apportionment
When items of cost cannot directly charge to or accurately identifiable with any cost centres, they are
prorated or distributed amongst the cost centres on some predetermined basis. This method is known
as cost apportionment. Thus we see that items of indirect costs residual to the process of cost
allocation are covered by cost apportionment. The predetermination of suitable basis of
apportionment is very important and usually following principles are adopted - (i) Service or use (ii)
Survey method (iii) Ability to bear. The basis ultimately adopted should ensure an equitable share of
common expenses for the cost centres and the basis once adopted should be reviewed at periodic
intervals to improve upon the accuracy of apportionment.
Cost Absorption
Ultimately the indirect costs or overhead as they are commonly known, will have to be distributed over the final
products so that the charge is complete. This process is known as cost absorption, meaning thereby that the costs
absorbed by the production during the period. Usually any of the following methods are adopted for cost absorption -
(i) Direct Material Cost Percentage (ii) Direct Labour Cost Percentage (iii) Prime Cost Percentage (iv) Direct Labour
Hour Rate Method (v) Machine Hour Rate, etc. The basis should be selected after careful maximum accurancy of
Cost Distribution to various production units. The basis should be reviewed periodically and corrective action
whatever needed should be taken for improving upon the accuracy of the absorption.

Conversion Cost
This term is defined as the sum of direct wages, direct expenses and overhead costs of converting raw material to the
finished products or converting a material from one stage of production to another stage. In other words, it means the
total cost of producing an article less the cost of direct materials used. The cost of indirect materials and consumable
stores are included in such cost. The compilation of conversion cost is useful in a number of cases. Where cost of
direct materials is of fluctuating nature, conversion cost is used to cost control purpose or for any other decision
making. In contracts/jobs where raw materials are on account of the buyers conversion cost takes the place of total
cost in the books of the producer. Periodic comparison/review of the conversion cost may give sufficient insight as to
the level of efficiency with which the production unit is operating.
Cost Control
Cost Control is defined as the regulation by executive action of the costs of operating an undertaking,
particularly where such action is guided by Cost Accounting

Cost Reduction
Profit is the resultant of two varying factors, viz., sales and cost. The wider the gap between these two factors,
the larger is the profit. Thus, profit can be maximised either by increasing sales or by reducing costs. In a
competition less market or in case of monopoly products, it may perhaps be possible to increase price to earn
more profits and the need for reducing costs may not be felt. Such conditions cannot, however, exist paramount
and when competition comes into play, it may not be possible to increase the sale price without having its
adverse effect on the sale volume, which, in turn, reduces profit. Besides, increase in price of products has the
ultimate effect of pushing up the raw material prices, wages of employees and other expenses- all of which tend
to increase costs. In the long run, substitute products may come up in the market, resulting in loss of business.
Avenues have, therefore, to be explored and method devised to cut down expenditure and thereby reduce the cost
of products. In short, cost reduction would mean maximization of profits by reducing cost through economics
and savings in costs of manufacture, administration, selling and distribution.
Classification based on Costs for Management Decision Making

Ascertainment of cost is essential for making managerial decisions. On this basis costing may be
classified into the following types.

Marginal Costing:
Marginal Cost is the aggregate of variable costs, i.e. prime cost plus variable overhead. Marginal
cost per unit is the change in the amount at any given volume of output by which the aggregate
cost changes if the volume of output is increased or decreased by one unit. Marginal Costing
system is based on the system of classification of costs into fixed and variable. The fixed costs are
excluded and only the marginal costs, i.e. the variable costs are taken into consideration for
determining the cost of products and the inventory of work-in-progress and completed products.

Differential Cost:
Differential cost is the change in the cost due to change in activity from one level to another.
Opportunity Cost:
Opportunity cost is the value of alternatives foregone by adopting a particular strategy or employing
resources in specific manner. It is the return expected from an investment other than the present one.
These refer to costs which result from the use or application of material, labour or other facilities in a
particular manner which has been foregone due to not using the facilities in the manner originally
planned. Resources (or input) like men, materials, plant and machinery, finance etc., when utilized in
one particulars way, yield a particular return (or output). If the same input is utilized in another way,
yielding the same or a different return, the original return on the forsaken alternative that is no longer
obtainable is the opportunity cost. For example, if fixed deposits in the bank are proposed to be
withdrawn for financing project, the opportunity cost would be the loss of interest on the deposits.
Similarly when a building leased out on rent to a party is got vacated for own purpose or a vacant
space is not leased out but used internally, say, for expansion of the production programme, the rent
so forgone is the opportunity cost.
Replacement Cost:
Replacement cost is the cost of an asset in the current market for the purpose of replacement. Replacement cost is
used for determining the optimum time of replacement of an equipment or machine in consideration of
maintenance cost of the existing one and its productive capacity. This is the cost in the current market of replacing
an asset. For example, when replacement cost of material or an asset is being considered, it means that the cost that
would be incurred if the material or the asset was to be purchased at the current market price and not the cost, at
which it was actually purchased earlier, should be take into account.

Relevant Costs:
Relevant costs are costs which are relevant for a specific purpose or situation. In the context of decision making,
only those costs are relevant which are pertinent to the decision at hand. Since we are concerned with future costs
only while making a decision, historical costs, unless they remain unchanged in the future period are irrelevant to
the decision making process.

Imputed Costs:
Imputed costs are hypothetical or notional costs, not involving cash outlay computed only for the purpose of
decision making. In this respect, imputed costs are similar to opportunity costs. Interest on funds generated
internally, payment for which is not actually made is an example of imputed cost. When alternative capital
investment projects are being considered out of which one or more are to be financed from internal funds, it is
necessary to take into account the imputed interest on own funds before a decision is arrived at.
Sunk Costs:
Sunk costs are historical costs which are incurred i.e. sunk in the past and are not relevant to the particular
decision making problem being considered. Sunk costs are those that have been incurred for a project and
which will not be recovered if the project is terminated. While considering the replacement of a plant, the
depreciated book value of the old asset is irrelevant as the amount is sunk cost which is to be written-off at
the time of replacement.

Normal Cost & Abnormal Cost:

Normal Cost is a cost that is normally incurred at a given level of output in the conditions in which that
level of output is achieved. Abnormal Cost is an unusual and typical cost whose occurrence is usually
irregular and unexpected and due to some abnormal situation of the production.

Avoidable Costs & Unavoidable Costs:

Avoidable Costs are those which under given conditions of performance efficiency should not have been
incurred. Unavoidable Costs which are inescapable costs, which are essentially to be incurred, within the
limits or norms provided for. It is the cost that must be incurred under a programme of business restriction.
It is fixed in nature and inescapable.
Uniform Costing:
This is not a distinct system of costing. The term applies to the costing principles and procedures which are
adopted in common by a number of undertakings which desire to have the benefits of a uniform system. The
methods of Uniform Costing may be extended so as to be useful in inter-firm comparison.

Engineered Cost:
Engineered Cost relates to an item where the input has an explicit physical relationship with the output. For
instance in the manufacture of a product, there is a definite relationship between the units of raw material and
labour time consumed and the amount of variable manufacturing overhead on the one hand and units of the
products produced on the other. The input-output relationship can be established the form of standards by
engineering analysis or by an analysis of the historical data. It should be noted that the variable costs are not
engineered cost but some administration and selling expenses may be categorized as engineered cost.

Out-of-Pocket Cost:
This is the portion of the cost associated with an activity that involve cash payment to other parties, as opposed
to costs which do not require any cash outlay, such as depreciation and certain allocated costs. Out-of-Pocket
Costs are very much relevant in the consideration of price fixation during trade recession or when a make-or-
buy decision is to be made.
Managed Cost:
Managed (Programmed or Discretionary) Costs all opposed to engineering costs, relate to such items where
no accurate relationship between the amount spent on input and the output can be established and sometimes
it is difficult to measure the output. Examples are advertisement cost, research and development costs, etc.,

Common Costs:
These are costs which are incurred collectively for a number of cost centres and are required to be suitably
apportioned for determining the cost of individual cost centres.
Examples are: Combined purchase cost of several materials in one consignment, and overhead expenses
incurred for the factory as a whole.

Controllable and Non-Controllable Costs:

Controllable Cost is that cost which is subject to direct control at some level of managerial supervision.
Non-controllable Cost is the cost which is not subject to control at any level of managerial supervision.
Techniques of Costing:

A. Marginal Costing

B. Standard Costing

C. Budgetary Control

D. Uniform Costing
A. Marginal costing:

Marginal Costing is the ascertainment of marginal costs and of the effect on profit of changes in
volume or type of output by differentiating between fixed costs and variable costs. Several other
terms in use like Direct Costing, Contributory Costing, Variable Costing, Comparative Costing,
Differential Costing and Incremental Costing are used more or less synonymously with Marginal
Costing. The term direct cost should not be confused with direct costing. In absorption Costing,
direct cost refers to the cost which is attributable to a cost centre of cost unit (e.g., direct labour,
direct material and direct expenses including traceable fixed expenses, i.e., the fixed expense
which are directly chargeable). In Direct Costing (or Marginal Costing), factory variable
overhead is taken as a direct cost while in the Absorption Cost Method, it is Indirect Cost.
B. Standard Costing:

Standard Costing is defined as the preparation and use of standard cost, their comparison with actual costs and the
measurement and analysis of variances to their causes and points of incidence. Standard Cost is a predetermined
cost unit that is calculated from the management’s standards of efficient operation and the relevant necessary
expenditure. Standard Costs are useful for the cost estimation and price quotation and for indicating the suitable
cost allowances for products, process and operations but they are effective tools for cost control only when
compared with the actual costs of operation. The techniques of standard costing may be summarised as follows :-

(i) Predetermination of technical data related to production. i.e., details of materials and labour operations
required for each product, the quantum of inevitable losses, efficiencies expected, level of activity, etc.
(ii) Predetermination of standard costs in full details under each element of cot, viz., labour, material and
overhead.
(iii) Comparison of the actual performance and costs will the standards and working out the variances, i.e., the
differences between the actual and the standards.
(iv) Analysis of the variances in order to determine the reasons for deviations of actuals from the standards.
(v) Presentation of information to the appropriate level of management to enable suitable action (remedial
measures or revision of the standard) being taken.
C. Budgetary Control:

Budgetary Control may be defined as the process of continuous comparison of actual

costs and performance with the pre-established budgets in relation to the responsibilities
of the executives to the specific budgets for the achievement of a target in accordance
with the policy of the organisation and to provide a basis for revision of budget.
Therefore, Budgetary Control involves mainly establishment of budgets, continuous
compassion of actual with budgets for achievement of targets, revision of budgets in the
light of changed circumstances. The classification of budgets into various categories
certainly helps to make the budgetary control more effective because the maximum use
is made of the functional budgets. Functional Budgets over the goals to be attained by
the functional executives and thus assume the greatest significance.
D. Uniform Costing:

Uniform Costing may be defined as the application and use of the same costing principles and procedures by different
Organizations under the same management or on a common understanding between members of an association. It is
thus not a separate technique or method. It simply denotes a situation in which a number of organizations may use the
same costing principles in such a way as to produce costs which are of the maximum comparability. From such
comparable costs valuable conclusions can be drawn. When the Uniform Costing is made use of by the different
concerns the same management it helps to indicate the strengths and/or weaknesses of those concerns. By studying
the findings, appropriate corrective steps may be taken to improve the overall efficiency of the organizations. When
used by the member concerns of a trade association Uniform Costing helps to reduce expenditure on a comparative
marketing, to determine and follow a uniform pricing policy, to exchange information between the members for
comprised and improvement and so on. Inter-firm Comparison as the name denotes means the techniques of
evaluating the performances, efficiencies, deficiencies, costs and profits of similar nature of firms engaged in the
same industry or business. It consists of exchange of information, voluntarily of course, concerning production, sales
cost with various types of break-up, prices, profits, etc., among the firms who are interested of willing to make the
device a success. The basic purposes of such comparison are to find out the work points in an organization and to
improve the efficiency by taking appropriate measures to wipe out the weakness gradually over a period of time.