COST AND ITS CONCEPTS

The dictionary meaning of cost is :

“A loss or sacrifice”,
Or
“an amount paid or
required in payment for a
Purchase/or the production / upkeep of something,
often measured in terms of effort /time expended”.
 Introduction
Cost and its aspects

 If we set up a small manufacturing unit, say

manufacturing packing boxes, a problem will arise
with what price of each box you should quote to
the buyer.

 Many factors are considered while fixing the price

of a product/item such as competitors’ prices etc.
One of the basic factors is the cost of its production.
 Cost is essential not only to fix price but also to
ascertain the margin of profit.
 Knowledge of the cost determination is also
necessary to keep a check on the cost of
product/control on wastages etc.
 The accounting used to study the various aspects of
cost is known as cost accounting.
 According to C I M A( Chartered Institute of
Management Accountants.) terminology cost is
defined as ‘resources sacrificed or forgone to
achieve a specific objective’.
 Cost is generally measured in monetary terms
 Cost’ is a term whereas ‘Costing’ is a process
for determining the cost.
 It may be called a technique for ascertaining
the cost of production of any product .or
 service in the business organization.
 For example, The cost of preparing one pizza
which in itself includes various other costs like
the cost of flour, other ingredients, labor,
electricity, and other overheads.
 Just the same way, the cost of production of
any product or service can be determined.
 Definitions : “Costing is an estimate of all the costs
involved in a project or a business venture.”
 It is “an estimate of the cost of a product, process, etc,
for the purposes of pricing, budgeting, control, etc”
 ELEMENTS OF COSTING:
There are three elements of cost:
 cost of material, labour and expensives.

Material Cost: 
 This is the cost of material or the commodity used by
the organisation for its production purpose.
 Material is the substance, from which a product is
made.
 Thus, it may be in a raw or a manufactured state. It
can be direct or indirect.
 Direct Material Cost
 It forms an integral part of the finished
product and is identified with the individual
cost centre.
 It is also described as process material, stores
material, production material, etc.
 Example: Raw materials purchased or
purchased primary packing material, etc.
 Indirect Material Cost

It is used for ancillary purposes of the business

and cannot be conveniently identified with the
individual cost centre.

Example: Consumable stores, oil and waste,

printing and stationery material etc.
  Labour Cost:
 This is the cost, incurred in the form of
remuneration paid to the employees or
labours of the organization.
 The workforce required to convert material
into finished product is called labour.
 It can be direct or indirect.
 Direct Labour Cost
 It is the cost incurred by those employees who
directly take part in the manufacturing process
and are easily identified with the individual cost
centre.
Examples: Wages paid to the goldsmith for
making gold ornament is an example of direct
labour.
 Indirect Labour Cost
 It is the cost incurred by those employees who
do not directly take part in the manufacturing
process and cannot identify with the individual
cost center.
Example: salary of foreman, salesmen, director’s
salary, etc.
 Expenses: 
 They are the costs of services provided to the
organization. It can be direct or indirect.
 Direct Expenses are the expenses that can be
directly identified with the individual cost
centers.
 Example: hire charges of machinery, cost of
defective work for a particular job or contract
etc.
 Indirect Expenses
 They are the expenses that cannot be directly
identified with the individual cost centers.
Example: rent, lighting, telephone expenses, etc.
 
 Types of cost
 Actual Cost/Opportunity Cost
 Sunk Cost/Incremental Cost
 Explicit Cost/Implicit Cost
 Book Cost/Out Of Pocket Costs
 Accounting Costs/Economic Costs
 Direct Cost/Indirect cost
 Actual cost
 It is defined as the cost or expenditure that a
firm incurs for producing or acquiring a good
or service. 
 The actual costs or expenditures are recorded
in the books of accounts of a business unit. 
 Actual costs are also called "Outlay Costs" or
"Absolute Costs" or "Acquisition Costs".
Examples: Cost of raw materials, Wage Bill etc.
 Opportunity Cost
 Opportunity cost is concerned with the cost of
forgone opportunities/alternatives. 
 In other words, it is the return from the
second best use of the firm’s resources that
the firm forgoes in order to avail of the return
from the best use of the resources. 
 It can also be said as the comparison between
the policy that was chosen and the policy that
was rejected. 
Examples of Opportunity Cost.
 Someone gives up going to see a movie to
study for a test in order to get a good grade.
 The opportunity cost is the cost of the movie
and the enjoyment of seeing it.
 The opportunity cost of taking a vacation
instead of spending the money on a new car is
not getting a new car.
 The concept of opportunity cost focuses on
the net revenue that could be generated in
the next best use of a scarce input. 
 If a firm owns the land, there is no cost of
using the land (ie., the rent) in the firm’s
account. 
 But the firm has an opportunity cost of using
the land, which is equal to the rent forgone by
not letting the land out on rent.
 Sunk Cost
 Sunk costs are those that do not alter by varying the
nature or level of business activity. 
 Sunk costs are generally not taken into consideration
in decision-making as they do not vary with the
changes in the future. 
 Sunk costs are a part of the outlay/actual costs. 
 Sunk costs are also called "Non-Avoidable
costs" or "Inescapable costs".
Examples: 
 All the past costs are considered sunk costs.
 The best example is the amortization of past
expenses, like depreciation.
 Incremental Cost
 Incremental costs are in addition to costs
resulting from a change in the nature of the
level of business activity. 
 As the costs can be avoided by not bringing
any variation in the activity they are also
called "Avoidable Costs" or "Escapable Costs".
 More ever incremental costs resulting from a
contemplated change in the Future, they are
also called "Differential Costs"
Example: Change in distribution channels
adding or deleting a product in the product
line.
 Explicit Cost
 Explicit costs are those expenses/expenditures
that are actually paid by the firm. 
 These costs are recorded in the books of accounts. 
 They are important for calculating the profit and
loss accounts and guiding economic decision-
making. 
 These costs are also called "Paid out costs"
Example: Interest paid on borrowed funds, rent
payment, wages, utility expenses, etc.
 Implicit Cost
 Implicit costs are a part of opportunity cost.

 They are the theoretical costs ie., they are not

recognized by the accounting system and are
not recorded in the books of accounts but are
very important in certain decisions. 
 They are also called the earnings of those
employed resources which belong to the owner
himself. 
 They are also called "Imputed costs".
Examples: Rent on idle land, depreciation on the
dully depreciated property still in use, interest on
equity capital, etc.
 Book Cost
 Book costs are those business costs that don’t
involve any cash payments
 A provision is made in the books of accounts in
order to include them in the profit and loss account
 They take tax advantages, like provision for
depreciation and for the unpaid amount of the
interest on the owner’s capital
 Out Of Pocket Costs
 Out-of-pocket costs are those costs are
expenses that are current payments to the
outsiders of the firm. 
 All the explicit costs fall into the category of
out-of-pocket costs.
Examples: Rent Played, wages, salaries,
interest, etc
 Accounting Costs

 Accounting costs are the actual or outlay costs

that point out the amount of expenditure that
has already been incurred on a particular
process or on production as such accounting
costs facilitate managing the taxation need
and profitability of the firm.
Examples: All Sunk costs are accounting costs
 Economic Costs
 Economic costs are related to the future. 
 They play a vital role in business decisions as
the costs considered in decision-making are
usually future costs. 
 They have a nature similar to that of
incremental, imputed explicit, and
opportunity costs.
 Direct Cost
 Direct costs are those which have a direct
relationship with a unit of operation like
manufacturing a product, organizing a process
or an activity, etc. 
 In other words, direct costs are those which
are directly and definitely identifiable. 
 The nature of the direct costs is related to a
particular product/process, they vary with
variations in them. 
 Therefore all direct costs are variable in nature. It
is also called "Traceable Costs“
 Examples: In operating railway services, the costs
of wagons, coaches, and engines are direct costs.
 Indirect Costs
 Indirect costs are those which cannot be easily
and definitely identifiable in relation to a
plant, a product, a process, or a department. 
 Like the direct costs indirect costs, do not
vary ie., they may or may not be variable in
nature. 
 However, the nature of indirect costs depends
upon the cost under consideration. 
 Indirect costs are both the fixed and the
variable type as they may or may not vary as a
result of the proposed changes in the
production process etc.
 Indirect costs are also called Non-traceable
costs.
Example: The cost of factory building, the
track of a railway system, etc., are fixed
indirect costs, and the costs of machinery,
labor, etc.
 Overheads
 Resource consumed or lost in completing a process that
does not contribute directly to the end product is
termed overhead.

Introduction
 They are ongoing operating expenses necessary to running
a business but are not attributed to a specific business
activity. 

 Also referred to as "indirect costs or burden cost”.

 These costs are non-directly related to the production
processes but supportive in nature for the organization to
work firmly.

 These costs cannot be directly traced out to specific

products or departments.

 They are allocated into a different department and finally

to the output of the organization for the cost of the product.

 The direct part of the cost of the total cost is known as

prime cost and an indirect portion is known as overhead.
 EXAMPLE: Generally, overhead expenses include
expenses that do not directly generate revenues, such as
labor and materials, but are needed to maintain the
business operations. 
 Overhead expenses include expenses such as accounting
, advertising, depreciation, insurance, interest, legal,
rent, repairs, office supplies, taxes, information and
communications, utilities, research and development,
customer relations and service, and travel.
 Classification of overhead
 Overhead classification is the process of grouping overhead
costs according to the common characteristic and establishing
a series of the special group according to which costs are
classified.
 Overhead can be studied by classifying as follows:
a. Overhead based on elements indirect
Material/labour/expenses
b. Overhead based on function
Manufacturing/nonmanufacturing
c. Overhead based on behavior
Fixed/variable/semi-variable
d. Overhead based on control
Controllable/uncontrollable
Based on element overheads may be classified into
three different categories
Indirect material/Indirect labour/Indirect expenses
 Indirect material: The materials which play a
supplementary role in the production and cannot be
allocated to a particular unit of the product nor form a
part of the finished product.
 These materials may not be visible in the finished
product.
 So, all those materials used to assist production,
processing, administrating, selling and distribution
are indirect materials.
 For example, lubricating oil, cotton waste, and parts
used for repair and maintenance.
Indirect labour overhead:
 For production and sales different types of payment
must be made to labour, which cannot be allocated
to a particular unit of product. Such a type of cost is
known as indirect labour.
 For example, wages for repair and maintenance,
fringe benefits, pay to leave salary to the
storekeeper, Foreman etc.
 Indirect expenses
 Except for indirect material and indirect
labour, there are some other expenses, which
do not come under these headings are
indirect expenses.
 Only indirect materials and indirect labour are
not sufficient to produce and sell the product.
 For example, rent, lighting and heating,
training expenses, insurance etc.
 Overhead based on function
The total functions of an organization can be
divided into Manufacturing / Non-Manufacturing
work.
 Manufacturing function of an organization is
concerned with transferring (raw material) input
to output (finished goods).
 Likewise, the non-manufacturing function of an
organization is concerned with the office,
administration, distribution, and selling of
manufactured goods.
 Based on work/job/function
Production/ manufacturing/ factory overhead/ work
overhead: 
 The total indirect cost incurred for the manufacturing
department i.e. within the factory is manufacturing
overhead.
 It is also production overhead, factory overhead and
work overhead.
 The manufacturing overhead starts with receiving
materials to producing the final product.
 The manufacturing overhead includes:
• Factory rent or depreciation of factory building.
• Lighting and heating, fuel.
• Insurance of factory building and equipment
• Stationery and printing and equipment.
• Depreciation of plant and equipment,
• Salaries and wages of factory staff,
• Fringe and benefit of factory workers.
• Repair and maintenance of factory building and equipment
 Non-manufacturing overhead
 Office and administrative overhead without
policy formulation where the production
process does not take place.
 To prepare policy office is needed. In the
office, different types of expenses were
incurred for policy formulation and
matriculation, and management.
 It includes all such expenses which are
incurred in the office for proper management
and administration i.e., planning, controlling,
directing, etc.
some other examples of office and administrative
overhead are as:
•Office rent or depreciation of office building
•Office lighting, heating, and cleaning
•Insurance & depreciation of office building and
office equipment,
•Repair and maintenance of office building and
 office equipment
•Salaries of office staff, office manager, director,
• Postage & telephone
•Legal expenses,
• Financial expenses
•Bank charges
•Printing and stationery
• Audit fee
•Repair and maintenance of office building etc.
 Selling and distributing overhead: 
 Selling is the function, which generates revenues and
distribution by means of delivery of the product to the
customer.
 All the indirect expenses incurred for the distribution and sales
of products come under this heading.
 Salesman salaries and commission, and advertisement are
examples of selling and distribution overhead.
 It includes:
 • Samples, display material expenses
• Salary and commission of salespersons
• Advertisement expenses
• Cash discount
• Packaging charges etc.
 BASIS OF CONTROL
1. Controllable overhead: controllable overheads are
those which can be controlled by efficient management.
Those overheads which incur in a particular cost center
or decrease due to managerial decisions are known as
controllable overheads. Indirect labour indirect material,
telephone expenses, and lighting and power expenses
are examples of controllable overhead.
2. Non-controllable overhead: those overheads that are
beyond the management or which do not change due to
managerial decisions are known as non-controllable
overhead. All types of fixed overhead rent, salaries,
depreciation, etc. are the best example.
 Overhead based on behaviour
Based on behaviours/ nature of overhead, it can
be classified into three parts
Variable overhead: 
 That portion of overhead which increases or
decrease proportionately with the increase or
decrease in output is known as variable
overhead.
 The variable overhead cost per unit remains
unchanged though the production unit changes.
For example, indirect material, direct labour etc.
2.Fixedoverhead: 
 The overhead which remains constant up to a
certain level of production is called fixed
overhead. In total, it does not change, though
production unit increase or decrease. But
fixed overhead per unit decrease when
production unit increase and fixed overhead
per unit increase, when production unit
decrease. For example, rent, salary
depreciation, etc.
3. Semi-variable overhead/mixed overhead: 
 Those indirect expenses, which neither remain
constant nor change proportionately as per
change in a production unit is called semi-
variable overhead.
 Semi-variable overhead is the aggregate of
variable overhead and fixed overhead.
 Example: electricity, water supply, telephone
expenses, supervision cost, repair and
maintenance cost.
 Overhead allocation and apportionment
 Allocation of overhead means assigning overhead
to the cost centre.
 It is the process of charging overhead to a particular
department or cost centre.
 Only those costs which are directly identified or
related to any specific cost centre be allowable.
 For example, repair and maintenance of equipment
are allocated to the factory department.
 In general, there are two departments
involved in manufacturing concerns; the
production department and the service
department.
 Allocation of overhead cost means thus
allotment whole amount of overhead cost not
in proportion to the cost center.
 Apportion of overhead
 Apportion means dividing up and sharing out.
 Some overhead cannot be identified with a
specific department, to distribute such
overhead to different departments, a different
basis is used.
 A portion of overhead is based on benefit or
service received or capacity to bear cost etc.
 Importance
 Overhead and allocation of overhead are important to
all concerned organization from the following reasons:
•Overhead is a significant part of the total cost of the
product, so it needs very careful allocation.
•It helps to make proper judgment for measurement
of department efficiency.
•It helps to provide cost information for
planning, controlling, and managerial decision-
making.
•It provides the basis for product costing.
•It helps to make accurate pricing for a
competitive market.
•It provides the basis for the effective use of
available resources.
•It can be used to control wastage and
defective.
 Absorption of overheads
 Absorption of overheads refers to charging of
overheads to individual products or jobs.
 It is a process of distribution of overheads allotted
to a particular department or cost centre over the
units produced.
 The absorption of overhead is done by applying
overhead absorption rates.
 The overheads allocated or apportioned over
different cost centers or cost units are again
absorbed into the unit cost on some equitable
basis.
 JOB COSTING:
 Job costing is a technique of costing where the
amount of work done is in the form of the
number of jobs completed.
 The production takes for the customer’s
orders and not as bulk for stocking purposes.
 Moreover, the cost does not take singularly
but as a bulk of objects.
Problem: A job No. 58 passes through three
departments namely X, Y and Z.
The following information is given to you
regarding this job
 Required: You are required to calculate the
cost of job No. 58 from the above figures.
Solution:
Note: Calculation of overhead chargeable to Job
No. 58 has been made as follows:
Problem No.2 :
The following expenses were incurred for a job during
the year ended on 31st March 2019:
 Single price for the above job was $1,80,000. You
are required to prepare a statement showing the
profit earned during the year ended 31.3.2019
from the job
 UNIT COSTING

This method is generally adopted when no of units of same job is to

be manufactured.
Expenditure incurred in producing one unit of a good or service,
computed usually as average cost.
Unit Cost = (Variable Costs + Fixed Costs) / Total Units Produced
Total cost/total units
For example, ABC Company has total variable costs of $50,000
and total fixed costs of $30,000 in May, which it incurred while
producing 10,000 widgets.
The cost per unit is:
($30,000 Fixed costs + $50,000 variable costs) ÷ 10,000 units = $8
cost per unit
 In the following month, ABC produces 5,000
units at a variable cost of $25,000 and the
same fixed cost of $30,000. The cost per unit
is:
• ($30,000 Fixed costs + $25,000 variable costs)
÷ 5,000 units = $11/unit
 PROCESS COSTING
 Meaning: It is a method of costing adopted to
find out the cost of those goods which are
manufactured in stages.
 Each stage is called a process. The output of
each process becomes the input for the next
process and so on.
 The product becomes a finished product only
after it passes through the process.
 Example: R/M Passes through FG
 Example: Process costing is applicable to
products in the sugar industry, oil industry, and
paper industry. etc.
 On account of processing, certain losses occur
at each process.
 There are two types of losses in process costing.
 Abnormal loss /Normal loss
 Example: Input 20 Kgs (–) Output 18 Kgs = Loss
of 2 Kgs
 A. Normal Loss
 It is a loss due to internal factors like heating, boiling,
evaporation, etc.
 It is an expected loss.
 It is a predetermined % of the input quantity.
 It is unavoidable and therefore it is an uncontrollable loss.
 It is normally of two types:
 (a) Scrap: It has realizable value.
 (b) Weight loss: It has no realizable value because it is an
invisible process.
 It is credited to Process A/c and calculated as a % of the
input quantity.
 B. Abnormal Loss
 It is loss due to external factors like natural calamity,
loss by fire or theft, strikes, breakdown of machine,
etc.
 It is an unexpected loss.
 It is avoidable to some extent and therefore
controllable.
 It is credited to Process A/c as a balancing figure in the
quantity column.
 The amount column is calculated by using the formula:
 Abnormal Loss (Amt.) =Dr – Cr (Qty to %) /Dr – Cr (Amt
Col.) × Abnormal Loss (Qty)
 C. Abnormal Gain/Profit
 When the actual loss is less than the expected
loss, it is called an abnormal gain.
 It is due to the superior quantity of R/M Raw
material, efficient labor, advanced technology, etc.
 Recorded on the debit side of Process A/c as a
balance figure in the quantity column.
 The amount column is calculated by using the
formula:
 Abnormal Gains (Amt.) =Debit-credit(Qty
column)/Debit-credit (Amount column)x
Abnormal gain (Qty)
Q1
The Bharat Manufacturing Company’s product passes through
two distinct processes, X and Y, and then to the finished
stock. It is known from the past experience that wastage
occurs in the process as under:
In Process X, 10% of the units entering the process.
In Process Y, 5% of the units entering the process.
The scrap value of the wastages in process X is Rs.8 per 100 units and in
process Y is Rs.10 per 100 units.
 Process x
 Material cost = 6000 Rs
 Wages= 7000 Rs
 Expenses= 2000 Rs
 Process cost of X= 5000 Rs
 Total cost at process X = 20000 Rs
 Wastage at X process= 5%
 No of units at the input to X = 10000 UNITS
 wastage = 5% of 10000 = 500 units
 Final units at X=9500 units
 Scrap cost = 8Rs/100units Total scrap cost = 500 x8/100 = 40 Rs
 Cost of 9500 units at Process X =
Total cost-scrap cost/total useful units=20000-40/9500=2.1 Rs/unit
 Total cost of 9500 units at end of process x is 19960 Rs
 Process Y
 Input units at end of X=9500 units
 Cost at end of process x=19960Rs
 Material cost =3000Rs
 Wages=4000 Rs
 Expenses= 2000 Rs
 Total cost at Y = 19960+(3000+4000+2000)= 28960RS
 WASTAGE AT PROCESS Y=10% OF 9500=950 UNITS
 USEFUL UNITS =9500-950 =8550 UNITS
 COST OF SCRAP AT Y – 950X 10/100 =95 RS
 COST/UNIT AT END OF PROCESS Y = 28960-95/8550= 3.37 RS
 COST OF PROCESSING 8550 UNITS =8550X3.37=28696Rs
 BUT IT IS GIVEN THAT USEFUL UNITS AT THE END OF PROCESS Y IS 8500
UNITS HENCE ABNORMAL LOSS= 8550-8500=50 UNITS
 TOTAL LOSS= 50 X3.37=169 Rs = abnormal loss
Process Costing Problem 2:
• ABC Ltd. is producing the product “P” required to be
processed in three continuous processes. They have laid
down the standards to produce 75 litres of finished product
as under:
Stage 1
 Material cost 100x2=200 Rs
 Quantity at process 1= 100 litres
 Direct wages=no of hours x cost/hour=6x7.5
Rs=45Rs
 Cost of overhead= no of hours x
cost/hour=3.5x6=21 Rs
 Total cost at X= 200+45+21=266Rs
 Wastage at end of process X=100x0.1=10
 Useful quantity at end of X = 100-10=90 litres
Stage 2
 Input is 90 liters
 Process cost at stage 1 =266 Rs
 Cost of wages =10/hour x 10 hours =100 Rs
 Overhead cost=3Rs/hour x 10 hours= 30 Rs
 Total cost at stage 2 is 266+100+30= 396Rs
 Wastage at stage 2=11.11/100x90= 10 litres
 Useful quantity at end of process y = 90-10 80
litres
Stage 3
 No of litres 80 litres
 Cost at end of stage 2 is 396 Rs
 wages 8hoursx12.50/hour= 100 Rs
 Overhead charges=8/hour x 8 hours=64 Rs
 Total cost at end of stage 3= 396+100+64=560 Rs
 Wastage at end of stage 3=80x6.25/100=5litres
 Useful quantity =80-5=75 litres
 S.p = 9/litre
 Cp of 75 litres= 75x9= 675 Rs
 Profit=675-560=115Rs
• You are required to prepare the statement
of standard cost and standard profit rate
per 75 litres of finished product.
Process Costing Problem 3:
 The product of a manufacturing concern
passes through two processes A and B and
then to finished stock. It is ascertained that in
each process normally 5% of the total weight
is lost and 10% is scrap which from processes
A and B realizes Rs.80 per ton and Rs.200 per
ton, respectively:
• The following are the figures relating to both
the processes:
 Prepare Process Accounts showing cost per
ton of each process. There was no stock or
work-in-progress in any process.