cost and cost concepts - reading materials

8/10/2019 Cost and Cost Concepts - Reading Materials

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S.K.PADHI, XAVIER INSTITUTE OF MANAGEMENT, BHUBANESWAR Page 1

COST CONCEPTS

( IN HOUSE READING MATERIAL )

COST & COST ACCOUNTING:

The definition of cost is different for different users. Generally we understand that cost of a product is

the sum of all expenditure incurred to produce the same. It includes the material, labour and expenses

incurred for producing the product. The same understanding of cost can be extended to rendering ofservice. In case of services, the material cost will be much less and the labour and other expenses will

be higher. The process through which these data relating to expenditure of material, labour and

expenses are captured is called cost accounting. Accounting is the language of business. While the

primary focus of Financial Accounting is providing information for use of external stakeholders, Cost

Accounting ( and the modern age Cost and Management Accounting) provides timely and relevant

information to managers for planning, control and decision making.

WHY TO KNOW ABOUT COST:

1. For a Price taker : Cost Minimization2. For a Price fixer : Determination of Price for a desired return

COST FOR WHOM:

Is it the cost to the buyer or seller ? For example let us consider a product X, per unit cost to a buyeris Rs.10/-. Therefore, the cost to the seller should be less than Rs.10/- ( if the seller is into a business

activity ) . Here, the Rs.10 should have a component of profit.

BASIC COST EQUATION: COST = SALES PRICE - PROFIT

COST CLASSIFICATION

Elements

Behaviour

Functions

Normality

Control

Decision Making


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ELEMENTS

Cost has been classified broadly into three elements namely:

1. MATERIAL:

The substance from which the product is made is known as material. It may be raw or a

manufacture state. It can be direct as well as indirect.

i. Direct Material:

All materials which becomes an integral part of the finished product and which can be

conveniently assigned to specific physical units is termed as Direct Material. The following are

some of the examples of direct material:

All materials or components specifically purchased, produced or requisitioned from stores.

Primary packing material (e.g., carton, wrapping, cardboard, boxes, etc.)

Partly produced or purchased components.

ii. Indirect Material :

All materials which is used for purposes ancillary to the business and which can notconveniently be assigned to specific physical units, is termed as 'indirect material'. Consumable

stores, oil an waste, printing and stationery material, etc., are a few examples of indirect

material.

2. LABOUR

For conversion of materials into finished goods, human effort is needed. Such human effort is

called labour. Labour can be direct as well as indirect.

i. Direct Labour :

Labour which takes an active and direct part in the production of a particular commodity iscalled direct labour. Direct labour costs are, therefore, specifically and conveniently traceable

to specific products.

ii. Indirect Labour :

Labour employed for the purpose of carrying out tasks incidental to goods produced or servicesprovided is indirect labour. Such labour does not alter the construction, composition or

condition of the product. It can not be practically traced to specific units of output. Wages of

store-keepers, foremen, timekeepers, directors' fees, salaries of salesmen, etc., are all examples

of indirect labour costs.

3. EXPENSESExpenses may be direct or indirect.

i. Direct expenses :


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These are expenses which can be directly, conveniently and wholly allocated to specific costcenters or cost units. Examples of such expenses are : hire of some special machinery requiredfor a particular job or contract, etc.

ii. Indirect Expenses :

These-are expenses which can not be directly, conveniently, and wholly allocated to cost

centers or cost units. Examples of such expenses are rent, lighting, insurance charges, etc.

OVERHEADS

The term overhead includes indirect material, indirect labour and indirect expenses. Thus, all

indirect costs are overheads. '

A manufacturing organization can be broadly divided into three divisions.

Factory or Works, where production is done

Office and administration, where routine as well as policy matters are decided. Selling and distribution, where products are sold and finally dispatched to the customers.

Overheads may be incurred in the factory or office or selling and distribution divisions. Thus,overheads may be of three types.

Factory Overheads: They include:

Indirect material used in the factory such as lubricants, oil, consumable stores, etc.

Indirect labour such as gate-keeper's salary, time-keeper's salary, works manager's salary, etc.

Indirect expenses such as factory rent, factory insurance, factory lighting, etc.

Office and Administration Overheads : They include:

Indirect material used in the office such as printing and stationery material, brooms and dusters,etc.

Indirect labour such as salaries payable to office manager, office accountant, clerks, etc.

Indirect expenses such as rent, insurance, lighting of the office.

Selling and Distribution Overheads : They include:

Indirect material used such as packing material, printing material and stationery material, etc.

Indirect labour such as salaries of salesmen and sales manager, etc.

Indirect expenses such as rent, insurance, advertising expenses, etc.

BEHAVIOUR

Fixed Cost: These are the costs which remain constants irrespective of the quantum of output withinand to the capacity that has been built up. Examples of such costs are; rent, insurance charges,

management salaries etc. Fixed cost remain constant per unit of time. As a result, they decrease perunit with every increase in output and vice versa. Fixed cost sometimes are also referred to as period

costs. They can further be divided into i. Committed fixed cost and it. Discretionary fixed costs.

Committed Fixed Costs consists largely of those fixed costs that arise from the possession of plant,equipment and a basic organizational structure. For example, once a building is constructed and plant

is installed, nothing much can be done to reduce the costs such as depreciation, property taxes,


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wastage of power in his department, but he can not control the power which is being wasted in the

power house itself resulting in higher cost per unit of power to him. Similarly he can not control theincrease in the cost of materials consumed in his department if the purchase department, which is the

supplying department, buys the material in higher prices due to its own inefficiency. Such costs are

controllable at some other level of the management.

DECISION MAKING

Direct and indirect Cost

Direct Costs: These are costs which can be directly, conveniently and wholly traced to a product,service or job. Example of such costs are: direct material, direct labour and direct expenses.

Indirect costs: These are costs which can not be directly, conveniently and wholly identified with aspecific product, service or job. They include all overhead costs such as salaries of time keepers, store

keepers, foreman, printing and stationery costs, etc- Indirect or overhead costs are apportioned to

different Jobs, products or services on a reasonable basis. For example, the indirect factory labour costmay be apportioned over different jobs according to their direct labour cost.

SHUT DOWN AND SUNK COSTS

Shut Down Costs: These represent the fixed costs which have to be incurred even during the periodwhen factory is shut down on account of some temporary difficulties, viz., shortage of raw materials,

non-availability of requisite labour force, etc. during this period, though no work is done, the fixed

costs, such as rent, insurance, depreciation, maintenance, etc. for the entire plant have still to beincurred. Such costs of the idle plan! are known as shut down costs.

Sunk Costs: These are historical or past costs, that is, costs which have been incurred as a result of adecision-made in the past. Such costs cannot be reversed or revised by subsequent decisions.

Investments in plant and machinery, building, etc. are some prominent examples of such costs. Sunkcosts are considered hot relevant for decisions concerning the increase in the present profit levels.

Imputed or Hypothetical Costs: These are costs which do not involve cash outlay. They are notincluded in cost accounts but arc important for making managerial decision making. If two projects

required unequal outlays of cash, the management must take into consideration interest on capital to

judge the relative profitability of the projects.

Differential, Incremental or Decremental Costs: The difference in total costs between twoalternatives is termed as differential cost. In case the choice of an alternative results in increase in the

total costs, the resulting decrease is known as decremental costs. While assessing the profitability of a

proposed change, the incremental costs are matched with incremental revenues.

Out-of-Pocket Costs: Out-of-Pocket cost means the present or future cash expenditure regarding acertain decision which may vary, depending upon the nature of the decision made. For example acompany has its own trucks for transporting raw materials and finished products from one place to

another. It seeks to replace these trucks by employing public carriers of goods. In making this

decisions, of course, the depreciation of the trucks is not to be considered, but the management musttake into account the present expenditure on fuel, salary to drivers and maintenance which have to be

incurred in cash. Such costs for arriving at a decision arc termed as out-of-pocket costs.

Opportunity Costs: Opportunity cost refers to the advantage, in measurable terms, which has been


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1'orcgoi on accounting of not using the facilities in the manner originally planned. For example, if an

owned building proposed to be utilized for housing a new project plant, the likely revenue, which thebuilding could fetch, if rented out, is the opportunity cost which should be taken into account while

evaluating the profitability of the project.

TRACEABLE, UNTRACEABLE AND JOINT COSTS

Traceable Costs: These are costs which can be identified or traced to specific products, services or

units of the company such as raw material and labour, etc.

Untraceable Costs: These are costs which cannot be identified with a department process or product.Such costs are also termed as common costs, as they are incurred collectively for a number of products

or cost centers e.g., overheads incurred for the factory as a whole. As such they arc apportioned among

various products or cost centers using suitable criterion.

Joint Costs; whenever two or more products are produced out of one and the same raw material orprocess the cost of material purchased and the processing are called joint costs. Take the example of anoil refinery. where a range of products such as bitumen, petrol, kerosene, diesel, etc. are derived in the

process of refinery crude oil. All these products have joint costs comprising the cost of crude and the

cost incurred in the course of refining. These joint costs are then apportioned to various products onsome basis.

Conversion Cost: The cost of transforming direct materials into finished products, exclusive of directmaterial cost, is known as conversion cost. It is usually taken as the aggregate of the cost of direct

labour, direct expenses and factory overheads.

Relevant Cost

Relevant costs are those future costs which differ between alternatives. Relevant costs may also bedefined as the costs which are affected and changed by a decision. On the contrary, irrelevant costs arethose costs which remain the same and not affected by the decision whatever alternative is chosen.

The above classification and concepts of costs help the management in the decision making process.

For example, segregation of cost into fixed and variable elements will help the management inanalyzing the total cost. Similarly, segregation of cost into controllable and uncontrollable categorieswill help the management in fixing responsibilities of different executives for unfavorable cost

variances.

STATEMENT OF COST

The elements or components of total cost can be presented in the form of a statement, popularly knownas cost sheet'. The cost sheet may be prepared separately for each cost center. It may have columns to

show total cost per unit, together with the relevant figures of the previous period.

TREATEMENT OF STOCK IN COST SHEET

1. Stock of raw material

2. Stock of W.I.P.

3. Stock of Finished product


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DIFFERENT COSTS FOR DIFFERENT PURPOSES

Cost of a product /process can be ascertained by:

1. Absorption costing

2. Marginal costing

ABSORPTION COSTING

Traditional or full cost method :

Cost of a product = V. C. + F. C.

Variable costs are directly charged to the product. Fixed costs are apportioned on suitable basis.

DISADVANTAGES:

It assumes that prices are simply a function of costs.

It includes past costs which may not be relevant to the pricing decision at hand.

CASE STUDY

THE FOLLOWING DATA RELATES TO A COMPANY:

Expected sales : 50,000 units , // Direct material cost : Rs. 2.50 per unit

Direct labour cost : Rs.2.00 per unit , // Variable Overhead :Rs. 1.50 per unit

Fixed cost : Rs. 1.50 per unit , // Selling price : Rs.10 per unit

The firm expects to get a special export order for 10,000 units at a price of Rs. 7.75 per unit. Advisewhether the export order should be accepted or not. The company has a capacity to produce 60,000

units.

INFERENCES: 1. An organization has different costs having different nature. Example;

Fixed, variable. Mixed cost

2. These costs behave differently to changes in the level of business activity.

3. Understanding this relationship helps in planning, control and developing successful business

strategies.

MARGINAL COSTING

Direct costing/ Variable Costing - a technique

Ascertainment of M.C- by differentiating between F.C.& V.C. and of the effect on profit ofchanges in volume or level of output.

Cost of a product:

Only VCs are considered :Product cost


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FCs are charged against the revenue of the period i.e. FC = Period costs

Valuation of inventory at M.C.

Contribution =C=S-V=F+P

Price = M.C. + Contribution

MARGINAL COST

Economists : The cost of producing one additional unit of output is the marginal cost of production.

BREAK-EVEN ANALYSIS

Narrow Sense : It refers to a sense of determination of that level of activity where total cost equals sell

price.

Broad Sense : It refers to that system of analysis which determines the probable profit at any level ofactivity (refers to Cost- Volume- Profit Analysis)

BEP - Represents a minimum acceptable level of operation

Level of activity where income equals expenditure

No profit no loss point

SALES FOR A DESIRED PROFIT

Sales = (FC+ desired profit) / p/v ratio

C = S - V = F + P

At BEP, P=0; Thus, C=F

Or, Units at BEP x Contribution per unit = F

Or, BEP(units) = F / Contribution per unit

BEP (sales) = F / Cont. per unit x S.P.per unit

=F /Cx S=F/c/s

= F / p/v ratio

C/S (P/V) ratio = Contribution / Sales = C/S

= Change in Profit / Change in Sales

MOS = Total SalesBEP Sales

BREAKEVEN ANALYSIS FOR MULTIPLE PRODUCTS

Multi products Company has a sales ratio of 2: 3: 5 for models X, Y and Z respectively. Total fixed

cost for year are Rs. 200,000, the other information are as follows:

Model X Model Y Model Z


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Sales Price Rs. 50 Rs. 25 Rs. 10

Variable Costs Rs. 30 Rs. 15 Rs. 8

Contribution Margin Rs. 20 Rs. 10 Rs. 2

A market basket approach is used to compute the breakeven point in units.

COST -VOLUME - PROFIT ANALYSIS

One of the decision models

One aspect of CVP Analysis is breakeven Analysis

A useful technique for planning profits (budgeting) pricing decisions, sales-mix decisions and

production capacity decisions.

CVP Analysis evaluates the effects of:

Price changes on Net Profit Volume changes on NP Price and volume changes on NP

An increase or decrease in VC on NP An increase or decrease in FC on NP

All four factors, viz., price, volume, VC and PC on NP.

WHAT IS PRICE :

Price is the amount of money charged for a product or service. It can also be defined as the sum of allthe values that consumers exchange for the benefits of having or using the product or service.Dynamic

Pricing: charging different prices depending on individual customers and situations.

HOW TO DETERMINE :

Pricing a product is a tough job. There is no single or instant formula available for setting the bestprice. It is also not easy to provide an answer for a decision. Mostly it is judgmental in nature based on

available information. The inherent risk are if it is highly priced, one may lose sales and if it is lowpriced, there is a possibility of loss of profit.

COST CENTRE

Manager is held accountable only for costs

incurred.

Out put of cost center is not measured in

monetary terms.

Evaluation: Actual cost vs. Budgeted cost

Employed in: Legal Dept, Accounting. Dept, Public Relation Dept, HRDept.

REVENUE CENTRE

Manager is held accountable for revenues

only.


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Evaluation : Actual Revenue Vs. Budgeted

Revenue Employed in : Sales Dept.,

Product Centre. .

PROFIT CENTRE

Manager is held responsible for both costs(inputs) and

revenues(outputs). i.e.,.. profits

Inputs and out puts are capable of financial

measurement.

Measures effectiveness and efficiency and

motivates managers.

Employed in: Production Dept., production

centers.

INVESTMENT CENTRE

Manager is responsible for costs, revenues as well as investment in

assets used.

Evaluation by profit and ROI

A measure of overall performance, and facilitates comparison.

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