Cost Concepts

Basic Cost Concepts
Learning Objectives
 To understand the meaning of different costing terms
 To understand different costing methods
 To have a basic idea of different costing techniques
 To understand the meaning of cost sheet
In order to determine and take a dispassionate view about what lies beneath the surface of accounting figures, a financial analyst has to make use of different management accounting techniques. Cost techniques have a precedence over the other techniques since accounting treatment of cost is often both complex and financially significant. For example, if a firm proposes to increase its output by 10%, is it reasonable to expect total cost to increase by less than 10%, exactly 10% or more than 10%? Such questions are concerned with the cost behavior, i.e. the way costs change with the levels of activity. The answers to these questions are very much pertinent for a management accountant or a financial analyst since they are basic for a firm’s projections and profits which ultimately become the basis of all financial decisions. It is, therefore, necessary for a financial analyst to have a reasonably good working knowledge about the basic cost concepts and patterns of cost behavior. All these come within the ambit of cost accounting.
Meaning of Cost Accounting
Previously, cost accounting was merely considered to be a technique for the ascertainment of costs of products or services on the basis of historical data. In course of time, due to competitive nature of the market, it was realized that ascertaining of cost is not so important as controlling costs. Hence, cost accounting started to be considered more as a technique for cost control as compared to cost ascertainment. Due to the technological developments in all fields, cost reduction has also come within the ambit of cost accounting. Cost accounting is, thus, concerned with recording, classifying and summarizing costs for determination of costs of products or services, planning, controlling and reducing such costs and furnishing of information to management for decision making.
According to Charles T. Horngren, cost accounting is a quantitative method that accumulates, classifies, summarizes and interprets information for the following three major purposes:
 Operational planning and control
 Special decisions
 Product decisions
According to the Chartered Institute of Management Accountants, London, cost accounting is the process of accounting for costs from the point at which its expenditure is incurred or committed to the establishment of the ultimate relationship with cost units. In its widest sense, it embraces the preparation of statistical data, the application of cost control methods and the ascertainment of the profitability of the activities carried out or planned.
Cost accounting, thus, provides various information to management for all sorts of decisions. It serves multiple purposes on account of which it is generally indistinguishable from management accounting or so-called internal accounting. Wilmot has summarized the nature of cost accounting as “the analyzing, recording, standardizing, forecasting, comparing, reporting and recommending” and the role of a cost accountant as “a historian, news agent and prophet.” As a historian, he should be meticulously accurate and sedulously impartial. As a news agent, he should be up to date, selective and pithy. As a prophet, he should combine knowledge and experience with foresight and courage.
Objectives of Cost Accounting
The main objectives of cost accounting can be summarized as follows:
1. Determining Selling Price
Business enterprises run on a profit-making basis. It is, thus, necessary that revenue should be greater than expenditure incurred in producing goods and services from which the revenue is to be derived. Cost accounting provides various information regarding the cost to make and sell such products or services. Of course, many other factors such as the condition of market, the area of distribution, the quantity which can be supplied etc. are also given due consideration by management before deciding upon the price but the cost plays a dominating role.
2. Determining and Controlling Efficiency
Cost accounting involves a study of various operations used in manufacturing a product or providing a service. The study facilitates measuring the efficiency of an organization as a whole or department-wise as well as devising means of increasing efficiency.
Cost accounting also uses a number of methods, e.g., budgetary control, standard costing etc. for controlling costs. Each item viz. materials, labor and expenses is budgeted at the commencement of a period and actual expenses incurred are compared with budget. This greatly increases the operating efficiency of an enterprise.
3. Facilitating Preparation of Financial and Other Statements
The third objective of cost accounting is to produce statements whenever is required by management. The financial statements are prepared under financial accounting generally once a year or half-year and are spaced too far with respect to time to meet the needs of management. In order to operate a business at a high level of efficiency, it is essential for management to have a frequent review of production, sales and operating results. Cost accounting provides daily, weekly or monthly volumes of units produced and accumulated costs with appropriate analysis. A developed cost accounting system provides immediate information regarding stock of raw materials, work-in-progress and finished goods. This helps in speedy preparation of financial statements.
4. Providing Basis for Operating Policy
Cost accounting helps management to formulate operating policies. These policies may relate to any of the following matters:
o Determination of a cost-volume-profit relationship
o Shutting down or operating at a loss
o Making for or buying from outside suppliers
o Continuing with the existing plant and machinery or replacing them by improved and economic ones
Concept of Cost
Cost accounting is concerned with cost and therefore is necessary to understand the meaning of term cost in a proper perspective.
In general, cost means the amount of expenditure (actual or notional) incurred on, or attributable to a given thing.
However, the term cost cannot be exactly defined. Its interpretation depends upon the following factors:
• The nature of business or industry
• The context in which it is used
In a business where selling and distribution expenses are quite nominal the cost of an article may be calculated without considering the selling and distribution overheads. At the same time, in a business where the nature of a product requires heavy selling and distribution expenses, the calculation of cost without taking into account the selling and distribution expenses may prove very costly to a business. The cost may be factory cost, office cost, cost of sales and even an item of expense. For example, prime cost includes expenditure on direct materials, direct labor and direct expenses. Money spent on materials is termed as cost of materials just like money spent on labor is called cost of labor and so on. Thus, the use of term cost without understanding the circumstances can be misleading.
Different costs are found for different purposes. The work-in-progress is valued at factory cost while stock of finished goods is valued at office cost. Numerous other examples can be given to show that the term “cost” does not mean the same thing under all circumstances and for all purposes. Many items of cost of production are handled in an optional manner which may give different costs for the same product or job without going against the accepted principles of cost accounting. Depreciation is one of such items. Its amount varies in accordance with the method of depreciation being used. However, endeavor should be, as far as possible, to obtain an accurate cost of a product or service.
Elements of Cost
Following are the three broad elements of cost:
1. Material
The substance from which a product is made is known as material. It may be in a raw or a manufactured state. It can be direct as well as indirect.
a. Direct Material
The material which becomes an integral part of a finished product and which can be conveniently assigned to specific physical unit is termed as direct material. Following are some of the examples of direct material:
 All material or components specifically purchased, produced or requisitioned from stores
 Primary packing material (e.g., carton, wrapping, cardboard, boxes etc.)
 Purchased or partly produced components
Direct material is also described as process material, prime cost material, production material, stores material, constructional material etc.
b. Indirect Material
The material which is used for purposes ancillary to the business and which cannot be conveniently assigned to specific physical units is termed as indirect material. Consumable stores, oil and waste, printing and stationery material etc. are some of the examples of indirect material.
Indirect material may be used in the factory, office or the selling and distribution divisions.
2. Labor
For conversion of materials into finished goods, human effort is needed and such human effort is called labor. Labor can be direct as well as indirect.
a. Direct Labor
The labor which actively and directly takes part in the production of a particular commodity is called direct labor. Direct labor costs are, therefore, specifically and conveniently traceable to specific products.
Direct labor can also be described as process labor, productive labor, operating labor, etc.
b. Indirect Labor
The labor employed for the purpose of carrying out tasks incidental to goods produced or services provided, is indirect labor. Such labor does not alter the construction, composition or condition of the product. It cannot be practically traced to specific units of output. Wages of storekeepers, foremen, timekeepers, directors’ fees, salaries of salesmen etc, are examples of indirect labor costs.
Indirect labor may relate to the factory, the office or the selling and distribution divisions.
3. Expenses
Expenses may be direct or indirect.
a. Direct Expenses
These are the expenses that can be directly, conveniently and wholly allocated to specific cost centers or cost units. Examples of such expenses are as follows:
 Hire of some special machinery required for a particular contract
 Cost of defective work incurred in connection with a particular job or contract etc.
Direct expenses are sometimes also described as chargeable expenses.
b. Indirect Expenses
These are the expenses that cannot be directly, conveniently and wholly allocated to cost centers or cost units. Examples of such expenses are rent, lighting, insurance charges etc.
4. Overhead
The term overhead includes indirect material, indirect labor and indirect expenses. Thus, all indirect costs are overheads.
A manufacturing organization can broadly be divided into the following three divisions:
o Factory or works, where production is done
o Office and administration, where routine as well as policy matters are decided
o Selling and distribution, where products are sold and finally dispatched to customers
Overheads may be incurred in a factory or office or selling and distribution divisions. Thus, overheads may be of three types:
d. Factory Overheads
They include the following things:
 Indirect material used in a factory such as lubricants, oil, consumable stores etc.
 Indirect labor such as gatekeeper, timekeeper, works manager’s salary etc.
 Indirect expenses such as factory rent, factory insurance, factory lighting etc.
e. Office and Administration Overheads
They include the following things:
 Indirect materials used in an office such as printing and stationery material, brooms and dusters etc.
 Indirect labor such as salaries payable to office manager, office accountant, clerks, etc.
 Indirect expenses such as rent, insurance, lighting of the office
f. Selling and Distribution Overheads
They include the following things:
 Indirect materials used such as packing material, printing and stationery material etc.
 Indirect labor such as salaries of salesmen and sales manager etc.
 Indirect expenses such as rent, insurance, advertising expenses etc.
Elements of Cost
o Direct material
o Direct labor
o Direct expenses
o Overheads
o Factory overheads
o Selling and distribution overheads
o Office and administration overheads
o Indirect material
o Indirect labor
o Indirect expenses
o Indirect material
o Indirect labor
o Indirect expenses
o Indirect material
o Indirect labor
o Indirect expenses
Components of Total Cost
1. Prime Cost
Prime cost consists of costs of direct materials, direct labors and direct expenses. It is also known as basic, first or flat cost.
2. Factory Cost
Factory cost comprises prime cost and, in addition, works or factory overheads that include costs of indirect materials, indirect labors and indirect expenses incurred in a factory. It is also known as works cost, production or manufacturing cost.
3. Office Cost
Office cost is the sum of office and administration overheads and factory cost. This is also termed as administration cost or the total cost of production.
4. Total Cost
Selling and distribution overheads are added to the total cost of production to get total cost or the cost of sales.