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COST ACCOUNTING

What is a Cost?
A cost can be defined as the value attributed to a resource.
There are three elements of a cost - material, labour and services (expenses) for a manufacturing organization.

Importance of Cost Data


A companys margin of profit and its financial strength depends on how strong, accurate, reliable and comprehensive its cost data is.
Normally there are exclusive departments in an organization dealing with cost data.

Cost data are internal for an organization and are normally not disclosed to outsiders unlike Balance Sheet and Profit and Loss Statements though these statements themselves may be based on cost data.

Importance of Cost Accounting


Cost accounting provides information about costs, which the management accountant uses to plan, control and make decisions.
Cost accounting, therefore, provides the basis for management accounting. Cost and management accounting formulate a management information system, which assists management in its tasks of planning, controlling and decision-making.

Cost Accounting yesterday and today!!!


In the recent past, cost accounting was limited to the tools used to calculate an inventory cost for balance sheet presentation and to calculate the cost of goods sold for the income statement.
Today, cost accounting is much more than an inventory cost tracking system. Today also cost accounting involves determining the costs of products and activities, but a part of it has a broader role: to furnish information used in planning and controlling activities, in improving quality and efficiency, and in formulating strategic policy.

Cost Accounting yesterday and today!!!


Technological changes and management innovations are drastically changing the nature of cost.
Many technologically advanced companies have lower inventory levels, use less labour and often experience increasing levels of fixed costs.

These developments are interesting and exciting, but they are also challenging cost accounting systems to provide reliable useful information and that can be used to keep a company efficient and, most of all, competitive in the global market.

Cost Accounting has made life simpler for the Management!!!


Formulating and implementing plans and budgets that motivate employees toward the achievement of company goals. Establishing cost tracking methods that allow control of operations, cost savings and improvements in quality. Controlling inventory cost, minimizing investment in inventory and determining the cost of each product or service. Pricing products and services in ways that are congruent with organizational goals. Making prudent decisions that impact both shortterm and long-term revenues and expenses.

Types of Cost Classification


By Time

Historic (Sunk) Cost


Already incurred.

Standard (Planned) Cost


Important for budgeting purposes.

Historic costs are used for comparison with budgeted performance in order to highlight areas where control action may be necessary.

Types of Cost Classification


By Financial Costing

Revenue Costs
Incurred when running the business and charged to the P&L account.

Capital Costs
Incurred in acquiring long-term assets, which are not purchased for resale purposes. This expenditure is shown in the balance sheet.

Types of Cost Classification


By Responsibility

Controllable Costs
Variable costs such as raw materials, labour, and other overheads deemed controllable by management. Some fixed costs (discretionary costs), such as advertising, accounting, legal and R&D can be controlled in the short run.

Uncontrollable Costs
Cannot be controlled by a specified member / department of an undertaking. Most of the fixed cost are uncontrollable cost. For example, factory manager's salary, Depreciation etc. Committed costs like rent etc.

Types of Cost Classification


By Identification with Stock

Product Costs
Those costs identified as part of stock are called product costs, and only become expenses in the form of cost of goods sold when the stock is sold.

Period Costs
Those costs that are not identified with stock are called period costs and are deducted as expenses during the period in which they are incurred. They are not carried forward in the closing stock to the next period.

Types of Cost Classification


By tracing costs to end - products

Direct Costs
All costs which are identifiable with the end-product: Raw material used in manufacturing the product - direct material; machine operators who make the product - direct labor; royalties paid or special plant hired direct expenses.

Indirect Costs
All costs which are not identifiable with the end-product: Lubricants and scrap metal indirect material; supervisors indirect labour, rent, rate and depreciation - indirect expenses. Indirect costs are often called overheads.

Types of Cost Classification


By function (analysis of overheads)

Factory or Production Overheads


Factory Depreciation Supervisors Salary Power Rent

Administration Overheads
Office Rent Power Salaries Office Utilities

Selling & Distribution Overheads


Advertising Salesmens salaries Vehicle Insurance Travel Bills

Types of Cost Classification


By behaviour (in relation to changes in activity )

Fixed Cost
Unaffected by changes in the level of activity: Salary Depreciation Rent

Variable Cost
Sensitive to changes in the level of activity: Direct Material Direct Labour Direct Expenses

Mixed Cost
Comprises both fixed and variable elements: Telephone bill having a fixed rental cost & variable costs varying with calls made.

Types of Cost Classification

It is important to identify the purpose for which the cost is required in order to classify it correctly.

Cost Object
A cost object is any unit or activity for which management wants to accumulate and measure a cost. The unit or activity may be a product or service unit; a batch of like units; or a contract, project, process, function, goal, department, business segment, or other subdivision of a company. The idea of a cost object is central to cost accounting. A cost object is always present when accumulation, measurement allocation, or reporting of costs occurs.

Cost accounting often involves the calculation of the cost of something - that something is a cost object.

Product Costs
In a manufacturing environment, product costs are those costs that incurred to manufacture inventory.
Thus, until the related goods are sold, product costs represent inventory and they are reported on the balance sheet as an asset. When the goods are ultimately sold, product costs are transferred from the balance sheet to the income statement, where they are deducted from revenue as the cost of goods sold.

Period Costs
Operating expenses that are associated with time periods, rather than with the production of inventory, are referred to as period costs. Period costs are charged directly to expense accounts on the assumption that their benefit is recognized entirely in the period when the cost is incurred. Period costs include all selling expenses, general and administrative expenses, interest expense and income tax expense. In short, period costs are classified on the income statement separately from cost of goods sold, as deductions from a companys gross profit.

Flow of Product and Period Costs

Significance of Product & Period Costs


The treatment of fixed production costs as either product or period costs forms the basis of difference between absorption costing and marginal costing methods!!!

Absorption Costing
Each unit of output is charged with both variable and fixed production costs. The fixed production costs are treated as part of actual production. Closing stock is therefore valued on a full production cost basis, and when sold in the next period these costs are released and matched with revenue of that period.

Marginal Costing
Each unit of output is charged with only variable production costs. The fixed production costs are not treated as part of actual production. Most fixed costs, such as rent, depreciation and salaries relate to time and therefore are charged to the period in which they are incurred. Closing stock is therefore valued on a variable production cost basis.

Absorption vs. Marginal Costing


X Ltd. has introduced a new product whose production commenced in the period just completed. The details are as follows: Sales 10000 units sold @ Rs. 5 each Production 15000 units, which were produced at the following costs: Direct Materials Rs. 15000 Direct Labour Rs. 30000 Variable expenses Rs. 6000 Fixed expenses Rs. 12000 Prepare P&L a/c for the period under absorption and marginal bases.

Absorption vs. Marginal Costing


Absorption Costing Sales Cost of Production: Direct Materials Direct Laour Variable O/H Fixed O/H 15000 30000 6000 12000 63000 51000 15000 30000 6000 50000 Marginal Costing 50000

Less: Closing Stock (5000 units) (21000)


(42000) Less: Fixed O/H Net Profit 8000

(17000)
(34000) (12000) 4000

Absorption vs. Marginal Costing


Lets change the scenario a little bit: Sales 10000 units sold @ Rs. 5 each Production 10000 units, which were produced at the following costs: Direct Materials Rs. 10000 Direct Labour Rs. 20000 Variable expenses Rs. 4000 Fixed expenses Rs. 12000 Prepare P&L a/c for the period under absorption and marginal bases.

Absorption vs. Marginal Costing


Absorption Costing Sales Cost of Production: Direct Materials Direct Laour Variable O/H Fixed O/H 10000 20000 4000 12000 46000 34000 10000 20000 4000 50000 Marginal Costing 50000

Less: Closing Stock (NIL)

(0)
(46000)

(0)
(34000) (12000) 4000 4000

Less: Fixed O/H Net Profit

Absorption vs. Marginal Costing


Now lets assume we are in year 2. Opening Stock 5000 units (valued at Rs. 21000 on absorption basis & Rs. 17000 on marginal basis) Sales 12500 units sold @ Rs. 5 each Production 7500 units, which were produced at the following costs: Direct Materials Rs. 7500 Direct Labour Rs. 15000 Variable expenses Rs. 3000 Fixed expenses Rs. 12000 Prepare P&L a/c for the period under absorption and marginal bases.

Absorption vs. Marginal Costing


Absorption Costing Marginal Costing

Sales
Cost of Production:

62500 7500
15000 3000 12000 37500 25500 (0) (37500) (0)

62500 7500
15000 3000

Direct Materials
Direct Laour Variable O/H Fixed O/H Less: Closing Stock (NIL) Less: Cost of Opening Stock (5000 units) Less: Fixed O/H Net Profit

(25500) (17000) (12000) 8000

(21000) 4000

Absorption vs. Marginal Costing


The following points should be noted about the difference between reported profits under absorption and marginal bases:

The difference is one of timing; the actual amount of expenses do not differ, only the periods in which they are charged against profits.
Over the complete life of a product, both methods will show the same total profits, as in the long run, production equals sales.

Absorption vs. Marginal Costing


When stock levels are constant / nil, there is no difference. Where stocks are increasing, i.e. closing stock > opening stock, higher profits are reported under absorption costing, as some fixed costs are carried forward in the stock valuation. Where stocks are decreasing, the converse applies and higher profits are reported under marginal costing.

Absorption vs. Marginal Costing


Both approaches are equally important. Any preference for one will depend upon the purpose for which the information is required.

In practice, some firms incorporate both costing techniques in their accounting systems.

Merits of Marginal Costing


Most fixed costs such as rent, salaries and depreciation relate to time and therefore should be charged to the period in which they are incurred. It avoids the arbitrary apportionment of fixed costs, as in absorption costing. Stock is valued on a variable basis, which is in sync with the argument that additional cost of stock is limited to its variable cost.

Merits of Marginal Costing


Less chance of fictitious profits arising in the period should unsalable stock be carried forward to the next period.

Allows more competitive pricing as fixed overheads are not included in production costs. The contribution approach aids profit planning.
Fixed costs may not be controlled at the departmental level, so should not be included in product costs at cost center level.

Merits of Absorption Costing


In the long run, decision making on a marginal costing approach may result in the contribution failing to cover fixed costs and losses being incurred. It avoids separation of costs into fixed and variable elements, which are not easily and accurately achieved. Fixed costs should be treated as actual costs of production, as production cannot occur without them being incurred.

Merits of Absorption Costing


Full cost (cost plus) pricing, as is true of absorption costing, ensures that all costs are covered. Analysis of under absorbed / over absorbed overheads is useful to identify inefficient utilization of production resources.

The allocation of fixed costs make managers more aware of these costs and of services they provide.

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