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Cup of tea

Some Questions
The cost accountant has the answers to the following questions;
• What was the cost of goods produced or services provided last period?
• What was the cost of operating a department last month?
• What revenues were earned last period?
• What are the future costs of goods and services likely to be?
• How do actual costs compare with planned costs?
• What information does management need in order to make sensible decisions* about profits
and costs?
[* effective decision making (relating to cost of production or service)]
Therefore
Knowing about costs incurred or revenues earned enables management to do the following.
 Assess the profitability of a product, a service, a department, or the whole organization.
 Perhaps, set selling prices with some regard for the costs of sale.
 Put a value on inventory (raw materials, work in progress, finished goods) that are still held in
store at the end of a period, for preparing a statement of financial position showing of the
company's assets and liabilities.

The Cost Accountant and the Management Accountant


• Cost accounting deal with ways of accumulating historical costs and of charging these costs to
units of output for inventory valuations, profits and statement of financial position.
• It has since been extended into planning, control and decision making [The role of cost
accounting in the provision of management information]
• It is therefore almost indistinguishable from that of management accounting, which is basically
concerned with the provision of information to assist management with planning, control and
decision making.
[Information – for DM]

Cost accounting is the 'gathering of cost information and its attachment to cost objects, the
establishment of budgets, standard costs and actual costs of operations, processes, activities or products;
and the analysis of variances, profitability or the social use of funds'. CIMA Official Terminology

Cost accounting is concerned with providing information to assist the following.


1. Establishing inventory valuations, profits and statement of financial position items.
2. Planning (for example the provision of forecast costs at different activity levels)
3. Control (such as the provision of actual and standard costs for comparison purposes)
4. Decision making.

Cost accounting and Financial Accounting


Objective Providing information Ascertainment of cost for cost
about financial control and DM
performance
Nature Classify financial classifies costs and interprets
transactions it in a significant manner
Recording of data historical data both historical data and pre
determined costs
Users of information stakeholders internal management and
regulators
Analysis of cost and profit Profit, segment wise or Cost details
whole
Time period for a financial year reports and statements
required as and when
required

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Financial accounts
Management accounts

Some Cost Accounting Concepts

1. Cost Object
If the users of accounting information want to know the cost of something, that something is called a cost
object.
Examples of cost objects include:
• A product
• A service to a hotel guest
• A sales territory

A cost object is 'for example a product, service, centre, activity, customer or distribution channel in relation to
which costs are ascertained'. CIMA Official
Terminology
2. Cost centres
 Cost centres are collecting places for costs before they are further analysed.
 For cost accounting purposes, departments are termed cost centres and the product produced by
anorganisation is termed the cost unit.

3. Cost Unit
Cost unit is a unit of product or service in relation to which costs may be ascertained. The cost unit should be
appropriate to the type of business.

Once costs have been traced to cost centres, they can be further analysed in order to establish a cost per cost
unit. Alternatively, some items of costs may be charged directly to a cost unit, for example direct materials and
direct labour costs, which you will meet later in this text

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For example:

Business Appropriate Cost Unit


Car manufacturer particular brand
car
Cigarette manufacturer packet
piece of cigarette
Builder Particular building
Flat
Audit company Audit File
Chargeable hour
Hospital Patient/ Day
Freight organisation Tonne/kilometre
Restaurant Meal served

A cost unit is a 'unit of product or service in relation to which costs are ascertained'.
CIMA Official Terminology

4. Cost
Cost accounting transactions are recorded at historic cost, but costs can be measured in terms of
economic cost (mainly for DM purpose). In practice most cost accounting systems use historical cost as a
measurement basis.
 Economic cost (opportunity cost) is the value of the best alternative course of action that was
notchosen. In other words, it is what could have been accomplished with the resources used in the
course of action not
 It represents opportunities forgone.

If a person has a job offer that pays Rs 25 for an hour's work, and instead chooses to take a nap for an hour, the
historicalcost of the nap is zero; the person did not hand over any money in order to nap. The economic cost of the nap is
the Rs 25 that could have been earned working.

Economic value is measured by the most someone is willing to give up in other products and services in order to obtain a
product or service. Currency is the universally accepted measure of economic value in many markets, because the number of
dollars that a person is willing to pay for something tells how much of all other goods and services they are willing to give up
to get that item. This is often referred to as ‘willingness to pay’.

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4 Composite cost units and they are used most often in service organisations.
Composite cost units help to improve cost control.

Summary

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CLASSIFICATION OF COSTS (CAS 1)
It means the grouping of costs according to their common characteristics. The important ways of
classification of costs are:
1. Nature or Element [Elements of Cost]
2. Functions
3. Timing
4. Variability or Behaviour
5. Classification by nature of production or process
6. Costs for Managerial Decision Making

1. Nature or Element [Elements of Cost]

Costs may be viewed as either direct or indirect in terms of the extent to which they are traceable to a particular
Cost object, such as products, jobs, departments, or sales territories.
 Direct costs are those costs that can be traced directly to the costing object. Examples are direct
materials, direct labour, and advertising outlays made directly to a particular sales territory.
 Indirect costs are costs that are difficult to trace directly to a specific costing object. Factory overhead
items are all indirect costs. Costs shared by different departments, products, or jobs, called common
costs or joint costs, are also indirect costs. National advertising that benefits more than one product
and sales territory is an example of an indirect cost.

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Production/Factory Overhead
OVERHEADS

Administrative Overhead

Selling and Distribution Overhead

2. Functions

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3. By their timing of charges against revenue or by whether they are inventoriable, costs are classified into
(a) product costs and (b) period costs.
Product costs are inventoriable costs, identified as part of inventory on hand. They are therefore assets until they are
sold. Once they are sold, they become expenses, i.e., cost ofgoods sold. All manufacturing costs are product costs.
Period costs are not inventoriable and hence are charged against sales revenue in the period in which the revenue is
earned. Selling and general and administrative expenses are period costs.

4. Variability or Behaviour

Variable costs are costs that vary in total in direct proportion to changes in activity. Examples are direct materials and
gasoline expense based on mileage driven.
Fixed costs are costs that remain constant in total regardless of changes in activity. Examples are rent, insurance, and
taxes.
Semi-variable (or mixed) costs are costs that vary with changes in volume but, unlike variable costs, do not vary in
direct proportion. In other words, these costs contain both a variable component and a fixed component.

5. Classification by nature of production or process

1 Costs for Managerial Decision Making


i. Marginal Costing: Marginal Cost is the aggregate of variable costs, i.e. prime cost plus variable overhead.
ii. Differential Cost: Differential cost is the change in the cost due to change in activity from one level to another.
iii. 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.
iv. 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.
v. 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.
vi. 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.
vii. 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.
viii. 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.
ix. 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.

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x. 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.
xi. 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.

Material Cost (CAS 6)

EOQ:
 Economic Order Quantity is ‘The size of the order for which both ordering and carrying cost are minimum’.
 The total costs of inventory usually consist of Buying Cost + Total Ordering Cost + Total Carrying Cost.
.

Example (EOQ)
Calculate the Economic Order Quantity from the following information. Also state the number of orders to be placed in a
year.
Consumption of materials per annum : 10,000 kg
Order placing cost per order : Rs 50
Cost per kg. of raw materials : Rs 2
Storage costs : 8% on average inventory

Just in time (JIT)


 Production strategy that strives to improve a business return on investment by reducing in-process
inventory and associated carrying costs. Inventory is seen as incurring costs, or waste, instead of adding and
storing value, contrary to traditional accounting.
 Just-in-Time inventory system focuses on “the right material, at the right time, at the right place, and in the
exact amount” without the safety net of inventory.

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Labour Cost (CAS 7)

As per CAS-7, Employee Cost is ‘The aggregate of all kinds of consideration paid, payable and provisions made for future
payments for the services rendered by employees of an enterprise (including temporary, part time and contract
employees). Consideration includes wages, salary, contractual payments and benefits, as applicable or any payment made
on behalf of employee. This is also known as Labour Cost.’

Labour Turnover
Labour Turnover of an organisation is change in the labour force during a specified period measured against a suitable
index. The rate of Labour Turnover in an industry depends upon several factors suchas, nature of the industry, its size,
location and composition of the labour force. A controlled level ofLabour Turnover is considered desirable because it helps
the firm to adjust the size of its labour force inresponse to needs such as for seasonal changes or changes in technology.
Causes of Labour Turnovers:
The causes giving rise to high labour turn over may be broadly classified under the following heads:
1. Personnel Causes: Workers may leave employment purely on personal grounds, e.g.,
 Dislike for the job, locality or environments.
 Domestic troubles and family responsibilities.
 Change of line for betterment.
 Retirement due to old age and ill health.
 Death.
In all such cases, personal factors count the most and employer can practically do nothing to help the situation.

2. Unavoidable Causes: In certain circumstances it becomes obligatory on the part of the management to ask some of
the workers to leave. These circumstances are:
 Retrenchment due to seasonal trade, shortage of any material and other resources, slack market for the product,
etc.
 Discharge on disciplinary grounds.
 Discharge due to continued or long absence.

3. Avoidable Causes: Under this head, may be grouped the causes which need the attention of the management most so
that the turnover may be kept low by taking remedial measures. The mainreasons for which workers leave are:
1. Unsuitability of job.
2. Low pay and allowance.
3. Unsatisfactory working conditions.
4. Unhappy relations with co-workers and unsatisfactory behaviour of superiors.
5. Dispute between rival trade unions.
6. Lack of transport, accommodation, medical and other factors.
7. Lack of amenities like recreational centres, schools, et

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Measurement of Labour Turnover:
1. Additions Method:
[Labour Turnover = (Number of additions/Average number of workers during the period) ×100]
2. Separation Method:
[Labour Turnover = Number of separations/Average number of workers during the period)×100]
3. Replacement Method:
[Labour Turnover = (Number of replacements/Average number of workers during the period)×100]
4. Flux Method: Under this method Labour Turnover is computed by taking into consideration the additions as well as
separations. The turnover can also be computed by taking replacements and separations also. Computation is done as
per the following methods.
[ Number of additions+ Number of seperations ]
Labour Turnover = ½ × × 100
Average number of workers during the period

Idle Time
Idle Time Cost represents the wages paid for the time lost during which the worker does not work, i.e time for which
wages are paid, but no work is done.
As per CAS-7, Idle Time is ‘The difference between the time for which the employees are paid and the employees time booked
against the cost object’.
Treatment
As per CAS-7, Idle Time Cost shall be assigned direct to the cost object or treated as overheads depending on the economic
feasibility and specific circumstances causing such idle time.
 Normal Idle Time is booked to factory or works overhead.
 Abnormal Idle Time would usually be heavy in amount involves longer periods and would mostly be beyond the
control of the management. Payment for such idle time is not included in cost and is adjusted through the Costing
Profit and Loss Account

Direct expenses (CAS-10)


 ‘Expenses relating to manufacture of a product or rendering a service, which can be identified or linked with the cost
object other than direct material cost and direct employee cost’

 The following expenses may be treated as direct expenses:


(a)Cost of patents, royalty payment;
(b) Hire charges in respect of special machinery or plant;
(c) Cost of special patterns, cores, designs or tools;
(d) Experimental costs and expenditure in connection with models and pilot schemes;
(e) Architects, surveyors and other consultants fee;
(f) Travelling expenses to sites;
(g) Inward charges and freight charges on special material.

Overhead (CAS 3)

Overhead costs are defined as, ‘the total cost of indirect materials, indirect labour and indirect expenses’.
CIMA terminology

‘Overheads comprise costs of indirect materials, indirect employees and indirect expenses which are not
directly identifiable or allocable to a cost object in an economically feasible manner’
CAS 3

Thus all indirect costs like indirect materials, indirect labour, and indirect expenses are called as ‘overheads’.
Examples of overhead expenses are rent, taxes, depreciation, maintenance, repairs, supervision, selling and
distribution expenses, marketing expenses, factory lighting, printing stationery etc.

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Overheads collection is the process of recording each item of cost in the records maintained for the purpose of
ascertainment of cost of each cost centre or unit.

Classification is defined by CIMA as;


 ‘The arrangement of items in logical groups having regard to their nature (subjective classification) or the
purpose to be fulfilled (Objective classification).
 Classification is the process of arranging items into groups according to their degree of similarity.

Overhead Accounting
The ultimate aim of Overhead Accounting is to absorb them in the product units produced by the firm.
 Absorption of overhead means charging each unit of a product with an equitable share of overhead
expenses. In other words, as overheads are all indirect costs, it becomes difficult to charge them to the product
units. In view of this, it becomes necessary to charge them to the product units on some equitably basis which is
called as ‘Absorption’ of overheads. The important steps involved in Overhead Accounting are as follows:-
o Collection, Classification of Overheads and codification.
o Allocation, Apportionment and Reapportionment of overheads.
o Absorption of Overheads.

 Codification of Overheads
Codification helps in easy identification of different items of overheads.
Cost Centre code – name of the overhead.

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Methods of classification of semi variable cost in fixed and variable
1 Graphical Method –
2 Simultaneous Equations – This uses the straight line equation of y = m x + c where y represents total cost, m
is variable cost per unit, x is the level of output and c is fixed costs. The total costs at two different volumes
are put into these equations which are solved for the values of m and c.
3 High and Low Method – The highest and lowest levels of output and costs are taken and the differential is
found. This difference arises only due to variable costs. The remaining portion will be fixed costs. Under this
method the variable cost per unit will be computed first and then the fixed cost will be derived. Variable
cost per unit is computed by dividing the difference in cost at highest level and lowest level with the
difference in volume between highest and lowest level.
4 Least Square Method – This statistical tool uses straight line equation and finds the line of best fit to solve
the equations. Also known as Simple Regression Method. Under this method first the mean of volume and
mean of costs are computed. The deviations in volume (x) from the mean and deviation in cost (y) from
mean are computed.

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Line of Best fit

Overhead absorption
 Method of arriving at an overhead cost p.u. (dividing total overheads by total production) is known as
the absorbing of overheads.
 Note that because we need the cost p.u. for things like fixing a selling price, we will usually absorb the
overheads based on estimated total cost and estimated production. This can lead to problems later
because obviously our estimates may not be correct.

Illustration 1:
X plc produces desks.
Each desk uses 3 kg of wood at a cost of Rs 4 per kg, and takes 4 hours to produce.
Labour is paid at the rate of Rs 2 per hour.
Fixed costs of production are estimated to be Rs 700,000 p.a..
The company expects to produce 50,000 desks p.a..

Illustration 2:
X plc produces desks and chairs in the same factory.
Each desk uses 3 kg of wood at a cost of Rs 4 per kg, and takes 4 hours to produce.
Each chair uses 2 kg of wood at a cost of Rs 4 per kg., and takes 1 hour to produce.
Labour is paid at the rate of Rs 2 per hour.
Fixed costs of production are estimated to be Rs 700,000 p.a. The company expect to produce 30,000
desks and 20,000 chairs p.a.
(Overheads are to be absorbed on a labour hour basis)
Calculate the cost per unit for desks and chairs

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