Financial ManagementJSS AHER

Unit 2 – Cost Accounting

Introduction:

The term cost management is widely used nowadays. It refers to the activities of managers in
short-run & long-run planning & control of costs. Therefore, cost accounting systems, methods
& techniques help cost management. Budgetary control & standard costing are two popular
examples of cost management tools. Cost management requires managers to actively seek ways
to reduce costs. Cost data plays significant role in informed decision-making that facilitates
cost management.
Cost management is broad in its focus. It includes reduction of costs continuously. Continuous
improvement in performance is considered as one of the key success factors in a competitive
environment.
Cost management is linked with revenue & profit planning. For example, additional costs may
be incurred by way of advertising, sales promotion, product modification etc. that may lead to
enhancement of revenues & profit.

Cost management cannot be practised in isolation – it should form part of general management
strategies & their implementations. For example, the term strategic cost management is widely
used. It includes value-chain approach, activity-based costing, life cycle costing, target costing,
profit planning, etc. as its tools.

Michael E. Porter in his theory of Generic Competitive Strategies has described ‘Cost
Leadership’ as one of the three strategic dimensions (others are ‘Product differentiation’ and
‘Focus or Niche’) to achieve competitive advantage in industry. Cost Leadership implies
producing goods or provision of services at lowest cost while maintaining quality to have better
competitive price. In a business environment where each entity is thriving to achieve apex
position not only in domestic but global competitive market, it is essential for the entity to fit
into any of the three competitive strategic dimensions. Cost Leadership, also in line with the
subject Cost and Management Accounting, can be achieved if an entity has a robust cost and
management accounting system in place.
Cost:
As a noun-The amount of expenditure (actual or notional) incurred on or attributable to a
specified article, product or activity.
As a verb- To ascertain the cost of a specified thing or activity.

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Costing:
Costing is defined as “the technique and process of ascertaining costs”.
According to CIMA “an organisation’s costing system is the foundation of the internal financial
information system for managers. It provides the information that management needs to plan
and control the organisation’s activities and to make decisions about the future.”

The technique in costing consists of the body of principles and rules for ascertaining the costs
of products and services. The technique is dynamic and changes with the change of time. The
process of costing is the day to day routine of ascertaining costs. It is popularly known as an
arithmetic process.

Cost Accounting
Cost Accounting is defined as “the process of accounting for cost which begins with the
recording of income and expenditure or the bases on which they are calculated and ends with
the preparation of periodical statements and reports for ascertaining and controlling costs.”

Cost Accounting may be defined as “Accounting for costs classification and analysis of
expenditure as will enable the total cost of any particular unit of production to be ascertained
with reasonable degree of accuracy and at the same time to disclose exactly how such total cost
is constituted”.
Thus Cost Accounting is classifying, recording an appropriate allocation of expenditure for the
determination of the costs of products or services, and for the presentation of suitably arranged
data for the purpose of control and guidance of management.

Cost Accounting can be explained as follows:-

 Cost Accounting is the process of accounting for cost which begins with recording of
income and expenditure and ends with the preparation of statistical data.
 It is the formal mechanism by means of which cost of products or services are
ascertained and controlled.

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Cost Accountancy:
Cost Accountancy has been defined as “the application of costing and cost accounting
principles, methods and techniques to the science, art and practice of cost control and the
ascertainment of profitability. It includes the presentation of information derived there from for
the purpose of managerial decision making.”

Management Accounting:
As per CIMA Official Terminology “Management accounting is the application of the
principles of accounting and financial management to create, protect, preserve and increase
value for the stakeholders of for profit and not-for-profit enterprises in the public and private
sectors.”
Management accounting is an integral part of management. It assists management by provision
of relevant information for planning, organising, controlling, decision making etc.

Cost Management:
It is an application of management accounting concepts, methods of collections, analysis and
presentation of data to provide the information needed to plan, monitor and control costs.

OBJECTIVES OF COST ACCOUNTING:

The main objectives of cost accounting are explained as below:
1. Ascertainment of Cost:
The main objective of cost accounting is accumulation and ascertainment of cost. Costs are
accumulated, assigned and ascertained for each cost object.

2. Determination of Selling Price and Profitability:

The cost accounting system helps in determination of selling price and thus profitability of a
cost object. Though in a competitive business environment, selling prices are determined by
external factors but cost accounting system provides a basis for price fixation and rate
negotiation.

3. Cost Control:
Maintaining discipline in expenditure is one of the main objective of a good cost accounting
system. It ensures that expenditures are in consonance with predetermined set standard and any

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variation from these set standards is noted and reported on continuous basis.

4. Cost Reduction:
It may be defined “as the achievement of real and permanent reduction in the unit cost of goods
manufactured or services rendered without impairing their suitability for the use intended or
diminution in the quality of the product.” Cost reduction is an approach of management where
cost of an object is believed to be further reducible. No cost is termed as lowest and every
possibility of cost reduction is explored.

5. Assisting management in decision making:

Cost and Management accounting by providing relevant information, assists management in
planning, implementing, measuring, controlling and evaluation of various activities. A robust
cost and management accounting system not only provides information internal to industry but
external also.

SCOPE OF COST ACCOUNTING:

Scope of cost accounting consists of the following functions:
1. Costing: Costing is the technique and process of ascertaining costs of products or services. The
cost ascertainment procedure is governed by some cost accounting principles and rules.
Generally, cost is ascertained using some arithmetical process.

2. Cost Accounting: This is a process of accounting for cost which begins with the recording of
expenditure and ends with the preparation of periodical statement and reports for ascertaining
and controlling cost. Cost Accounting is a formal mechanism of cost ascertainment.

3. Cost Analysis: It involves the process of finding out the factors responsible for variance in
actual costs from the budgeted costs and accordingly fixation of responsibility for cost
differences. This also helps in better cost management and strategic decisions.

4. Cost Comparisons: Cost accounting also includes comparisons of cost from alternative courses
of actions such as use of different technology for production, cost of making different products
and activities, and cost of same product/ service over a period of time.

5. Cost Control: It involves a detailed examination of each cost in the light of advantage received

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from the incurrence of the cost. Thus, we can state that cost is analysed to know whether cost
is exceeding its budgeted cost and whether further cost reduction is possible.

6. Cost Reports: This is the ultimate function of cost accounting. These reports are primarily
prepared for the use by the management at different levels. Cost Reports helps in planning and
control, performance appraisal and managerial decision making.

7. Statutory Compliances: Maintaining cost accounting records as per the rules prescribed by the
statute to maintain cost records relating to utilization of materials, labour and other items of
cost as applicable to the production of goods or provision of services as provided in the Act
and these rules.

Financial Accounting and Cost Accounting:

Financial Accounting is primarily concerned with the preparation of financial statements,
which summarize the results of operations for selected period of time and show the financial
position of the company at particular dates. In other words Financial Accounting reports on the
resources available (Balance Sheet) and what has been accomplished with these resources
(Profit and Loss Account). Financial Accounting is mainly concerned with requirements of
creditors, shareholders, government, prospective investors and persons outside the
management. Financial Accounting is mostly concerned with external reporting.

Financial Accounting Cost Accounting

It provides the information about the business in
a general way. i.e Profit and Loss Account,
Balance Sheet of the business to owners and
other outside partners.
It classifies, records and analyses the
transactions in a subjective manner, i.e
according to the nature of expense.
It lays emphasis on recording aspect without
attaching any importance to control.
It reports operating results and financial position It gives information through cost reports to
usually at the end of the year.
Financial Accounts are accounts of the whole
business. They are independent in nature.
It provides information to the management for
proper planning, operation, control and decision
making.
It records the expenditure in an objective manner,
i.e according to the purpose for which the costs are
incurred.
It provides a detailed system of control for
materials, labour and overhead costs with the help
of standard costing and budgetary control.
management as and when desired.
Cost Accounting is only a part of the financial
accounts and discloses profit or loss of each
product, job or service.

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Financial Accounts records all the commercial
transactions of the business and include all
expenses i.e Manufacturing, Office, Selling etc.
Financial Accounts are concerned with external
transactions i.e. transactions between business
concern and third party.
Only transactions which can be measured in
monetary terms are recorded.
Financial Accounting deals with actual figures
and facts only.
Financial Accounting do not provide
information on efficiencies of various workers/
Plant & Machinery.
Stocks are valued at Cost or Market price
whichever is lower.
Financial Accounting is a positive science as it
is subject to legal rigidity with regarding to
preparation of financial statements.
These accounts are kept in such a way to meet
the requirements of Companies Act 2013 as per
Sec 128 & Income Tax Act, 1961 Sec 44AA.
Cost Accounting relates to transactions connected
with Manufacturing of goods and services, means
expenses which enter into production.
Cost Accounts are concerned with internal
transactions, which do not involve any cash
payment or receipt.
Non-Monetary information likes No of Units /
Hours etc are used.
Cost Accounting deals with partly facts and figures
and partly estimates / standards.
Cost Accounts provide valuable information on the
efficiencies of employees and Plant & Machinery.
Stocks are valued at Cost only.
Cost Accounting is not only positive science but
also normative because it includes techniques of
budgetary control and standard costing.
Generally Cost Accounts are kept voluntarily to
meet the requirements of the management, only in
some industries Cost Accounting records are kept
as per the Companies Act.

COST OBJECTS:
Cost object is anything for which a separate measurement of cost is required. Cost object may
be a product, a service, a project, a customer, a brand category, an activity, a department or a
programme etc.

Examples of cost object are:

Product Smart phone, Tablet computer, SUV Car, Book etc.
Service An airline flight from Delhi to Mumbai, Concurrent audit assignment, Utility
bill payment facility etc.
Project Metro Rail project, Road projects etc.
Activity Quality inspection of materials, Placing of orders etc.
Process Refinement of crudes in oil refineries, melting of billets or ingots in rolling
mills etc.
Department Production department, Finance & Accounts, Safety etc.

COST UNITS:
It is a unit of product, service or time (or combination of these) in relation to which costs may

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be ascertained or expressed.
Cost units are usually the units of physical measurement like number, weight, area, volume,
length, time and value.

A few typical examples of cost units are given below:

Industry or Product Cost Unit Basis

Automobile Number
Cement Ton/ per bag etc.
Chemicals Litre, gallon, kilogram, ton etc.
Power Kilo-watt hour (kWh)
Steel Ton
Transport Passenger- kilometre
Gas Cubic feet

Some examples from the CIMA terminology are as follows:

Industry Sector Cost Unit
Brewing Barrel
Brick-making 1,000 bricks
Coal mining Tonne/ton
Electricity Kilowatt-hour (kWh)
Engineering Contract, job
Oil Barrel, tonne, litre
Hotel/Catering Room/meal
Professional services Chargeable hour, job, contract
Education Course, enrolled student, successful student
Hospitals Patient day

COST DRIVER:
A Cost driver is a factor or variable which effect level of cost. Generally, it is an activity which
is responsible for cost incurrence. Level of activity or volume of production is the example of
a cost driver. An activity may be an event, task, or unit of work etc.

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CIMA Official terminology defines cost driver as “Factor influencing the level of cost. Often
used in the context of ABC to denote the factor which links activity resource consumption to
product outputs, for example the number of purchase orders would be a cost driver for
procurement cost.”
Examples of cost drivers are number of machines setting ups, number of purchase orders, hours
spent on product inspection, number of tests performed etc.

Methods of Costing:
The methods or types of costing refer to the techniques & processes employed in the
ascertainment of costs. Several methods have been designed to suit the needs of different
industries. The method of costing to be applied in a particular concern depends upon the type
& nature of manufacturing activity.

1. Job order costing:

This method applies where work is undertaken to customers’ special requirements. Cost unit
in job order costing is taken to be a job or work order for which costs are separately collected
& computed. A job, big or small, comprises a specific quantity of a product or service to be
provided as per customer’s specifications. Industries where this method is used include printing
repair shops, interior decoration & painting.

2. Contract costing or terminal costing:

This is a variation of job costing & therefore, principles of job costing apply to this method.
The difference between job & contract is that job is small & contract is big. It is well said that
a contract is a big job & a job is a small contract. The cost unit here is a ‘contract’ which is of
a long duration & may continue over more than one financial year. Contract costing is most
suited to construction of buildings, dams, bridges & roads, shipbuilding, etc.

3. Batch costing:
Like contract costing, this is also a variation of job costing. In this method, the cost of a batch
or group of identical products is ascertained & therefore each batch of products is a cost unit
for which costs are ascertained. This method is used in companies engaged in the production
of readymade garments, toys, shoes, tyres & tubes, component parts, bakery, etc.

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4. Process costing:
As distinct from job costing, this method is used in mass production industries manufacturing
standardised products in continuous processes of manufacturing. Costs are accumulated for
each process or department. Here raw material has to pass through a number of processes in a
particular sequence to the completion stage. In order to arrive at cost per unit, the total cost of
a process is divided by the number of units produced. The finished product of one process is
passed on to the next process as raw material. Textile mills, chemical works, sugar mills,
refineries, soap manufacturing, etc., are the examples of industries which employ this method.

5. Operating costing:
This is nothing but a refinement & a more detailed application of process costing. A process
may consist of a number of operations & operation costing involves cost ascertainment for each
operation instead of a process where distinctly separate operations are involved in a process,
cost of each operation is found for effective control mechanism.

6. Single, output or unit costing:

This method of cost ascertainment is used when production is uniform & consists of a single
or two or three varieties of the same product. Where the product is produced in different grades,
costs are ascertained grade-wise. As the units of output are identical, the cost per unit is found
by dividing the total cost by the number of units produced. This method is applied in mines,
quarries, brick kilns, steel production, floor mills, etc.

7. Operating or service costing:

This method should not be confused with operation costing. It is used in undertakings which
provide services instead of manufacturing products. For example, transport undertakings (road
transport, railway, airlines, and shipping companies), electricity companies, hotels, hospitals &
cinemas, use this method. The cost units are passenger-kilometre or tonne- kilometre, kilowatt
hours, a room per day in a hotel, a seat per show in a cinema hall, etc. this method is a variation
of process costing.

8. Multiple or composite costing:

It is an application of more than one method of cost ascertainment with respect to the same
product. This method is used in industries where a number of components are separately
manufactured & then assembled into a final product.

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For example, in a television set manufacturing company, manufacture of different component

parts may require different production methods & thus different methods of costing may have
to be used. Assembly of these components into final product requires yet another method of
costing. Other examples of industries which make use of this method are air-conditioners,
refrigerators, scooters, cars & locomotives.

Techniques of costing:
Techniques may be used for special purpose of control & policy in any business irrespective
of the method of costing being used there. These techniques have been briefly explained below:

1. Standard costing:
This is a very valuable technique of controlling cost. In this technique, standard cost is
predetermined as target of performance, & actual performance is measured against the
standard. The difference between standard & actual costs are analysed to know the reasons for
the difference so that corrective actions may be taken.

2. Budgetary control:
A budget is an expression of a firm’s business plan in financial form & budgetary control is a
technique applied to the control of total expenditure on materials, wages & overheads by
comparing actual performance with planned performance. Thus, in addition to its use in
planning, the budget is also used for control & co-ordination of business operations.

3. Marginal costing:
In this technique, separation of costs into fixed & variable (marginal) is of special interest &
importance. This is so because marginal costing regards only variable costs as the cost of the
products. Fixed cost is treated as period cost & no attempt is made to allocate or apportion this
cost to individual cost centres or cost units. It is transferred to costing profit & loss account of
the period. This technique is used to study the effect on profit of changes in volume or type of
output.

4. Total absorption costing:

It is a traditional method of costing whereby total costs (fixed & variable) are charged to
products. This is in complete contrast to marginal costing where only variable costs are charged
to products. Although until recently, this was the only technique employed by cost accountants,

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but now a days it is considered to have only a limited application.

5. Uniform costing:
This is not a separate technique or method of costing like standard costing or process costing.
It simply denotes a situation in which a number of firms adopt a uniform set of costing
principles. It has been defined by CIMA, London as ‘the use by several undertakings of the
same costing principles &/or practices.’ This helps to compare the performance of one firm
with that of other firms & thus, to derive the benefit of anyone’s better experience &
performance.

Elements of Cost:
A cost is composed of three elements, i.e., material, labour & expense. Each of these elements
may be direct or indirect. This is shown below:

Total Cost

Direct cost Indirect cost

Direct Direct Direct Indirect Indirect Indirect

Material Labour Expenses Material Labour Expenses

1. Material Cost:
According to CIMA, London, material cost is ‘the cost of commodities supplied to an
undertaking.’ Material cost includes cost of procurement, freight inwards, taxes, insurance, etc.
directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks, etc. are
deducted in determining the cost of material. Material may be direct or indirect.

Direct materials:
It is that which can be easily identified with & allocated to cost units. Direct materials generally
become a part of the finished product.
For example, cotton used in a textile mill is a direct material. However, in many cases, though
a material forms a part of the finished product, yet, it is not treated as direct material; for
instance, nails used in furniture, thread used in stitching garments, etc. this is because value of
such materials is so small that it is quite difficult & futile to measure it. Such materials are

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treated as indirect materials.

Indirect materials:
These are those materials which cannot be conveniently identified with individual cost units.
These are minor in importance, such as (i) small & relatively inexpensive items which may
become a part of the finished product, e.g., pins, screws, nuts & bolts, thread, etc., (ii) those
items which do not physically become a part of the finished products e.g., coal, lubricating oil
& grease, sand paper used in polishing, soap, etc.

2. Labour Cost:
“Labour cost means the payment made to the employees, permanent or temporary, for their
services.” It includes salaries, wages, commission & all fringe benefits like P.F. contribution,
gratuity, ESI, overtime, incentive bonus, wages for holidays, idle time, etc.

Direct labour:
It is a cost consists of wages paid to workers directly engaged in converting raw materials into
finished products. These wages can be conveniently identified with a particular product, job or
process. Wages paid to a machine operator is a case of direct wages.

Indirect labour:
It is of general character & cannot be conveniently identified with a particular cost unit. In
other words, indirect labour is not directly engaged in the production operations but only to
assist or help in production operations.

3. Expenses:
All costs other than material & labour are termed as expenses. It is defined as ‘the cost of
services provided to an undertaking & the notional cost of the use of owned assets’ (CIMA).

Direct Expenses:
According to CIMA, London, ‘direct expenses are those expenses which can be identified with
& allocated to cost centres or units.’ These are those expenses which are specifically incurred
in connection with a particular job or cost unit. Direct expenses are also known as chargeable
expenses.

Indirect expenses:

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All indirect costs, other than indirect materials & indirect labour costs, are termed as indirect
expenses. These cannot be directly identified with a particular job, process or work order & are
common to cost units or cost centres.

4. Overheads:
These are the aggregate of indirect material cost, indirect labour cost & indirect expenses.

Overheads are divided into three groups:

i. Production overheads:
It is also known as factory overheads, works overheads or manufacturing overheads, these are
those overheads which are concerned with the production function. They include indirect
materials, indirect wages & indirect expenses in producing goods or services.
 Indirect material: coal, oil, grease etc.; stationery in factory office, cotton waste,
brush & sweeping broom.
 Indirect labour: works manager’s salary, salary of factory office staff, salary of
inspector & supervisor, wages of factory sweeper & wages of factory watchman.
 Indirect expenses: factory rent, depreciation of plant, repair & maintenance of plant,
insurance of factory lighting & power & internal transport expenses.
ii. Office & administration overheads:
These are the indirect expenditure incurred in general administrative function, i.e., in
formulating policies, planning & controlling the functions, directing & motivating the
personnel of an organisation in the attainment of its objectives. These overheads are of general
character & have no direct connection with production or sales activities.
 Indirect material: stationery used in general administrative office, postage, sweeping
broom & brush.
 Indirect labour: salary of office staff, salary of managing director, remunerations of
directors of the company.
 Indirect expenses: rent of office building, legal expenses, office lighting & power,
telephone expenses, depreciation of office furniture & equipments, office air-
conditioning & sundry office expenses.
iii. Selling distribution overheads:
Selling overheads are the costs of promoting sales & retaining customers. They are defined as
‘the cost of seeking to create & stimulate demand & of securing orders.’ Examples are
advertisements, samples & free gifts & salaries of salesmen.

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Distribution cost includes all expenditure incurred from the time the products is completed until
it reaches its destination. It is defined as ‘the cost of sequence of operations which begins with
making the packed product available for dispatch & ends with making the reconditioned
returned empty packages if any, available for reuse.’ Examples are carriage outwards,
insurance of goods in transit, upkeep of delivery vans & warehousing.

 Indirect material: packing material, stationery used in sales office, cost of samples,
price list, catalogues, oil, grease etc., for delivery vans etc.
 Indirect labour: salary of sales manager, salary of sales office staff, salary of
warehouse staff & salary of drivers of delivery vans.
 Indirect expenses: advertising, travelling expenses, showroom expenses, carriage
outwards, rent of warehouse, bad debts & insurance of goods in transit.

Classification/Types of costs:
Classification is the process of grouping costs according to their common characteristics. It is
a systematic placement of like items together according to their common features. There are
various ways of classifying costs as given below.

1. Element wise classification:

a. Costs of direct material:
Costs of materials that are traced to the cost object. Materials issued to a job order or batch
or process; & processed materials transferred from one process to another.

b. Direct wages:
Costs of labour hours booked against the cost object. Wages to machine operators; wages to
drivers & conductors of a bus; & salaries to consultants booked against a specific
assignment.

c. Direct expenses:
Costs of services that are traced to the cost object. Costs of special designs; & hire charges
of special equipment.

d. Overheads:
Costs of materials, employees, & services, which are not traced to cost object. They are

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assigned to cost object, on some equitable basis. Consumables; wages of unskilled labour;
salaries to supervisors; depreciation ; rent of building; lighting charges; time office
expenses; and back office expenses of a consulting organisation.

2. Behaviour pattern classification:

a. Fixed costs:
Costs, which are not affected by the volume of output. This relationship remains valid for a
given range of activity, & over a short time period. In other words these costs remains
constant in ‘total’ amount over a specific range of activity for a specified period of time,
i.e., these do not increase or decrease when the volume of production changes.
Example: building rent & managerial salaries remain constant & do not change with change
in output level & thus are fixed costs. Depreciation; salaries of executives; insurance
premium; rent & rates of building; & expenses on preventive maintenance.

b. Variable costs:
Cost, which vary in direct proportion to the volume of output. These costs tend to vary in
direct proportion to the volume of output. In other words, when volume of output increases,
total variable cost also increases & vice versa, when volume of output decreases, total
variable cost also decreases, but the variable cost per unit remains constant.
Example: direct material, direct wages paid on piece rate & salesmen commission.

c. Semi-variable costs or semi-fixed costs:

Costs, which change with change in the activity level, but not in direct proportions. These
costs are partly fixed & partly variable. These costs include both a fixed & a variable
component, i.e. these are partly fixed & partly variable. A semi-variable cost has a fixed
cost element which needs to be incurred irrespective of the level of activity achieved. On
the other hand, the variable element in semi-variable costs changes either at a constant rate
or in lumps.
Example: telephone charges, power charges & repair & maintenance.

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3. Function-wise classification:
a. Product cost:
Cost attributable to activities directly related to the production of goods or services. These
costs include all such costs that are involved in acquiring or making a product. For a trader,
product cost includes purchase cost plus freight inwards. For a manufacturer, these consist
of direct materials, direct labour & factory overheads. Product costs are ‘absorbed by’ or
‘attached to’ the units produced. These are called inventoriable costs because these are
included in the cost of product as work-in-progress, finished goods or cost of sales.

b. Administrative costs:
Cost attributable to administrative functions such as formulation of business policy, &
planning & control of overall business performance. General administrative expenses;
corporate office expenses. It does not include administration costs related to production
facilities (e.g. factory)

c. Selling costs:
Cost attributable to marketing function such as creating & stimulating demand, & securing
orders. Sales promotion expenses; expenses related to customer services.

d. Distribution costs:
Costs attributable to distribution functions such as, packing & dispatch, & reconditioning of
empty packages. Depreciation of delivery vehicles; running & maintenance of delivery
vehicles & warehousing expenses.

e. Research & development costs:

Costs attributable to research & development activities. Expenses of the research centre;
costs of manufacturing the prototype, & expenses for testing the new product or method.

4. Recognition in financial statements:

a. Capitalized costs:
Costs of acquiring fixed assets. Cost of equipment, costs incurred to enhance the
performance of an existing fixed asset.

b. Inventoriable costs or production cost:

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Costs, which are incurred to bring the product in the saleable condition & the location of
sale. Direct material, direct wages, direct expenses & manufacturing overhead.

c. Period costs:
Expenditure, which are recognized as expenses in the profit & loss account for the period in
which they are incurred. Those costs relate to passage of time, rather than closely associated
with manufacturing activities.
These are those costs which are not necessary for production & are incurred even if there is
no production. These are written off as expenses in the period in which these are incurred.
Administration costs, selling & distribution costs & research costs.

5. Normality Classification:
a. Normal cost:
A cost that is usually incurred at a given level of capacity utilization in a normal
environment. In other words, a cost which is normally incurred on expected lines at a given
level of output. This cost is a part of cost of production.

b. Abnormal cost:
A cost that results from abnormal reasons. Abnormal cost is that which is an unusual or a
typical cost whose occurrence is usually irregular & unexpected & due to some abnormal
situation of the production. Such cost is over & above the normal cost & is not treated as a
part of the cost of production. Abnormal costs result from natural calamity, sudden
breakdowns, & from such other similar reasons.

6. Classification into historical & predetermined costs:

a. Historical costs:
These are the costs which are ascertained after these have been incurred. Historical costs are
thus, nothing but actual costs. These costs are not available until after the completion of the
manufacturing operations.

b. Predetermined costs:
These are future costs which are ascertained in advance of production, on the basis of a
specification of all the factors affecting cost. These costs are extensively used for the
purpose of planning & control.

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7. Cost classification for Decision Making:

a. Marginal cost:
At any given volume of output, the amount by which aggregate cost changes with change
in the volume of output by one unit. Marginal cost of an item sold is the total variable costs
incurred to produce & sell one unit the product. Example: costs of direct materials, direct
wages, direct expenses, variable manufacturing overheads, salesmen’s commission & other
variable selling & distribution costs.
It is the same thing as variable cost. In other words, marginal cost is the aggregate of variable
costs, i.e., prime cost plus variable overhead. Marginal costing (or variable costing) is a
technique of charging only variable costs to products. Inventory is also valued at variable
cost only. Marginal costing is also a very important analytical & decision making tool in the
hands of management.

b. Sunk cost:
Cost that has already been incurred at the time of evaluating the economics of the proposed
activity. This is irretrievable by managerial actions & is therefore, not relevant for the
decision under consideration.
A sunk cost is an expenditure made in the past that cannot be changed & over which
management no longer has control. These costs are not relevant for decision making about
the future. Thus, book value of an asset currently being used is not relevant in making the
decision to replace it. Similarly, the cost of land purchased in the year 2001 is not relevant
in deciding whether to sell the land or hold it. What is relevant is how much cash could be
realized in future by selling it.
Despite the fact that sunk costs, which are historical costs, are irrelevant for making
decision, they are frequently analysed in detail before decisions about future courses of
action are made. For example, historical costs may affect future tax payments which will
differ depending on the course of action selected by management. Moreover, an analysis of
historical costs may provide information about how future costs will differ under alternative
courses of action. Cost of equipment already purchased & installed, cost of marketing
research completed.

c. Committed costs:
Costs that are necessarily incurred for the organization to function. Those costs are related

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 Financial ManagementJSS AHER

to facilities created for the business. In short run managers have very little control over these
costs. Example: rent of buildings, rates payable to local authorities, depreciation of plants
& equipment & salaries to employees required to maintain the minimum organization
structure.

d. Opportunity cost:
The amount of benefit foregone in favour of the alternative course of action under
consideration. If a firm decides to use a scarce resource for a particular activity, it sacrifices
benefits from the next best alternative use.
Opportunity cost is the value of the alternatives foregone by adopting particular strategy.
In other words, it is a cost that measures the benefit that is lost or sacrificed when the
choice of one course of action requires that other alternative course of action be given up.
For example, a company has deposited Rs.1 lakh in bank at 10 per cent p.a. interest. Now,
it is considering a proposal to invest this amount in debentures where the yield is 17 per
cent p.a. if the company decides to invest in debentures, it will have to forego bank interest
of Rs.10,000 p.a. which is the opportunity cost.
Opportunity cost is a pure decision making cost. It is an imputed cost that does not require
a cash outlay & it is not entered in the accounting books.

e. Incremental cost (Differential cost):

It represents increase of cost (and revenue) arising from a decision to graduate from one
level of activity to another. This cost may be regarded as the difference in total cost resulting
from a contemplated change. In other words, differential cost is the increase or decrease in
total cost that results from an alternative course of action. It is ascertained by subtracting the
cost of one alternative the cost of another alternative. The alternative choice may arise
because of change in method of production, in sales volume, change in product mix, make
or buy decisions, take or refuse decision, etc.

f. Imputed costs:
These are hypothetical or notional costs which are specially computed outside the
accounting system for the purpose of decision making. Interest on capital invested is a
common type of imputed cost. As interest on capital is usually not included in cost, it is
considered necessary to take it into account when deciding about the alternative capital
investment projects. The failure to consider imputed interest cost may result in an erroneous

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 Financial ManagementJSS AHER

decisions. For example, project A requires a capital investment of $50,000 & project B
$40,000. Both the projects are expected to yield $10,000 as additional profit. Obviously,
these two projects are not equally profitable since project B requires less investment & thus,
it should be preferred. Similarly, rental value of building owned by a firm is also an imputed
cost.

g. Replacement cost:
This is the cost at which there could be purchased an asset identical to that which is being
replaced. In simple words, replacement cost is the current market cost of replacing an asset.
When the management considers the replacement of an asset, it has to keep in mind its
replacement cost & not the cost at which it was purchased earlier. For example, a machinery
purchased in 2001 at Rs.10,000 is discarded in 2009 & a new machinery of the same type is
purchased for $15,000. So the replacement cost of the machinery is $15,000.

h. Explicit cost & Implicit cost (Out-of-pocket Cost):

There are certain costs which require cash payment to be made (such as wages, rent) whereas
many costs do not require cash outlay (such as depreciation). Out-of-pocket costs, also
known as explicit costs, are those costs that involve cash outlays or require the utilization of
current resources.
Examples of out-of-pocket costs are wages, material cost, insurance & power cost. Out-of-
pocket cost may be either fixed (manager’s salary) or variable (raw materials & direct
wages). Depreciation on plant & machinery does not involve any cash outlay & therefore is
not an out-of-pocket cost. Such costs are also known as implicit costs. Out-of-pocket cost is
frequently used as an aid in make or buy decision, price fixation during depression & many
other decisions.

i. Avoidable & unavoidable costs:

An avoidable cost is that which could be avoided if the activity or the sector of the business
did not exist. An unavoidable cost is the cost that must be incurred irrespective of the
outcome of the decision.
Common costs apportioned to an activity are usually unavoidable costs. Those costs that are
specifically incurred for an activity are avoidable costs. Hiring charge of an equipment
specifically hired for the activity is an avoidable cost. Rent of a factory premise is
unavoidable cost for a particular workstation.

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j. Controllable & non-controllable costs:
A controllable cost is one, which can be controlled by the relevant responsibility centre
(e.g. cost centre) manager. The relevant responsibility centre manager cannot control a
non-controllable cost.
Controllable costs are those costs which are subject to the discretion of the manager &
hence can be kept within predefined limits. Variable costs are generally controllable by
department heads. For example, cost of raw material may be controlled by purchasing in
larger quantities.
Non-controllable costs are those costs which cannot be influenced by the action of a
specified member of an enterprise. For example, it is very difficult to control costs like
factory rent, managerial salaries, etc.

Cost Sheet:
Cost sheet is defined as ‘a document which provides for the assembly of the detailed cost of
a cost centre or cost unit.’

It is a statement which is prepared periodically to provide detailed cost of a cost centre or cost
unit. A cost sheet not only shows the total cost but also the various components of the total
cost. Period covered by a cost sheet may be a year, a month or a week, etc.

Purposes:
1. It reveals the total cost & cost per unit of goods produced.
2. It discloses the break-up of total cost into different elements of cost.
3. It provides a comparative study of the cost of current period with that of the
corresponding previous period.
4. It acts as a guide to management in fixation of selling prices & quotation of tenders.
 Overheads

MEANING OF OVERHEAD COST:

An overhead is the amount which is not identified with any product. The name overhead might
have come due to the reason of over and above the normal heads of expenditure. It is the aggregate
of indirect material, indirect labour and indirect expenditure. The generic term used to denote
indirect material, indirect labour and indirect expenses. Thus overheads forms a class of cost that
cannot be allocated or absorbed but can only be apportioned to cost units.

The total of all direct costs (i.e., direct material cost, direct labour cost and direct expenses) is
known as Prime cost and the total of all indirect costs (i.e., indirect material cost, indirect labour
cost and indirect expenses) is termed as Overhead cost. Various other names of overheads are:
(a) On cost; (b) supplementary cost; (c) burden; (d) non-productive cost, etc.

 ‘Overhead is the aggregate of indirect materials, indirect wages and indirect expense.’
- CIMA London
 ‘Overhead may be defined as the cost of indirect materials, indirect labour and such other
expenses, including services as cannot conveniently be charged direct to specific cost units.
Alternatively, overheads are all expenses other than direct expenses.’
- Wheldon
 ‘Overheads are those which do not result from existence of individual cost units.’
- Harper

Thus, overhead cost is the total of all indirect expenditure. It comprises those costs which the cost
accountant is either unable or unwilling to allocate to particular cost units.
Accounting and control of overhead costs is more complex than that of other elements of cost, i.e.,
direct materials and direct labour. This is because overheads by definition, are indirect costs which
cannot be conveniently allocated to cost units. Hence there arises the knotty problem of
apportioning these indirect costs to cost centres and cost units.
 Collection of Overheads
The procedure of classification of production overheads and of assigning standing order (code)
numbers has already been discussed. Such classification and codification is pre-requisite for the
collection of overheads.
Production overheads should be collected understanding order numbers. The main sources from
which overhead costs are collected are as follows:
(a) Invoice – For collection of indirect expenses, like rent, insurance, etc.
(b) Stores Requisitions – For collection of indirect materials.
(c) Wages Analysis Sheet – For collection of indirect wages.
(d) Journal entries – for collection of those overhead items which do not result in current cash
outlay and need some adjustment, e.g., depreciation, charge in lieu of rent, outstanding rent, etc.

Classification of Overhead Costs

Overhead costs may be classified according to:
1. Functions
2. Elements
3. Behaviour

1. Classification according to Functions

The main group of overheads on the basis of this classification are as follows:
(a) Production Overheads: It is also termed as factory overheads, works overheads or
manufacturing overheads, they are indirect expenditures incurred in connection with production
operations. They are the aggregate of factory indirect material cost, indirect wages and indirect
expenses.

(b) Administration Overheads: These overheads are of general nature and consist of all costs
incurred in the direction, control and administration (including secretarial, accounting and
financial control) of an undertaking, which are not related directly to production or selling and
distribution function.
 (c) Selling and Distribution Overheads: Selling overheads are the cost of seeking to create and
stimulate demand or of securing orders. Examples: advertising, salaries and commission of sales
personnel, showroom expenses, travelling expenses, bad debts, catalogues and price lists.
Distribution Overheads comprise all expenditures incurred from the time product is completed in
the factory till it reaches its destination or customer. It includes packing cost, carriage outward,
delivery van expenses, warehousing costs, etc.
Selling overheads and distribution overheads are both related to sales function and thus are
combined into one category of selling and distribution overheads. These are often referred to as
‘after production costs’ because these costs are incurred after production work is over.

2. Element-wise Classification:
Under this method, the classification is done according to the nature and sources of the
expenditure. This method fellows logically from the definition of overhead costs. On the basis,
expenses are classified under three main groups given below:
(a) Indirect materials: They are material costs, which cannot be allocated but which are to be
apportioned to or absorbed by cost centres or cost units. Examples are stationery, coal, lubricants
and tools for general use.

(b) Indirect wages: Indirect wages are those which cannot be allocated but which are to be
apportioned to or absorbed by cost centres or cost units. Examples are wages of sweeper, idle time
wages, maintenance and repair wages, foreman’s pay and chowkidar’s pay.

(c) Indirect expenses: Expenses which cannot be allocated but which are to be apportioned to or
absorbed by cost centres or cost units are indirect expenses. For example, power, depreciation,
insurance, taxes and rates and rent.

3. Classification according to Behaviour or Variability

Different overhead costs behave in different ways when volume of production changes. On the
basis of behaviour, overheads may be classified into: (a) Fixed overheads; (b) Variable overheads;
and (c) Semi-variable overheads.
(a) Fixed overheads: These overheads unaffected or fixed in total amount by fluctuation in
volume of output. Examples are rent and rates, managerial salaries, building depreciation, postage,
stationery and legal expenses.

(b) Variable overheads: this is the cost which, in aggregate, tends to vary in direct proportion to
changes in the volume of output. Variable overheads per unit remain fixed. Examples are indirect
materials, indirect labour, salesmen’s commission, power, light, fuel etc.

(c) Semi-variable overheads: These overheads are partly fixed and partly variable. In other
words, semi-variable overhead costs vary in part with the volume of production and in part they
are constant, whenever there is change in volume of production. Examples are supervisory salaries,
depreciation, repairs and maintenance, etc.

Steps in Overheads Distribution

Unlike direct materials and direct wages, overhead cannot be charged to cost units directly. The
various steps taken for distribution of overhead costs are as follows:
1. Classification and collection of overheads.
2. Allocation and apportionment of overheads to production departments and service
departments.
3. Re-apportionment of service department costs to production departments.
4. Absorption of overheads of each production department in cost units.
These steps are explained in detail in the following sections.

Allocation of overheads:
CIMA defines Cost Allocation as, “the charging of discrete, identifiable items of cost to cost
centres or cost units”. In simple words complete distribution of an item of overhead to the
departments or products on logical or equitable basis is called allocation.
Certain items of overhead costs can be directly identified with a particular department or cost
centre as having been incurred for that cost centre. Allotment of such costs to the departments or
cost centres are known as allocation. Thus, allocation may be defined as ‘the assignment of whole
items of cost directly to a cost centre.’
 In other words, allocation is charging to a cost centre those overheads that result solely from the
existence of that cost centre. For example, rent cannot normally be allocated since rent is payable
for the factory as a whole and exact amount of rent for each department cannot be known. Indirect
materials, on the other hand, can be easily allocated to various departments in which they are
incurred. Other items which are allocated include indirect wages, overtime and idle time cost,
power (when sub-meters are installed in departments), depreciation of machinery, supervision, etc.

Apportionment of overheads:
Certain overhead costs cannot be directly charged to a department or cost centre. Such costs are
common to a number of cost centres or departments and do not originate from any specific
department. Distribution of such overhead costs to various departments is known as
apportionment.
Thus, apportionment may be defined as ‘the distribution of overheads to more than one cost centre,
on some equitable basis.’ In other words, it is charging a fair share of an overhead cost to a cost
centre.
Where an item of overhead cost is common to various cost centres, it is allocated to different cost
centres proportionately. Again taking the cases of rent, as it cannot be allocated, it is apportioned
to various departments on some equitable basis, i.e., in the ratio of area occupied. Similarly, salary
of a general manager cannot be allocated wholly to any one department as he attends in general to
all the departments. It should, therefore, be apportioned to the required departments on some
equitable basis. Other items generally cannot be allocated but are apportioned include fire
insurance, lighting and heating, time keeping expenses, canteen expenses, medical and other
welfare expenses, etc.

Principles of Apportionment
Apportionment of overheads to various production and service departments is based on the
following principles:
1. Service or use: This is the most common principle of apportionment of overhead costs. It is based
on the theory that greater the amount of service or benefit received by a department, the larger
should be the share of cost to be borne by that department. For example, rent is
 apportioned to various departments according to the number of extension telephones in each
department, and so on.
2. Survey method: this method is used for those overhead costs that are not directly related to
departments and whose remoteness necessitates an arbitrary distribution. For example, salary of a
general manager of a company may be apportioned on the basis of the results of a survey which may
reveal that 30% of his salary should be apportioned to sales, 10% to administration and 60% to various
producing departments. Similarly, lighting expenses may be apportioned on the basis of a survey of
the number of light points, size, estimated hours of use, etc.
3. Ability-to-pay method: This is based on the theory of taxation which holds that those who have the
largest income should bear the highest proportion of the tax burden. In overhead cost distribution,
those departments which have the largest income may be charged with the largest amount of
overheads. This method is generally considered inequitable because it penalizes the efficient and
profitable departments to the advantage of inefficient ones.

Basis of apportionment
The following are some of the common bases of apportionment of overheads:
Overhead Cost Basis of Apportionment
Rent and other building expenses
Lighting and heating Floor area, or volume of department
Fire precaution service
Air-conditioning
Fringe benefits
Labour welfare expenses
Time keeping Number of workers
Personnel office
Supervision
Compensation to workers
Holiday pay Direct wages
ESI and PF contribution
Fringe benefits
 General overheads
Depreciation of plant
machinery
Repairs and maintenance of plant
and machinery
Insurance of stock
Power/steam consumption
Internal transport
Managerial Salaries
Lighting expenses
Electric power
Material handling
Stores overheads
Direct labour hours, or Direct wages, or machine hours
and
Capital values
Technical estimates
No. Of light points, or Area
Horse power of machines, or Number of machine
hours, or Value of machines
Weight of materials, or Volume of materials, or Value
of materials

Re-apportionment of service department costs (secondary distribution)

Once the overheads have been allocated and apportioned to production and service departments and
totaled, the next step is to re-apportion the service department costs to production departments. This
is necessary because our ultimate objective is to charge overheads to cost units, and no cost units are
produced in service departments. Therefore, the costs of service departments must be charged to
production departments which directly come in contact with cost units. This is called secondary
distribution.

The method of re-apportionment of service department costs is similar to apportionment of overheads

discussed earlier. Some of the important bases of apportionment of service department costs to
production departments are as follows:
Service department Bases of apportionment
1. Store-keeping department Number of material requisitions, or value/ quantity of
materials consumed in each department.
2. Purchase department Value of materials purchased for each deportment, or
number of purchase orders placed
 3. Time-keeping department and
payroll department
4. Personnel department
5. Canteen, welfare and recreation
services
6. Maintenance department
Number of employees, or total labour or machine
hours
`rate of labour turnover, or number of employees in
each department
Number of employees, or total wages
Number of hours worked in each department.

7. Internal transport service Value or weight of goods transported, or distance

covered
8. Inspection department Direct labour hours or machine operation hours
9. Drawing office No. of drawings made or man hours worked

Difference between Allocation and Apportionment

The difference between Allocation and Apportionment is important to understand. As seen
above, the purpose of both cost allocation and cost apportionment is the identification or
allotment of items of cost to cost centres or cost units. However, the main difference between
the two procedures is that while allocation deals with whole items of cost, apportionment deals
with proportions of the item cost. Allocation is a direct process but apportionment may be made
only indirectly and for which suitable bases are to be selected. Whether an item of cost can be
allocated or apportioned does not depend upon the nature of cost but upon its relation with the
cost centres or cost units to which it is to be charged.
Overheads should always be allocated, as far as possible. If an over head cost cannot be
allocated, it is apportioned. This involves finding some basis of apportionment that will enable
the overhead cost to be equitably distributed over various production and service department.