Lecture Notes on Module-2

Cost concepts:

Cost
In economics, cost can be defined as a monetary valuation of efforts, material, resources,
time and utilities consumed, risks incurred, and opportunity forgone in the production of a
good or service.

An organization incurs a number of costs, such as opportunity costs, fixed costs, implicit
costs, explicit costs, social costs, and replacement costs. On the other hand, revenue is the
income earned by an organization from the sales of goods or services. It excludes
deductions of tax, interest, and dividend paid by an organization. The level of profitability
of an organization can be determined by analyzing its costs and revenue.

Cost analysis
Cost analysis involves the study of total costs incurred by an organization to acquire
various resources, such as labor, raw materials, machines, land, and technology. It helps an
organization to make various managerial decisions, including determination of price and
level of current production.

Cost functions
Cost functions express the relationships between cost and its determinants, like the size of
plant. Level of output, prices, technology, etc. In a mathematical form it can be expressed
as
C = f(S, 0, P, T, M)
Where C- Cost (unit cost or total cost)
S -Size of plant
0 -Level of Output
P -Price of inputs used in production
T- Nature of Technology
M -Managerial efficiency
f - Function.

Determinants of Cost
(i) Size of Plant: Plant size is an important variable influencing cost. The relation between
scale of operations or size of plant to the unit cost is negative in the sense that, as the
former increases, per unit cost decreases and vice versa.
(ii) Output level: Level of output and total cost are obviously related. Total cost increasing
with increase in output. But average total cost or marginal cost function are derived by the
increase in the output. The average total cost or marginal cost function are derived by
relating the relevant costs with the level of capacity utilization of given plant size. Since
such a cost function forms:
(a) V-shaped curve quadratic or cubic function is more appropriate to use.
(b) Price a/inputs: Changes in input prices influence costs. Depending on the selective
usage of the inputs and relative changes in the prices. When a factor which is a major
component in production becomes relatively costly it raises the cost significantly.

(iii) Technology: Technology is often qualified as capital-output ratio. Modern and

efficient technology is certainly cost saving. Generally this is found to have higher capital-
output ratio.

(iv) Managerial Efficiency: Generally cost is influenced by a managerial efficiency and it is

difficult to quantify it. However, a change in cost at two points of time may explain how
organizational or marginal changes within the form have brought labor cost efficiency.
Sometimes it is possible to exclude the effect of other factors.

Classification of Cost
The different bases of cost classification are:
1. By time (historical, pre-determined).
2. By nature of elements (material, labour and overhead).
3. By degree of traceability to the the product (direct, indirect).
4. Association with the product (product, period).
5. Change in the activity or volume (fixed variable, semi-variable).
6. By function (manufacturing, administrative, selling, research and development, pre-
production).
7. Relationship with accounting period (capital, revenue).
8. Controllability (controllable, noncontrollable).
9. Cost of analytical and decision-making purposes (opportunity, sunk, differential joint,
common, imputed, out-of-pocket, marginal, uniform, replacement).

Classification on the Basis of Time

(a) Historical cost: These costs are ascertained after they have incurred. Such costs
are available only when the production of a particular thing has already been done.
They are objective in nature and can be verified with reference to actual operations.
(b) Pre-determined costs: These costs are calculated before they are incurred on the
basis of a specification of all factors affecting cost. Such costs may be :
(i) Estimated costs: Costs are estimated before goods are produced; these are naturally less
accurate than standards.
(ii) Standards costs: This is a particular concept and technique. This method involves:
(a) Setting up pre-determined standards for each element of cost and each product;
(b) comparison for actual with standard; and
(c) pin pointing the causes of such variances and taking remedial action.

Obviously, standard costs, though pre-determined, are arrived with much greater care than
estimated costs.

By changes in Activity or Volume

Costs can be classified as fixed, variable and semi-variable cost.

Fixed costs:
Fixed cost as "The cost which is incurred for a period, and which within certain output and
turnover limits, tends to be unaffected by fluctuations in' the levels of activity (output or
turnover)".
These costs are incurred so that physical and human facilities necessary for business
operations can be provided. These costs arise due to contractual obligations and
management decisions. They arise with the passage of time and not with production and
are expressed in terms of a time. Examples are rent, property taxes, insurance, supervisors'
salaries etc.

Variable cost:
Variable costs are those costs that vary directly and propol1ionately with the output e.g.,
direct labour. It should be kept in mind that the variable cost per unit is constant but the
total cost changes corresponding to the levels of output. It is always expressed in terms of
units, not in terms of time.

Semi-fixed (or semi-variable) costs:

Such costs contain fixed and variable elements. Because of the variable element, they
fluctuate with volume and because of the fixed element; they do not change in direct
portion to output. Semi-variable costs change in the same direction as that of the output
but not in the same proportion. Depreciation is an example; for two shifts working the total
depreciation may be only 50% more than that for single shift working. They may change
with comparatively small changes in output but not in the same proportion.

Functional Classification of Costs

A company performs a number of functions. Functional costs may be classified as follows:
(a) Manufacturing/Production costs: It is the cost of operating the manufacturing
division of an undertaking. It includes the cost of direct materials, direct labour, direct
expenses, packing (primary) cost and all overhead expenses relating to production.
(b) Administration costs: They are indirect and covers all expenditure incurred in
formulating the policy, directing the organization and controlling the operation of a
concern, which is not related to research, development, production, distribution or selling
functions.
(c) Selling and distribution costs: Selling cost is the cost of seeking to create stimulate
demand e.g. advertisements, market research etc. Distribution cost is the expenditure
incurred which begins with making the reconditioned packages available for reuse
e.g. warehousing, cartage etc. It includes expenditure incurred in transporting articles to
central or local storage. Expenditure incurred in moving articles to and from prospective
customers as in the case of goods on sale or return basis is also distribution cost.
(d) Research and development costs: They include the cost of discovering new ideas,
processes, and products by experiment and implementing such results on a commercial
basis.
(e) Reproduction costs: When a new factory is started or when a new product is
introduced, certain expenses incurred. There are trial runs. Such costs are termed as
reproduction costs and treated as differed revenue expenditure. They are charged to the
cost of future production.

Controllability
Cost can be controllable and non-controllable.
Controllable cost: Controllable cost is which can be influenced by the budget holder.
Non-Controllable cost: It is the cost which is not subject to control at any level of
managerial supervision. The difference between the terms is very important for the
purpose of the cost accounting, cost control and responsibility accounting.
A controllable cost can be controlled by a person at a given organizational level.
Controllable costs are not totally controllable. Some costs are partly controllable by one
person and partly by another. Example maintenance cost can be controllable by both the
production, maintenance manager. The term "controllable cost" is often used to mean
variable cost and non-controllable cost as fixed.

Cost of Analytical and Decision-Making Purposes

(a) Opportunity cost: It is the cost of selecting one cost of action and losing of their
opportunities to carry out that course of action. It is the amount that can be received if the
asset is utilized in its next best alternative.
(b) Sunk Cost: It is the one which has already been incurred and cannot be avoided by
decision taken in the future. As it refers to past costs, it is called an unavoidable cost. Sunk
cost is defined as an expenditure for equipment or productive resources which has an
economic relevance to the present decision-making process. This cost is not essential for
decision-making as all past costs are irrelevant. It has also been defined as the difference
between the purchase price of an asset and its salvage value.

(c) Differential cost: It has been defined as the difference in total cost between
alternatives, calculated to assist decision making.

(d) Joint Cost: The processing of a single raw material results in two or more products
simultaneously. The joint products are not identifiable as different types of products until a
certain stage of production known as the split off point is reached. Joint costs are the costs
incurred up to the point of separation. One product may be of major importance and others
of minor importance which are called by products.
(e) Common Cost: Common costs are those costs which are incurred for more than one
product, job, territory or any other specific costing object. They are not easily related with
individual products and hence are generally apportioned. It should be kept in mind that
management decisions influence the incurrence of common costs.
Example: Rent of a factory is common cost to all departments located in factory.
(f) Imputed cost: Some costs are not incurred and are useful while taking decision
pertaining to a particular situation. These costs are known as imputed or notional costs and
they do not enter into traditional accounting systems.
Examples: Interest on internally generated funds, salaries of owners of proprietorship or
partnership, notional rent etc.
(g) Out- of- pocket costs: Out-of-pocket costs signify the outlay required for an activity.
The management would like to know that the income from a particular project will at least
cover the expenditure for the project. Acceptance of a special order requires to be
considered as additional costs need not be incurred if the special order is not accepted
hence the importance of out-of-pocket costs.
(h) Uniform costs: They are not distinct costs as such. Uniform costing signifies common
costing principles and procedures adopted by a number of firms. They are useful in inter-
firm-comparison.
(i) Marginal costs: It is the aggregate of variable costs, i.e., prime cost plus variable
overheads. Thus costs are classified as fixed and variable.
(j) Replacement costs: This is the cost of replacing an asset at current market values e.g.,
when the cost of replacing an asset is considered, it means the cost of purchasing the asset
at the current market price is important and not the cost at which it was purchased.
Other Costs:

(i) Conversion cost: It is the cost of a finished product or work-in- progress comprising
direct labour and manufacturing overhead. It is production cost less the cost of raw
material but including the gains and losses in weight or volume of direct material arising
due to production.

(ii) Normal Cost: This is the cost which is normally incurred at a given level of output in
the conditions in which that level of output is achieved.

(iii) Traceable cost: It is the cost which can be easily associated with a product, process or
department.

(iv) Avoidable costs: Avoidable costs are those costs which under the present conditions
need not have been incurred.

(v) Total cost: This is the sum of variable and fixed costs.

(vi)Value added cost: Strictly, it is not cost. It means the selling price of the product /
service less the cost of materials used in the product or the service. Often depreciation is
also deducted for ascertaining "value added".

(vii) Long run cost: It is defined as period of adequate length during which a company
with all factors of production is at high degree of flexibility.

(viii)Short run cost: It is defined as the period of relatively shorter duration when at least
some of the factors of production are fixed. It refers to what are recorded as expenses in
the books of accounting records. The accountant recognizes the cost only when it is
incurred and recorded, as this necessarily fonns the legal point of view. In accounting
system, the assets are valued at the book value. Book value means the cost of acquisition
less depreciation.

(ix) Accounting cost: It is the sum of all cost associated to a particular unit, or process or
department or batch or the entire concern. It may also mean the sum total of material,
labour and overhead. The term accounting cost however, is not precise, if needs to be made
precise by using terms that indicated the elements of cost included.

(x) Economic cost: The economic cost looks beyond the accounting cost. Economists and
mangers recognize that there are other implicit cost that are never recorded in the books.
However, these must be considered in managerial decision making. The Economist or
manager tries to ascertain the costs much before they are incurred and trials to explain
how the managerial decision can be made based on this; for example, an economist would
like to see the value of these assets in terms of replacement costs.

Cost in short-run
Cost in the short-run can be classified into fixed cost and variable cost. The fixed cost may
ascertain in terms of total fixed cost and average fixed cost per unit. The variable cost can
be determined in terms of average variable cost, total variable cost.
1. Total fixed cost remained fixed irrespective of increase or decrease in production of
activity.
2. The total variable cost increases proportionately with production. Here the rate of
increase is not constant.
3. The total cost increases with volume of production. The average fixed cost per unit
decreases as the volume of production increases; whenever production increases, the fixed
costs are shared to a greater number of units, thus, fixed cost of unit variable declines.
4. The average total cost decreases upto a certain level of production. After this level it rises
slowly. If this is represented graphically, it results in a flat U-shaped curve. The lowest
point of the average total cost curve denotes the ideal level of production.
5. Marginal cost is the change in total cost resulting from unit change in output.
6. The marginal cost also decreases up to a certain level of production, later it raises slowly.

Elements of cost
There are three broad elements of costs:
1. Material: The substance from which the product is made is known as material. It can be
direct as well as indirect.
 (a) Direct materials: It refers to those materials which become a major part of the
finished product and can be easily traceable to the units. Direct materials include:
(i) All material specially purchased for a particular job/process.
(ii) All material acquired and later requisitioned from stores.
(iii) Components purchased or produced.
(iv) Primary packing materials.
(v) Materials passing from one process to another.

(b) Indirect Materials: All materials which are used for purposes ancillary to
production and which can be conveniently assigned to specific physical units are
termed as indirect materials. E.g. oils, grease, printing, stationary materials and
consumable stores etc.

2. Labour: Labour cost can he classified into direct labour and indirect labour.

Direct Labour:
It is defined as the wages paid to workers who are engaged in the production
process whose time can be conveniently and economically traceable to units to
products. For example, wages paid to compositors in a printing press, to workers in
the foundry in cast iron works etc.

Indirect Labour:
Labour employed for the purpose of carrying on tasks incidental to goods or
services provided, is indirect labour. It cannot be practically traced to specific units
of output. Examples: wages of store keepers, foreman, time - keepers, supervisors,
inspectors etc.

3. Expenses: Expenses may be direct or indirect.

Direct expenses: These expenses are incurred on a specific cost unit and
identifiable with the cost unit. E.g. cost of design, layout or drawings, hiring of a
particular tool or equipment for a job, fees paid to consultant etc.

Indirect expenses: These arc expenses which cannot be directly, conveniently and
wholly allocated to cost centre or cost unit. Examples are rent, rates and taxes,
insurance, power, lighting and heating, depreciation etc.

Prime cost
The direct cost of a commodity in terms of the materials and labour involved in its
production, excluding fixed costs.

Prime cost = Direct material + Direct labour + Direct expenses

Overheads:
Indirect expenses are called overheads, which include material and labour.

Overheads = Indirect material + Indirect labours + Indirect expenses

Overheads are classified as:

Production or manufacturing overheads – Connected with factory production function

like indirect material labour,etc.

Administrative expenses – Indirect expenditures incurred in general administrative

function, they don’t have any direct connection with production or sales activity. For
example stationeries used, sweeping brooms, salary of a peon, etc.

Selling expenses – It is the cost of promoting the sales and retaining the customers. For
example advertisement and gifts, etc.

Distribution expenses – All the expenses incurred from the time of the production
completion to the time it reaches its destination. For example packing material, salary of
drivers and insurance of the goods.

Research and development expenses – Any expenses associated with the research and
development of a company’s goods or services.

Here,
Factory cost = Prime cost + Factory overheads
Cost of production = Factory cost + Office and administrative overheads
Sales cost = Cost of production + Selling and distribution overheads
Selling price = Cost of sales + Profit
Cost/ unit = Selling price / Total production.

Example 1: The following expenses were incurred for a job during the year ended on
31st March 2019:
Single price for the above job was $1,80,000. You are required to prepare a statement
showing the profit earned during the year ended 31.3.2019 from the job and an estimated
price of a job which is to be executed in the year 2019-20, charging the same percentage of
profit on sales as it was during the year 2019-20. Materials, wages and chargeable expenses
will be required of $50,000, $70,000 and $20,000 respectively for the job. The various
overheads should be recovered on the following basis while calculating the estimated
price:
(a). Factory overheads as a percentage of direct wages.
(b). Administrative and selling and distribution overheads as a percentage of factory cost.
Example-2
The data pertaining to Heavy Engineering Ltd. using are as follows at the end of
31.3.2017. Direct material Rs. 9,00,000; Direct wages Rs.7,50,000; Selling and
distribution overhead Rs.5,25,000; Administrative overhead Rs.4,20,000, Factory
overhead Rs.4,50,000 and Profit Rs.6,09,000.
(a) Prepare a cost sheet showing all the details.
(b) For 2012-13, the factory has received a work order. It is estimated that the
direct materials would be Rs.12,00,000 and direct labour cost Rs.7,50,000. What
would be the price of work order if the factory intends to earn the same rate of
profit on sales, assuming that the selling and distribution overhead has gone up by
15%? The factory recovers factory overhead as a percentage of direct wages and
administrative and selling and distribution overheads as a percentage of works cost,
based on the cost rates prevalent in the previous year
Methods or Types of Costing
Costing is the technique and process of ascertaining costs. In order to do the same, it is
necessary to follow a particular method of ascertaining cost. Different methods of costing
are applied to different industries depending upon the type of manufacture and their
nature.
Broadly the costing methods are classified into the following:
(a) Specific Order Costing (Job or Terminal Costing)
(b) Operation Costing or Process or Period Costing
Specific Order Costing: Specific order costing is the category of basic costing methods
applicable where the work consists of separate jobs, batches or contracts each of which is
authorized by a specific order or contract. It includes job costing consisting batch costing
and contract costing.

Job Order Costing: Industries which manufacture products or render services against
specific orders as distinct from continuous production for stock or sales use the job costing
or job order method of cost accounting. The method is also known under various other
names, such as specific order costing, production order costing, job lot costing or lot
costing. Every order in job costing is separate and it is not essential that the same
manufacturing operations be carried out or the same materials be utilized in respect of
each. However, a number of identical orders or identical products may be combined
together to form lots or batches, each such lot or batch constituting a job order. In the job
costing system, an order or a unit, lot, or batch of a product may be taken as a cost unit, i.e.
a job.
In job costing, there is no averaging of costs except to the extent that in the ascertainment
of unit cost, the cost of a lot of products in one order is obtained. A job or an order may
extend to several accounting periods and job costs are, therefore, not related to particular
periods.
Advantages of Job Costing:

(a) The cost of material, labour and overhead for every job or product in a department is
available daily, weekly or as often as required while the job is still in progress.
(b) On completion of a job, the cost under each element is immediately ascertained. Costs
may be compared with the selling prices of the products in order to determine their
profitability and to decide which product lines should be pushed or discontinued.
(c) Historical costs for past periods for each product, compiled by orders, departments, or
machines, provide useful statistics for future production planning and for estimating the
costs of similar jobs to be taken up in future. This assists in the prompt furnishing of price
quotations for specific jobs.
(d) The adoption of predetermined overhead rates in job costing necessitates the
application of a system of budgetary control of overhead with all its advantages.
(e) The actual overhead costs are compared with the overhead applied at predetermined
rates; thus, at the end of an accounting period, overhead variances can be analyzed.
(f) Spoilage and defective work can be easily identified with specific jobs or products.
(g) Job costing is particularly suitable for cost-plus and such other contracts where selling
price is determined directly on the basis of costs.
Limitations of Job Costing:
(a) Job costing is comparatively more expensive as more clerical work is involved in
identifying each element of cost with specific departments and jobs.
(b) With the increase in the clerical processes, chances of errors are enhanced.
(c) The cost as ascertained, even where they are compiled very promptly, are historical as
they are compiled after incidence.
(d) The cost compiled under job costing system represents the cost incurred under actual
conditions of operation. The system does not have any scientific basis.

Process Costing
Process costing is that aspect of operation costing which is used to ascertain the cost of the
product at each process or stage of manufacture. This method of accounting used in
industries where the process of manufacture is divided into two or more processes. The
objective is to find out the total cost of the process and the unit cost of the process for each
and every process. Usually the industries where process costing used are textile, oil
industries, cement, pharmaceutical etc.
Features of Process Costing:
(a) Production is done having a continuous flow of products having a continuous flow of
identical products except where plant and machinery is shut down for repairs etc.
(b) Clearly defined process cost centers and the accumulation of all costs by the cost
centers.
(c) The maintenance of accurate records of units and part units produced and cost incurred
by each process.
(d) The finished product of one process becomes the raw material of the next process or
operation and so on until the final product is obtained.
(e) Avoidable and unavoidable losses usually arise at different stages of manufacture for
various reasons.
(f) In order to obtain accurate average costs, it is necessary to measure the production at
various stages of manufacture as all the input units may not be converted into finished
goods.
(g) Different products with or without by-products are simultaneously produced at one or
more stages or processes of manufacture. The valuation of by-products and apportionment
of joint cost before joint of separation is an important aspect of this method of costing.
(h) Output is uniform and all units are exactly identical during one or more processes. So
the cost per unit of production can be ascertained only by averaging the expenditure
incurred during a particular period.
Applications of Process Costing: The industries in which process costs may be used are
many. In fact a process costing system can usually be devised in all industries except where
job, batch or unit or operation costing is necessary. In particular, the following are
examples of industries where process costing is applied:

Difference between Job Costing and Process Costing:

Unit or output costing
Unit or output costing is that method of costing in which cost are ascertained per unit of a
single product in a continuous manufacturing activity. Per unit cost is calculated by
dividing total production cost by number of units produced. This method is also known as
single costing. This method is known as ‘single costing’ as industries adopting this method
manufacture, in most cases, a single variety of product.

Features of Output Costing:

(1) Output costing is the method of costing adopted in concerns where there is a
production of single product or a few grades of the same product differing only in size,
shape or quality by continuous process of manufacture. The units of production or output
are identical and the costs of units are physical and natural.
(2) Under this method, the cost per unit of output, say, per ton, per barrel, per kilogram, per
metre, per quintal, per bag, etc. is ascertained. The cost per unit of output is ascertained by
dividing the total cost incurred on a product during a given period of time by output
produced during the period.
Where the products manufactured are of different grades, first, the costs of products are
ascertained grade-wise, and then the total cost of each grade of the product is divided by
the number of units of that grade so as to ascertain the cost per unit of each grade of the
product.
(3) Equality of cost is an important feature of this method. That is, under this method, cost
units, which are identical, will have identical cost.
(4) Under this method, the cost of product is ascertained at the end of the accounting
period.
(5) Under this method, the cost information relating to a product may be presented in the
form of either cost sheet or production account.
(6) This method is the simplest method of all the methods of costing; in the sense that the
cost collection and the cost ascertainment are quite simple.
(7) The cost per unit of output, determined under single. Costing enables the management
to make real comparison between different periods and between different firms within the
same industry, as the unit of output is a common factor between different periods and
between different firms within the same industry.

Objectives of Output Costing:

They are:
(1) To ascertain the total cost of the output as well as the cost per unit of output.
(2) To ascertain the profit or loss on production.
(3) To analyze the expenditure by nature, classify them into element of cost and know the
extent to which each element of cost contributes to the total cost.
(4) To facilitate comparison of the cost of one period with the cost of another period to
know the efficiency or otherwise of the production.
(5) To facilitate the preparation of tender or quotation.
(6) To control the cost of the product through comparative study of the costs of any two
periods or through the comparison of the actual costs with the pre-determined standard
cost.