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Learning Objectives:
Definitions
Cost is the value of assets or resources given up to acquire other assets or services for a particular purpose,
which is usually for the purpose of making money.
The monetary amount to be recorded as cost is inclusive of all costs that have been incurred until the product
or service can be used.
Some costs are reported as assets whilst some as expenses. Costs are expenses if the benefits are consumed
in the current accounting period. Costs are assets if the benefits are consumed over more than one
accounting period.
Cost object is any activity or output for which the cost is measured. (e.g. cost of making a product or providing
a service)
Cost object for a business can be a product, product line, department, division, geographical area or a
country.
Cost unit is a quantitative unit of either a product or service in relation to which costs can be computed.
For example:
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
Cost centre is a part of the organization within which the manager or the person-in-charge is made
responsible only for the amount of costs incurred in that particular centre.
For example, divisions or sections which provide services such as maintenance and computing services to
other centres.
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
A classification by traceability
Ease of
traceability
Cost traceability refers to whether the cost can be directly or indirectly traced to the specific cost object.
Direct costs can be specifically and exclusively identified with a given cost object.
For example, the cost of salaries for employees who work directly on the cost object of a car, such as
assembling parts of a car is classified as direct labour.
Indirect costs cannot be specifically and exclusively identified with a given cost object. It is normally shared
between different cost objects and is difficult to directly trace the costs to a specific cost object.
Indirect costs (i.e. overheads) are assigned to cost objects on the basis of cost allocations.
For example, utility expenses or rental costs of a factory building to manufacture several products are shared
expenses and cannot be directly traceable to a particular individual product.
A classification by behaviour
Behavior
Mixed or semi-
Fixed costs Variable costs
variable costs
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Cost behaviour refers to how cost reacts to changes in volume of production. Fixed cost does not change but
variable cost changes proportionately with volume. Segregating costs into either fixed or variable helps in
predicting how cost will change with changes in the volume of production.
It is important to predict costs and revenues at different activity levels for many decisions.
Fixed costs remain constant over wide ranges of activity, for example: Eg: rent, insurance, depreciation of
office facilities.
Variable costs vary in direct proportion with activity, for example: Eg: direct materials costs and direct labour
costs.
Semi-fixed costs are fixed within specified activity levels, but they eventually increase or decrease by some
constant amount at critical activity levels. This type of cost includes both a fixed and a variable component
(e.g. telephone charges).
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
A classification by functions
Functions
Non-
Manufacturing
manufacturing
costs
costs
Direct Manufacturing
Direct labour
material overhead
Indirect Indirect
Others
labour material
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
Manufacturing costs are all the costs incurred in transforming raw materials into a finished product in a
factory.
Direct material costs are costs of materials that are conveniently and economically traceable to specific units
of output, for example, raw cotton in textiles, crude oil to make diesel, steel to make automobile bodies.
Direct labor costs are the wages or salaries paid to the workers who are actively and directly engaged in the
production process and are conveniently traceable to products, for example, the labor of machine operators
and assembleRM
Both of direct material and direct labour costs are also called prime costs.
Conversion costs or a total of direct labour and manufacturing overhead costs are costs of converting
materials into finished or semi-finished products.
Manufacturing overhead costs are the cost of indirect materials, indirect labor and other indirect
manufacturing costs that cannot be traced directly to specific units produced. For example, costs related to
rent, utilities, depreciation, property insurance, property tax and so on.
Selling & distribution expenses: begins when the product is in saleable condition, for example: cost of making
sales, delivering/dispatching products.
Administrative expenses: includes costs that cannot be charged either to production or sales division, for
example: fees of BOD, chairman’s salary, rent for general offices.
Non-manufacturing costs are costs incurred in functions other than manufacturing such as distribution,
selling, marketing and administrative functions. These costs are necessary but do not become a part of
product costs.
For financial
reporting
Product costs are manufacturing costs and are reported as current assets in the balance sheet. The
components of product costs are direct material, direct labour and manufacturing overhead costs.
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
Period costs are non-manufacturing costs and are reported as expenses in the income statement. These costs
incurred during a particular period and are identified with the period rather than units of production.
Controllability of costs forms the basis for performance evaluation. Only those costs that can be controlled are
included for evaluation of performance.
Controllable costs are costs which can be changed by the decisions of the managers, while uncontrollable
costs are costs that do not get influenced by the decisions or actions taken by the manageRM
Costs for decision-making are classified as relevant and non-relevant. Only costs that are relevant are
incorporated for consideration in decision-making.
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
Relevant costs are relevant for the purpose of decision-making and are therefore included or considered
before the decisions are made. These costs will be affected by the choice of alternatives in the decision-
making process and are costs that will incur in future.
Non-relevant costs are costs that have already been incurred or will remain unaffected by the decision taken.
These costs are historical costs and will not change with the decision to be taken, and are not relevant and are
not taken into consideration when making decisions.
Avoidable costs are future costs which can be changed but unavoidable costs are past costs which cannot be
changed or will continue in the future.
Differential costs are costs that will differ in amount with the alternative decision, while non-differential costs
are the costs that do not differ with the choice of alternatives.
Opportunity costs are the foregone benefits or revenue which would have come with the alternative that is
not chose.
Sunk costs are costs that have been incurred in the past due to the decisions taken in the past and cannot be
altered by decisions made later.
As has been discussed already, ‗cost‘ is referred to ―the amount of expenditure (actual
or notional) incurred on, or attributable to, a given thing‖. However, an exact definition of the
term
‗cost‘ is difficult as its interpretation depends upon the nature of the business, or industry, and
the context in which it is used.
For example, the cost of a product can be calculated excluding packaging expenses if the same
are nominal in amount (eg. soap bar) while this treatment of exclusion of cost will not be
feasible in case the nature of the product requires heavy packaging cost (eg. perfumes).
Cost can also be considered as monetary valuation of effort, risk involved, opportunity forgone
in production and delivery of a good or service and most importantly, resources like time,
material and utilities. It is also imperative to remember that all expenses are costs, but not all
costs, especially the ones incurred in acquisition of an income-generating asset, are expenses.
Before proceeding with the elements and components of cost, a basic understanding of cost
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
COST OBJECT
Cost object may be defined as anything for which a separate measurement of cost is desired.
The following examples will further enhance the understanding:
COST DRIVER
An activity can have more than one cost driver attached to it. For example, a production activity
may have a machine, machine operator(s), floor space occupied, power consumed as the
associated cost-driveRM
UNIT
The Chartered Institute of Management Accountants (CIMA), London, defines a unit of cost as
―a unit of quantity of product, service or time in relation to which costs may be ascertained or
expressed.‖
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
The preparation of cost accounts requires selection of a unit for identification of expenditure.
The quantity upon which cost can be conveniently allocated is known as cost unit.
For example: in case of electricity companies cost unit will be per unit of electricity generated
and in case of transport companies, it will be per passenger-km. or per tonne-km.
COST CENTRE
According to the Chartered Institute of Management Accountants, England, cost center means
―a location, person or item of equipment or group of these for which costs may be ascertained
and used for the purpose of cost control‖. It can be a department or a sub-departmentor an
item of equipment or machinery or a group of persons.
PROFIT CENTRE
A profit center is a business unit or department within an organization that generates revenues
and profits or losses. Here, both the inputs and outputs are measured in monetary terms, and
accounting for both costs and revenues results in automatic computation of profit with respect
to this centre, termed as profit centre.
ELEMENTS OF COST
Elements of
cost
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
Overheads
The broad elements of cost are categorized as Material, Labour and Expenses, which are further
classified as direct and indirect. The indirect material, labour and expenses together are termed
as overheads.
1. Material: The basic substance used for producing the product is referred to as material.
Material can be direct or indirect in nature.
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
- Direct Material: The materials which directly contribute to the production of the product and
are easily identifiable in the finished product are called direct materials. Cloth in shirt, paper in
books, wood in furniture are examples of direct materials.
- Indirect Material: Other material which is ancillary in the production of any finished product
and cannot be conveniently assigned to specific physical units is called indirect material. For
example, printing in stationery, scissors used in cutting cloth for shirt, nails in shoes or furniture.
2. Labour refers to the human effort needed for conversion of materials into finished goods.
Labour can be direct or indirect.
- Direct Labour: Labour which takes an active and direct part in the production of a particular
commodity and can be directly co-related to any specific activity of production is termed as
direct labour. Process labour, productive labour, operating labour, manufacturing labour, direct
wages etc are used synonymously with direct labour.
- Indirect Labour: Employees who do not directly take part in the manufacturing process and
whose cost cannot be identified with the individual cost centre are included under indirect
labour. Such labour does not alter the construction, composition or condition of the product.
Salary of foreman, salesmen and director are some examples of indirect labour.
3. Expenses: Costs incurred in the production process but not included under material or
labour are generally expenses. They can be direct or indirect.
-Direct Expenses: These are expenses which can be directly, conveniently and wholly allocated
to specific cost centres or cost units. Direct expenses are sometimes also described as
―chargeable expenses.‖
- Indirect Expenses: All expenses other than direct expenses are indirect in nature.
OVERHEADS
People generally use the terms overheads and indirect expenses synonymously. But, it needs to
be understood that ―overheads‖ has a wider meaning than the term ―indirect
expenses‖. Overheads include the cost of indirect material, indirect labour besides indirect
expenses.
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
1. Prime Costincludes all the direct costs, viz. direct material, direct labour and direct
expenses. It is also known as basic, first or flat cost.
2. Factory Costcomprises of prime cost and factory overheads. It is also known as works
cost, production or manufacturing cost.
3.Office Costsummates office and administration overheads and factory cost. This is also
termed as administration cost or the total cost of production.
4.Total Cost or cost of sales is the sum total of selling and distribution overheads and the
total cost of production.
The components of cost can be summarized in the form of a statement, usually referred to as
Cost Sheet. The same can be presented in a tabular manner as follows:
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
Profit ***
Sales ***
Illustration 1
Wages RM 9,52,000
Solution: -
Illustration 2
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
Solution
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
Illustration 3
2,40,000
Solution
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
Illustration 4
Calculate (a) Cost of raw-materials consumed; (b) Total cost of production; (c) Cost ofgoods
sold and (d) The amount of profit from the following particulars :
Opening Stock
: Raw-materials 2,00,000
: Finished goods 1,60,000
Closing Stock
: Raw-materials 1,60,000
: Finished goods 2,00,000
Raw-materials-purchased 20,00,000
Wages paid to labourers 8,00,000
Chargeable expenses 80,000
Rent, rates and taxes 2,00,000
Power 96,000
Factory heating and lighting 80,000
Factory insurance 40,000
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
Solution
Amount Amount
Particulars (RM) (RM)
Raw-materials purchased 20,00,000
Add : Opening stock 2,00,000
Less : Closing stock 1,60,000
COST OF RAW-MATERIALS CONSUMED 20,40,000
Less : Sale of wastage of materials 8,000
Material-Direct 20,32,000
Labour—direct 8,00,000
Chargeable expenses 80,000
PRIME COST 29,12,000
Add : Production overheads :
Rent, rates and taxes 2,00,000
Power 96,000
Heating & lighting 80,000
Insurance 40,000
Experimental expenses 20,000 4,36,000
FACTORY COST 33,48,000
Add : Administrative overheads
Office management salary 1,60,000
Office printing & stationery 8,000 1,68,000
TOTAL COST OF PRODUCTION 35,16,000
Add : Opening stock of finished goods 1,60,000
Less : Closing stock of finished goods 2,00,000
COST OF PRODUCTION OF GOODS SOLD 34,76,000
Add : Selling and distribution overheads :
Salaries of salesmen 80,000
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
CLASSIFICATION OF COSTS
Cost Classification refers to a complete and transparent idea of separation of expenses in the
different sector as like manufacturing cost, product cost, sunk cost, variable cost, direct cost, and
indirect cost etc. Classifications of cost are a vital part of a company. It is almost impossible to
operate a business without understanding it properly. Recently I was researching on cost
classification. I have gathered a complete idea about it. Today I am writing to you about
the importance of cost classification. So, are you fond of knowing it? Let’s look at this paragraph for
one time.
Cost classification is an extensive motive. We can divide the cost classification into several
categories. Here are including the main categories.
Direct cost:
It is such a cost that is able to mark directly any particular cost such as raw materials, labor included
operating expenses and some other costs are belongs to the direct cost. These costs are bind in a unit.
For example, we can say a total cost of an advertisement for several products. The direct cost has
some subcategories.
Direct element: Direct element refers to that material which is related all of the finished
product. This material is a part to complete any product. It can have imposed conveniently
on the particular product. The purchased and upcoming requisite products are including in
direct element. As like, all kinds of initial packing material.
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
Direct labor: Direct labor means the paid salary to the employee who is directly engaged in
manufacturing, handling and processing a product. Actually, they are responsible for the
observation and maintenance of the product also.
Direct expense: Which cost is directly related to any particular expenses is called direct
expense. If a company needs to buy some specific product, equipment or tools are the
examples of direct expense.
Indirect cost:
Indirect cost means the opposite side of direct cost. Which cost is related to a unit or department and
can’t trace for any specific product is called indirect cost. The indirect cost has also some
subcategories.
Factory overheads:
It is related to all kinds of indirect costs like manufacturing products and time keeper’s
salary.
Prime cost: Prime cost is the adjustment of the direct material, direct labor, and direct
costs. It is actually the result of these three elements.
Product cost: It means the factory cost with administrative and office overheads
Factory cost: Factory cost is also known as work cost. It is combined with work cost and
work expenses
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ACA 2407 COST ACCOUNTING STUDY MATERIAL
By behavior or variability cost is classified as Variable cost, Fixed cost and Mixed cost which is
explained below.
Variable cost: Variable cost is such a cost which proportion is changing with the amount of
production. Such as direct material and changeable costs
Fixed cost: This cost won’t change with the proportion of production. It is maximum time
fixed. But it is notable that this cost may be changed after a long time. For example, office
rent, insurance, and hospital cost.
Mixed cost: Mixed cost can change overall but not with the proportion of production. More
changeable cost is count under a Mixed cost. The example of a mixed cost is electricity
expenses.
Relevant cost: Which cost can be by making a new decision is called relevant cost.
Occasionally there may have many relevant costs. This cost is not fixed from before.
Opportunity cost: Opportunity cost is the system of getting some extra advantages from
the existing things of a factory like land, money and time etc. Someone can rent his office
for another purpose of advantages. Moreover, they can rent their other things also. It is
actually an extra benefit for a company.
Standard cost: Standard cost is fixed from the previous experience. It was fixed according
to the specific budget, the volume of an industry. The actual cost is also included with this
cost.
Controllable cost: Which cost can be controlled by management is called controllable cost.
The manager can control some cost.
Sunk cost: It is known as a historical cost. Sunk cost effect is most important for a company.
It is such a cost which is already lost and can’t be undone anymore. If a company is paid
their monthly rent than we can say this rent cost is sunk cost.
Manufacturing cost: Manufacturing cost refers to the total cost of a product from the raw
materials to finish the product. It is mainly the combination of direct material cost, labor
cost, and manufacturing overheads.
Non-manufacturing cost: In order, the rules of GAAP Non-manufacturing cost are not
actual product cost. It is a part of the company’s income statement.
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