Unit 1: Cost Accounting 552 AC 56

1.2
COST ACCOUNTING

TOPICS
 Definition of costing
 Scope, objectives and functions of cost accounting
 Differences between cost accounting and financial
accounting
 Classification of costs
 Elements of cost
 Methods and techniques of costing

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Unit 1: Cost Accounting 552 AC 56
1.2
COST ACCOUNTING.
Cost Accounting is an art or process of recording, analyzing and classifying of
expenditure for the purpose of product costing or service costing, ascertainment of
profitability, operational planning and cost control. It is a forward looking approach which
is related to the recording, analyzing and classifying of expenditure with the objective of
ascertaining the total and per unit cost of product or service. The scope of cost
accounting is very wide and includes the following segments.
Cost accounting is a method of managerial accounting which aims to capture the total
production cost of a business by measuring the variable costs of each production phase
as well as fixed costs, such as a lease expense.
Cost accounting includes several forms of costs which are listed below.

 Fixed costs
 Operating costs
 Direct costs
 Variable costs
 Indirect costs

Types of Cost Accounting

 Standard Costing
 Activity-Based Costing
 Lean Accounting
 Marginal Costing

DIFFERENCES BETWEEN COST ACCOUNTING AND FINANCIAL ACCOUNTING

Although both cost accounts and financial accounts are prepared based on common
principles and well-known vouchers and documents, they differ from each other on the
following points:
(i) Financial accounts are very comprehensive in nature and cover all business
transactions. By contrast, cost accounts cover only the transactions relating to the
manufacturing and sale of products and services.
(ii) Financial accounts deal with all items of expenses, losses, income, and gains, but
cost accounts only deal with those items of expenses that enter into the cost of
production.
(iii) Financial accounts do not contain an analysis of expenditure according to elements,
functions, behavior, departments, or products. Cost accounts record expenses by
elements, functions, variability, departments, and so on, to study them analytically.

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(iv) Financial accounts do not present accounting information in a well-classified format
so as to disclose the cost per unit at all stages. However, cost accounts do this for all
expenses to disclose the per-unit cost at all stages of production.
(v) Financial accounts disclose the overall profitability of the business, whereas cost
accounts deal with product-wise, job-wise, department-wise, and process-wise
profitability.
(vi) Financial accounts deal with facts or actual figures alone. Dissimilarly, cost
accounts deal with facts as well as estimates, as a result of which the data in cost
accounts do not always tally with those in financial accounts.
(vii) Financial accounts do not disclose information relating to wastage of materials and
the loss of man hours and machine hours. Cost accounts, on the other hand, contain full
information relating to all types of wastage incurred during production.
(viii) The maintenance of financial accounts is compulsory in business. However, cost
accounts, despite being important and advantageous, need not be maintained.
(ix) Financial accounts cannot be incorporated into cost accounts whereas cost
accounts may be incorporated into financial accounts.
(x) Financial accounts do not provide any means to measure efficiency and to
exercise control over costs. Cost accounts develop standard costs against which actual
costs can be compared, and the reasons for variances can be identified to assist
corrective action.
(xi) Financial accounts fail to guide managers in fixing selling prices and calculating
estimates. However, cost accounts provide detailed cost information at different levels
of production, which assists in fixing selling prices and calculating the tender price.

Features of Cost Accounting

 It is a sub-field in accounting. It is the process of accounting for costs

 Provides data to management for decision making and budgeting for the future

 It helps to establish certain standard costs and budgets.

 provides costing data that helps in fixing prices of goods and services

 Is also a great tool to figure out the efficiency of a unit or a process. It can disclose
wastage of time and resources

OBJECTIVES OF COST ACCOUNTING

Cost accounting was born to fulfill the needs of manufacturing companies. It is a

mechanism of accounting through which costs of goods or services are ascertained and
controlled for different purposes. It helps to ascertain the true cost of every operation,
through a close watch, say, cost analysis and allocation. The main objectives of cost
accounting are as follows:-

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 Cost Ascertainment: The main objective of cost accounting is to find out the cost of
product, process, job, contract, service or any unit of production. It is done through
various methods and techniques.
 Cost Control: The very basic function of cost accounting is to control costs.
Comparison of actual cost with standards reveals the discrepancies (Variances). The
variances reveal whether cost is within control or not. Remedial actions are suggested
to control the costs which are not within control.
 Cost Reduction: Cost reduction refers to the real and permanent reduction in the unit
cost of goods manufactured or services rendered without affecting the use intended. It
can be done with the help of techniques called budgetary control, standard costing,
material control, labor control and overheads control.
 Fixation of Selling Price: The price of any product consists of total cost and the margin
required. Cost data are useful in the determination of selling price or quotations. It
provides detailed information regarding various components of cost. It also provides
information in terms of fixed cost and variable costs, so that the extent of price reduction
can be decided.
 Framing business policy: Cost accounting helps management in formulating business
policy and decision making. Break even analysis, cost volume profit relationships,
differential costing, e.t.c are helpful in taking decisions regarding key areas of the
business.

Functions of Cost Accounting

 ascertain the cost per unit of every product that the company manufactures

 to identify any wastages whether in material, expense, time, tools and spares etc.
Also, suggest ways to minimize this wastage

 also, provide data that helps in the process of price fixing

 calculate with accuracy the profitability of each of the company’s products. And
figure out ways to maximize these profits

 cost accounting is also responsible for the control of raw material and raw material
ordering. So it must ensure that we are not over ordering which leads to capital
being locked-up unnecessarily. And under ordering will lead to inefficiency in the
manufacturing process,

 also, perform the functions of cost control for materials, labor, and other
miscellaneous expenses

 present data to the management that allows them to interpret the data and make
business decisions

 help management with incentive plans that are based on efficiency

 also, help the management with the preparation of budgets and setting up budgetary
controls.

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Unit 1: Cost Accounting 552 AC 56
1.2
Cost Classification
Definition: Cost classification is the logical process of categorising the different costs
involved in a business process according to their type, nature, frequency and other
features to fulfill accounting objectives and facilitate economic analysis. Cost refers to
the value sacrificed with the aim of gaining something in return. Every business process
involves some cost. It is the basis of profit determination for an organisation.

Knowing about the different expenses facilitate the procedure of cost accounting in an
organization. A particular cost can be allocated under multiple categories. For instance;
salary paid to an employee is a labour cost as well as a fixed cost. Moreover, the
different elements of cost classification are linked to each other in one or the other way.

Basis of Classification

 Cost Classification by Nature

 Cost Classification by Relation to Cost Centre
 Cost Classification by Functions
 Cost Classification by Behaviour
 Cost Classification by Management Decision Making
 Cost Classification by Production Process
 Cost Classification by Time

Basis of Classification

There are various kinds of cost incurred in the production of goods or services, and
these costs are categorised systematically.

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Some of the principal basis on which different costs can be allocated are as follows:

Cost Classification by Nature

The cost can be differentiated by its nature or the purpose for which it has
occurred. It can be treated as an expense under this category and the

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expenses so incurred is divided as follows:

 Material: Material cost is the cost of the raw material and its related cost such as
procurement cost, taxes, insurance, freight inwards, etc.
 Labour: Labour cost is the salary and wages paid to the employees, i.e.
permanent, temporary or contractual employees working in an organisation. It also
includes contribution, bonus, commission, incentives, allowances, overtime pay,
etc.
 Other Expenses: All the other overheads excluding material and labour comes
under this head. Some of these are packaging, promotion, job processing
charges, etc.

Cost Classification by Relation to Cost Centre

Another basis of differentiating the costs is categorising them by their allocation in the
production process of goods or services.

The points as mentioned earlier under the cost classification by nature are used under
this category to further sub-categorise the elements of this category. To get a better

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understanding of it, let us read below:

 Direct Cost: Direct cost is the significant cost immediately associated with a
production process. It can be seen as a prime cost for any business. It is sub-
divided into direct material cost, direct labour cost and other direct expenses.
 Indirect Cost: Indirect cost is the cost which cannot be directly allocated to a
particular process of production. It is a secondary cost and is majorly seen as of
three types – indirect material cost, indirect labour cost and other indirect
expenses.

Cost Classification by Functions

The cost can also be classified by the business functions for which the resources have
been used.

There are five significant functions of a business which involves some expense and are
essential to the organisation in their way. The cost involved in such business operations

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are explained below:

 Production: Production cost comprises of all the direct and indirect costs incurred
in the production of goods and services.
 Administration: The costs involved in the management activities of an
organisation like electricity, stationery, telephone expenses, rent etc. These are
also known as administrative overheads.
 Selling: The indirect costs incurred on the sales function of the goods and
services like an advertisement, promotion, research, customer service, etc. are
clubbed under selling cost.
 Distribution: Distribution cost refers to the cost incurred for making the goods or
services available to the customers. These are warehousing, delivery service,
transportation, etc.
 Research and Development: Research is essential to develop a new product or
modify an existing one. The cost incurred on the research team, research
implementation, findings, etc. comes under this category.

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Cost Classification by Behaviour

The cost involved in any business process can be differentiated on the grounds of its
volatility concerning the fluctuation in business activity in the short run.

The following classification of cost by its behaviour will give a clear illustration

 Fixed Cost: The cost which is hardly affected by the temporary change taking
place in business activity is known as a fixed cost. It includes rent, depreciation,
lease, salary, etc.
 Variable Cost: The cost which changes proportionately with the change in
production quantity or other business activity is termed under variable cost. Raw
material, packaging, sales commissions, wages, etc. are variable costs.
 Semi-Variable Cost: The cost which is moderately influenced by the change in
business activity is called semi-variable cost. It includes power consumption,
maintenance cost, management cost, supervision cost, etc.

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Cost Classification by Management Decision Making

Cost is not just a price paid to generate some value, but it is also used as a tool by the
management for decision making. Managerial decisions are framed depending upon the
following types of cost involved in carrying out of business:

Marginal Cost: Marginal cost is the cost of producing an additional unit and its impact
on the total cost of production.

Differential Cost: When there is an increment or decrement in the cost of bulk

production, the change in the cost of a single unit is also determined which is known as
differential cost.

Opportunity Cost: The value of one or more products given up to acquire the desired
product or service is known as opportunity cost. For instance; while choosing green tea,
a person has to give up the value he must have derived from coffee or regular tea.

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Replacement Cost: When machinery or any other asset becomes obsolete or involve
high maintenance cost, and simultaneously a better asset is available in the market
which can replace it, then the cost involved in such substitution is known as
replacement cost. For example; a transportation company needs to replace its trucks
from time to time to avoid excessive repairing expenses.

Sunk Cost: The cost which has been born by the organisation in the past and cannot
be recovered at any stage of the business process is termed as a sunk cost. Freight
inwards paid at the time of buying machinery has to be written off at the time of selling
it.

Normal Cost: The routine cost associated with the manufacturing of goods or services
under usual circumstances is called a normal cost. It includes all direct expenses such
as salary, material, rent, etc.

Abnormal Cost: The cost that arises suddenly and unknowingly under unfavourable
situations is known as abnormal cost. For instance; workers go on strike, theft or
robbery, fire in the premises, etc.

Avoidable Cost: Such costs are under the control of management and can be
prevented as per the organisational need. For example; an enterprise upgrades its
technology by installing self-operative machines to avoid the labour charges it pays.

Unavoidable Cost: The cost which is pre-determined and inevitable is called an

unavoidable cost.

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Cost Classification by Production Process

This basis of cost classification is significantly applicable in the manufacturing industries

or factories where goods are produced.

All production or manufacturing activities involve different types of costs. According to

the nature of the production process, these costs can be classified as below:

 Batch Cost: The cost incurred while producing a whole lot comprising of identical
products (batch) is known as batch cost. Each batch differs from the other, and
the units lying under a batch are identified by their batch number.
Pharmaceuticals, automobiles, electronic products are some of the examples.
 Process Cost: The cost incurred on performing different operations in a
streamlined production process is termed as a process cost. By dividing the total
cost of a process with the number of units produced, we can derive the process
cost of a single unit or product.

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 Operation Cost: The cost involved in a particular business function contributing to
the production process is known as operation cost. It helps in regulating the
mechanism of business activities by monitoring the cost incurred on each
business operation.
 Operating Cost: Operating cost refers to the day to day expenses incurred by an
organisation to ensure uninterrupted functioning of the business is known as an
operating cost.
 Contract Cost: The cost of entering into a contract with a buyer or seller by
mutually agreeing to the terms and conditions so mentioned is called a contract
cost. It includes a bidding contract, price escalation contract, tenders, etc.
 Joint Cost: The combined cost involved in the production of two or more useful
products simultaneously is known as the joint cost. For example; the cost of
processing milk to get cottage cheese and buttermilk.

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Cost Classification by Time

The nature, importance and liability of a cost vary as per the time it takes place or has
been assessed.

A cost which is a priority today, may not be that important tomorrow or a cost which has
been overlooked today, may be considered as a relevant cost tomorrow.

Thus, depending upon the period a cost has occurred or assessed, it can be
categorised under the following heads:

 Historical Cost: Any actual cost ascertained and evaluated after it has been
incurred, is termed a historical cost. It can be committed either on the production
of goods and services or asset acquisition.
 Pre-determined Cost: The cost which can be identified and calculated before the
production of goods and services based on the cost factors and data is called a
pre-determined cost. It can be either a standard cost or an estimated cost.
 Standard Cost: An actual cost which is pre-determined as per certain norms and
guidelines to provide as a base for cost control, is termed as a standard cost.
 Estimated Cost: The cost of business operation presumed on the grounds of
experience is known as an estimated cost. It is merely based on assumptions and
therefore considered to be less accurate to determine the actual cost.

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Unit 1.Cost Accounting
1.3
ELEMENTS OF COST IN COST ACCOUNTING
These elements of cost are divided into two categories such as Direct Material and
Indirect Material, Direct Labour and Indirect Labour, Direct Expenses and Indirect
Expenses. All direct material, direct labour and direct expenses are added to get prime
cost. Likewise all indirect material, indirect labour and indirect expenses are added to
get overhead. Again, overhead is divided into four categories. They are factory
overhead, administration overhead, selling overhead and distribution overhead.
1. Direct Material: It refers to material out of which a product is to be produced or
manufactured. The cost of direct material is varying according to the level of output. For
example: Milk is the direct material of butter.
2. Indirect Material: It refers to material required to produce a product but not directly
and does not form a part of a finished product. For example: Nails are used in furniture.
The cost of indirect material is not varying in direct proportion of product.
3. Direct Labour: It refers to the amount paid to the workers who are directly engaged
in the production of goods. It varies directly with the output.
4. Indirect Labour: It refers to the amount paid to the workers who are indirectly
engaged in the production of goods. It does not vary directly with the output.
5. Direct Expenses: It refers to the expenses that are specifically incurred by the
company to produce a product. A product cannot be produced without incurring such
expenses. It varies directly with the level of output.
6. Indirect Expenses: It refers to the expenses that are incurred by the organization to
produce a product. But, these expenses cannot be easily found out accurately. For
example: Power used for production.
7. Overhead: It is the combination of all indirect materials, indirect labour and indirect
expenses.
8. Factory Overhead: It is otherwise called Production Overhead or Works Overhead. It
refers to the expenses that are incurred in the production place or within factory

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premises. For example: Indirect material, rent, rates and taxes of factory, canteen
expenses etc.
9. Administration Overhead: It is otherwise called Office Overhead. It refers to the
expenses that are incurred in connection with the general administration of the
company. For example: Salary of administrative staff, postage, telegram and telephone,
stationery etc.
10. Selling Overhead: It refers to all expenses incurred in connection with sales. For
example: Salary of sales department staff, travelers’ commission, advertisement etc.
11. Distribution Overhead: It refers to all expenses incurred in connection with the
delivery or distribution of goods and services from the producer to the consumer. For
example: Delivery van expenses. loading and unloading, customs duty, salary of
deliverymen.

Cost Centre
In simple terms, you can define the cost centre as the one or more units of the firm that
don’t contribute directly to the process of revenue generation in an organization but
incur expenses. This is a type of responsibility centre that is accountable for incurring
expenses that are under the control. It indicates any section of the organization’s
product or service for which specific cost collection is looked for.
Cost Centre Example-

The research and development wing (R&D) is responsible for developing new
techniques and products for the organization. This department incurs a lot of expenses
while coming up with new ideas, technologies, and products. There is no revenue
generated for the department because the credits are transferred to the sales
department for selling the products.

The cost centre meaning is important so that it doesn’t take over the profits of the
company. The top management of the company always laid down precise guidelines for
such departments to prevent the cost from crossing the specific amount.

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Cost Unit?

The cost unit is defined as the unit of product, service, time, activity, or combination in
relation to which cost is estimated. At the time of preparing the cost statements and
accounts, a particular unit is required to be selected. It helps to identify the cost
accurately and allocate the various expenses. It assists the cost measurement process
of the company and promotes comparison.
Cost Unit Example-

The cost unit of the hotel industry is a room and the cost unit of the steel industry would
be a ton. This is preceded by the cost centre. There are both simple units and complex
units in cost units. A simple unit represents a single standard measurement like per
kilogram, per piece, per meter, etc. a complex unit uses a combination of two simple
units like per kilowatt-hour, per tonne- kilometre, etc.

Methods of costing
1] Job Costing

Many firms and businesses work on a job work basis. In such cases, we use the job
costing method. Here the cost is assigned to a specific job, assignment etc. There is no
pre-production here, each order is made to the specifications needed. If the system is
implemented accurately we can find the profitability of each job. Some important features
of job costing are,

 It concerns itself with specific order costing, i.e the cost of each order or job
regardless of the time taken to finish the job. But usually, the duration of each job is
relatively short.

 The costs are collected at the completion of the job

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 Prime costs are traced and overheads are assigned to each job on some
appropriate proportionate basis.

2] Batch Coting

Batch costing is used when the goods are not produced to demand but are pre-produced.
Here the production process is continuous and occurs in batches. These batches may be
for a specific order or some pre-determined quantity. In this system, the goods are more or
less uniform. The total cost incurred during the production of one such batch of goods is
divided by the number of units produced to give us the cost per unit. This method is very
useful for consumer electronic goods such as televisions, washing machines etc.

3] Process Costing

This is one of the most popular methods of costing. There are many goods that are
produced continuously. These goods are homogeneous and are usually produced in huge
quantities. So the method of process costing is used to find the cost of production of each
unit. In continuous processing, the output of one process becomes the input of the next
process and so on until we achieve our finished product. So for the purposes, we find out
the costs of each process and divided it by the number of units produced in this process.
Some examples of products that use process costing are sugar, edible oil, chemicals, salt
etc.

4] Operating Costing

Among all the methods of costing, the one best suited to the service sector is operating
costing. We use operating costs to calculate the cost of the services provided to the
customers. The service must be uniform service provided to all customers, not specialized
services. And to ascertain the cost we average the total cost over the total services
rendered.

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5] Contract Costing

To work out the cost of a contract undertaken we employ contract costing. So it will help us
track the costs of a specific contract with a specific customer. These methods of costing
are mainly used for construction contracts, like the construction of complexes, highways,
bridges, dams etc. As you can see there are a lot of similarities between job costing and
contract costing. But job costing is usually for a shorter period. While contract costing is for
a much longer time, several years usually. So there is work-in-progress at the end of a
year in contract costing.

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