Chapter 9 COST DETERMINATION AND CONTROL

9.1 COST CALCULATION OF INDUSTRIAL PRODUCTS

The expenses incurred to manufacture a product are considered as cost. They may be estimated or
accounted.
Accurate cost determination is very important in order to fix the price of a product. Some industrialists
want to know the exact cost of the product to fix the selling price, others do not. In free enterprise
system, the price of the products and services is determined by the supply and demand basis.
However, in Pakistan the price of goods and services are generally
determined on actual cost basis. Therefore, scientific costing is
essential to have an idea of the exact costs and profits. Costing makes
possible the analysis by various cost elements. This enables the
management to account for the excess cost and wastages.

OBJECTIVES

1. To determine the price of the product on the basis of exact cost.

2. Making production and sale policies of the business.
3. To make suitable steps at various stages of production to control cost and wastages.
4. To control expenditures at every level in the organization.

ELEMENTS OF COST

The industrial expenditures can be put under the following heads.

MATERIAL COST:
Material is divided into two main categories.
(a) Material for fabricated parts
(b) Standard purchased parts
The total cost of these two will give the material cost. Again there are two kinds of materials, which
include the factory cost of a product. These are direct materials and indirect materials.

i) Direct materials
Direct materials are the materials that become the part of the product in manufacturing process. Any
standard part, which also becomes a part of the finished product, will come under the category of direct

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materials.

ii) Indirect materials

Indirect materials are those, which help in processing of direct materials into the finished product.
Indirect materials costs are included in the factory overhead. Examples are lubricating oil and cotton
wastes. Indirect material costs are included in the factory overhead.

LABOUR COSTS
Labour costs, which enters into the manufacture of product, is of two categories: direct labour and
indirect labour.

i) Direct labour
The operators, who actually process the same material either on machines or manually, form the direct
labour.

ii) All the staff excepting administrative and sales office staff, which helps in running the plant is under
the category of indirect labour. Indirect labour includes: foreman, supervisors, maintenance staff, store
personnel, time office staff, drawing office staff, etc. Indirect labour costs are included in the factory
overhead.

FACTORY OVERHEAD

These include all the expenses other than direct materials and direct labour incurred in the operation
of the factory. The following things can be put under the factory overheads.

Direct Materials Direct Materials

1) Capital taxes Material Cost

2) Insurance charges Indirect Materials

Direct Labour
3) Depreciation of building, plant Direct Labour
Labour Cost Production Cost
machinery etc.
4) Rent of buildings Indirect Labour

5) Transport charges Factory Overhead

Other Expenses Other Expenses
6) Power/other sources of energy (Indirect Materials)
(Indirect Labour)
7) Stores expenses
Structure of Costs
8) Factory lighting and heating
9) Repairs and maintenance of miscellaneous tools
10) Indirect material

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11) Indirect labour

PRIME COST

Prime cost or direct cost is given as:

Prime cost = direct materials + direct labour (+direct expenses (if any))
Prime cost is an important element of product cost. Generally, it may be 50% to 80% of the unit
cost/item cost.

FACTORY COST

This cost is given as:

Factory cost = prime cost + factory expenses (factory overhead)
Factory cost is also called as “work cost”.

MANUFACTURING COST

Manufacturing cost or cost of production is given as:

Manufacturing cost = factory cost + administrative expenses

TOTAL COST

Total cost is given as:

Total cost = manufacturing cost + selling and distribution expenses.

SELLING PRICE

Selling price is given as:

Selling price = total cost + profit

Toyota’s way of thinking on selling price

Toyota uses the formula of selling price, not “selling price = total cost + profit” but “total cost =
selling price – profit”.
The reason why the company thinks that way is that the selling price and profit are decided in the
market and the company MUST produce cars at the cost decided by the market.
Selling price of cars are decided by customers or the car market. Also, profit is decided by

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 shareholders or the capital market.

ITEM COST

The cost of manufacturing incurred on each unit is called “item cost”. It is the sum of direct material
cost, direct labour cost and factory overheads divided by the number of products.
Mathematically:
Item cost = manufacturing cost/No. of products

DIRECT EXPENSES
These expenses like the direct material and direct labour costs are directly chargeable to finished
products. These are also known as “chargeable expenses”.
These also include:
a) Cost of patterns, jigs, fixtures, dies, drawing as designs specially prepared for a particular product,
which cannot be used for other purposes.
b) Cost of any experimental work done specially for a particular product.
c) Rent of special or single purpose tool for equipment of a particular product.

INDIRECT EXPENSES

These are also called overhead or “burden”. These include cost of indirect materials, cost of indirect
labour and other expenses that cannot be conveniently charged directly to a particular job. Indirect
expenses may be divided into:
a) Factory expenses or overheads.
b) Office or administrative expenses.
c) Selling or distribution expenses.

9.2 COST CONTROL

COST COMPARISON

Cost comparison is to compare the actual cost against predetermined cost. If any difference occurs,
we have to control the variances. This can be achieved through cost control.
Cost control operates through a comparison of actual costs against predetermined cost. Cost control
applies the regulation of business operation by an equation of measured performance against cost.

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The principles through which cost control system operates are:
a) The coordination between costing department and other departments (production) is necessary so
that input expenses and outputs can be calculated.
b) We need to classify costs to identify the nature of expenditures.
c) We need to determine standards of performance, output and expenditures through time and motion
study.
d) There should be periodical reports, to identify problems and finding cost control.
e) There should be set up to utilize cost reports in areas of inefficiency and implement measurement
for rectification.

HOW COSTS ARE CONTROLLED

Direct material cost is an important element of cost of product. In the control of material cost, designer,
planner and production engineer can play an important role. The designer should design as simple as
possible while production engineer can save through controlling wastages.
Labour cost is another important element of cost-performance standards; standard time should be set
up through time and motion study.
Overhead expenses should be controlled through budget.

QUESTIONS
1. What are the four objectives of cost calculation?
2. What are the two major direct costs?
3. What are the three major costs that consist of product costs?
4. Selling price = ( )+( )
5. What do you compare in the cost comparison?