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1 Introduction 2019
1 Introduction 2019
If you set up a small manufacturing unit, say manufacturing of packing boxes, a problem will
arise what price of each box you should quote to the buyer. Many factors are considered while
fixing the price of a product/item such as competitors’ price etc. One of the basic factors is the
cost of its production. Cost is essential not only to fix price but also to ascertain the margin of
profit. Knowledge of the cost determination is also necessary to keep a check on the cost of
product/control on wastages, etc. The accounting used to study the various aspects of cost is
known as cost accounting
COST ACCOUNTING
Cost accounting is the process of determining and accumulating the cost of product or
activity. It is a process of accounting for the incurrence and the control of cost. It also
covers classification, analysis, and interpretation of cost.
In other words, it is a system of accounting, which provides the information about the
ascertainment, and control of costs of products, or services. It measures the operating
efficiency of the enterprise.
It is an internal aspect of the organization
Cost Accounting is accounting for cost aimed at providing cost data, statement and
reports for the purpose of managerial decision making.
There is a relationship among information needs of management, cost accounting objectives, and
techniques and tools used for analysis in cost accounting. Cost accounting has the following
main objectives to serve:
• Determining selling price
The objective of determining the cost of products is of main importance in cost
accounting. The total product cost and cost per unit of product are important in deciding selling
price of product. Cost accounting provides information regarding the cost to make and sell
product or services. Other factors such as the quality of product, the condition of the market, the
area of distribution, the quantity which can be supplied etc., are also to be given consideration by
the management before deciding the selling price, but the cost of product plays a major role
Controlling cost
Cost accounting helps in attaining aim of controlling cost by using various techniques
such as Budgetary Control, Standard costing, and inventory control.
Each item of cost [viz. material, labour, and expense] is budgeted at the beginning of the
period and actual expenses incurred are compared with the budget. This increases the efficiency
of the enterprise.
Ascertaining costing profit
Cost accounting helps in ascertaining the costing profit or loss of any activity on an
objective basis by matching cost with the revenue of the activity.
BRANCHES OF ACCOUNTING
Accounting information can be classified broadly between financial accounting and
management accounting.
Financial accounting is the process of preparing financial statements that companies’ use to
show their financial performance and position to people outside the company, Including
investors, creditors, suppliers, and customers.
It is sometimes referred to as meeting the external accounting needs of the organization, and as
such is subject to many rules and regulations (a regulatory framework) imposed by company
legislation and accounting standards.
Or the process of preparing management reports and accounts that provide accurate and timely
financial and statistical information required by managers to make day-to-day and short-term
decisions.
Cost accounting is a branch of management accounting and involves the application of various
techniques to monitor and control costs. Its application is more suitable to manufacturing
concerns
DIFFERENCES BETWEEN FINANCIAL ACCOUNTING AND MANAGEMENT
ACCOUNTING
PRODUCT COST
Product cost refers to the costs used to create a product. These costs include direct labour, direct
materials, consumable production supplies, and factory overhead. Product cost can also be
considered the cost of the labour required to deliver a service to a customer. In the latter case,
product cost should include all costs related to a service, such as compensation, payroll taxes,
and employee benefits.
The cost of a product on a unit basis is typically derived by compiling the costs associated with a
batch of units that were produced as a group, and dividing by the number of units manufactured.
The calculation is:
(Total direct labour + total direct materials + Consumable supplies + Total allocated overhead) ÷
Total number of units
= Product unit cost
Product cost can be recorded as an inventory asset if the product has not yet been sold. It is
charged to the cost of goods sold as soon as the product is sold, and appears as an expense on
the income statement.
These are the elements of product cost which can be divided into three groups
Material
Labour
Expense
MATERIAL
To produce or manufacture material is required. For example to manufacture shirts cloth is
required and to produce flour wheat is required. All material which becomes an integral part of
finished product and which can be conveniently assigned to specific physical unit is termed as
“Direct Material”. It is also described as raw material, process material, prime material,
production material, stores material, etc.
Actually, raw materials refer to any materials that are used in the final product; and the finished
product of one company can become the raw materials of another company. For example, the
plastics produced by X are a raw material used by Y in its personal computers.
Direct material
Direct Material is that material which can be easily identified and related with specific product,
job, and process. Timber is a raw material for making furniture, cloth for making garments,
sugarcane for making sugar, and Gold/silver for making jewellery, etc are some examples of
direct material.
Indirect material
Indirect Material is that material which cannot be easily and conveniently identified and related
with a particular product, job, process, and activity. Consumable stores, oil and waste, printing
and stationery etc, are some examples of indirect material. Indirect materials are used in the
factory, the office, or the selling and distribution department.
LABOUR
Labour is the main factor of production. For conversion of raw material into finished goods,
human resource is needed, and such human resource is termed as labour. Labour cost is the main
element of cost in a product or service. Labour can be classified into two categories:
Direct labour
Labour which takes active and direct part in the production of commodity. Direct labour is that
labour which can be easily identified and related with specific product, job, process, and activity.
Direct labour cost is easily traceable to specific products.
Cost of wages paid to carpenter for making furniture, cost of a tailor in producing readymade
garments, cost of washer in dry cleaning unit are some examples of direct labour.
Indirect labour
Indirect labour is that labour which cannot be easily identified and related with specific product,
job, process, and activity. It includes all labour not directly engaged in converting raw material
into finished product. Wages of store-keepers, time-keepers, salary of works manager, salary of
salesmen, etc, are all examples of indirect labour cost.
EXPENSES
All cost incurred in the production of finished goods other than material cost and labour cost are
termed as expenses. Expenses are classified into two categories
Direct expenses, and
Indirect expenses (An item of overheads)
Direct expenses
These are expenses which are directly, easily, and wholly allocated to specific cost centre or cost
units. All direct cost other than direct material and direct labour are termed as direct expenses.
Direct expenses are also termed as chargeable expenses. Some examples of the direct expenses
are hire of special machinery, cost of special designs, moulds or patterns, feed paid to architects,
surveyors and other consultants, inward carriage and freight charges on special material, Cost of
patents and royalties.
Indirect expenses
These expenses cannot be directly, easily, and wholly allocated to specific cost centre or cost
units. All indirect costs other than indirect material and indirect labour are termed as indirect
expenses
Indirect expenses are treated as part of overheads. Rent, rates and taxes of building, repair,
insurance and depreciation on fixed assets, etc, are some examples of indirect expenses
MANUFACTURING OVERHEADS
Manufacturing overhead is all of the costs that a factory incurs, other than the variable costs
required to build products, such as direct materials and direct labour.
Manufacturing overhead includes items such as indirect materials; indirect labour;
maintenance and repairs on production equipment; and heat and light, property taxes,
depreciation, insurance on manufacturing facilities and indirect expenses.
A company also incurs costs for heat and light, property taxes, insurance, depreciation,
and so forth, associated with its selling and administrative functions, but these costs are
not included as part of manufacturing overhead.
Only those costs associated with operating the factory are included in manufacturing
overhead.
CLASSIFICATION OF COST
Classification of cost is the arrangement of items of costs in logical groups having regard to their
nature or purpose. Items should be classified by one characteristic for a specific purpose without
ambiguity. OR
Classification is the process of grouping costs according to their common characteristics
or features. There are various methods of classifying costs on the basis of requirements.
Scheme of classification should be such that every item of cost can be classified the basis for
cost classification is as follows:
(a) Nature/Elements of expense
(b) Functions / Activities
(c) Behaviour – Fixed, Semi-variable or Variable
(d) Association with the Product
(e) Time
(a) Classification by Nature/Elements of Expense
Costs should be gathered together in their natural groping such as Material, Labour and Other
Direct expenses. Items of costs differ on the basis of their nature. The elements of cost can be
classified in the following three categories. 1. Material 2.Labour 3. Expenses
Material Cost: Material cost is the cost of material of any nature used for the purpose of
production of a product or a service. It includes cost of materials, freight inwards, taxes & duties,
insurance ...etc directly attributable to acquisition, but excluding the trade discounts, duty
drawbacks and refunds on account of excise duty and vat.
Labour Cost: Labour cost means the payment made to the employees, permanent or
temporary for their services. Labour cost includes salaries and wages paid to permanent
employees, temporary employees and also to the employees of the contractor. Here salaries and
wages include all the benefits like provident fund, gratuity, ESI, overtime, incentives...etc
Expenses: Expenses are other than material cost or labour cost which are involved in an activity.
They can be further subdivided into direct and indirect material cost, direct and indirect labour
cost and direct and indirect other expenses
(b) Classification by Functions:
A business enterprise performs a number of functions like manufacturing, selling, research...etc.
Costs may be required to be determined for each of these functions and on this basis functional
costs may be classified into the following types:-
(i) Production or Manufacturing Costs
(ii) Administration Costs
(iii) Selling & Distribution cost
(iv) Research & Development costs
(i)Production or Manufacturing Costs: Production cost is the cost of all items involved in the
production of a product or service. These refer to the costs of operating the manufacturing
division of an undertaking and include all costs incurred by the factory from the receipt of raw
materials and supply of labour and services until production is completed and the finished
product is packed with the primary packing.
The followings are considered as Production or Manufacturing Costs:-
(1) Direct Material
(2) Direct Labour
(3) Direct Expenses and
(4) Factory overhead,
(ii)Administration Costs: Administration costs are expenses incurred for general management
of an organization. These are in the nature of indirect costs and are also termed as administrative
overheads. For understanding administration cost, it is necessary to know the scope of
administrative function.
Administrative function in any organization primarily concerned with following activities:-
(1) Formulation of policy
(2) Directing the organization and
(3) Controlling the operations of an organization. But administrative function will not include
control activities concerned with production, selling and distribution and research and
development. Therefore, administration cost is the cost of administrative function, i.e., the cost
of formulating policy, directing, organizing and controlling the operations of an undertaking
(Administrative cost will include the cost of only those control operations which are not related
to production, selling and distribution and research and development). In most of the cases,
administration cost includes indirect expenses of following types:
Salaries of office staff, accountants, directors
Rent, rates and depreciation of office building
Postage, stationery and telephone
Office supplies and expenses
General administration expenses.
(iii)Selling & Distribution Costs: Selling costs are indirect costs related to selling of products
are services and include all indirect costs in sales management for the organization. Distribution
costs are the costs incurred in handling a product from the time it is completed in the works until
it reaches the ultimate consumer. Selling function includes activities directed to create and
stimulate demand of company’s product and secure orders. Distribution costs are incurred to
make the saleable goods available in the hands of the customer.
Following are the examples of selling and distribution costs:
Salaries and commission of salesmen and sales managers.
Expenses of advertisement.
Rent, rates, depreciation and insurance of sales office and warehouses.
Cost of insurance, freight, export, duty, packing, shipping, etc.,
Maintenance of Delivery vans.
(iv)Research &Development Costs:Research & development costs are the cost for undertaking
research to improve quality of a present product or improve process of manufacture, develop a
new product, market research...etc. and commercialization thereof.
R&D Costs comprises of the following:-
Development of new product.
Improvement of existing products.
Finding new uses for known products.
Solving technical problem arising in manufacture and application of products.
Development cost includes the costs incurred for commercialization / implementation of
research Findings
(e) By Time: Costs can be classified as 1) Historical cost and 2) Predetermined Costs.
The costs which are ascertained and recorded after it has been incurred are called historical
costs.
They are based on recorded facts hence they can be verified and are always supported by
evidences.
Predetermined costs are also known as estimated costs as they are computed in advance of
production taking into consideration the previous periods’ costs and the factors affecting such
costs.