Cost Accounting

DEFINITIONS
Cost
Cost is forgoing (exchange price, sacrifice), measured in monetary terms, incurred or
potentially to be incurred to achieve specific objective.
Expense
The expired cost is called expense OR the decrease in net assets as a result of the use of
economic services in the creation of revenue.
Use of Cost Data
1. Planning Profit by means of budgets.
2. Controlling costs via responsibility accounting.
3. Measuring annual or periodic profit, inventory costing.
4. Assisting in pricing policy.
5. Furnishing cost data for analytical processes for decision making.

Definition of Management Accounting

According to the Chartered Institute of Management Accountants (CIMA), Management
Accounting is "the process of identification, measurement, accumulation, analysis, preparation,
interpretation and communication of information used by management to plan, evaluate and
control within an entity and to assure appropriate use of and accountability for its resources.

Classification of Cost
1. Natural Classification
A). Manufacturing Costs
 Direct Materials
 Direct Labour
 Factory Overheads
B). Commercial Expenses
 Marketing
 Administration
2. With respect to Accounting Period
A). Capital Expenditures
B). Revenue Expenditures

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 3. By their Tendency to vary with Volume or Activity
A). Variable Costs
B). Semi-Variable Costs
C). Fixed Costs
4. Costs for Planning and Control
A). Budgeted Costs
B). Standard Costs

5. Costs for Analytical Processes

 Opportunity Cost
 Differential Cost
 Sunk Cost
 Out-of-Pocket Costs
 Imputed Costs
 Relevant and Irrelevant Costs.
6. With respect to Stock Valuation & Profit Measurement
 Period Cost
 Product Cost
Elements of Cost
 Material
 Labour
 Factory Overheads

Direct Material
The material that forms an integral part of finished product and that can be easily
identified with the product.
Examples:
 Lumber to make furniture
 Steel to make automobile bodies
 Crude Oil to make gasoline

Direct Labour
The labour (working hands involved in production) that applies directly to the
material comprising finished product.

Factory Overheads
FOH are also called “manufacturing overheads”, “manufacturing expenses”, or
“factory burden”. FOH may be defined as the cost of indirect materials, indirect labour and all
other manufacturing costs that can not conveniently be charged to specific jobs, units or
products.

Costs in their tendency to vary with Volume or Activity

A. Variable Costs
B. Fixed Costs
C. Semi-Variable Costs

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A. Variable Costs
Following are the characteristics of variable costs:
 Vary in direct proportion to the volume of production
 Comparatively constant per unit within a relevant range
 Control of their incurrence and consumption by their responsible department
head.
Examples of Variable Costs:
 Direct Materials
 Direct Labour
 Supplies
 Fuel
 Power
 Small tools
 Receiving costs
 Communication Costs
 Over time premiums

B. Fixed Costs
Following are the characteristics of fixed costs:
 Fixed in total within relevant range.
 Vary per unit with increased production.
 Control of incurrence in most cases rests with executive management.

Examples:
 Salaries of Production Executives
 Depreciation
 Factory Rent
 Maintenance of Factory Building
 Insurance- Property
 Wages of security Guards

C. Semi-Variable Costs
Semi-variable costs contain both fixed and variable elements.
Examples:
 Supervision
 Inspection
 Maintenance & Repairs of machinery
 Health and Accident Insurance
 Payroll Taxes
 Heat, Light and Power

Prime Cost = Direct Material + Direct Labour

Conversion Cost = Direct Labour + Factory Overheads

Manufacturing Cost = Direct Material + Direct Labour + Factory Overheads

OR
= Prime Cost + Factory Overheads

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 OR
= Direct Materials + Conversion Cost

Cost of Goods Sold Section comprises of:

 Direct Materials
 Direct Labour
 Factory Overheads
 Work in Process
 Finished Goods
Opportunity Cost
An opportunity cost is a cost that measures the opportunity that is lost or sacrificed when the
choice of one course of action requires that an alternative course of action be given up.
OR
Opportunity Cost is the measurable value of an opportunity bypassed by rejecting an alternative
use of resources.
Example
A company has an opportunity to obtain a contract for the production of a special component.
This component will require 100 hours of processing on machine X. Machine X is working at
full capacity on the production of Product A; and the only way in which the contract can be
fulfilled is reducing the output of Product A. This will mean a loss of revenue of Rs.200. The
contract will result in additional variable cost of Rs.1,000.
If the company takes on the contract, it will sacrifice revenue of Rs.200 from the lost output of
product A. This represents an opportunity cost, and should be included as a part of the cost when
negotiating the contract. The contract price should at least cover the additional cost of Rs.1,000
plus Rs.200 opportunity cost to ensure that the company will be better off in the short term by
accepting the contract.

Differential Cost
Differential cost is the difference in the cost of alternative choices. Differential cost is often
referred to as marginal or incremental cost.
Example
Variable production cost is the typical example of differential cost. If, however, the selection of
other alternative requires additional fixed cost, then this cost will also be considered as
differential cost.

Sunk Costs
These costs are the cost of resources already acquired where the total will be unaffected by the
choice between various alternatives. These are the costs that have been created by a decision
made in the past and can not be changed by any decision that will be made in future.
Example
Written-down Value (Depreciation) of an asset previously purchased is sunk costs.
For example, if a machine was purchased 4 years ago for Rs.100,000 with an expected life of 5
years with no salvage value and then written down value will be Rs.20,000 p.a. if straight line

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depreciation is used. The written down value will have to be write off, no matter what possible
alternative future action might be chosen. If the machine was scrapped, the Rs.20,000 would be
written off; if the machine was used for production, Rs.20,000 still have to be written off. This
cost can not be changed by any future decision and is therefore classified as a sunk cost. It is
irrelevant for decision making.

Imputed Costs
Imputed costs are hypothetical costs representing the cost or value of resource measured by its
use value. These costs do not involve actual cash outlay.
Examples
Interest on invested capital, rental-value of company-owned properties.

Out-of-Pocket Costs
While imputed costs do not lead to cash outlays, out-of-pocket costs do, either immediately or at
some future date. These costs are often identified as variable or direct costs, because these costs
are relevant to any decision when the total product costs are not pertinent.
Relevant and Irrelevant Costs
Relevant Costs are those costs that will bee changed by a decision, whereas irrelevant costs are
those costs that will not be affected by the decision.
Example
A company purchased raw materials a few years ago for Rs.100. There appears no possibility of
selling these materials or using them in future production apart from in connection with an
inquiry from a former customer. This customer is prepared to purchase a product that will require
the use of all these materials, but he is not prepared to pay more than Rs.250. The additional
costs of converting these materials into the required product are Rs.200. Should the company
accept the order for Rs.250?
It appears that cost of the order is Rs.300, consisting of Rs.100 material cost and Rs.200
conversion cost, but it is incorrect because the Rs.100 material cost will remain the same whether
order is accepted or rejected. The material cost is, therefore, irrelevant for the decision; but if the
order is accepted, the conversion cost will change by Rs.200, and this conversion cost is a
relevant cost. If we compare the revenue of Rs.250 with the relevant cost for the order of Rs.200,
it means that the order should be accepted, assuming of course that no higher-priced orders can
be obtained elsewhere. The following calculations show that this is correct decision to accept the
order:

Don’t Accept Order Accept Order

Rs. Rs.
Materials 100 100
Conversion cost ---- 200
Revenue ---- (250)
Net Cost 100 50

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The net cost of the company is Rs.50 less, or alternatively the company is Rs.50 better off as a
result of accepting the order. This agrees with the Rs.50 advantage which was suggested by the
relevant cost method.
Period Costs
Period costs are charged against the income of the current period. In direct costing, fixed FOH as
well as selling and administrative expenses are treated as period costs.
Product Costs
Costs that apply to the production of goods are called period costs. Variable manufacturing costs
(Direct Materials, Direct Labour and Variable FOH) are typical product costs in Direct Costing
and are charged against the income when the units to which they relate are sold.

Questions on Cost of Goods Sold

Question 1
From the following information, calculate the amount of Raw Material used.
Opening inventory Raw Material --------------------------------------------- Rs.35,000
Raw Materials Purchased ------------------------------------------------------ 90,000
Freight Inward ------------------------------------------------------------------- 5,000
Raw Materials Returned to Supplier ------------------------------------------ 10,000
Raw Materials Ending Inventory ---------------------------------------------- 20,000
Question 2
The accounting department of Shellay Company provided the following data:
Direct Material put into process -----------------------------------------------Rs.50,000
Direct Labour incurred ---------------------------------------------------------- 80,000
Factory Overheads --------------------------------------------------------------- 40,000
Required:
1. Prime Cost
2. Conversion Cost
3. Manufacturing Cost
Question 3
The accounting department of Sapphire Company provided the following data:
Direct Material put into process -----------------------------------------------Rs.80,000
Direct Labour incurred ---------------------------------------------------------- 90,000
Factory Overheads --------------------------------------------------------------- 25,000
Inventories: Opening Ending
Raw Materials 10,000 20,000
Work-in-Process 15,000 10,000
Finished Goods 20,000 35,000
Required:
1. Purchases
2. Prime Cost
3. Conversion Cost
4. Manufacturing Cost
5. Cost of Goods Manufactured

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 6. Cost of Goods Sold
Question 4
On October 1st, the Florida Company had the following inventories:
Materials Rs. 24,000
Work in Process 12,000
Finished Goods 36,000
During the month, materials costing Rs.56,000 was purchased. Direct Labour was Rs.40,000 and
actual FOH for the month were Rs.48,000.
Inventories on October 31st were as follows:
Materials Rs. 20,000
Work in Process 8,000
Finished Goods 40,000
Required:
1. Prime Cost
2. Conversion Cost
3. Cost of Goods Manufactured
4. Cost of Goods Sold
Question 5
The following information was taken from the books of Spider Manufacturing Corporation for
the year ended December 31st 2004.
Units Rs.
Sales during the year------------------------------------------------------------------ 8,000 ?
Opening Inventories:
Work in process ---- ----
Finished Goods ----------------------------------------------------------------- 1,800 14,850
Closing Inventories:
Work in process ----------------------------------------------------------------- 100 ?
Finished Goods --------------------------------------------------------------- 2,000 ?
Manufacturing Costs:
Direct Materials Cost ------------------------------------------------------------------------------- 30.000
Direct Labour ---------------------------------------------------------------------------------------- 20,000
Factory Overheads ---------------------------------------------------------------------------------- 16,000
The foreman has submitted the following estimate of Work in process ending Inventory:
Direct Materials-----------------Rs.2,700
Direct Labour-----------------------1,000
FOH---------------------------------- ?
The Company’s past experience shows that FOH cost tends to fluctuate closely in proportion to
Direct Labour Cost.
Required:
1. Calculate the number of units manufactured during the year.
2. Complete the Forman’s estimate of cost of work in process.
3. Calculate the Cost of each unit manufactured during the year.
4. Prepare Cost of goods sold statement.
5. Calculate Sales figure by assuming that sales price consists of a markup of 25% of its
total production cost.

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Question 6
From the following data, compute the sales price per unit.

Estimated Annual Sales 16,000 units

Estimated Cost Total Per Unit
Materials Rs.96,000 Rs.6.00
Direct Labour 14,400 0.90
Factory Overheads 24,000 1.50
Administrative Expenses 28,800 1.80
Rs.163,200 Rs.10.20

Marketing expenses are expected to be 10% of sales and profit is Rs.2.04 per unit

Question 7
You are given the following data of KKJ Manufacturing Company.

Prime Cost ----------------------------------------------- 70% of cost of goods manufactured

Gross Profit --------------------------------------------- 20% of net sales
Factory Overheads ------------------------------------- 40% of conversion cost
Cost of goods to be sold ------------------------------- Rs.300,000
Direct Materials Purchased --------------------------- Rs.135,000
Opening WIP ------------------------------------------- Rs.84,000
Opening Direct Material Inventory ------------------ Rs.15,000
Opening Finished Goods ------------------------------ Rs.60,000
Sales ------------------------------------------------------ Rs.307,500
Direct Labour ------------------------------------------- Rs.42,000

Required:
Calculate Closing Inventories of:
 Direct Materials
 WIP
 Finished Goods

Question 8
Following information relates to Ciza Chemical industries for the month of December:
Materials purchased during December -------------------------------------- Rs.110,000
Cost of goods sold ------------------------------------------------------------- Rs.345,000
FOH was 50% of Direct Labour Cost.
Inventories were as follows:
Beginning Ending
Finished Goods --------------------------------------- Rs.102,000----------------Rs.105,000
Work in Process -------------------------------------- Rs. 40,000----------------Rs. 36,000
Materials------------------------------------------------ Rs. 20,000----------------Rs. 26,000
Required: Prepare a cost of goods sold for the month of December.
Question 9

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You have been given the following data of Ammar Textiles Limited for the year ended Dec.31,2006

Inventories
Opening Closing
Rs.(000) Rs.(000)
Finished Goods 10,000 15,000
Work in Process 2,000 8,000
Materials 35,000 16,000

Rs.(000)
Material Purchased 125,000
Freight In 3,000
Direct Labour 95,000

Factory Overheads: Rs.(000) Rs.(000)

Indirect Labour 10,000
Indirect material 5,000
Overtime Premium 2,000
Fuel 9,000
Light & Power 25,000
Factory Insurance 5,000
Factory Depreciation 2,000
Defective Work 1,000
Repairs & maintenance 2,000 61,000

Sales salaries 20,000

Sales Commission 10,000
Office Supplies Used 5,000
Postage 2,000
Advertising Expenses 20,000
Convocations & Exhibits 5,000
Sales 325,000

NOTE: FOH are applied @ 70% of Direct labour Cost. Under/Over applied FOH are closed to CGS.

Required: Prepare an Income Statement for the Year Ended December 31, 2006.

Question 10
The proprietor of Decent Industries has a limited knowledge of accounting. At the end of the
accounting year he prepared the following income statement:

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 Decent Industries
Income Statement
For the Year Ended December 31, 2005

Rs. Rs.

Sales 675,000
Less Operating expenses:
Direct Labour 137,500
Indirect Labour 18,000
Selling & Administrative Expenses 48,000
Raw Materials Purchased 248,500
Electricity Bill 22,500
Insurance Expense 6,000
Depreciation Expense of Factory Equipment 33,000
Depreciation of Head Office Equipment 4,500
Rent of Premises 75,000
Advertising 81,500 674,500
Net Profit 500

The proprietor is concerned as to the accuracy of the above statement and has requested you to
check over the statement and make necessary corrections.

During analysis, you have determined the following additional information:

1. 80% of the electricity bill, 75% of the insurance expense, and 70% of rent of premises
apply to factory operations and the remaining amounts apply to the selling and
administrative activities.
2. Beginning and ending inventories were:
January 1st December 31st
Finished Goods Rs.50,000 Rs.60,000
Work in Process 42,500 30,000
Raw Materials 7,500 18,000

3. FOH are applied @ Rs.5 per machine hour. Machine hours during the year totaled
26,400. Under/over applied FOH are to be closed to the cost of goods sold.
Required:
1. Prepare cost of goods manufactured and sold statement indicating cost of goods sold at
normal and at actual.
2. Prepare revised income statement.
3. Explain the reason for difference between net profit as per proprietor’s income statement
and your revised income statement.

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