INTRODUCTION TO COST ACCOUNTING

Introduction, Meaning and Definitions of Cost, Costing and Cost Accounting. Need and Objectives of Cost Accounting.
Distinctions between Financial Accounting and Cost Accounting. Advantages and Limitations of Cost Accounting.
Classification of Cost: Material Cost, Labour Cost and Overheads. Important terminologies – Cost Unit, Cost Center, Direct
Cost, Indirect Cost, Prime Cost, Production Cost, Administration Cost, Selling and Distribution Cost, Fixed Cost, Variable
Cost, Semi- variable Cost, Period Cost, Product Cost, Explicit Cost, Implicit Cost, Historical Cost, Current Cost, Future or
Predetermined Cost, Opportunity Cost. Installation of Cost Accounting System – Features of good cost accounting system,
precautions for installing effective cost accounting system, challenges in installing effective cost accounting system.

Chapter 1:

INTRODUCTION TO COST ACCOUNTING

Introduction

Accounting is the process of identifying, measuring, recording, classifying, summarising, interpreting and
communicating financial information, relating to an organisation to the interested users for judgment and decision
making. Accounting information is important for every business which will serve the needs of variety of interested
parties. To satisfy the needs of all interested parties a sound accounting system is very necessary. Accounting may be
divided into three parts

i. Financial accounting
ii. Cost accounting
iii. Management accounting.

 Financial Accounting: Financial accounting is mostly concerned to record the business transactions in books
of accounts so that final accounts can be prepared.
 Cost Accounting: Cost accounting developed to help the internal management in decision making. The
information provided by cost accounting acts as a managerial tool so that business can utilise the available
resources at optimum level.
 Management Accounting: Management accounting is an extension of management aspects of cost
accounting. It provides the information to management so that planning, organizing, directing and controlling
of business operations can be done in an orderly manner.

COST ACCOUNTING

Basic Concepts of Cost Accounting:

Cost: Cost is the amount of resource given up in exchange of some goods or services. The amount of
expenditure (actual or notional) incurred on or attributable to a specified article, product or activity.
Costing: According to CIMA “An organisation’s costing system is the foundation of the internal financial
information system for managers. It provides the information that management needs to plan and control the
organisation’s activities and to make decisions about the future.”
Cost Accounting: Cost Accounting is defined as "the process of accounting for cost which begins with the
recording of income and expenditure or the bases on which they are calculated and ends with the
preparation of periodical statements and reports for ascertaining and controlling costs."
Cost Accountancy: Cost Accountancy has been defined as “the application of costing and cost accounting
principles, methods and techniques to the science, art and practice of cost control and the ascertainment of
profitability. It includes the presentation of information derived there from for the purpose of managerial
decision making.

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Assistant Professor
Department of Commerce
Evolution of Cost Accounting:

Cost accounting traces back to ancient civilizations where rudimentary

forms of record-keeping and cost assessment existed. However, it gained
more significance during the Renaissance period when early merchants and
traders started employing basic cost control measures. With the advent of
mass production and industrialization, cost accounting became more
formalized. Managers recognized the need to track costs more systematically
to optimize production processes. This period saw the emergence of basic
costing methods like job costing and process costing.

In the early 19th century, the principles of scientific management introduced by Frederick Taylor emphasized
efficiency and productivity in manufacturing. Cost accounting played a crucial role in this era by providing data to
support managerial decision-making, particularly in optimizing labour and material costs.

The early 20th century saw the development of standard costing and variance analysis techniques. These methods
allowed managers to compare actual costs with standard costs, enabling better control over operations and identifying
areas for improvement. The aftermath of World War II brought about significant changes in cost accounting practices.
The emphasis shifted towards budgeting, cost control, and performance measurement. Concepts like activity-based
costing (ABC) also emerged during this period, offering more accurate cost allocation methods.

Objectives of Cost Accounting:

Ascertainment of Cost: The main objective of Cost Accounting is accumulation and ascertainment of cost. Costs are
accumulated, assigned and ascertained for each cost object. This cost object may be a unit, job, operation, process,
department or service.

Determination of Selling Price and Profitability:

The cost accounting system helps in determination of selling price and thus profitability of a cost object. Though in a
competitive business environment selling prices are determined by external factors but cost accounting system
provides a basis for price fixation and rate negotiation.

Cost Control: Maintaining discipline in expenditure is one of the main objectives of a good cost accounting system.
It ensures that expenditures are in consonance with predetermined set standard and any variation from these set
standards is noted and reported on continuous basis. To exercise control over cost, following steps are followed:

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Assistant Professor
Department of Commerce
  Determination of pre-determined standard or results: Standard cost or performance targets for a cost
object or a cost centre are set before initiation of production or service activity. These are desired cost or result
which needs to be achieved.
 Measurement of actual performance: Actual cost or result of the cost object or cost centre is measured.
Performance should be measured in the same manner in which the targets are set i.e. if the targets are set up
operation-wise, and then the actual costs should also be collected and measured operation-wise to have a
common basis for comparison.
 Comparison of actual performance with set standard or target: The actual performance so measured is
compared against the set standard and desired target. Any deviation (variance) between the two is noted and
reported to the appropriate person or authority.
 Analysis of variance and action: The variance in results so noted is further analysed to know the reasons for
variance and appropriate action is taken to ensure compliance in future. If necessary, the standards are further
amended to take developments into account.

Cost Reduction: It may be defined “as the achievement of real and permanent reduction in the unit cost of goods
manufactured or services rendered without impairing their suitability for the use intended or diminution in the
quality of the product.”

Assisting management in decision making: Cost and Management Accounting by providing relevant information,
assist management in planning, implementing, measuring, controlling and evaluating of various activities. A robust
cost and management accounting system provides internal and external information to the industry which will be
relevant for decision making.

Difference between Cost Control and Cost Reduction

Cost Control Cost Reduction

1. Cost control aims at maintaining the costs in 1. Cost reduction is concerned with reducing costs. It
accordance with the established standards. challenges all standards and endeavors to improvise
them continuously

2. Cost control seeks to attain lowest possible 2. Cost reduction recognises no condition as permanent,
cost under existing conditions. since a change will result in lower cost.

3. In case of cost control, emphasis is on past 3. In case of cost reduction, it is on present and future.
and present
4. Cost control is a preventive 4. Cost reduction is a corrective function. It
function Operates even when an efficient cost control system
exists.
5. Cost control ends when targets are 5. Cost reduction has no visible end and is a continuous
achieved. process.

Cost Accounting v/s Management Accounting

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Assistant Professor
Department of Commerce
 Basis Cost Accounting Management Accounting
(i) Nature It records the quantitative aspect It records both qualitative and
only. quantitative aspect.
(ii) Objective It records the cost of producing a It provides information to management
product and providing a service. for planning and co-ordination.
(iii) Area It only deals with cost It is wider in scope as it includes
Ascertainment. financial accounting, budgeting, taxation,
planning etc.
(iv) Recording of data It uses both past and present figures. It is focused with the
projection of figures for future.
(v) Development Its development is related to Its development is related to the need
industrial revolution. of modern business world.
(vi) Rules and It follows certain principles and It does not follow any specific rules
Regulation procedures for recording costs of and regulations.
different products.

Cost Accounting v/s Financial Accounting

Basis Cost Accounting Financial Accounting

(i) Nature It classifies, costs records, present, and
It classifies records, present and
interprets it in a significant manner. interprets transactions in
monetary terms
(ii) Objective Ascertainment of cost for the purpose It provides information about
of cost control and decision making. the financial performance of an
entity.

(iii) Recording of It makes use of both historical and pre- It records Historical data.
data determined costs.
(iv) Users of The cost accounting information is The users of financial accounting
information generally used by internal management. statements are shareholders,
But sometime regulatory authorities creditors, financial analysts and
also. government and its agencies, etc.
(vi) Analysis of cost It provides the cost details for each cost It shows profit or loss of the
and profit object i.e. product, process, job, organization either segment wise
operation, contracts, etc or as a whole.

(vii) Time period Reports and statements are prepared as Financial Statements are
and when required prepared usually for a year.

(viii) Presentation of In general, no set formats for presenting A set format is used for
information cost information is followed. presenting financial information

Advantages of Cost Accounting:

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Assistant Professor
Department of Commerce
Costing as an Aid to Management

 Cost accounting helps in periods of trade depression and trade competition:

In periods of trade depression, the organisation cannot afford to have losses which pass unchecked. The
management must know the areas where economies may be sought, waste eliminated and efficiency
increased. The organisation has to wage a war not only for its survival but also continued growth. The
management should know the actual cost of their products before embarking on any scheme of price
reduction. Adequate system of costing facilitates this.
 Cost accounting aids price fixation - Although the law of supply and demand to a great extent determines
the price of the article, cost to the producer does play an important role. The producer can take necessary
guidance from his costing records in case he is in a position to fix or change the price charged.
 Cost accounting helps in making estimates - Adequate costing records provide a reliable basis for making
estimates and quoting tenders.
 Cost accounting helps in channelising production on right lines - Proper costing information makes it
possible for the management to distinguish between profitable and non-profitable activities. Profits can be
maximised by concentrating on profitable operations and eliminating non-profitable ones.
 Cost accounting eliminates wastages - As cost accounting is concerned with detailed break-up of costs, it is
possible to check various forms of wastages or losses.
 Cost accounting makes comparisons possible - Proper maintenance of costing records provides various
costing data for comparisons which in turn helps the management in formulation of future lines of action.
 Cost accounting provides data for periodical profit and loss account - Adequate costing records provide
the management with such data as may be necessary for preparation of profit and loss account and balance
sheet at such intervals as may be desired by the management.
 Cost accounting helps in determining and enhancing efficiency - Losses due to wastage of materials, idle
time of workers, poor supervision, etc., will be disclosed if the various operations involved in the production
are studied carefully. Efficiency can be measured, costs controlled and various steps can be taken to increase
the efficiency.
 Cost accounting helps in determining and enhancing efficiency - Losses due to wastage of materials, idle
time of workers, poor supervision, etc., will be disclosed if the various operations involved in the production
are studied carefully. Efficiency can be measured, costs controlled and various steps can be taken to increase
the efficiency.
 Cost accounting helps in inventory control - Cost accounting furnishes control which management requires
in respect of stock of materials, work-in-progress and finished goods.

Costing as an Aid to Creditors:

Investors, banks and other money lending institutions have a stake in the success of the business concern and are,
therefore, benefited immensely by the installation of an efficient system of costing. They can base their judgment
about the profitability and future prospects of the enterprise on the costing records.

Costing as an Aid to Employees:

Employees have a vital interest in their employer’s enterprise in which they are employed. They are benefited by a
number of ways by the installation of an efficient system of costing. They are benefited, through continuous
employment and higher remuneration by way of incentives, bonus plans, etc.

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Assistant Professor
Department of Commerce
Costing as an Aid to National Economy

An efficient system of costing brings prosperity to the business enterprise which in turn results in stepping up of the
government revenue. The overall economic development of a country takes place as a consequence increase in
efficiency of production. Control of costs, elimination of wastages and inefficiencies led to the progress of the
industry and, in consequence of the nation as a whole.

Limitations of Cost Accounting:

Expensive: It is expensive because analysis, allocation and absorption of overheads requires considerable amount of
additional work, and hence additional money.

Requirement of reconciliation: The results shown by cost accounts differ from those shown by financial accounts.
Thus preparation of reconciliation statements is necessary to verify their accuracy.

Duplication of work: It involves duplication of work as organization has to maintain two sets of accounts i.e.
Financial Accounts and Cost Accounts.

Not Applicable to Many Industries: There is any ready-made system of cost accounting applicable to all concerns.
But the cost system, in the modified form, can be adopted to suit the special requirements of an industry. A modified
costing system has to be devised to suit the concern and not the business to suit the system.

Concepts in Cost Accounting:

Cost Unit:

A cost unit is a unit of product, service or time in terms of which costs are ascertained or expressed. It is basically a
unit of measurement like number, weight, length, etc., It depends on the nature and type of industry. The main purpose
of selecting a cost unit is to express cost per such unit. There are two types of Cost Units they are:

a) Units of production: These are used in manufacturing industries. Example: A tonne of coal/10 gram of gold
b) Units of Service: These are used in service industries. Example: Passenger Km, Per bed per day.

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Assistant Professor
Department of Commerce
 Industry or Product Cost Unit Basis
Automobile Number
Cement Ton/ per bag etc.
Chemicals Litre, gallon, kilogram, ton etc.
Power Kilo-watt hour (kWh)
Industry Sector Cost unit
Brewing Barrel
Brick-making 1,000 bricks
Coal mining Tonne/ton
Electricity Kilowatt-hour (kWh)
Engineering Contract, job
Oil Barrel, tonne, litre Cost
Hotel/Catering Room/meal Centre

Professional services Chargeable hour, job, contract A Cost

Centre is
Education Course, enrolled student, successful student
a
Hospitals Patient day location,
person or
Activity Cost unit item of
Credit control Accounts maintained
Selling Customer call, value of sales, orders taken
Materials storage/handling Requisition unit issued/received, material movement,
value issued/received
Personnel administration Personnel record
equipment for which costs may be ascertained and used for the purpose of cost control. The main purpose of
ascertaining the cost of a cost centre is to control the cost and to fix the responsibility of the person in charge of
a cost centre, for the control of cost of that centre.

Types of Cost Centre:

 Personal Cost Centre: It consists of person or a group of persons. Example: Machine operator, Driver
of a deliver van
 Impersonal Cost Centre: It consists of a location or an item of equipment or group of these. Example:
Location: Factory, Sales area
 Production Cost Centre: It is a cost centre where the actual production work takes place. Example:
production area
 Service Cost Centre: It is a cost centre which renders services to production cost centres and other cost
centres. Example: In a textile Mill, Spinning department, Weaving department etc.,
 Operation Cost Centre: It consists of machines and/or persons carrying out similar operations.
Example: Repairs and Maintenance Department, Purchase Department etc.,
 Process Cost Centre: It consists of a continuous sequence or operations.

Cost Object: Cost object may be defined as anything for which a separate measurement of cost is required. It
may be a product, service, activity or process.
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Assistant Professor
Department of Commerce
Example:

Product: Computer, Mobile phone, Tv, Car

Service: Hotel service, hospital service, transport service
Process: Spinning process, Weaving Process in a textile Mill
Activity: Placing purchase order, receiving deliveries of materials

Responsible Centre: is unit or function of an organisation under the control of a manager who has direct
responsibility for its performance.

 Cost Centre: is a responsibility centre for which costs are accumulated. The main objective of cost
centre is to minimise the centre’s cost.
 Revenue Centre: is a responsibility centre for which only revenues are accumulated. The main
objective of revenue centre’s is to maximise the centre’s revenue.
 Profit Centre: is a responsibility centre for which both costs and revenue are accumulated. The main
objective of profit centre is to maximise the centre’s profit.
 Contribution Centre: is a responsibility centre for which variable costs and revenues are accumulated.
The main objective of contribution centre is to maximise the centre’s contribution.
 Investment Centre: is a responsibility centre for which costs, revenues and investment in assets are
accumulated. The main objective of investment centre is to maximise the centre’s Return on
Investment(ROI) or Return on Capital Employed(ROCE).

Methods of Costing

 Job Costing:
Is that form of specific order costing under which each job is treated
as cost unit and costs are accumulated and ascertained separately for
each job, batch of products, contract, a service or any specific order.
Job Costing is applied in those industries where goods are
manufactured or services are rendered against specific order as per
customer’s specifications. It is generally applied in:
a) Engineering industries
b) Construction Industries
c) Ship-Building Industries

i. Contract Costing: Is that form of specific order costing under which each contract is treated as cost
unit and costs are accumulated and ascertained separately for each contract. Example: Construction
of building, roads, bridges or other construction work.
ii. Batch Costing: Is that form of specific order costing under which each batch is treated as a cost unit
and costs are accumulated and ascertained separately for each batch. Each batch consists of a number
of like units. Example: Readymade garments, Toys manufacturing industries.

 Process Costing:
Is a method of costing under which all costs are accumulated for each
stage of production and the cost per unit of product is ascertained at each
stage of production by dividing the total cost of each process by the
normal output of that process.
Example: Paper Industries, Chemical Industries, Sugar Industries.

i. Operating Costing: Is a form process costing under which costs

are accumulated for each operation and the cost per unit is
ascertained at each stage of production by dividing the cost of each operation by the normal output of
that operation.
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Assistant Professor
Department of Commerce
 It is used in those industries where the manufacturing process consists of a number of distinct
operations.

ii. Unit Costing or Single/output Costing: Unit Costing is a form of process costing under which costs
are accumulated and analysed under various elements of costs and the cost per unit is ascertained by
dividing the total cost by the number of units produced. This costing is applied in those industries
where –
a) Only are product or a few grades of the same produced
b) Production involves only a single process or operation
c) Production is uniform and continuous
d) Units of output are identical
For Example: Brick-making industry

iii. Operating/Service Costing: Is used to ascertain the cost of providing services in case of those
undertaking which provide services and are not engaged in the manufacture of tangible products.
Example: Railways, Airlines, Hospital.

iv. Multiple/Composite Costing: It involves the application of two or more methods of costing in
respect of same product. It is used in industries where a number of components are separately
produced and then assembled into a final product. For Example: Air-Conditioners, Motor Cycle.

Techniques of Costing

Historical Costing
It refers to the determination of costs after they have been actually incurred. It means that cost of a product can
be calculated only after its production. This system is useful only for determining costs, but not useful for
exercising any control over costs. It can serve as guidance for future production only when conditions continue
to be the same in future.

Standard Costing
It refers to the preparation of standard costs and applying them to measure the variations from standard costs and
analysing the variations with a view to maintain maximum efficiency in production. What is done in this case is
that costs of each article are determined before-hand under current and anticipated conditions, but sometimes
they are determined before-hand under normal or ideal conditions. Then actual costs are compared with the pre-
determined costs and deviations known as variances are noted down. Thereafter, the reasons for the variances
are ascertained and necessary steps are taken to prevent their recurrence.

Marginal Costing
It refers to the ascertainment of marginal costs by differentiating between fixed costs and variable costs and the
effect on profit of the changes in volume or type of output. In this case, only the variable costs are charged to
products or operations while fixed costs are charged to profit and loss account of the period in which they arise.

Uniform Costing
A technique where standardized principles and methods of cost accounting are employed by a number of
different companies and firms is termed as uniform costing. This helps in comparing performance of one firm
with that of another.

Direct Costing
The practice of charging all direct costs to operations, process or products leaving all indirect costs to be written
off against profits in the period in which they arise, is termed as direct costing.

Absorption Costing
The practice of charging all costs both variable and fixed to operation, process or products or process is termed
as absorption costing.

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Assistant Professor
Department of Commerce
 Budgetary Control:
It is a system which involves:
a) Establishment of budgeted performance for each activity of the business for the budget period
b) Comparison of actual performance with the budgeted performance to ascertain variances.
c) Analysis of variances to ascertain the reasons for the variance.
d) Taking corrective action.

Classification of Costs

Classification of costs refers to grouping of costs according to their common features.

It means the grouping of costs according to their common characteristics. The important ways of classification of
costs are:
 By Nature or Element
 By Functions
 By Variability or Behaviour
 By Controllability
 By Normality
 By Costs for Managerial Decision Making

 By Nature or Element:

Material Cost: The substance from which the product is made is known as material. It can be direct as well
as indirect.

ELEMENT OF COST

Material Cost Employee (Labour) Cost Other Expenses

Direct Material Indirect Direct Indirect Direct Indirect

cost Employee
Material Cost Employee Expenses Expenses
(Labour) Cost (Labour) Cost

Overheads

Production Administration Selling and

Overheads Overheads Distribution Overheads

Direct Material Cost:

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Assistant Professor
Department of Commerce
It refers to those materials which become a major part of the finished product and can be easily traceable to
the units.
Direct materials include:
(i) All materials specifically purchased for a particular job/process.
(ii) All material acquired and latter requisitioned from stores.
(iii) Components purchased or produced.
(iv) Primary packing materials.
(v) Material passing from one process to another.

Indirect Cost:
All material which is used for purposes ancillary to production and which can be conveniently assigned to
specific physical units is termed as indirect materials.
Examples oil, grease, consumable stores, printing and stationary material etc.,

Employee (Labour Cost):

Labour cost can be classified into direct labour and indirect labour.

Direct Labour Cost:

Labour which can be economically identified or attributed wholly to a cost object is termed as direct
labour. For example, employee engaged on the actual production of the product or in carrying out the
necessary operations for converting the raw materials into finished product.

Indirect labour: Labour employed for the purpose of carrying tasks incidental to goods or services
provided, is indirect labour. It cannot be practically traced to specific units of output. Examples,
wages of store-keepers, foreman, time-keepers, supervisors, inspectors etc.,

Other Expenses: Expenses: Expenses may be direct or indirect.

Direct Expenses: All expenses other than direct material or direct labour which are specially incurred
for a particular cost object and can be identified in an economically feasible way are termed as Direct
Expenses. For example, hire charges for some special machinery, cost of defective work etc.

Indirect Expenses: Expenses other than direct expenses are known as indirect expenses. These
cannot be directly, conveniently and wholly allocated to cost centres. Factory rent and rates,
insurance of plant and machinery, power, light, heating, repairing, telephone etc., are some
examples of indirect expenses.

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Assistant Professor
Department of Commerce
 Overheads: The aggregate of indirect material costs, indirect labour costs and indirect expenses is
termed as Overheads. The main groups into which overheads may be subdivided are as follows:

Production or Works Overheads: Indirect expenses which are incurred in the factory and
for the running of the factory. E.g.: rent, power etc.

Administration Overheads: Indirect expenses related to management and administration of business. E.g.:
office rent, lighting, telephone etc.

Selling Overheads: Indirect expenses incurred for marketing of a commodity. E.g.: Advertisement expenses,
commission to sales persons etc.

Distribution Overheads: Indirect expenses incurred for dispatch of the goods E.g.: warehouse charges,
packing (secondary) and loading charges.

 By Functions: Under this classification, costs are divided according to the function for which they have
been incurred. It includes the following:

Production/ Manufacturing Overheads

Administration Overheads
Selling Overheads
Distribution Overheads
Research and Development costs etc.,

Production/ Manufacturing Overheads

Is the cost of sequence of operations which begins with supplying materials, labour and services and ends with
the primary packing of the product.
Example: Wood in making furniture, Cloth in making a shirt

Administrative Overheads:
It represents the cost of formulating the policy, directing the organisation and controlling the operations of
undertaking which is not related directly to production, selling, distribution, research or development activity
or function.

Selling Overheads:
It represents the cost of seeking to create and stimulate demand and securing order. Thus, this is the cost of
promoting sales and retaining customers.

Distribution Overheads:
It represents the cost of the sequence of operations which begins with the making the product available for
dispatch and ends with making the reconditioned returned empty package, if any available for re-use.

Research and Development Cost

The cost of the process which begins with the implementation of the decision to produce a new or improved
product or to employ a new or improved method and ends with the commencement of formal production of
that product or by the method.

 By Variability or Behaviour

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Assistant Professor
Department of Commerce
 Based on this classification, costs are classified into three groups viz., fixed, variable and semi-variable.
Fixed costs– These are the costs which are incurred for a period, and which, within certain output and
turnover limits, tend to be unaffected by fluctuations in the levels of activity (output or turnover). They do
not tend to increase or decrease with the changes in output. For example, rent, insurance of factory
building etc., remain the same for different levels of production.
Variable Costs– These costs tend to vary with the volume of activity. Any increase in the activity results in
an increase in the variable cost and vice-versa. For example, cost of direct material, cost of direct labour, etc.
Semi-variable costs– These costs contain both fixed and variable components and are thus partly affected
by fluctuations in the level of activity. Examples of semi variable costs are telephone bills, gas and electricity
etc.

 By Controllability
Controllable Costs: - Cost that can be controlled, typically by a cost, profit or investment centre manager
is called controllable cost. Controllable costs incurred in a particular responsibility centre can be influenced
by the action of the manager heading that responsibility centre. For example, direct costs comprising direct
labour, direct material, direct expenses and some of the overheads are generally controllable by the shop floor
supervisor or the factory manager.
Uncontrollable Costs: Costs which cannot be influenced by the action of a specified member of an
undertaking are known as uncontrollable costs. For example, expenditure incurred by, say, the tool room is
controllable by the foreman in-charge of that section but the share of the tool-room expenditure which is
apportioned to a machine shop is not controlled by the machine shop foreman.

 By Normality
Normal Cost - It is the cost which is normally incurred at a given level of output under the conditions
in which that level of output is normally attained. Abnormal Cost - It is the cost which is not normally
incurred at a given level of output in the conditions in which that level of output is normally attained.
It is charged to Costing Profit and loss Account.

 By Costs used in Managerial Decision Making

Pre-determined Cost: A cost which is computed in advance before production or operations start, on the basis
of specification of all the factors affecting cost, is known as a pre-determined cost

Standard Cost - A pre-determined cost, which is calculated from managements ‘expected standard of efficient
operation’ and the relevant necessary expenditure. It may be used as a basis for price fixation and for cost
control through variance analysis.

Marginal Cost - The amount at any given volume of output by which aggregate costs increases if the volume of
output is increased or decreased by one unit.

Estimated Cost - Kohler defines estimated cost as “the expected cost of manufacture, or acquisition, often in
terms of a unit of product computed on the basis of information available in advance of actual production or
purchase”. Estimated costs are prospective costs since they refer to prediction of costs.

Differential Cost (Incremental and decremental costs). It represents the change (increase or decrease) in total
cost (variable as well as fixed) due to change in activity level, technology, process or method of production,
etc. For example, if any change is proposed in the existing level or in the existing method of production, the
increase or decrease in total cost or in specific elements of cost as a result of this decision will be known as
incremental cost or decremental cost.

Imputed Costs - These costs are notional costs which do not involve any cash outlay. Interest on capital,
the payment for which is not actually made, is an example of imputed cost. These costs are similar to
opportunity costs.

Capitalized Costs -These are costs which are initially recorded as assets and subsequently treated as expenses.
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Assistant Professor
Department of Commerce
 Example, installation expenses on the erection of a machine are added to the cost of a machine.

Product Costs - These are the costs which are associated with the purchase and sale of goods (in the case of
merchandise inventory). In the production scenario, such costs are associated with the acquisition and
conversion of materials and all other manufacturing inputs into finished product for sale. Hence, under marginal
costing, variable manufacturing costs and under absorption costing, total manufacturing costs (variable and
fixed) constitute inventoriable or product costs.

Opportunity Cost - This cost refers to the value of sacrifice made or benefit of opportunity foregone in
accepting an alternative course of action. For example, a firm financing its expansion plan by withdrawing
money from its bank deposits. In such a case the loss of interest on the bank deposit is the opportunity cost for
carrying out the expansion plan.

Out-of-pocket Cost - It is that portion of total cost, which involves cash outflow. This cost concept is a short-
run concept and is used in decisions relating to fixation of selling price in recession, make or buy, etc.
Out–of–pocket costs can be avoided or saved if a particular proposal under consideration is not accepted.

Shut down Costs - Those costs, which continue to be, incurred even when a plant is temporarily shut-down e.g.
rent, rates, depreciation, etc. These costs cannot be eliminated with the closure of the plant. In other words, all
fixed costs, which cannot be avoided during the temporary closure of a plant, will be known as shut down costs.

Sunk Costs - Historical costs incurred in the past are known as sunk costs. They play no role in decision
making in the current period. For example, in the case of a decision relating to the replacement of a
machine, the written down value of the existing machine is a sunk cost and therefore, not considered.

Absolute Cost - These costs refer to the cost of any product, process or unit in its totality. When costs are
presented in a statement form, various cost components may be shown in absolute amount or as a percentage of
total cost or as per unit cost or all together. Here the costs depicted in absolute amount may be called absolute
costs and are base costs on which further analysis and decisions are made.

Discretionary Costs – Such costs are not tied to a clear cause and effect relationship between inputs and
outputs. They usually arise from periodic decisions regarding the maximum outlay to be incurred. Examples
include advertising, public relations, executive training etc.

Period Costs - These are the costs, which are not assigned to the products but are charged as expenses
against the revenue of the period in which they are incurred. All non-manufacturing costs such as general &
administrative expenses, selling and distribution expenses are recognised as period costs.

Engineered Costs - These are costs that result specifically from a clear cause and effect relationship between
inputs and outputs. The relationship is usually personally observable. Examples of inputs are direct material
costs, direct labour costs etc. Examples of output are cars, computers etc.

Explicit Costs - These costs are also known as out-of-pocket costs and refer to costs involving immediate
payment of cash. Salaries, wages, postage and telegram, printing and stationery, interest on loan etc. are
some examples of explicit costs involving immediate cash payment.

Implicit Costs - These costs do not involve any immediate cash payment. They are not recorded in the books of
account. They are also known as economic costs.

Cost Accounting System

A costing system is designed to monitor the costs incurred by a business. The system is comprised of a set of forms,
processes, controls, and reports that are designed to aggregate and report to management about revenues, costs, and
profitability.
Harshitha P
Assistant Professor
Department of Commerce
Factors to be considered before installing a Costing System

Objective: The objective of setting up the costing system, for example whether it is being introduced for fixing
prices or for establishing a system of cost control.

Nature of Business or Industry: The industry in which the business is operating. Every business or industry has its
own uniqueness and objectives. According to its cost information requirement, cost accounting methods are followed.
For example, an oil refinery maintains process wise cost accounts to find out the cost incurred on a particular
process, say in crude refinement process etc.

Organisational Hierarchy: Costing system should fulfil the information requirements of different levels of
management. Top management is concerned with the corporate strategy, strategic level management is concerned
with marketing strategy, product diversification, product pricing etc. Operational level management needs the
information on standard quantity to be consumed, report on idle time etc.

Knowing the product: Nature of the product determines the type of costing system to be implemented. The product
which has by-products requires costing system which accounts for by-products as well. In case of perishable or
short self-life products, marginal costing is appropriate to know the contribution and minimum price at which
products could be sold.

Knowing the production process: A good costing system can never be established without the complete knowledge
of the production process. Cost apportionment can be done on the most appropriate and scientific basis if a cost
accountant can identify degree of effort or resources consumed in a particular process. This also includes some basic
technical know-how and process peculiarity.

Information synchronisation: Establishment of a department or a system requires substantial amount of

organisational resources. While drafting a costing system, information needs of various other departments should be
taken into account. For example, in a typical business organisation accounts department needs to submit monthly
stock statement to its lender bank, quantity wise stock details at the time of filing returns to tax authorities etc.

Method of maintenance of cost records: The organization must determine beforehand the manner in which Cost and
Financial accounts could be inter-locked into a single integral accounting system and how the results of separate sets
of accounts i.e. cost and financial, could be reconciled by means of control accounts.

Statutory compliances and audit: Records are to be maintained to comply with statutory requirements and
applicable cost accounting standards should be followed.

Information Attributes: Information generated from the Costing system should possess all the attributes of useful
information i.e. it should be complete, accurate, timely, relevant to have an effective management information system
(MIS).

Practical difficulties in installing a costing system

 Lack of support from top management

 Resistance from the accounting staff
 Non-cooperation of working and supervisory staff
 Shortage of trained staff

Essential features of a good Cost Accounting System

 Suitability
 Tailor made system
Harshitha P
Assistant Professor
Department of Commerce
 Simplicity
 Economical
 Flexibility
 Accuracy
 Promptness
 Cost Control
 Clearly defined Cost Centres

Harshitha P
Assistant Professor
Department of Commerce