NATURE OF ACCOUNTING AND

COST CLASSIFICATION

BY
SC MALHOTRA
ASSOCIATE PROFESSOR
SHRI RAM COLLEGE OF COMMERCE
DELHI - 110007
Branches of accounting for business

• Accounting may be defined as a system of collecting,

summarizing, analyzing and reporting information
about a business enterprise in monetary terms.

• Accounting for business may broadly be categorized

into three parts as –
– Financial Accounting
– Cost Accounting
– Management Accounting
FINANCIAL ACCOUNTING
• Financial accounting is mainly concerned with recording business
transactions in the books of accounts for the purpose of communicating
economic information about the enterprise to the users of such
information.
• In financial accounting, business transactions are recorded in a manner
which is helpful in preparing financial statements for the purpose of
reporting to the management, shareholders, tax authorities, creditors, etc.

COST ACCOUNTING
• It is that branch of accounting information system, which records,
measures and reports information about costs.
• It is the process of accounting for costs. It aims at providing cost data,
statements and reports for the purpose of managerial decision making.
• It embraces the accounting procedures relating to recording of all income
and expenditure and the preparation of periodical statements and reports
with the object of ascertaining, controlling and reducing costs.
Management Accounting
• Management accounting is that branch of accounting which designs
accounting information in such a way that it helps management in
decision making. It is tailored to meet the needs of management of the
specific business.

• It has shifted focus of accounting from ‘recording and analyzing financial

transactions’ to generating information for management decisions.

• The criterion for inclusion of any information in management

accounting is its utility.

• Thus management accounting is concerned with accounting

information which is useful to the management in formulating policies
and controlling the business operations.
 Distinction between
Financial accounting and
management accounting
1. Users Cost accounting and
2. Source of authority management accounting
3. Nature of information 1. Scope
4. Terms of expression 2. Functions
5. Time frame 3. Organization structure
6. Report criterion 4. Source of information
5. Planning

Management accounting is the blending together of financial accounting, cost accounting

And financial management so as to serve as a good guide to management in planning,
coordinating, executing, controlling and motivating.
Nature and functions of cost accounting
As Cost accounting is the process of accounting for costs, it
embraces the accounting procedures relating to recording
of all income and expenditure and the preparation of
periodical statements and reports with the object of
ascertaining, controlling and reducing costs.
 
• Cost ascertainment. The main purpose of accounting
initially was to ascertain cost of products, operations,
processes, jobs, etc. Cost ascertainment is concerned
with computation of actual cost incurred. It refers to
methods and processes employed in ascertaining costs.
Nature and functions of accounting………………cotd.

• Cost control. A cost accountant is now concerned with

furnishing such information that enables the management to
control the costs of operating the business. As a matter of fact,
this function has become the prime function of the cost
accountant these days. Cost control is exercised by a variety of
techniques such as those of standard costing, budgetary control,
quality control etc.
 
• Cost reduction. This is a new dimension to the function of a cost
accountant. In the era of liberalization and competition only
those will survive who can deliver quality goods and services at
the least cost. This needs constant research and development in
the areas of product design, production procedures etc. for
reducing costs.
Meaning of some important terms
• Cost It may be defined as the amount of expenditure (actual or notional)
incurred on or attributable to a given object. Cost represents the resources
that have been or must be sacrificed to attain a particular objective. Sacrifice
may be direct or indirect but must be able to be measured in terms of money.
 
• Cost unit It is a quantitative unit of output (product or service) in relation to
which costs are ascertained by means of allocation, apportionment and
absorption. For example, tonnes in cement/coal/sugar industry,, metre in
textile industry, crate (of 24 or 12 bottles) in soft drink industry, kilogram of
yarn spun in spinning industry, kilowatt-hour (Kwh.) in electricity industry,
room per day in hotel industry, passenger kilometer or tonne kilometer in
transport industry, are some of the examples of cost unit.

In the case of service organisations a composite cost unit is used such as

tonne-kilometre, kilowatt-hour, patient-day etc., to be more meaningful.
 
Meaning of some important terms………….cotd.

• Cost object A cost object is something for which we want to

compute a cost. It can be a product (motor car), service (airline
flight from Delhi to Dubai), project (construction of a building),
activity (holding games), program (malaria eradication), etc. Thus
cost object may be anything for which a separate measurement
of costs is desired.
 
• Cost centre It is a location, person or item of equipment (or
group of these) for which costs may be ascertained and used for
the purpose of control. Thus a cost centre refers to a section of
the business to which costs can be charged. The purpose of
creation of cost centre is basically (i) the recovery of costs and (ii)
cost control.
Elements Of Cost
• Material cost The substance from which the product is made is
known as material. The cost of this material is material cost. It may
be in a raw or manufactured state. It can be direct as well as
indirect. Examples of direct material cost are: cotton in cloth, cloth
in garments, leather in leather products, jute in gunny bags, iron in
iron products, timber in furniture, paper in books, clay in bricks, etc.
• Labour cost For conversion of materials into finished goods, human
effort is needed. Such human effort is called labour. Thus the cost of
remuneration (wages, salaries, commissions, bonuses, etc.) of the
employees is called labour cost. Labour cost can be direct as well as
indirect.
• Expenses All costs other than material and labour are termed as
expenses. They may be direct or indirect.
ELEMENTS OF COST

ELEMENTS
OF COST

MATERIAL LABOUR OTHER

COSTS COSTS COSTS

DIRECT DIRECT DIRECT

INDIRECT INDIRECT INDIRECT

 ELEMENTS OF COST

LABOUR OTHER
MATERIAL
COST COSTS
COST

DIRECT INDIRECT DIRECT INDIRECT DIRECT INDIRECT

OVERHEADS
Overheads

• Overheads include the cost of indirect

material, indirect labour and indirect expenses.
• These overheads may be classified under the
following three categories:
– Manufacturing (works, factory or production)
expenses
– Office and administrative expenses
– Selling and distribution expenses
 ELEMENTS OF
COST

DIRECT MATERIAL DIRECT LABOUR

DIRECT EXPENSES OVERHEADS
COST COST

MANUFACTURING

OFFICE AND
ADMINISTRATIVE

SELLING AND
DISTRIBUTING
Elements of Cost

Prime Cost Overheads Cost

Factory Overheads
Office & Admin Overheads
Selling & Distribution
Overheads
Components of total cost

Direct material cost (Cost of direct material consumed):

Opening stock of direct material xxx
Add Direct material purchased xxx
Less Closing stock of direct material (xxx) xxx

Direct labour cost xxx

Direct expenses xxx
PRIME COST xxx
Works or factory overheads xxx
GROSS WORKS OR FACTORY COST xxx
Add Opening work-in-progress xxx
Less Closing work-in-progress (xxx)
WORKS OR FACTORY COST xxx

cotd….
Components of total cost ……………….cotd.

WORKS OR FACTORY COST xxx

Office and administrative overheads xxx
OFFICE COST OR TOTAL COST OF PRODUCTION xxx
Add Opening stock of finished goods xxx
Less Closing stock of finished goods (xxx)
COST OF GOODS SOLD xxx
Selling and distribution overheads xxx
COST OF SALES xxx
Profit xxx
SALES xxx
COST CLASSIFICATION – PURPOSE WISE

(1)COST CONCEPTS RELATING TO STOCK VALUATION AND

INCOME MEASUREMENT

 Direct and indirect costs

 Product costs and period costs
 Expired and unexpired costs
 Joint product costs and separable costs
Cost classification – purpose wise ……….cotd.

2) COST CONCEPTS RELATING TO PROFIT, PLANNING AND CONTROL

 Fixed, variable and semi-variable/mixed costs

 Fixed costs - *Committed fixed costs *Discretionary fixed costs
 Variable costs
 Semi-variable costs (Mixed costs)
 Methods of mixed cost segregation - *Graphic method *Two
point method *Analytical approach * Method of least
squares
 Controllable and non-controllable costs
Cost classification – purpose wise ……….cotd.

(3) COST CONCEPTS FOR DECISION-MAKING

 Relevant and irrelevant costs

 Incremental cost/differential cost
 Out of pocket costs and sunk costs
 Opportunity costs and imputed costs
 Avoidable costs and unavoidable costs
Cost classification – purpose wise ……..contd.

Direct and indirect costs

• Direct costs are those costs which can be conveniently and
wholly identified with a cost unit or a cost centre, i.e.,
product, process, job, contract, department, etc.
• These are costs of resources that are acquired for or used by
a single cost object. The cost of wood in furniture making,
the cost of cloth in textile factory, the cost of computer chip
in computer assembly unit are examples of direct cost.
• Since these costs are incurred exclusively for a particular
cost object, they are conveniently identified with the cost
object for which they are purchased.
Cost classification purpose wise …….contd.
Indirect costs
• Indirect costs are those costs which cannot be conveniently and wholly
identified with a cost unit or cost centre. These are the costs of resources
that are acquired for or used by more than one cost object. Since these
costs are common to certain number of cost units or cost centres, they
need to be distributed among those cost units (or cost centres) on some
reasonable basis. Their distribution involves exercise of judgment.
• Salaries of timekeepers, storekeepers, foreman, etc. engaged in production
and expenses incurred for running the administration are examples of
indirect costs.

• Sometimes, certain costs which can be identified with a cost unit may be
treated as indirect costs due to convenience and small size of such costs.
For example, in a garment factory threads, buttons, stiffeners, buckles, etc.
may be treated as indirect materials.
• Thus classification of cost as direct or indirect is situational. A cost may be
direct in one situation and indirect in another situation.
Cost classification – purpose wise …….cotd.
Product costs and period costs
• Cost which becomes part of the cost of the product rather than
expenses of the period in which they are incurred are called as
product costs. They are included in inventory values. In financial
statements such costs are treated as assets until the goods, to which
they are assigned, are sold. Product costs become expense at the time
of sale. These costs may be fixed as well as variable, e.g., cost of raw-
materials and direct wages, depreciation on plant and machinery etc.
 
• Costs which are not associated with production are called period
costs. They are treated as an expense of the period in which they are
incurred. They may also be fixed as well as variable. Such costs include
general administrative costs, salesmen salaries and commission,
depreciation on office facilities. They are charged against the revenue
of the relevant period.
Cost classification – purpose wise ……….cotd.

Expired and unexpired cost

An expired cost is one which cannot contribute to the production
of future revenues. In contrast, an unexpired cost is one which
has the capacity of contributing to the production of revenue
in the future.
Inventory constitutes a good example of unexpired cost, as it can
be sold in subsequent years and will influence future
revenues.
Cost classification – purpose wise ……….cotd.
Joint product costs and separable costs
Joint product costs are the costs of a single process, or series of
processes that simultaneously produce two or more products of
significant sales value. In this case, it is not possible to precisely
determine the cost of each joint product because these costs
cannot be identified with individual products.

The share of individual joint products in common costs can only be

approximately estimated. For example, in a petroleum refinery
industry, petrol, diesel oil, kerosene oil, naptha, tar, etc. are
produced jointly in the refinery process.

Separable cost, in contrast, refers to any cost that can be attributed

exclusively and wholly to a particular product, process, division
or department.
Cost classification – purpose wise ……….cotd.

Cost concepts relating to profit, planning and control

Fixed, Variable and Semi-variable costs
• Fixed costs are fixed, their totals do not change with
change in the output over a wide range of activity in a
given period. For example, rent and insurance of
building, municipal taxes, salaries of permanent staff,
etc. remain fixed irrespective of actual output. Since
total of fixed costs remains constant, fixed costs per
unit of output decreases with the increase in output
and it increases with decrease in output.
Cost classification – purpose wise ………cotd.
• Variable costs are those costs which vary in direct proportion to change in
output. These costs increase or decrease in the same proportion in which
output increases or decreases. In other words, there is perfect positive
correlation between variable cost and output. It holds true when variable
cost per unit is constant.
 
• As a matter of fact, this concept of fixed cost and variable cost holds good in
short-run and hence it is more a theoretical concept. Further, variable costs
remain constant per unit of output and fixed costs remain constant in total
or per unit of time.
 
• Semi-variable costs are also called as semi-fixed or mixed costs. These costs
fall between the two extreme of fixed costs and variable costs. They are
neither perfectly variable nor absolutely fixed in relation to changes in level
of activity. They vary with the change in output but not in the same
proportion in which output varies.
Cost classification – purpose wise ………..cotd.

• Both fixed and variable costs are relevant for decision making
purposes. However, there relative importance differs at proposal stage
and at operations stage.

• At proposal stage, all costs are important whether they are fixed or
variable. A project will not be accepted, if it does not hope to recover
both fixed and variable costs at the anticipated level of activity. At this
stage, fixed costs are rather more important because they are, usually,
irrevocable and involve relatively large sums of money.

• On the other hand, at operations stage, decisions are mainly guided by

variable costs as fixed costs become irrelevant for a number of
decisions.
Cost classification – purpose wise ……….cotd.

Controllable and Uncontrollable Costs

An item of cost is controllable if the amount of cost incurred (or
assigned to) a responsibility centre is significantly influenced
by the actions of the manager of the responsibility centre.
Otherwise, it is uncontrollable.
(3) COST CONCEPTS FOR DECISION-MAKING

 Relevant and irrelevant costs

 Incremental cost/differential cost
 Out of pocket costs and sunk costs
 Opportunity costs and imputed costs
THANK YOU