Cost Concepts

 by Anchal (2910072)

Cost Definition:-Introduction

An amount that has to be paid or given up in order to get something.

In business, cost is usually a monetary valuation of (1) effort, (2) material, (3) resources, (4) time and utilities consumed, (5) risks incurred, and (6) opportunity forgone in production and delivery of a good or service.

         All expenses are costs, but not all costs acquisition of an income- are expenses.

1.Cost Function:-

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salary of an IT professional leaving the organization.”3 In addition, this rule of thumb understates the cost of lost productivity when many employees in any given functional area must be replaced over a short period.

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2.Concept of Cost :-

Cost accounting is concerned with cost and therefore is necessary to understand the meaning of term cost in a proper perspective. In general, cost means the amount of expenditure (actual or notional) incurred on, or attributable to a given thing.

However, the term cost cannot be exactly defined. Its interpretation depends upon the following factors:

• The nature of business or industry
• The context in which it is used

In a business where selling and distribution expenses are quite nominal the cost of an article may be calculated without considering the selling and distribution overheads. At the same time, in a business where the nature of a product requires heavy selling and distribution expenses, the calculation of cost without taking into account the selling and distribution expenses may prove very costly to a business. The cost may be factory cost, office cost, cost of sales and even an item of expense.

       For example, prime cost includes expenditure on direct materials, direct labor and direct expenses. Money spent on materials is termed as cost of materials just like money spent on labor is called cost of labor and so on. Thus, the use of term cost without understanding the circumstances can be misleading.

Different costs are found for different purposes. The work-in-progress is valued at factory cost while stock of finished goods is valued at office cost. Numerous other examples can be given to show that the term “cost” does not mean the same thing under all circumstances and for all purposes. Many items of cost of production are handled in an optional manner which may give different costs for the same product or job without going against the accepted principles of cost accounting. Depreciation is one of such items.

Elements of Cost :-

Following are  the three broad elements of cost:

1.Material:-

The substance from which a product is made is known as material. It may be in a raw or a manufactured state. It can be direct as well as indirect.

(a)  Direct Material:

The material which becomes an integral part of a finished product and which can be conveniently assigned to specific physical unit is termed as direct material. Following are some of the examples of direct material:

Ø .All material or components specifically purchased, produced or requisitioned from stores.

Ø  Primary packing material (e.g., carton, wrapping, cardboard, boxes etc.)

Ø  Purchased or partly produced components .

Direct material is also described as process material, prime cost material, production material, stores material, constructional material etc.

(b) Indirect Material:  The material which is used for purposes ancillary to the business and which cannot be conveniently assigned to specific physical units is termed as indirect material. Consumable stores, oil and waste, printing and stationery material etc. are some of the examples of indirect material. Indirect material may be used in the factory, office or the selling and distribution divisions.

2.Labor:- For conversion of materials into finished goods, human effort is needed and such human effort is called labor. Labor can be direct as well as indirect.

(a) Direct Labor: The labor which actively and directly takes part in the production of a particular commodity is called direct labor. Direct labor costs are, therefore, specifically and conveniently traceable to specific products.

Direct labor can also be described as process labor, productive labor, operating labor, etc.

(B) Indirect Labor:

The labor employed for the purpose of carrying out tasks incidental to goods produced or services provided, is indirect labor. Such labor does not alter the construction, composition or condition of the product. It cannot be practically traced to specific units of output. Wages of storekeepers, foremen, timekeepers, directors’ fees, salaries of salesmen etc, are examples of indirect labor costs.

3.Expenses:- Expenses may be direct or indirect.

(a)Direct Expenses:  These are the expenses that can be directly, conveniently and wholly allocated to specific cost centers or cost units. Examples of such expenses are as follows:

Ø  Hire of some special machinery required for a particular contract

Ø  Cost of defective work incurred in connection with a particular job or contract etc.

(c)   Indirect Expenses:- These are the expenses that cannot be directly, conveniently and wholly allocated to cost centers or cost units. Examples of such expenses are rent, lighting, insurance charges etc.

1.      4.Overhead:- The term overhead includes indirect material, indirect labor and indirect expenses. Thus, all indirect costs are overheads.

A manufacturing organization can broadly be divided into the following three divisions:

Ø  Factory or works, where production is done

Ø  Office and administration, where routine as well as policy matters are decided

Ø  Selling and distribution, where products are sold and finally dispatched to customers

Overheads may be incurred in a factory or office or selling and distribution divisions. Thus, overheads may be of three types:

A.Factory Overheads:- They include the following things:

Ø  Indirect material used in a factory such as lubricants, oil, consumable stores etc.

Ø  Indirect labor such as gatekeeper, timekeeper, works manager’s salary etc.

Ø  Indirect expenses such as factory rent, factory insurance, factory lighting etc.

B.Office and Administration Overheads :- They include the following things:

Ø  Indirect materials used in an office such as printing and stationery material, brooms and dusters etc.

Ø  Indirect labor such as salaries payable to office manager, office accountant, clerks, etc.

Ø  Indirect expenses such as rent, insurance, lighting of the office

C.Selling and Distribution Overheads:- They include the following things:

Ø  Indirect materials used such as packing material, printing and stationery material etc.

Ø  Indirect labor such as salaries of salesmen and sales manager etc.

Ø  Indirect expenses such as rent, insurance, advertising expenses etc.

Components of Total Cost :-

1.Prime Cost :- Prime cost consists of costs of direct materials, direct labors and direct expenses. It is also known as basic, first or flat cost.

2.Factory Cost :- Factory cost comprises prime cost and, in addition, works or factory overheads that include costs of indirect materials, indirect labors and indirect expenses incurred in a factory. It is also known as works cost, production or manufacturing cost.

3.Office Cost:-  Office cost is the sum of office and administration overheads and factory cost. This is also termed as administration cost or the total cost of production.

4.Total Cost :- Selling and distribution overheads are added to the total cost of production to get total cost or the cost of sales.

Various components of total cost can be depicted with the help of the table below:

Components of total cost
Direct material Direct labor Direct expenses	Prime cost or direct cost or first cost
Prime cost plus works overheads	Works or factory cost or production cost or manufacturing cost
Works cost plus office and administration overheads	Office cost or total cost of production
Office cost plus selling and distribution overheads	Cost of sales or total cost

Classification of Cost:-  Cost may be classified into different categories depending upon the purpose of classification. Some of the important categories in which the costs are classified are as follows:

1. Fixed, Variable and Semi-Variable Costs :- The cost which varies directly in proportion with every increase or decrease in the volume of output or production is known as variable cost. Some of its examples are as follows:

Ø  Wages of laborers

Ø  Cost of direct material

Ø  Power

The cost which does not vary but remains constant within a given period of time and a range of activity inspite of the fluctuations in production is known as fixed cost. Some of its examples are as follows:

Ø  Rent or rates

Ø  Insurance charges

Ø  Management salary

The cost which does not vary proportionately but simultaneously does not remain stationary at all times is known as semi-variable cost. It can also be named as semi-fixed cost. Some of its examples are as follows:

Ø  Depreciation

Ø  Repairs

Fixed costs are sometimes referred to as “period costs” and variable costs as “direct costs” in system of direct costing. Fixed costs can be further classified into:

Ø  Committed fixed costs

Ø  Discretionary fixed costs

2.      Product Costs and Period Costs:- The costs which are a part of the cost of a product rather than an expense 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 they are assigned to are sold. They become an expense at that time. These costs may be fixed as well as variable, e.g., cost of raw materials and direct wages, depreciation on plant and equipment etc. The 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

3.      Direct and Indirect Costs:- The expenses incurred on material and labor which are economically and easily traceable for a product, service or job are considered as direct costs. In the process of manufacturing of production of articles, materials are purchased, laborers are employed and the wages are paid to them. Certain other expenses are also incurred directly. All of these take an active and direct part in the manufacture of a particular commodity and hence are called direct costs.

4.      Decision-Making Costs and Accounting Costs :-  Decision-making costs are special purpose costs that are applicable only in the situation in which they are compiled. They have no universal application. They need not tie into routine-financial accounts. They do not and should not conform the accounting rules. Accounting costs are compiled primarily from financial statements. 

5.        Relevant and Irrelevant Costs:-  Relevant costs are those which change by managerial decision. Irrelevant costs are those which do not get affected by the decision. For example, if a manufacturer is planning to close down an unprofitable retail sales shop, this will affect the wages payable to the workers of a shop. This is relevant in this connection since they will disappear on closing down of a shop. But prepaid rent of a shop or unrecovered costs of any equipment which will have to be scrapped are irrelevant costs which should be ignored.

6.      Differentials, Incremental or Decrement Cost :-

The difference in total cost between two alternatives is termed as differential cost. In case the choice of an alternative results in an increase in total cost, such increased costs are known as incremental costs. While assessing the profitability of a proposed change, the

incremental costs are matched with incremental revenue. This is explained with the following example:

Example

A company is manufacturing 1,000 units of a product. The present costs and sales data are as follows:

Selling price per unit	$. 10
Variable cost per unit	$. 5
Fixed costs	$. 4,000

7.Production, Administration and Selling and Distribution Costs:-        

A business organization performs a number of functions, e.g., production, illustration, selling and distribution, research and development. Costs are to be curtained for each of these functions. The Chartered Institute of Management accountants, London, has defined each of the above costs as follows:

·         Production Cost :-The cost of sequence of operations which begins with supplying materials, labor and services and ends with the primary packing of the product. Thus, it includes the cost of direct material, direct labor, direct expenses and factory overheads.

·         Administration Cost :-The cost of formulating the policy, directing the organization and controlling the operations of an undertaking which is not related directly to a production, selling, distribution, research or development activity or function.

·         Selling Cost :-It is the cost of selling to create and stimulate demand (sometimes termed as marketing) and of securing orders.

·         Distribution Cost :-It is the cost of sequence of operations beginning with making the packed product available for dispatch and ending with making the reconditioned returned empty package, if any, available for reuse.

·         Research Cost :-It is the cost of searching for new or improved products, new application of materials, or new or improved methods.

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

·         Pre-Production Cost :-The part of development cost incurred in making a trial production as preliminary to formal production is called pre-production cost.

Main Considerations :-

In view of the above difficulties and suggestions, following should be the main considerations while introducing a costing system in a manufacturing organization:

1. Product :-The nature of a product determines to a great extent the type of costing system to be adopted. A product requiring high value of material content requires an elaborate system

·         of materials control. Similarly, a product requiring high value of labor content requires an efficient time keeping and wage systems. The same is true in case of overheads.

2. Organization :-The existing organization structure should be distributed as little as possible. It becomes, therefore, necessary to ascertain the size and type of organization before introducing the costing system.

3.Objective :-The objectives and information which management wants to achieve and acquire should also be taken care of. For example, if a concern wants to expand its operations, the system of costing should be designed in a way so as to give maximum attention to production aspect. On the other hand, if a concern were not in a position to sell its products, the selling aspect would require greater attention.

4. Technical Details :-The system should be introduced after a detailed study of the technical aspects of the business. Efforts should be made to secure the sympathetic assistance and support of the principal members of the supervisory staff and workmen.

Methods of Costing:-

Costing can be defined as the technique and process of ascertaining costs. The principles in every method of costing are same but the methods of analyzing and presenting the costs differ with the nature of business. The methods of job costing are as follows:

1. Job Costing :-The system of job costing is used where production is not highly repetitive and in addition consists of distinct jobs so that the material and labor costs can be identified by order number. This method of costing is very common in commercial foundries and drop forging shops and in plants making specialized industrial equipments. In all these cases, an account is opened for each job and all appropriate expenditure is charged thereto.

2. Contract Costing :-Contract costing does not in principle differ from job costing. A contract is a big job whereas a job is a small contract. The term is usually applied where large-scale contracts are carried out. In case of ship-builders, printers, building contractors etc., this system of costing is used. Job or contract is also termed as terminal costing.

3. Cost Plus Costing :-In contracts where in addition to cost, an agreed sum or percentage to cover overheads and fit is paid to a contractor, the system is termed as cost plus costing. The term cost here includes materials, labor and expenses incurred directly in the process of production. The system is used generally in cases where government happens to be the party to give contract.

4.Batch Costing :-This method is employed where orders or jobs are arranged in different batches after taking into account the convenience of producing articles. The unit of cost is a batch or a group of identical products instead of a single job order or contract. This method is particularly suitable for general engineering factories which produce components in convenient economic batches and pharmaceutical industries.

5. Process Costing :-If a product passes through different stages, each distinct and well defined, it is desired to know the cost of production at each stage. In order to ascertain the same, process costing is employed under which a separate account is opened for each process.

 e.g., chemical manufacture, paints, foods, explosives, soap making etc.

6.Operation Costing:- Operation costing is a further refinement of process costing. The system is employed in the industries of the following types:

v  The industry in which mass or repetitive production is carried out

v  The industry in which articles or components have to be stocked in semi-finished stage to facilitate the execution of special orders, or for the convenience of issue for later operations

The procedure of costing is broadly the same as process costing except that in this case, cost unit is an operation instead of a process. For example, the manufacturing of handles for bicycles involves a number of operations such as those of cutting steel sheets into proper strips molding, machining and finally polishing.

Techniques of Costing :-

Besides the above methods of costing, following are the types of costing techniques which are used by management only for controlling costs and making some important managerial decisions. As a matter of fact, they are not independent methods of cost finding such as job or process costing but are basically costing techniques which can be used as an advantage with any of the methods discussed above.

1. Marginal Costing :-Marginal costing is a technique of costing in which allocation of expenditure to production is restricted to those expenses which arise as a result of production, e.g., materials, labor, direct expenses and variable overheads. Fixed overheads are excluded in cases where production varies because it may give misleading results. The technique is useful in manufacturing industries with varying levels of output.
2. Direct Costing :-The practice of charging all direct costs to operations, processes or products and leaving all indirect costs to be written off against profits in the period in which they arise is termed as direct costing. The technique differs from marginal costing because some fixed costs can be considered as direct costs in appropriate circumstances.
3.  Absorption or Full Costing :-The practice of charging all costs both variable and fixed to operations, products or processes is termed as absorption costing.

4. 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. Standardization may extend to the methods of costing, accounting classification including codes, methods of defining costs and charging depreciation, methods of allocating or apportioning overheads to cost centers or cost units. The system, thus, facilitates inter- firm comparisons, establishment of realistic pricing policies, etc.

Systems of Costing :-

It has already been stated that there are two main methods used to determine costs. These are:

v  Job cost method

v  Process cost method

It is possible to ascertain the costs under each of the above methods by two different ways:

v  Historical costing

v  Standard costing

Historical Costing :-

Historical costing can be of the following two types in nature:

v  Post costing

v  Continuous costing