COST ACCOUNTING Managing Resources, Activities, and People An organization . . . Directing Acquires Resources Decision Organized set Making of activities Controlling Planning Hires People Accounting Discipline Overview • Managerial Accounting – measures, analyzes and reports financial and nonfinancial information to help managers make decisions to fulfill organizational goals. Managerial accounting need not be GAAP / IFRS compliant. • Financial Accounting – focus on reporting to external users including investors, creditors, and governmental agencies. Financial statements must be based on GAAP / IFRS. Managerial versus Financial Accounting Accounting System (accumulates financial and managerial accounting data) Managerial Accounting Financial Accounting Information for decision Published financial making, planning, and statements and other controlling an financial reports. organization’s operations. Internal External 1-4 Users Users A Typical Organizational Structure and the Management Accountant Controller The chief managerial and financial accountant responsibility for: – Supervising accounting personnel – Preparation of information and reports, managerial and financial – Analysis of accounting information – Planning and decision making Treasurer Responsible for raising capital and safeguarding the organization’s assets. – Supervises relationships with financial institutions. – Work with investors and potential investors. – Manages investments. – Establishes credit policies. – Manages insurance coverage 1-8 Internal Auditor Responsible for reviewing accounting procedures, records, and reports in both the controller’s and the treasurer’s area of responsibility. – Expresses an opinion to top management regarding the effectiveness of the organizations accounting system. Cost Accounting • It is the method of accounting for cost which begins with incurrence of costs & ends with control of cost. • It is the process of accounting for costs. • It includes the accounting procedures relating to recording of all income and expenditure and the preparation of periodical statements and reports with the objective of ascertaining and controlling costs. Objectives of Cost Accounting – To ascertain cost – To control cost – To provide information for decision making – To determine selling price – To ascertain profit – To facilitate cost reduction Advantages of Cost Accounting • Helps in ascertainment of cost • Helps in control of cost • Helps in decision making (make or buy, retain or replace, continue or shut down, accept or reject orders, etc) • Helps in fixing selling prices • Helps in inventory control • Helps in cost reduction • Helps in preparation of budgets • Helps in identifying unprofitable activities • Helps in identifying material losses • Helps in improving productivity • Helps in cost comparison Financial & Cost Accounting No. Basis Financial Accounting Cost Accounting Financial performance and 1. Objective Ascertain cost and cost control position Shows overall costs and profit / Shows details for each product, 2. Costs and profits loss process, job, contract, etc Emphasis on control and 3. Control / Report Emphasis on reporting reporting 4. Decision making Limited use Designed for decision making 5. Responsibility Does not fix responsibility Can effectively fix responsibility 6. Time frame Focus on historical data Focus on present and future General reports like P&L Can generate special reports 7. Type of reports Account, Balance Sheet, Cash and analysis Flow Statement Voluntary, except for some 8. Legal need Statutory requirement cases Records internal and external 9. Transactions Records external transactions transactions 10. Reader Everybody Internal management 11. Formats Standard, as per law Tailor made 12. Access Everybody, except for some Very limited access 13. Unit of value Monetary Monetary and physical Cost Management Systems Objectives Measure the cost of resources consumed. Identify and eliminate non-value-added costs. Cost Management System Cost Management Systems Objectives Determine efficiency and effectiveness of major activities. Identify and evaluate new activities that can Cost Management improve performance. System Costing System • An accounting system established to monitor a company's costs, providing management with information on operations and performance. • A cost accounting system may said to be a system which: Accumulation of costs Assigns them to cost objectives. Reports cost information Ascertain the product profitability It helps the management in planning and controlling activities of the organization. Installation of costing system • Mostly employed in manufacturing industries (including mining, construction etc). • Factors to be considered while designing a costing system: – Objective of the system – Objective of the management – Nature of business – Nature of product – Manufacturing Process – Types of cost information desired and required by the management – Flexibility and Accuracy of data – Key personnel and employees of the organization – Availability of qualified technical personnel – Materiality of the cost items – Selection of suitable unit of cost – Statutory and other legal provisions to be complied with Practical Difficulties in installing costing system • Lack of support from the Head of the Departments • Inadequate trained personnel • Heavy costs • Resistance from the staff • Non co-operation at the other levels of organizations Cost Concepts Cost Control • It is the Prime function of Cost Accountant. • “The act of controlling costs through the application of management tools and techniques keeping in mind the most predetermined objectives of quality, quantity, value and time at an optimum outlay.” Cost Reduction • Cost reduction is concerned with achieving real and permanent reduction on the unit cost of goods produced or services rendered without impairing their quality or suitability. Cost Audit • Cost Audit is the verification of cost accounts and a check on the adherence to the Cost Accounting plan. • It involves checking up the arithmetical accuracy of cost accounts and verifying whether the principles laid down have been followed or not. Elements of Cost • Three broad elements of costs: • Material • Labour • Expenses 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 Material Indirect Material 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: • All material or components specifically purchased, produced or requisitioned from stores • Primary packing material (e.g., carton, wrapping, cardboard, boxes etc.) • Purchased or partly produced components Direct material is also described as process material, prime cost material, production material, stores material, constructional material etc. 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.Labour: • For conversion of materials into finished goods, human effort is needed and such human effort is called labour. • Labour can be: Direct Labour Indirect Labour Direct Labour: • The labour which actively and directly takes part in the production of a particular commodity is called direct labour. • Direct labour costs are specifically and conveniently traceable to specific products. • Direct labour can also be described as process labour, productive labour, operating labour, etc. Indirect labour: – The labour employed for the purpose of carrying out tasks incidental to goods produced or services provided, is indirect labour. – Such labour does not alter the construction, composition or condition of the product. It cannot be practically traced to specific units of output. – Wages of storekeepers, timekeepers, directors’ fees, salaries of salesmen etc, are examples of indirect labour costs. – Indirect labour may relate to the factory, the office or the selling and distribution divisions 3. Expenses: • All costs other than material and labour are termed as expenses. • Expenses may be: Direct Expenses Indirect Expenses DIRECT EXPENSES: • Expenses which are directly identified with a particular job, process, or operation. • These are expenses incurred on one particular job or task. • E.g. Cost of transportation of raw material, cost of hiring a machine. INDIRECT EXPENSES : • Expenses which are not directly identified with a particular job, process, but common for many jobs or processes. • These include factory expenses, administrative expenses, selling and distribution expenses. Overheads • The term overhead includes indirect material, indirect labor and indirect expenses. • Thus, all indirect costs are overheads. Types of Overheads: 1. Factory Overheads 2. Office and Administration Overheads 3. Selling and Distribution Overheads 1. Factory Overheads: include • Indirect material used in a factory such as lubricants, oil, consumable stores etc. • Indirect labour such as gatekeeper, timekeeper, works manager’s salary etc. • Indirect expenses such as factory rent, factory insurance, factory lighting etc. 2. Office and Administration Overheads include • Indirect materials used in an office such as printing and stationery material, brooms and dusters etc. • Indirect labor such as salaries payable to office manager, office accountant, clerks, etc. • Indirect expenses such as rent, insurance, lighting of the office 3. Selling and Distribution Overheads Include • Indirect materials used such as packing material etc. • Indirect labour such as salaries of salesmen and sales manager etc. • Indirect expenses such as advertising expenses etc. Components of Total Cost 1. Prime Cost : • Prime cost consists of costs of direct materials, direct labours 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. Components of total cost Direct material Prime cost or direct cost or first cost Direct labour Direct expenses Prime cost plus works overheads Works or factory cost or production cost or manufacturing cost Works cost plus office and administration Office cost or total cost of production overheads Office cost plus selling and distribution Cost of sales or total cost overheads COST SHEET • The components of cost can be presented in the form of a statement. Such a statement of cost giving total cost is known as Cost sheet. Basic Cost Terminology • Cost – sacrificed resource to achieve a specific objective • Actual cost – a cost that has occurred • Budgeted cost – a predicted cost • Cost object – anything of interest for which a cost is desired Cost Centre: • “It is defined a location, person, or item of equipment (or group of these) for which costs may be ascertained and used for the purpose of control.” • Cost centre refers to a section of the business to which costs can be charged. • It may be a location( a department, a sales area), an item of equipment (a machine, a delivery van), a person (a salesman, a machine operator), or a group of these (two automatic machines operated by one workman). • Purpose of ascertaining cost of a cost centre is control of cost. Types of cost centre: • Personal cost centre: which consists of a person or a group of persons. • Impersonal cost centre: which consists of a location or an item of equipment or group of these. Cost unit • Cost unit is unit of measurement of cost. • Cost unit is defined as “unit of product, service, or time in relation to which cost may be ascertained or expressed.” • E.g. Chemicals – tonne, kilogram, litre, gallon Bricks – 1,000 bricks or 500 bricks Soft drink – crate of 24 bottles or 12 bottles Cotton or jute – Bale Timber – cubic foot Classification of Cost 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. E.g. Wages of laborers, Cost of direct material, 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. E.g. Rent, Insurance charges, 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. E.g. Depreciation, Repairs 2. Product Costs and Period Costs • Product cost : 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. e.g. cost of raw materials and direct wages, depreciation on plant and equipment etc. • Period Costs : 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. They may also be fixed as well as variable. Such costs include general administration costs, salaries salesmen and commission, depreciation on office facilities etc. They are charged against the revenue of the relevant period. 3. Direct and Indirect Costs • Direct 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. these take an active and direct part in the manufacture of a particular commodity and hence are called direct costs. E.g. In the process of manufacturing of production of articles, materials are purchased, laborers are employed and the wages are paid to them, are all direct costs. • Indirect Costs: The expenses incurred on those items which are not directly chargeable to production are known as indirect costs. For example, salaries of timekeepers, storekeepers and foremen. All of these cannot be conveniently allocated to production and hence are called indirect costs. 4. Decision-Making Costs & 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 do not and should not conform the accounting rules. • Decision-making costs are future costs. They represent what is expected to happen under an assumed set of conditions. • Accounting costs are compiled primarily from financial statements. • Moreover, they are historical costs and show what has happened under an existing set of circumstances. • Decision-making costs are future costs. They represent what is expected to happen under an assumed set of conditions. 5. Relevant and Irrelevant Costs • Relevant costs are those which are affected and changed by managerial decision. • Irrelevant costs are those which do not get affected by the decision. 6. Shutdown and Sunk Costs • Shutdown Costs: A manufacturer or an organization may have to suspend its operations for a period on account of some temporary difficulties, e.g., shortage of raw material, non-availability of requisite labor etc. During this period, though no work is done yet certain fixed costs, such as rent and insurance of buildings, depreciation, maintenance etc., for the entire plant will have to be incurred. Such costs of the idle plant are known as shutdown costs. • Sunk costs: Sunk costs are historical or past costs. These are the costs which have been created by a decision that was made in the past and cannot be changed by any decision that will be made in the future. E.g. Investments in plant and machinery, buildings etc. 7. Controllable and Uncontrollable Costs • Controllable costs are those costs which can be influenced by the action of a specified member of the undertaking. • Controllable costs are the costs over which a manager has direct and complete decision authority. • The costs that cannot be controlled are termed as uncontrollable costs. 8. Avoidable or Escapable Costs and Unavoidable or Inescapable Costs • Avoidable costs are those which will be eliminated if a segment of a business (e.g., a product or department) with which they are directly related is discontinued. • Unavoidable costs are those which will not be eliminated with the segment. Such costs are merely reallocated if the segment is discontinued. • For example, in case a product is discontinued, the salary of a factory manager or factory rent cannot be eliminated. 9. Imputed or Hypothetical Costs • These are the costs which do not involve cash outlay. • They are not included in cost accounts but are important for taking into consideration while making management decisions. • For example, rent of owned building, interest of owned capital, etc. 10. Opportunity Cost • Opportunity cost is the cost related to the next-best choice available to someone who has picked among several choices. • It refers to an advantage in measurable terms that have foregone on account of not using the facilities in the manner originally planned. 11. Differentials, Incremental or Decremental Costs • 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. • In case the choice results in decrease in total costs, this decreased costs will be known as decremental costs 12. Out-of-Pocket Costs • Cost which requires cash payments to be made to other parties. • It means the present or future cash expenditure regarding a certain decision, that will vary depending upon the nature of the decision made. 13. Traceable, Untraceable or Common Costs • Traceable costs: The costs that can be easily identified with a department, process or product. • For example, the cost of direct material, direct labor etc. • Untraceable or common costs: costs that cannot be identified with a dept. process or product. These costs are incurred collectively for a number of operations. • E. g. overheads incurred for a factory as a whole, combined purchase cost for purchasing several materials in one consignment etc. 14. Production, Administration and Selling and Distribution, etc. Costs • 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. • 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. 15. Conversion Cost • The cost of transforming direct materials into finished products (excluding direct material cost) is known as conversion cost. It is usually taken as an aggregate of total cost of direct labor, direct expenses and factory overheads. Methods of costing: 1. Job / job order costing 2. Contract costing or terminal costing 3. Batch costing 4. Process costing 5. Operation costing 6. Single, output, or unit costing 7. Operating or service costing 8. Multiple or composite costing 1. Job / job order costing • This method “applies where work is undertaken to customers’ special requirements”. • A job comprises a specific quantity of a product or service to be provided as per customer’s specification. • E.g. printing press, repairs shop, interior decorators, painters etc. 2. Contract costing or terminal costing • This is a variation of job costing. • Difference: job is small and contract is big. • The contract is of a long duration and may continue over more than one financial year. • e.g. construction of buildings, dams, bridges, roads etc. 3. Batch costing • Also a variation of job costing. • In this method, the cost of a batch or group of identical products is ascertained and therefore each batch of product is a cost unit for which costs are ascertained. • E.g. production of readymade garments, toys, shoes, etc. 4. Process costing • This method is used in mass production industries manufacturing the standardized products in continuous processes of manufacturing. • Here, raw material has to pass through a number of processes in a particular sequence to completion stage. • Costs are accumulated for each process or department. 5. Operation costing • This is a more detailed application of process costing. • A process may consists of a number of operations and operation costing involves cost ascertainment for each operation instead of a process. • This method provides minute analysis of costs and ensures greater accuracy and better control. 6. Single, output, or unit costing • This method is used when production is uniform and consists of a single or two or three varieties of the same product. • Where the product is produced in different grades, costs are ascertained grade-wise. • As the units of output are identical, the cost per unit is found by dividing the total cost by the number of units produced. 7. Operating or service costing • It is used in companies which provide services, instead of manufacturing products. • E.g. transport co., hotels, hospitals, cinemas, etc. 8. Multiple or composite costing • It is the application of more than one method. • It is used in industries where a no. of components are separately manufactured and then assembled into a final product. • e.g. T.V., A.C., refrigerators, cars, etc.