CHAPTER 111

Introduction to the study:

Introduction
Basic concept of financial management beside the regulatory framework within which a
finance manager has to be operate. In this section we intend to provide to an additional
perspective by looking at the underlying assumptions about costs, problems of forward
estimates and involving alternative choices.

Meaning of cost accounting

According to the Chartered institute of management accounts, London, cost accounting is
the process of accounting for costs from the point at which its expenditure is incurred or
committed to the ultimate relationship with cost units. In its widest sense, it embraces the
preparation of statistical data, the application of cost control methods and the
ascertainment of the profitability of the activities carried out or planned.

Concept of cost
Cost accounting is concerned with cost and, therefore, it is but appropriate to understand
the meaning of the 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
(a) the nature of the business or industry, and
(b) the context in which it is used
In a business where selling and distribution expenses are quite nominal, the cost of the
article may be calculated without considering the selling and distribution overheads.
While in a business where the nature of the product requires heavy selling and
distribution expenses, calculation of cost without taking into account selling and
distribution expenses may be very costly to the business. Then cost may be factory cost,
office cost, cost of sale and even an item of expenses is also termed as cost.

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Elements of cost
Material
The substance from which the 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.

Direct material
All material which becomes an integral part of the finished product and which can be
conveniently assigned to specific physical units is termed as “direct material”. Following
are some of the examples of direct material:
 All material or components specifically purchased 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, constructional material, etc.

Indirect material
All materials which are 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 the few
examples of indirect material.

Labour
For conversion of material into finished goods, human effort is needed; such human
effort is called as Labour. Labour can be direct as well as indirect.

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Direct Labour
Labour which plays an active and direct part in the production of a particular commodity
is called direct labour. Direct Labour costs are therefore, specifically and conveniently
traceable to specific products.
Direct Labour is also described as process labour, productive labour, operating
labour, etc.

Indirect Labour
Labour employed for the purpose of carrying outs 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 store-keepers, foreman, time-keepers, director’s fees, salaries of
salesman etc. are all examples of indirect labour costs.
Indirect labour may relate to the factory, the office or the selling and distribution
divisions.

Expenses
These are expenses which can be directly, conveniently and wholly allocated are: hire of
some special machinery required for a particular contract, cost of defective work incurred
in connection with a particular job or contract, Etc.
Direct expenses are sometimes also described as “chargeable expenses.”

Indirect expenses
i. These are expenses which cannot be directly, conveniently and wholly allocated
to cost centers or cost units. Examples of such expenses are rent, lighting,
insurance charges, etc.

Over head
The term overhead includes indirect material, indirect labour and indirect expenses. Thus,
all indirect are overheads.

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A .manufacturing organization can broadly be divided into three divisions:

i. Factory or works where production is done;
ii. Office and administration, where routine as well as policy matters are decided by
the management.
iii. Selling and distribution where products are sold and finally dispatched to the
customer.

Overheads may be incurred in the factory or office or selling and distribution divisions.
Thus, overheads may be of three types:
a. Factory overheads.
i. Indirect material used in the factory such as lubricants, oil, consumable
stores, etc.
ii. Indirect labour such as gate-keepers salary, timekeeper’s salary, works
manager’s salary, etc.
iii. Indirect expenses such as factory rent, factory insurance, factory lighting,
etc.

b. Office and administration overheads.

i. Indirect material used in the office such as printing and stationary material,
blooms and dusters, etc.
ii. Indirect labour such as salaries payable to office manager, office accountant,
clerks, etc.
iii. Indirect expenses such as rent, insurance, lighting of the office.

c. Selling and distribution overheads.

i. Indirect material used such as packing material, printing and stationary
material, etc.
ii. Indirect labour such as salaries of salesmen and sales manager etc..
iii. Indirect expanses such as rent, insurance, advertising expenses, etc.

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COMPONENTS OF TOTAL COST

Prime cost
It consists of costs of direct material, direct material, and direct labour and direct
expenses. It is also known as basic, first or flat cost.

Factory cost
It comprises prime cost and in addition works or factory overheads which include costs
of indirect materials, indirect labour and indirect expenses incurred in the factory. This
cost is also known as works cost or manufacturing cost.

Office cost
If office and administration overheads are added to factory cost, office cost is arrived at.
This is also termed as administration cost or the total cost of production

Total cost
Selling and distribution overheads are added to total cost of production to get the total
cost or cost of sales. The various components of the total cost can be depicted through
the following chart:

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Chart
Figure No.:
Components of total cost
Direct material
Direct labour prime cost or direct cost or first cost.
Direct expenses

Prime cost plus works or factory cost or production

Works overheads or Manufacturing cost

Works cost plus

And administration office cost or total cost of production
Overheads

Office cost plus selling

And distribution cost of sales or total cost
Overheads

MARGINAL COSTING AND DIFFERENTIAL COSTING

Marginal costing is sometimes confused with differential costing. The term Differential
Costing’ means “a technique used in the preparation of ad hoc information in which only
cost and income differences between alternative courses of action are taken into
consideration”, 1 Thus, in case of differential costing a comparison is made between the
cost differential and income differential between two or more situations and decision
regarding adopting a particular course of action is taken if it is on the whole profitable.

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DIFFERENTIAL COST METHOD

According to this method, the selling price of each additional unit is based on its
differential cost. In other words a lower selling price is acceptable so long as the extra
revenue is sufficient to meet the additional cost and also earn some profit, provided it
does not disturb the existing market for the product. Fixation of selling price according to
this method is resorted to in times of severe competition or under recessionary conditions.

COST VOLUME PROFIT ANALYSIS

Cost volume profit [CVP] Analysis is an important tool of profit planning. It provides
information about the following matters;
1. The behavior of cost in relation to volume.
2. Volume of production or sales, where the business will break even.
3. sensitivity of profits due to variation in output
4. Amount of profit for a projected sales volume.
5. Quantity of production and sales for a target profit level.
6. Cost-volume-profit analysis may therefore be defined as a managerial tool
showing the relationship between various ingredients of profit planning, viz.,
cost [both fixed and variable], selling price and volume of activity, etc.
7. such an analysis is useful to the finance manager in the following
respects;
[i] It helps him in forecasting the profit fairly accurately.
[ii] It is helpful in setting up flexible up flexible budgets, since on the basis of
this relationship, it can ascertain the cost, sales and profits at different levels of
activity.
[iii] It also assists him in performance evaluation for purposes of management
control.

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[iv] It helps in formulating price policy by projecting the effect which different
price structures will have on cost and profits.
[v] It helps in determining the amount of overhead cost to be charged at various
levels of operations, since overhead rates are generally pre-determined on the
basis of a selected volume of production.

Thus, cost-volume-profit analysis is an important media through which the

management can have an insight into effects on profit on account of variations in
costs [both fixed and variable] and sales [both volume and value] and take
appropriate decisions.

ACTIVITY BASED COST

These days the term “Activity-based Costing” is growingly used. It is necessary to view
this term in the context of job costing and process costing. Job costing and process
costing are two basic methods of cost accounting. Activity-based costing is not a distinct
method of costing like ‘job costing’ and ‘process costs’.
Activity-Based Costing refines a costing system by focusing on individual activities as
the fundamental cost objects. An activity can be an event, or unit of work with a specified
purpose, such as designing products, setting up machines, operating machine etc. ABC
systems calculate the costs of individual activities and assign costs to cost objects such as
product and services on the basis of the actual consumption of activities needed to
produce such a product or service.
ABC first allocates costs to activity cost pools and then to the products, based on each
products use of those activities. The reasoning behind ABC cost allocation is simple and
logical: ‘Products consume activities; activities consume resources’.
Activity Based Costing is a more accurate cost management system as it focuses on the
indirect costs (overhead) and traces (rather than allocates) each expense category to the
particular cost object, in a way making ‘indirect’ expenses ‘direct’.

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Basic Premise of (ABC)

• Cost objects consume activities.
• Activities consume resources.
• This consumption of resources is what drives the cost.
• Understanding this relationship is crucial for successfully managing overheads.
When to use (ABC)
• When overheads are high.
• Products are diverse: complexity, volume, amount of direct labour.
• Competition is stiff and the cost of error is very high.

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