• UNIT 1

• ADVANCED COST AND MANAGEMENT

ACCOUNTING
• SUBJECT CODE :CMC653

Copyright © 2006 Pearson Addison-

9-1
Wesley. All rights reserved.
 Learning Objectives

1. Understand the importance of different types

of costs in taking financial decisions that
financial managers make.

2. Identify the key differences between all types

of costs
 Learning Objectives (cont.)

• To help students to understand the role of the

financial manager within the firm and the goal
for making financial choices.
• To make them understand the use of marginal
accounting.
 Cost(Introduction)
• Cost is a measurement, in monetary terms, of
the amount of resources used for the purpose
of production of goods or rendering services.

• Cost is the amount of actual or notional

expenditure relating to a product, job, service,
process or activity.

• Cost is often used as a generic term to

describe various types of costs.
 Cost
Concepts
 Cost Unit –It is a unit of product, service or time in terms
of which costs are ascertained or expressed. It is a unit
of measurement.
 It is unit of measurement of cost
 Example for unit of production: a tonne of steel, a meter
of cloth, a ream of paper, a bale of cotton, a barrel of
petrol etc.
 Example for unit of services: passenger miles, cinema
seats, consulting hours etc.

 Responsibility Centers – is the unit or function of an

organization under the control of a manager who has
direct responsibility for its performance. E.g. Cost
Center, Revenue Center, Profit Center, Investment
Center.

 Cost Object – any product, service, process or activity for

which a separate measurement of cost is required. For
 Cost Concepts
 Cost Center – Is a location, person or item of equipment
for which costs may be ascertained and used for the
purposes of cost control.

 Types of Cost Centers:

◦ Personal Cost Center – person or group of persons
◦ Impersonal Cost Center – location or equipment
◦ Production Cost Center – where actual production takes place
◦ Service Cost Center – departments which render service to other
cost centers
 Cost Ascertainment and Cost Estimation
• Cost ascertainment: It is concerned with the computation
of actual costs incurred. It refers to the methods and
processes employed in ascertaining costs.
• Actual cost is useful to know unprofitable activities,
losses and inefficiencies occurring in the form of idle
time, excessive scrap etc.
• Cost estimation: It is pre-determination of cost of goods
or services. Estimated costs are definitely the future
costs and depends upon the past actual costs adjusted
for anticipated future.
• It is useful in making price quotations, bidding for
contracts, preparation of budgets, evaluating
performance, preparing projected financial statements
and controlling etc.
 Costing and CostAccounting
• The CIMA, London has defined Costing as “the
techniques and processes of ascertaining costs”
• Wheldon has defined Costing as “the proper
allocation of expenditure and involves the
collection of costs for every order, job, process,
• service or unit”
Thus it simply means cost finding by any
process or technique
•It consists of principles and rules which are
used
The costforof determining:
manufacturinga product or the cost of
providing a service
 Introduction
• Cost Accounting is the process of accounting from the
point at which expenditure is incurred or committed to
the establishment of its ultimate relationship with cost
centers and cost units. It includes:
– Collecting, classifying, recording, allocating and analyzing costs
– Preparation of periodical statements and reports for ascertaining
and controlling costs
– Application of cost control methods
– Ascertainment of profitability of activities carried out or planned.

• Cost Accounting is the processing and evaluation of

monetary and non-monetary data to provide information
for internal planning, control of business operations,
managerial decisions and special analysis.
 Objectives and Functions of Cost Accounting
I. Ascertainment of cost: In cost accounting, cost of each
unit of production, job, process, or department etc. Is
ascertained. Costs are also predetermined for various
purposes.

II. Cost control and cost reduction: It aims to improve

profitability by reducing and controlling costs. For this
various specialized techniques like standard costing,
budgetary control, inventory control etc. are used.
III. Guide to business policy: Cost data provide guidelines for
various managerial decisions like make or buy, selling
below cost, utilisation of idle plant capacity, introduction of
a new product etc.
 Objectives and Functions of Cost Accounting
IV. Determination of selling price: It provides cost
information on the basis of which selling prices of
products or services may be fixed.

In order to realize these objectives, the data provided by

cost accounting may have to be re-classified, re-
organized and supplemented by other relevant business
data from outside the formal cost accounting system
 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 measurement of efficiency Helps in preparation of budgets
• Helps in identifying unprofitable activities Helps in identifying
• material losses
• Helps in identifying idle time, idle capacity Helps in improving
• productivity
• Helps in cost comparison
•
•
•
 Introduction
• Cost Accountancy is 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.
• Cost Accountancy includes cost
costing, accounting, cost
control and cost audit
 Financial & CostAccounting
No. Basis Financial Accounting Cost Accounting
Financial performance and
1. Objective Ascertain cost and cost control
position
Shows overall costs and profit / loss Shows details for each product,
2. Costs and profits
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 Account,
Can generate special reports
7. Type of reports Balance Sheet, Cash Flow Statement
and analysis

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
 Management Accounting (Introduction)
According to CIMA, “management accounting is
an integral part of management concerned with
identifying, presenting and interpreting
information used for-
i) Formulating strategy
ii) Planning and controlling activities iii)Decision
making
iv)Optimizing the use of resources
v) Disclosure to shareholders and others external
to the entity
vi)Disclosure to employees vii)Safeguarding
assets”
 Management Accounting (Introduction)

The ICWAI has defined management accounting

as “a system of collection and presentation of
relevant economic information relating to an
enterprise for planning, controlling and decision-
making

The management accountant is called “Controller

or Financial Controller” and generally is a part of
top management team
 Characteristics/ Nature of Management Accounting

• Useful in decision making

• Derived from Financial and Cost
Accounting information
• Exclusively for internal use
• Purely optional
• Concerned with future
• Flexibility in presentation of information
 Functions/ Objectives of
Management Accounting
• Planning
• Coordinating
• Controlling
• Communication
• Financial analysis and interpretation
• Qualitative information
• Tax policies
• Decision making
Financial Accounting vs Management Accounting
Basis Financial Accounting Management Accounting
External and Mainly for external users Mainly meant for internal
internal users user i.e. management
Accounting method Double entry system Not based on Double entry
system
Statutory As per company law and tax It is optional
requirement laws
Analysis of It shows loss/profit of business It provides detailed
cost and
profit as a whole. It does not show information about individual
the
cost and profit for individual product, plant, process or
product, process or deptt. deptt.
Past and future It represents past/historical It uses past data for future
data records projections
Periodic and Usually on an year to year These are prepared
Continuous basis frequently
reporting
Accounting As per accounting standards It is not bound by
standards issued by ICAI accounting standards
 Financial Accounting vs Management Accounting
Basis Financial Accounting Management Accounting

Types of P & L Account and Balance Special purpose reports like

statements Sheet performance report of a
prepared manager, department,
product etc.

Publication and Financial statements are These statements are for

audit published for general public internal use and thus neither
use and also sent to published nor are required to
shareholders. These are be audited by the Chartered
required to be audited by the accountants
Chartered accountants
Monetary and It provides information in May apply monetary or non-
Non – monetary terms of money only monetary units of
measurement measurement. For e.g.
quantity, machine hour,
labour hour etc.
 Cost Accounting vs Management Accounting
Basis Cost Accounting Management Accounting
Scope Limited to providing cost Broader scope as it provides all
information for managerial uses types of information
Emphasis Mainly on cost ascertainment Mainly on planning, controlling and
and cost control to ensure decision making to maximize profit
maximum profit
Techniques Standard costing and variance All the techniques of cost accounting
employed analysis, marginal costing and but in addition it also uses ratio
cost volume profit analysis, analysis, fund flow statement,
budgetary control, uniform statistical analysis, operation
costing etc. research, mathematics, economics
etc., whatsoever help management
in tasks
Evolution Its evolution is mainly due to the Its evolution is due to the limitations
limitations of financial accounting of cost accounting

Statutory Maintenance of cost records has It is purely voluntary and its use
requiremen been made compulsory in depends upon the utility of
t selected
industries as notified by the govt. management
 Cost Accounting vs Management Accounting
Basis Cost Accounting
Data base It is based on data derived
from financial accounts
Status in In an organisational setup,
cost
organisatio accountant is placed at a
n lower
level in hierarchy than the
management accountant
Installation Cost accounting can be
installed without
management accounting
Management Accounting
It is based on data derived from
financial accounting, cost accounting
and other sources
In an organisational setup,
management accountant is placed at
a
higher level in hierarchy than the cost
accountant
Management accounting cannot be
installed without a proper system of
cost accounting
 Elements of costs
In order to interpret the term cost correctly and to
ascertain the cost with respect to the cost
centers, the cost attached with the
manufacturing process may be subdivided,
known as Elements of Costs.

(A)Material
(B)Labour (C)Expenses
 Elements of Cost

Material Labour Expenses

Direct Indirect Direct Indirect Direct Indirect

Selling
Factory / Administrati &
Works on Distributi
Overheads Overheads on
Overhea
 Material Cost
The cost of commodities and materials used by the
organization. It includes cost of procurement, freight
inwards, taxes, insurance etc.
Direct Material Cost –
all raw materials, either purchased from outside or
manufactured in house, that can be conveniently
identified with and allocated to cost units.
It generally becomes part of the finished product.
However in many cases a material becomes part of
finished product but not considered as direct material
because the value of such material is so small that it is
quite difficult and futile to measure it. e.g. nails in
furniture, thread in garments etc.
e.g. Cotton used in a textile firm, Clay in bricks, leather in
shoes Cloth in garments, Timber in furniture etc.
Indirect Material Cost –
material which cannot be identified with the
individual cost centre, assist the
manufacturing process and does not
become an integral part of finished goods.
These are minor in importance i.e. small
and relatively inexpensive items which may
become the part of finished product. E.g.
Consumable stores, pins, screws, nuts and
bolts, thread etc.,
also those items which do not become part
of finished product e.g. coal, Cotton, oils
and lubricants, stationary material, sand
 Labour Cost
• The cost ofand
process
commission
remuneration
is (wages,
incurred
etc.) paid to
salaries,
for those
themanufacturing
bonus,
employees
employees of theprocess.
who are engaged
organisation.
in the
• Direct
Indirect
Labour
identifiedLabour
Costthe
with – Cost – cost centre i.e. it can
individual
• conveniently
cost which cannot
identified withbe identified
a particular withjob the
product, be
individual cost centre and is incurred for those or
employees who are not engaged in the
manufacturing process but only assist.
• wages paid to foreman/storekeeper, salary of
works manager, Accountant/Personnel dept.
salaries etc.
 Expenses
This is the cost of services provided to the organisation and
the notional cost of assets owned.
Direct Expenses Cost –
Expenses which can be identified with and allocated to
individual cost centers or units.
Also known as chargeable expenses
Hire charges of machinery/equipment for particular job, cost
of defective work , cost of patent rights, experimental cost,
cost of special design, drawings, layout, royalty,
depreciation on plant etc.
Indirect Expenses Cost –
Expenses which cannot be identified by individual cost
centers.
Rent , Telephone expenses, Insurance, Lightening ,
Advertising, repairs etc.
 Direct Material Cost
+
Direct Labour Cost Prime Cost
+
Direct Expenses Cost

Indirect Material Cost

+
Overheads Indirect Labour Cost
+
Indirect Expenses Cost
 Overheads- Classification
Production/ Manufacturing/Factory / Works
Overheads
Consist of all overhead costs incurred
from the stage of procurement of material till the
production of finished goods.
Indirect material
laboursuch as Consumable
suc as stores,
wagesCotton waste,
paid to
oils and lubricants,
cost stationary
h material
of etc.works
foreman/storekeeper, salary
Accountant/Personnel dept. manager,
salaries, salaries
of factory office staff etc.
Indirect Expenses cost such as Carriage inward cost,
Factory lightening/power expenses, rent/ Insurance
/repairs for factory building/machinery, depreciation on
factory building or machinery etc.
 Overheads- Classification
Office and Administrative Overheads
These overheads consists of all overheads costs incurred for
the overall administration of the organisation. i.e. planning
and controlling the functions, directing and motivating the
personnel etc. They include :
Indirect material such as stationary items, office supplies
,broom, brush etc.
Indirect labour cost such as salaries paid to account and
administrative staff, office staff, Directors’ remuneration etc.
Indirect expenses such as postage/telephone, depreciation
on office building, legal/audit charges, Bank charges .
Rent/insurance / repairs in offices etc.
 Overheads- Classification
Selling and Distribution Overheads
Selling cost is the cost of promoting sales and retaining
customers. Distribution cost consist of all overhead costs
incurred from the stage of final manufacturing of finished goods
till the stage of sale of goods in the market and collection of
dues from customers.
 Indirect material such as packaging material, samples ,
catalogues, oil, grease for delivery vans etc.
Indirect labour like salaries paid to sales personnel,
commission paid to sales manager, salary of warehouse staff,
salary of driver of delivery vans etc.
Indirect expenses like carriage outward, warehouse charges,
advertisement, bad debts, repairs and running of distribution
van, discount offered to customers , insurance of goods in
transit etc.
 Classification Meaning Example
By Nature or Element
Which can be directly allocated to a product, Basic raw material,
Direct Material Cost
job or process primary packing material
Which cannot be directly allocated to a Stores, consumables,
Indirect Material Cost product, job or process some low value items
Labour directly engaged for a specific job,
Direct Labour Cost Shop floor labour
contract or work order.
Labour not directly engaged for a
Indirect Labour Cost Staff departments
specific job, contract or work order.
Processing charges,
All direct costs other than materials
Direct Expenses machine hire charges,
and labour costs. excise duty, etc
Rent, repairs, telephones,
All indirect costs other than indirect
Indirect Expenses materials and indirect labour costs. electricity, utility costs,
insurance, depreciation
Sum of indirect material, indirect labour and
Factory Overheads
indirect expenses for the factory.
Administration Sum of indirect material, indirect labour and
Overheads indirect expenses for the office.
Sum of indirect material, indirect labour
Selling Overheads
and indirect expenses for selling.
Distribution Overheads Sum of indirect material, indirect labour and
indirect expenses for distribution.
 Output or Unit Costing (Cost Sheet)

Output/ Unit/ Single costing is a method of cost

ascertainment which is used in those industries where:
Production consist of a single or few variety of
same product with variation in size, shape, colour etc.
Production is uniform and on continuous basis

It is a statement which is prepared periodically to provide

detailed cost of a cost center or cost unit. A cost sheet
not only shows the total cost but also the various
components of the total cost.

7-35
 Costing P&LAccount
No. Particulars Amount Per Unit

Direct Material Cost

= Opening Stock of Materials
+ Purchases
A + Expenses on Purchases (on number of units produced)
- Purchase Returns
- Closing Stock of Materials
- Value of Normal Scrap of Direct Materials
Direct Labour Cost
= Direct Labour Cost Paid
B (on number of units produced)
+ Outstanding / Payable
- Prepaid

C Direct Expenses (on number of units produced)

D Prime Cost = (A + B + C) (on number of units produced)

Works / Factory Overheads

= Factory Overheads Paid
E - Value of Normal Scrap of Indirect Materials (on number of units produced)
+ Opening Stock of WIP
- Closing Stock of WIP

F Works or Factory Cost = (D + E) (on number of units produced)

 Costing P&LAccount
No. Particulars Amount Per Unit

G Office and Admin Expenses (on number of units produced)

H Cost of Goods Produced = (F + G) (on number of units produced)

FG Stock Adjustment
I + Opening Stock of FG
- Closing Stock of FG

J Cost of Goods Sold = (H + I) (on number of units sold)

K Selling & Distribution Expenses (on number of units sold)

L Cost of Sales = (J + K) (on number of units sold)

M Profit (on number of units sold)

N Sales = (L + M) (on number of units sold)

 Expenses excluded from Costs

Item of expenses which are apportionment of profit should

not form a part of the costs. These are-
Income tax
Dividend to share holders
Commission to partners, managing agents etc.
Capital Loss
Interest on Capital
Interest paid on debentures
Capital expenses etc.
 Statement of Cost / Cost
Sheet
Rs. Rs.
Raw Materials
Opening stock of Raw materials  
Raw Material purchased  
Cost of Materials available for use  
Less : Closing stock of raw Materials () 
Cost of Raw materials used / Consumend  
Direct labour Wages  
Other Direct charges  
Prime Cost  
Factory Overheads:  
Indirect materials  
Indirect Labour  
Depreciation on factory Building  
Depreciation on Factory equipments  
Insurance  
Repairs and maintenance  
Other factory overheads  
Gross Factory Cost  
Add : Work-in-progress (Opening)  
Less: Work-in-progress (Closing)  ()
Factory cost  
Office and Administrative overheads  
Office salaries  
Office rents, Insurance  
Other office overheads  
Office Cost / Cost of Production  
Add : Opening Stock of Finished goods  
Goods available for sale  
Less: Closing Stock of Finished Goods  ()
Cost of Goods sold  
Selling and Distibution Expenses  
Cost of Sales  
Profit  
From the viewpoint of managerial needs, cost concepts fall into
four broad categories.

((1) IInncomeMeasurement

((2) ProfititPlalannnining

((3) CostContrrooll

((4) SpeciaialSituatioionns

7-40
 COST CONCEPTS RELATING TO
INCOME MEASUREMENT

((ii)i)Absorbed
(i) Product
Costs aand
Costs and
Unabsoorrbed
PerioioddCosts
Costs

(iii)i)Expirireed
Costs and (iviv))Joint
Unexpirireed prroodduct Costs
Coosts and Sepaarablele
Costs 7-41
 (i) Product costs and Periodcosts

Production costs are costs which can be identified with

goods produced/purchased for resale. Period costs
are costs which
are not necessary for production and are incurred even if
there is no production and matched against the
revenue of the current period.

(ii) Absorbed costs and Unabsorbed costs Absorbed

costs are defined as those costs, which have been

charged to production. Costs, which remain uncharged
to production are referred
to as unabsorbed costs.
7-42
 (iii) Expired costs and Unexpiredcosts

An expired cost is one which cannot contribute

to the production of future revenues. An unexpired
cost has the capacity to contribute to the
production of revenue in future, for example,
inventory.

(iv) Joint product costs and Separable costs

Joint product costs are the costs of a single

process/series of processes that simultaneously
produce two or more products of significant sale
value. Separable costs refer to any cost that can be
attributed exclusively and wholly to a particular
7-43
product/process/division/department.
Example 1: Absorbed, Underabsorbed and Overabsorbed Costs
Suppose that fixed costs are Rs 30,000 and the normal production is
15,000 units. The standard fixed overhead rate (SFOR) of recovery is Rs
2 per unit (Rs 30,000 ÷ 15,000 units). In other words, every unit of
production absorbs Rs 2 of fixed costs.

If the company produces 10,000 units, the total absorbed costs will be Rs
20,000 (10,000 units × Rs 2, SFOR). Obviously, Rs 10,000 constitutes
unabsorbed costs (Rs 30,000, actual cost – Rs 20,000, absorbed costs).

In contrast, overabsorbed costs represent the positive difference of fixed

costs charged to production and actual fixed costs. Such a situation will
arise if actual production is more than the normal production.

In the above example, if the company produces 16,250 units, the costs
charged to production will be Rs 32,500 (16,250 units × Rs 2, SFOR). The
overabsorbed cost will be Rs 2,500 [Rs 30,000, actual fixed costs (AFC) –
Rs 32,500 charged to production]. Figure 1 portrays these relationships.

7-44
 Absorbed costs = Units produced ×SFOR
Unabsorbed costs = [AFC – (Units produced × SFOR)]
Overabsorbed = [Units produced ×SFOR)–AFC]
costs
X

32,500

Over-absorption
30,000 FCLine

Under-absorption
Full absorption
1,5000
aehr ev OdexiF

Y
10,000 1,5000 1,5000
Volume of Activity (inUnits)

d
s
Figure
( 1: Absorbed and Unabsorbed Costs
i n
)seepur

7-45
COST CONCEPTS RELATING TO
PROFIT PLANNING

(i) Fiixxed,,VVaarriiaablle
and Semii--
variiaabbllee/Mixed
Costs

(ii) Future Costs and

Budgeted Costs

7-46
 FixedCosts
Fixed (non-variable) costs do not change with
changes in volume of output or activity within a
specified range of
activity/output (relevant range) for a given budget
period.
Committed Fixed Costs
Committed fixed costs are costs that are incurred in
maintaining physical facilities and managerial
setup.
Discretionary/ Programmed Fixed Costs

Discretionary fixed costs are costs caused

by management policy decisions i.e. these may beavoided
7-47
 Table 1: Production Volume and Fixed Costs
Total fixed cost Production (in units) Average fixed cost per unit
Rs 10,000 1,000 Rs 10
10,000 2,000 5
10,000 5,000 2
10,000 10,000 1

Y Y
10,000 10

2
dexi Fegar evA
oC dexi Fl atoT

X X
0 0 2,000 4,000 6,000 8,000 10,000 X
2,000 4,000 6,000 8,000 10,000
Volume of Activity (inUnits) Volume of Activity (in
st C
o Units)
Figure
( 2: Volume and Total FixedCosts Figure
s 3: Volume and Fixed Costs Per Unit
s eepur ni

pur ni(t

7-48
 Variable costs

Costs that tend to vary in total in direct proportion within

a relevant range and for a given period
to production/sales/some other measure of volume are
variable costs.

7-49
 Table 2: Production Volume and Variable Costs
Production (unit) Material costs Labour costs Total variable cost
1 Rs 5 Rs 2 Rs 7
10 50 20 70
100 500 200 700
1,000 5,000 2,000 7,000

Y Y

TVCLine TVCLine

s oC elbaira V
bair aVl at oT

) s eepurni(
)seepur

X X
Production in Units Production in Units
l
e ts
Figure
C
o 5: Total Variable Cost Figure
p
e 6: Variable Cost Per Unit
r
ni( sts

ti nu

7-50
 Semi-Variable (mixed) Costs
All costs which are neither perfectly variable nor
absolutely fixed in relation to volume changes
are called semi-variable (mixed) costs.
They consist of both fixed costs and variable costs.

Y
bair a V-imeS
)seepur

le
C
Figure
o 7: Semi-Variable Cost
ni( sts

7-51
 Future Costs
Future costs are costs reasonably expected to
be incurred at some future date as a
result of a current decision.

Budgeted Costs

Budgeted costs are costs which are

incorporated formally in the budgeted of a
specific period.

7-52
Cost Concepts For Control

(i)i)RessppoonssibibililtityCost

(ii)i)Controllalabblele andNon-
ControllalabbleleCosts

(ii)i)DDirireect and IndiIrireectCosts

7-53
 (i) Responsibility costs
Responsibility costs are costs which are classified/identified
/accumulated with the person(s) responsible for their
incurrence.
(ii) Controllable
(ii) Controllableand
and Non-controllable costs
Non-controllable costs

The costs which may be directly regulated at a given level of management

authority. VC are generally controllable by Management heads. Otherwise,
it is non-controllable like factory rents, salaries etc.

(ii) Direct and indirect costs

Those costs which can be identified logically and
practically in their entirety to a particular
department/product/cost unit/process are called
direct costs. Those costs which are not practically
identifiable exclusively and wholly to a particular
product/division/segment are called indirect
7-54
(common) costs.
 Cost Concepts
For Decision- Making

Relevaanntaannd
Diiffferennttial Costs
Irrelevant Costs

Out-of- Oppppoortuunnit
ppoocket y Costs and
Costs and Imputed Costs
Sunk Costs
7-55
 Relevant and Irrelevant costs

Not all costs are relevant for specific decisions. Costs which are
influenced by a decision are a relevant. These are future cost which
are affected by a decision being made and cost which is not affected
by a decision is irrelevant cost.

Differential costs

Differential/incremental costs are the differential/additional costs

which would be incurred if the management chooses one course of
action as opposed to another. They are differential/incremental
costs caused by a particular decision.

7-56
 Out-of-pocket costs and Sunk costs

A cost which requires a current/future cash expenditure

as a result of a decision is an out of pocket cost. Costs
which have already been incurred in the past are sunk
costs.

Opportunity costs and Imputed costs

Opportunity cost represents the benefits foregone by

not choosing the second best alternative in favour
of the best one. Imputed costs are hypothetical
costs that must be considered for correct decision,
for example, interest on capital, rented value of
building owned by the firm.

7-57
 Marginal Cost

Additional cost of producing one additional unit. It is same as

variable costs. It helps is decision like make or buy, pricing of
products, selection of sales mix etc.

Conversion Cost

It is the total cost of converting raw material into finished product. In

other words it is the total of direct labour and factory overhead costs

7-58
1
 Characte
Introduction & Cost ristics
Definitions Classification &
Facts
Distinction –
Assumptions CVPAnalysis
MC & AC

Methods of CVP – Imp. Limitations of

BEP Analysis Formulae MC

6
0
 Marginal Costing

1 6
1
 Marginal Marginal Direct
Costing Cost Costing

Differential Incremental
Contribution
Cost Cost

Key Factor

1 6
2
 The ascertainment of marginal cost and the effect on
profit of changes in volume or type of output by
differentiating between fixed costs and variable costs.

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The amount of any given volume of output by which
aggregate variable costs are changed if the volume of output
is increased by one unit.

In practice, it is measured by the ‘Total Variable Cost’

attributable to ‘1 unit’.

Also, it can be called the sum of ‘Prime Cost’* and ‘Variable

overhead’.

*Prime cost = D. Material + D. Labour + D. Expenses

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 Direct costing is the practice of charging all direct cost to
operations, processes or products, leaving all the indirect cost to
be written off against profit in the period in which they arise.

In this method, the stocks are valued at Direct cost, whether

fixed or variable.

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It can be defined as the increase or decrease in the total cost or the
changes in the specific element of cost that result from any
variations in operations.

It represents change in cost of

Producing or distributing different quantity of products. Change in

method of production or of distribution.

An addition or deletion of a product or territory.

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6
 The additional costs of a change
in the level or
nature of activity.
It is a part of ‘Differential costing’, where production(level
of activity) Increases.

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7
Contribution is the difference between sales and
marginal cost(variable cost).

It can also be defined as excess of sales revenue over

the variable cost.

For an easy understanding consider the following :

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Variable Cost = Rs. 50,000
Fixed Cost = Rs. 20,000 Selling Cost = Rs.

80,000

Contribution = Rs. 80,000 – 50,000 = Rs. 30,000

Profit = Rs. 30,000 – 20,000 = Rs. 10,000

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Key factor or Limiting In simple words, it is
factor is a factor a crucial element
which at a particular whose presence, (or
time or over a period absence) may affect
limits the activity of the activities of the
an undertaking. undertaking.

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 Shortage of
Level of Shortage of
Raw
demand. labor.
Material.

Sales/Plant
Cash
capacity
availability.
available.

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 Technique of Costing

For Managerial Decision Making

To Measure Profitability of Products

To study Cost Volume Profit Analysis

On the basis of nature of costs

Mainly Fixed and Variable costs

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 An Intro.

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3
 Costs

Semi
Fixed Variable
Variable

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4
 Cost

Fixed Cost Variable Costs Semi Variable

Costs :

Does not change Changes in exact Changes with level

with Level of proportion with of activity but not in
Activity level of Activity exact proportion

Example:
Example: Rent, Example: Material, Maintenance costs
Salary etc. Labor etc etc
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 They are
incurred
It ‘does not’
regardless
changes with
level of activity.
of the
volume of
production
Even at 0 level of For eg. Salary,
production, a firm .
Rent,
incurs this cost. Depreciation etc.

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6
It changes with level of activity at exact proportion, i.e.

If there is 10 % increase in level of activity there is 10 %

increase in Variable cost.

It is Nil at 0 level of production.

For eg : Material, Labor etc.

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 It changes with level of activity
but not in exact estimation.
‘Maintenance cost’ is a Semi-variable cost as it is not nil
at 0 level of production as no matter if there is production
or not some maintenance cost is maintained.

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 Marginal Costing

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9
All elements are classified in fixed and variable costs.

Variable cost is treated as cost of product.

Value of Inventory and W.I.P comprises only of variable cost.

Fixed cost are charged for the period they are incurred for.

Profitability of deptts and products is determined with reference

to their contribution margin.

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Not a Distinct Method :
• It is not a distinct method, but a special technique
used for managerial decision making.
Cost Ascertainment :
• It tells us about how different cost is going to affect
the profitability of the firm.

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Decision Making :

Total Cost, Under this method is sum total of direct labor, direct
material, direct expenses manufacturing, selling and distribution
overheads.

If fixed cost would have been added it had been posed a threat
to the management in taking decisions.

Hence, it has given a wide recognition in the field of decision

making.

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 Q. How adding Fixed cost
would have affected
management decisions?
Ans:
•Supposing Fixed cost = Rs. 15, Var. Cost = Rs. 3
•of an item on a particular day, Total Cost = Rs. 18
•And Next day, If 2 units are produced Fixed cost being the same,
•Var. Cost = Rs. 6 ; Total Cost = Rs. 21
•If Fixed cost is added: Increase in Cost = 16.67 %
•While actual increase in cost( as per Mar. Costing is) = 200% .
•As fixed cost has to be same in any production, we need to consider
variable cost for effective decision making.

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 Distinction

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4
 All costs of
production
Costs are (Fixed or
classified on the Variable)
Basis of Functions are included in
Inventory
Valuation

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5
 Sales Value xxxx
less: Direct materials (xxxx)
less: Direct labour (xxxx)
less: Factory overheads (xxxx)
Gross profit xxxx
less: Administrative expense (xxxx)
less: Selling & Distribution expense (xxxx)
Net profit xxxx

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Sales xx

Less: Variable Costs xx

D. Material
D. Labour
D. Expenses
Var. Production Overheads
Var. Selling & Distribution Overheads

Contribution xx
Less: Fixed Costs xx
Fixed Production Overheads Administrative Overheads
Fixed Selling & Distribution Overheads

Net Profit xx

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 Marginal Costing Absorption Costing

Cost data Cost data

presented presented
highlights the highlights Gross
contribution of each Profit and Net
product. Profit.

Only variable costs Both fixed and

are considered for Variable cost are
product costing and considered for
inventory valuation. inventory
valuation.

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 Marginal Costing Absorption Costing

Sales Sales
- variable cost -Cost of goods sold
= Contribution = Gross Profit
- Fixed cost - Indirect expenses
= Profit = Net Profit

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9
 An Intro.

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 Break Even Margin of
PV Ratio
Point Safety

Cost Sales to
Shut Down
Indifference Earn Desired
Point
Point Profit

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 Relation between
Contribution and Sales
Also Known as Contribution to Sales Ratio

P V Ratio =
• Total Contribution/Total Sales
• Contribution per unit/Sales per unit
• ( Fixed Cost + Profit )/ Sales
• ( Sales- Variable costs)/ Sales
• 1- Variable Cost Ratio
• Profit/ Margin of Safety
• Fixed Costs / Break Even Point
• Change in Contribution/Change in sales
• Change in Profit /Change in Sales

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 Sales Where Total Costs is equal to
Total Sales
•Total costs = Fixed Costs + Variable Costs
• At BEP There is No Profit or No Loss

• Total Contribution = Fixed Costs

•Contribution =( Sales – Variable costs) or Fixed
costs + Profit)
• BEP ( in units) =
•Total Fixed Costs/Contribution per unit
• BEP ( in amount) =
•Total Fixed costs / Profit Volume Ratio
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 Excess of Sales over
Break Even
MOS = Sales – BEP
Sales
Alternatively MOS =
• Profit / Contribution per unit ( in units)
• Profit / P V Ratio ( in amount)
Profit = MOS x P V Ratio

P V Ratio = Profit / MOS

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 Activity Level at which Two different Options result in
same Costs

Cost Indifference Point =

• Change in Fixed Costs /Change in variable Costs per unit

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 Sales below which Business can not be persued
Temporary Closure of Business To Avoid Off Season, Recession etc
Here Business must be able to generate Avoidable Fixed Costs
•Avoidable Fixed Costs = Total Fixed Costs – Minimum or unavoidable fixed
costs
Shut Down Point =
•Avoidable Fixed Costs / Contribution p.u. (in units )
•Avoidable Fixed Costs / P V Ratio ( in amount )

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 Here Only Cash Fixed Costs are Considered

Non cash costs like Depreciation etc are not Considered

Cash Break Even Point =

• Cash Fixed Costs / Contribution p u ( in units)
• Cash Fixed Costs / P V Ratio (in amount)

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Here we calculate sales for given profit.

It can be calculated in units.

X = (Total fixed cost + Desired profit) / (Contribution per unit)

It can also be calculated in Rupees.

Sales = (Total fixed cost + Desired profit ) / (P.V. Ratio)

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 Break Even Chart
Algebraic Method

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 Break-Even Point refers to a situation in the business
where there is neither a loss nor any profit. Here,
Sales = Total Cost.

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1 0
 Sales Where Total Costs is equal to
Total Sales
•Total costs = Fixed Costs + Variable Costs
• At BEP There is No Profit or No Loss

• Total Contribution = Fixed Costs

•Contribution =( Sales – Variable costs) or Fixed
costs + Profit)
• BEP ( in units) =
•Total Fixed Costs/Contribution per unit
• BEP ( in amount) =
•Total Fixed costs / Profit Volume Ratio
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 A mathematical or graphical
representation, showing
approximate profit or loss of
an enterprise at different
levels of activity within a
limited range.

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 Break Even Chart With Angle Of Incidence
25

20
Cost & Revenue

15 TC
TR
10

0
Break E venPoint
1 2 Units 3 4
1
1 0
 An Intro.

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 Simplifying Proper Shows
Pricing recovery of Realistic
Policy. Overheads. Profit.

Helps in More Control

How much
Decision- over
to Produce. Making. Expenditure.

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1 0
 Difficult to Classify fixed and variable elements.
Dependence on key factors. Scope for Low

Profitability.

Faulty valuation. Unpredictable nature of cost.

Marginal Costing ignores time factor and Investment.

Understanding the W.I.P.

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 Marginal Costing

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Change in levels of revenues and cost is only because of
number of units produced and sold.
Total cost can be separated in 2 components i.e. Fixed cost
and Variable Cost

Linear Relationship of cost and revenue.

Selling price, Variable cost per unit, and Total fixed cost
remains Constant.
Single product or proportion of sales is same for multi-
Product.

Time Value of Money is not considered.

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 A brief Recap of all the formulas
we have learnt so far.

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Sales – variable cost = Contribution = Fixed cost + Profit

P.V. Ratio = Contribution / Sales

Break-Even Point
A) BEP Units = (Fixed Cost) / (Contribution per unit)
B) BEP(Rs.) = (Fixed Cost) / P.V. Ratio

Margin of Safety (MOS) = Sales – Break-Even Sales

A) MOS Units = Profit / (Contribution per unit)
B) MOS (Rs.) = Profit / P.V. Ratio

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Sales to Earn Desired Profit
A)In Units = (Total Fixed Cost + Desired Profit) /
(Contribution Per unit)
B)In Rs. = (Total Fixed Cost + Desired Profit) /
(P.V. Ratio)

Shut Down Point

A)In units = (Avoidable Fixed Cost) / (Contribution
per unit)
B)In Rs. = (Avoidable Fixed Cost) / (P.V. Ratio)

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Cost Indifference point
A) In units = (Change in Total Fixed Cost) / (Change in Variable cost per unit)
B) In Rs. = (Change in Total Fixed Cost) / (Change in variable cost ratio or P.V. ratio)

Contribution = Sales X P.V. Ratio

Profit = Margin of safety X P.V. Ratio

Fixed Cost = Break-Even Sales X P.V. Ratio

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 Application of Marginal costing

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 A Company produces a product whose Selling Price is Rs. 25 per unit.

Variable Cost is Rs. 15 per unit and Total fixed Cost is Rs. 15000.

Company is producing and selling 20000 units Find

•Contribution per unit

•P V Ratio
•Break Even Point
•Margin of safety
•Shut Down Point if Minimum Fixed Cost is Rs. 10000

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4
 Contribution per unit = Sales – Variable cost

Hence Contribution per unit=Rs.25-15=Rs.10

P V Ratio=Contribution /Sales So, P V Ratio=10/25=40%

Break Even Point = Total Fixed Cost /PV Ratio So, Break

Even Point= 15000/40%=Rs.37500

Note : Break even Point can also computed in terms of units.

In that case
•BEP=Total fixed Costs /Contribution Per Unit
•BEP =15000/10=1500 units

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 Margin of Safety (MOS) = Sales – BEP

MOS ( in units ) = 2000- 1500 =500 units

MOS (in amount) =2000 * 25 -37500

• =Rs. 12500

Shut down point =

• Avoidable fixed cost/contribution per unit (in units )
• Avoidable Fixed cost / PV Ratio ( in amount)
• Note : Avoidable Fixed Cost =
• Total Fixed Cost – Minimum Fixed Cost
• Rs. 15000 – 10000 = Rs. 5000

Shut Down Point = Rs. 5000/10 = 500 units

Shut Down Point =Rs. 5000/ 40% =Rs 12500

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 Machine A has a
A Company is to Fixed Cost of Rs.
select a machine out 20000 and Variable
of 2 machines A & B. Cost of Rs.20 per
unit

While Machine B
has a Fixed Cost Rs.
10000 and Variable Find Cost
Cost of Rs.25 per Indifference Point
unit

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 Cost Indifference point =
• Change in Total Fixed Cost /Change in Var. Cost per unit
• Change in Total Fixed Cost =
• Rs. 20000-10000=Rs.10000
• Change in Var. Cost per unit = Rs. 25 -20 = Rs. 5
Cost Indifference Point = Rs. 10000/Rs. 5
• 2000 units

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 Transfer Pricing
• Internal charges for the
exchange of goods or services
within the organization
• Promote goal congruence
• Make performance evaluation
among segments more
comparable
• Transform a cost center into a
profit center
• Encourages managers to be
entrepreneurial
• Advantages
– Encourage development of
beneficial services
– Promote cost
consciousness of services
provided
– Promote making a service
department a profit center
Transfer prices are for internal use only.
They are eliminated on external
financial reports.
Certain ImportantPoints
Interdepartmental Transfer

Inter-departmental transfer (IDT)means

• Transferring goods or services from one department to other

Goods and services in IDT are charged as per follows

• Cost
• Ruling Market Price
• Cost plus agreed percentage of profit
 STOCK RESERVE
• Unrealised profit included in unsold inventory
at the end of accounting period is eliminated
by creating an appropriate stock reserve by
debiting the combind profit and loss account.
• The amount of stock reserve is calculated as

• Transfer price of unsold stock *profit included

in transfer price
Transfer Price
Inter-Departmental/ Inter company
transfers
 Advantages and Disadvantages of
Transfer Pricing Systems
• Advantages
– Permit evaluation of segment
performance
– Allow for rational acquisition
of goods and services
between corporate divisions
– Provide flexibility to respond
to changes
– Encourage and reward goal
congruence
• Disadvantages
– May cause disagreement
among managers
– Adds costs and takes time
– May not work for all
departments
– May cause underutilization or
overutilization of services
– May cause dysfunctional
organizational behavior
– Causes a need for year-end
entries to eliminate transfer
prices
Multinational Transfer Pricing Objectives
• Internal • External
– Better goal congruence – Less taxes and tariffs
– Better performance – Less foreign exchange risks
evaluations – Better competitive
– More motivated managers positions
– Better cash management – Better relations with
government
 We now have a better understanding of following aspects:

1 • Cost classification
2 • Profit Volume Ratio - PV Ratio
3 • Break Even Point
4 • Margin of Safety
5 • Shut Down Point
6 • Cost Indifference Point
7 • Cash Break Even point
8 • Break Even Charts & Angle of Incidence
9 • Marginal Costing Vs. Absorption Costing

1
1 2
 OUTCOMES
• Students can learn difference b/w cost and
management
• Students can learn about various costing
decisions with the help of different techniques
of costing
 REFERENCES
• Reference Material –
• V.K.Saxana & C.D.Vashist, Advanced Cost of
Management Accounting, Sultan Chand &
Sons, New Delhi, 1998.
• Dr.Manmohan & S.N.Goyal, Principles of
Management Accounting Shakithabhavan
Publication, Agra,