Unit 7: Basic Aspects of Cost Accounting

Cost accounting is the branch of accounting that records, classifies and analyses the expenditure incurred in producing goods or rendering services, so that management can control costs and fix selling prices. It grew out of the limitations of financial accounting, which reports overall profit but cannot tell you the cost of a single product, job or process. Cost accounting fills that gap by tracing every rupee of expense to a cost object.

• Cost object: any unit for which cost is separately measured — a product, a job, a batch, a department or a service.
• Cost unit: the quantitative unit against which cost is expressed, e.g. per tonne of steel, per litre of paint, per passenger-kilometre.
• Cost centre: a location, person or item of equipment for which costs are accumulated, e.g. the machining department.
• Objective: ascertainment of cost, control of cost, and provision of data for pricing and decision-making.
• Convention followed throughout: costs are built up in a defined sequence — prime cost, then works cost, then cost of production, then cost of sales — with each stage adding a specific class of expense.

II. Meaning of Cost and Cost Accounting

A. Cost defined

Cost is the amount of expenditure, actual or notional, incurred on or attributable to a given thing.

• Actual vs notional: actual cost is money paid (wages of ₹50,000); notional cost is an imputed charge with no cash outflow, e.g. rent on owned premises.
• Expense vs cost vs loss: a cost that has expired and been matched against revenue becomes an expense; a cost yielding no benefit is a loss (e.g. stock destroyed by fire).
• Cost is always relative: it must be tied to a cost object and a purpose — "the cost of what, and for what decision".

B. Meaning of cost accounting

Cost accounting is the formal process of ascertaining and controlling costs, beginning where financial accounting stops.

• Costing: the technique and process of ascertaining costs.
• Cost accountancy: the wider discipline covering costing, cost accounting, budgetary control and cost audit.
• Distinction from financial accounting: financial accounting is statutory and reports to outsiders; cost accounting is largely internal, product-focused and forward-looking.

III. Cost Concepts

A. Definition and purpose

A cost concept is a way of viewing cost tailored to a particular managerial question; the "right" cost changes with the decision at hand.

B. Element-based concepts

• Material cost: cost of substances entering the product — direct material (leather in a shoe) and indirect material (thread, glue in bulk).
• Labour cost: remuneration to workers — direct labour (machine operator) and indirect labour (supervisor, cleaner).
• Expenses: costs other than material and labour — direct expenses (hire of a special mould for one job) and indirect expenses (factory rent).

C. Behaviour-based concepts

These describe how a cost reacts to a change in the volume of output.

• Fixed cost: total remains constant within a range while per-unit cost falls as output rises, e.g. factory rent of ₹1,00,000 whether 1,000 or 2,000 units are made.
• Variable cost: total rises proportionately with output while per-unit cost stays constant, e.g. ₹20 of raw material per unit.
• Semi-variable cost: contains both elements, e.g. a telephone bill with a fixed rental plus per-call charges.

D. Decision-oriented concepts

• Opportunity cost: benefit foregone by choosing one option over the next best, e.g. interest lost by using own funds.
• Sunk cost: past, irrecoverable cost irrelevant to future decisions, e.g. the written-down value of an old machine.
• Marginal cost: the addition to total cost from producing one more unit — equals the variable cost per unit.
• Differential cost: the change in total cost between two alternative courses of action.
• Replacement cost: current cost of replacing an asset or material, as opposed to historical cost.

IV. Cost Classification

A. Purpose of classification

Classification groups costs by common characteristics so that each grouping serves a distinct control or reporting need; the same cost can appear under several classifications at once.

B. By element

• Three natural elements: material, labour and expenses, each split into direct and indirect.
• Direct costs: traceable wholly to a cost unit; together they form prime cost.
• Indirect costs (overheads): not economically traceable to a single unit and therefore apportioned.

C. By function

Costs are grouped according to the business function that incurs them.

• Factory / works overhead: incurred in production, e.g. power, factory rent.
• Office and administration overhead: incurred in general management, e.g. office salaries.
• Selling and distribution overhead: incurred in securing and fulfilling orders, e.g. advertising, delivery van running cost.

D. By behaviour

• Fixed, variable and semi-variable: as defined under cost concepts; central to break-even and marginal analysis.

E. By controllability and normality

• Controllable vs uncontrollable: whether a manager can influence the cost within a period.
• Normal vs abnormal: normal cost is expected at a given output and enters the cost sheet; abnormal cost (loss from a strike) is charged to profit and loss, not to the product.

V. Preparation of Cost Sheet

A. Purpose and principle

A cost sheet is a statement that presents the total and per-unit cost of output for a period, arranged element by element and stage by stage so that each level of cost is visible.

• Presentation rule: costs are accumulated in ascending stages, each stage adding one group of expenses and adjustments for stock.
• Per-unit column: total cost at each stage divided by units produced (or sold) gives cost per unit.

B. The build-up of cost — stages

The four stages accumulate as follows:

Direct Material                          xxx
Add: Direct Labour                       xxx
Add: Direct Expenses                     xxx
= PRIME COST                             xxx
Add: Factory / Works Overhead            xxx
Add: Opening WIP  -  Closing WIP         xxx
= WORKS (FACTORY) COST                   xxx
Add: Office & Administration Overhead    xxx
= COST OF PRODUCTION                     xxx
Add: Opening FG stock - Closing FG stock xxx
= COST OF GOODS SOLD                     xxx
Add: Selling & Distribution Overhead     xxx
= COST OF SALES (TOTAL COST)             xxx
Add: Profit                              xxx
= SALES                                  xxx

• Prime cost: sum of all direct elements — the traceable core of the product.
• Works cost: prime cost plus factory overhead, adjusted for work-in-progress.
• Cost of production: works cost plus administration overhead.
• Cost of sales: cost of goods sold plus selling and distribution overhead.
• Sales: cost of sales plus profit (or minus loss).

C. Treatment of stock

• Raw materials: purchases adjusted — Opening stock + Purchases − Closing stock = material consumed.
• Work-in-progress: adjusted within works cost because it is partly processed.
• Finished goods: adjusted after cost of production to reach cost of goods sold.

D. Items excluded

• Financial items: interest on loans, dividends paid, loss on sale of assets, income tax and cash discount are kept out because they are not costs of manufacture.

E. Worked example

Given: Direct material ₹40,000; direct wages ₹20,000; direct expenses ₹5,000; factory overhead ₹15,000; admin overhead ₹8,000; selling overhead ₹6,000; profit 20% on sales; output 1,000 units.

Prime cost         = 40,000 + 20,000 + 5,000 = 65,000
Works cost         = 65,000 + 15,000         = 80,000
Cost of production = 80,000 + 8,000          = 88,000
Cost of sales      = 88,000 + 6,000          = 94,000
Sales (94,000/0.80)                          = 1,17,500
Profit             = 1,17,500 - 94,000       = 23,500
Cost per unit      = 94,000 / 1,000          = ₹94

VI. Preparation of Estimated Cost Sheet

A. Purpose and principle

An estimated (or expected) cost sheet is prepared before production to forecast the cost of a proposed order, quotation or budget, using anticipated prices and quantities rather than actual records.

• Direction of use: it looks forward, whereas the ordinary cost sheet looks back at costs already incurred.
• Basis: past cost data adjusted for expected changes in material rates, wage rates and overhead levels.

B. How it differs from an actual cost sheet

The two are structurally identical but differ in the data feeding them.

1. Actual cost sheet: built from recorded, historical figures; used to ascertain what a product has cost and to check profit.
2. Estimated cost sheet: built from projected figures; used to quote a tender price, plan output and set standards before the work begins.

C. Method of estimation

• Absorb overheads on a rate: apply factory overhead as a percentage of wages, and office/selling overhead as a percentage of works cost, drawn from past ratios.
• Adjust for expected change: raise material cost if prices are forecast to climb, e.g. add 10% to last period's material rate.
• Add desired profit: load the estimated cost of sales with the target margin to arrive at the quotation price.

D. Uses

• Price quotation and tendering: submit a competitive yet profitable bid.
• Budgeting and planning: fix production and expenditure targets.
• Control benchmark: compare later actuals against the estimate to reveal variances and their causes.