Unit 7: Basic Aspects of Cost Accounting - Subjective Questions

Cost Accounting is the process of accounting for costs from the point at which expenditure is incurred, through its classification, recording, allocation and reporting, up to the establishment of the cost of a product, service or activity.

Main objectives of Cost Accounting:

• Ascertainment of cost: Determining the cost per unit of product or service using suitable methods and techniques.
• Cost control: Comparing actual costs with predetermined standards or budgets and taking corrective action.
• Cost reduction: Achieving a real and permanent reduction in unit cost without compromising quality.
• Fixation of selling price: Providing cost data as a basis for pricing decisions.
• Aiding managerial decision-making: Supplying information for decisions such as make or buy, product mix, and shutdown.
• Ascertaining profitability: Determining the profitability of each product, department or activity.

Thus, cost accounting is primarily an internal tool that helps management plan, control and make informed decisions.

The key differences between Cost Accounting and Financial Accounting are:

• Purpose: Financial accounting records transactions to prepare financial statements for external parties, whereas cost accounting ascertains and controls costs for internal management.
• Users: Financial accounting serves external users (shareholders, creditors, government); cost accounting serves internal management.
• Statutory requirement: Financial accounting is legally mandatory for most entities; cost accounting is generally optional (except where prescribed).
• Nature of data: Financial accounting deals mainly with historical monetary data; cost accounting deals with both historical and estimated/future data and non-monetary information (units, hours).
• Focus: Financial accounting shows overall results of the business; cost accounting analyses cost by product, process, department or job.
• Reporting period: Financial reports are usually annual; cost reports are prepared as frequently as required (daily, weekly, monthly).
• Format: Financial statements follow prescribed formats; cost statements have flexible formats suited to management needs.

These four terms are related but distinct:

• Cost: The amount of expenditure (actual or notional) incurred on, or attributable to, a given product, service or activity. It is measured in monetary terms.
• Costing: The technique and process of ascertaining costs. It refers to the principles and rules used to determine the cost of products and services.
• Cost Accounting: The formal process of classifying, recording and allocating expenditure to determine costs, and presenting suitably arranged data for control and decision-making. It includes maintaining cost books and records.
• Cost Accountancy: The broadest term, covering the application of costing and cost accounting principles, methods and techniques to the science, art and practice of cost control and ascertainment of profitability, along with presentation of information for managerial decision-making.

Relationship: Cost Accountancy is the widest concept and includes Costing, Cost Accounting and the use of cost data for control and decisions.

On the basis of behaviour or variability with the level of output, costs are classified as:

1. Fixed Cost:

• Costs that remain constant in total within a relevant range, irrespective of output.
• Per unit fixed cost decreases as output increases.
• Examples: factory rent, salary of permanent staff, insurance premium.

2. Variable Cost:

• Costs that vary in total in direct proportion to output.
• Per unit variable cost remains constant.
• Examples: direct materials, direct wages, power consumed.

3. Semi-variable (Semi-fixed) Cost:

• Costs that are partly fixed and partly variable.
• They change with output but not in direct proportion.
• Examples: telephone charges (fixed rental + call charges), electricity, depreciation on usage basis.

The total cost relationship can be shown as:

On the basis of elements, cost is divided into three main components:

1. Material Cost:

• Direct Material: Material that can be conveniently identified with and allocated to a product (e.g., cloth in garments, timber in furniture).
• Indirect Material: Material that cannot be directly traced to a product (e.g., lubricants, cotton waste, small tools).

2. Labour Cost:

• Direct Labour: Wages paid to workers directly engaged in production (e.g., machine operators).
• Indirect Labour: Wages not directly identifiable with a product (e.g., supervisors, storekeepers).

3. Expenses:

• Direct Expenses: Expenses directly attributable to a product other than material and labour (e.g., hire of special machinery, royalty on production).
• Indirect Expenses: Expenses not directly allocable (e.g., rent, insurance, depreciation).

All indirect items collectively form Overheads (indirect material + indirect labour + indirect expenses).

A Cost Sheet is a statement that shows the various components of total cost of a product for a given period, arranged in a logical sequence, along with cost per unit.

Purposes / Advantages:

• Ascertainment of total cost and unit cost: Shows prime cost, works cost, cost of production, and cost of sales.
• Analysis of cost: Presents cost element-wise, helping identify where costs are incurred.
• Price fixation: Provides a basis for determining selling price and quoting tenders.
• Cost control: Enables comparison of costs across periods to detect variations.
• Budgeting and estimation: Serves as a basis for preparing estimated cost sheets and budgets.
• Decision-making: Assists management in decisions relating to production and profitability.

A cost sheet may be prepared on a historical basis (actual costs) or on an estimated basis (for future periods).

The build-up of total cost in a cost sheet follows this sequence:

1. Prime Cost:

2. Works / Factory Cost:

(adjusted for opening and closing work-in-progress)

3. Cost of Production:

4. Cost of Goods Sold:

5. Cost of Sales (Total Cost):

6. Sales:

Each stage adds a specific category of overhead to the previous total, giving a clear picture of how cost accumulates.

Cost Sheet

Working:

An Estimated Cost Sheet is a statement prepared in advance of production, showing the expected or anticipated cost of a product for a future period, based on estimates of material, labour and overheads.

Differences from a historical cost sheet:

• Basis of data: An estimated cost sheet uses expected/future figures; a historical cost sheet uses actual past figures.
• Timing: Estimated cost sheet is prepared before production begins; historical cost sheet is prepared after production is complete.
• Purpose: Estimated cost sheet is used for quoting prices, tenders and budgeting; historical cost sheet is used for control and profit ascertainment.
• Accuracy: Estimates are approximations subject to variance; historical costs are accurate records.
• Use in decision-making: Estimated cost sheets help in forward-looking decisions such as tender pricing, whereas historical cost sheets help in analysing past performance.

Estimated cost sheets are especially useful for preparing tenders and quotations where a selling price must be quoted before the work is undertaken.

Direct Cost:

• Costs that can be conveniently and economically identified with and allocated to a specific cost unit or cost centre.
• They vary with the product being made.
• Examples: direct materials (raw material in a product), direct wages (wages of machine operators), direct expenses (royalty per unit).
• Together they form the Prime Cost.

Indirect Cost:

• Costs that cannot be directly identified with a particular cost unit and must be apportioned or absorbed.
• They are incurred for the benefit of production generally.
• Examples: factory rent, indirect materials (lubricants), indirect wages (supervisor salary), depreciation.
• Together they form Overheads.

Key distinction: Traceability is the basis. If a cost can be directly traced to a product, it is direct; otherwise it is indirect and must be shared among products on a suitable basis.

On the basis of functions, costs are classified according to the major activities of the business:

1. Production / Manufacturing Cost:

• Cost incurred in manufacturing the product, from procurement of raw material to completion of finished goods.
• Includes direct material, direct labour, direct expenses and factory overheads.

2. Administration Cost:

• Cost of formulating policy, directing the organisation and controlling operations.
• Includes office rent, salaries of office staff, printing and stationery.

3. Selling Cost:

• Cost of creating and stimulating demand and securing orders.
• Includes advertising, salesmen's salaries, sales promotion expenses.

4. Distribution Cost:

• Cost of making the packed product available for despatch and delivery to customers.
• Includes warehousing, carriage outward, packing for delivery.

5. Research and Development Cost:

• Cost of researching new products/processes and developing them.

This functional classification helps in preparing the cost sheet and in analysing cost by activity.

Stock adjustments at three stages are made in the cost sheet as follows:

1. Raw Material Stock (adjusted at Prime Cost stage):

This gives the direct material consumed used in prime cost.

2. Work-in-Progress (WIP) (adjusted at Works Cost stage):

• Opening WIP is added and closing WIP is deducted while computing Works Cost.
  
• WIP is valued at prime cost plus factory overheads.

3. Finished Goods Stock (adjusted at Cost of Goods Sold stage):

• Finished goods are valued at cost of production.

Proper treatment of stock ensures the cost sheet reflects the cost of only those goods actually sold during the period.

(a) Sunk Cost:
A cost that has already been incurred in the past and cannot be recovered or changed by any future decision. It is irrelevant for decision-making. Example: written-down value of an old machine.

(b) Opportunity Cost:
The value of the benefit foregone by choosing one alternative over the next best alternative. Example: interest lost by investing money in one's own business instead of in a bank.

(c) Marginal Cost:
The additional cost of producing one more unit of output. It equals the variable cost per unit.

(d) Differential Cost:
The difference in total cost between two alternatives or levels of activity. If it increases, it is called incremental cost; if it decreases, decremental cost.

(e) Replacement Cost:
The cost at which an asset or material could be replaced at current market prices, as opposed to its original (historical) cost.

A. On the basis of Controllability:

• Controllable Cost: Costs that can be influenced or regulated by the action of a specific manager within a given time. Example: direct material, direct labour at the shop-floor level.
• Uncontrollable Cost: Costs that cannot be influenced by the action of a particular manager. Example: factory rent, allocated corporate overheads.

Whether a cost is controllable often depends on the level of management and the time period considered.

B. On the basis of Normality:

• Normal Cost: Cost that is normally incurred at a given level of output under normal conditions. It is a part of the cost of production. Example: normal spoilage.
• Abnormal Cost: Cost that arises due to abnormal or unusual circumstances not expected in normal operations. It is charged to the Costing Profit and Loss Account and not to product cost. Example: cost of abnormal wastage, loss due to fire.

This classification aids in cost control and correct product costing.

Cost Sheet (Output = 1,000 units)

Workings:

Overheads are the aggregate of all indirect costs, i.e., indirect material, indirect labour and indirect expenses that cannot be conveniently traced to individual cost units.

Classification of Overheads:

A. On the basis of Function:

• Factory / Works Overheads: e.g., factory rent, power, depreciation of plant.
• Office and Administration Overheads: e.g., office salaries, printing, stationery.
• Selling and Distribution Overheads: e.g., advertising, carriage outward, warehouse rent.

B. On the basis of Behaviour:

• Fixed Overheads: remain constant (e.g., rent).
• Variable Overheads: vary with output (e.g., power).
• Semi-variable Overheads: partly fixed, partly variable (e.g., telephone).

C. On the basis of Element:

• Indirect material, indirect labour, indirect expenses.

Proper classification of overheads is essential for their allocation, apportionment and absorption into product cost.

Estimated Cost Sheet for 500 units

Workings:

Cost Unit:

• A cost unit is a unit of product, service or time (or a combination) in relation to which costs are ascertained or expressed.
• It is the measure used to quantify the cost of output.
• Examples:
  • Cement industry: per tonne
  • Transport: per passenger-kilometre
  • Electricity: per kilowatt-hour
  • Hospital: per patient-day

Cost Centre:

• A cost centre is a location, person, item of equipment or a group of these, for which costs are ascertained and used for cost control.
• Types:
  • Personal cost centre: consists of a person or group of persons (e.g., a supervisor).
  • Impersonal cost centre: consists of a location or equipment (e.g., a department or machine).
  • Production cost centre: where actual production takes place.
  • Service cost centre: which renders services to production centres (e.g., maintenance).

Difference: A cost centre is a point where costs are collected, whereas a cost unit is the measure to which those costs are finally related.

Certain items of a purely financial nature are excluded from the cost sheet because they do not form part of the cost of production or sales. These are dealt with only in financial accounts.

Items excluded (financial / non-cost items):

• Financial expenses/appropriations: income tax, dividends paid, transfers to reserves.
• Purely financial charges: interest on loans/debentures, loss on sale of assets or investments, discount on issue of shares/debentures, penalties and fines.
• Purely financial incomes: interest received, dividend received, profit on sale of assets or investments, rent received, transfer fees.
• Abnormal items: abnormal losses (loss by fire, theft) and abnormal gains are excluded from cost and taken to the Costing P&L.
• Appropriation of profit: donations, charity, and provision for taxation.
• Writing off intangibles: goodwill, preliminary expenses, patents written off.

Excluding these ensures the cost sheet reflects only the true operational cost of the product, giving a correct basis for pricing and control.

A. On the basis of Time:

• Historical Cost: Costs ascertained after they have been incurred. They are actual and accurate but available only after the event, so of limited use for control.
• Predetermined Cost: Costs computed in advance of production, based on specification and past data. These include:
  • Estimated Cost: based on rough estimates.
  • Standard Cost: scientifically predetermined cost used as a benchmark for control.

B. On the basis of Decision-Making (Relevance):

• Relevant Cost: Costs that are affected by a decision and hence considered in decision-making (e.g., differential cost, opportunity cost, marginal cost).
• Irrelevant Cost: Costs that are not affected by a decision and are ignored (e.g., sunk cost, committed fixed cost).
• Imputed / Notional Cost: Hypothetical costs not actually incurred but considered for decision-making (e.g., notional rent of owned premises).
• Out-of-pocket Cost: Costs involving actual cash outflow, relevant for certain short-term decisions.

This classification helps management select only those costs that are pertinent to the specific decision being made.