Cost Accounting chapter - 1

CHAPTER – 1

Introduction to Cost Accounting

Branches of Accounting:
 Financial Accounting
 Cost Accounting
 Management Accounting

Cost Accounting is a branch of accounting which specializes in the ascertainment of cost of

products and services. It is for use by management. It is important to understand three terms i.e.
cost, costing and cost accounting.

Meaning and definition of Cost:

Cost is an amount of expenses incurred on the production of a particular goods or service.

“It is the amount of expenditure incurred on or attributable to a given thing” – CIMA

London

Meaning and definition of Costing:

Costing is a process in which we use different techniques to ascertain the various costs. Thus,
costing simply means cost finding by any process or technique.

The Chartered Institute of Management Accountants (CIMA) of UK has defined costing as, “the
techniques and processes of ascertaining costs”.

Meaning of Costing Accounting:

Costing Accounting is the process of recording, classifying, allocating and reporting the various
costs incurred in the operation of an enterprise.

Objectives or Importance or Functions of Cost Accounting

The main objectives of cost accounting are as follows:
(1) Ascertainment of cost:
This is the primary objective of cost accounting. In other words, the basic objective of
cost accounting is to ascertain the cost of products and services. For cost ascertainment
different techniques and systems of costing are used in different industries.

(2) Control and reduction of cost:

Cost Accounting aims at improving efficiency by controlling and reducing cost. This
objective is becoming increasingly important because of growing competition.

(3) Guide to business policy:

Cost accounting aims serving the needs of management in conducting the business with
utmost efficiency. Cost data provides guidelines for various managerial decisions like
make or buy, selling below cost, utilization of idle plant capacity, introduction of a new
product, etc.

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Cost Accounting chapter - 1
(4) Determination of selling price:
Coat Accounting provides cost information on the basis of which selling prices of
products or services may be fixed. In periods of depression, cost accounting guides in
deciding the extent to which the selling prices may be reduced to meet the situation.

(5) Measuring and improving performance:

Cost accounting measures efficiency by classifying and analyzing cost data and then
suggest various steps in improving performance so that profitability is increased.
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.

Advantages of Cost Accounting:-

A. Advantages of Management
1. Reveals profitable and unprofitable activities:
2. Helps in cost control:
3. Helps in decision making:
4. Guides in fixing selling prices:
5. Helps in inventory control:
6. Aids in formulating policies:
7. Helps in cost reductions:
8. Reveals idle capacity:
9. Checks the accuracy of financial accounts:
10. Prevents frauds and manipulation:

B. Advantages to Workers:
Workers are benefited by introduction of incentive plans which is an integral part of a
cost system. This results not only in higher productivity but also higher earnings for
workers.

C. Advantages to Society:
An efficient cost system is bound to lower the cost of production, the benefits of which
are passed on to the public at large in the form of lower prices of products and services.

D. Advantages to Government Agencies and Others:

A cost system produces ready figures for use by government, wage tribunals, trade
unions, etc., for use in problems like price fixing, wage level fixation, settlement of
industrial disputes, etc.

Limitations of Cost Accounting:-

(1) It is not necessary.
(2) It is expensive.
(3) It is inapplicable.
(4) It is a failure.
(5) Matter of routine forms and statement

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Cost Accounting chapter - 1
Essentials of Good Cost Accounting System:-
a) Suitability.
b) Specially designed system.
c) Support of executives.
d) Cost of the system.
e) Clearly defined cost system centers.
f) Controllable cost.
g) Financial Integration.
h) Continuous Education.
i) Prompt and Accurate reports.
j) Avoid unnecessary details.

Difference between cost accounting and financial accounting

Financial accounting Costing Accounting
The main purpose of financial accounting The main purpose is cost control and cost
is to fulfil the legal aspects and to know reduction.
the financial position of the firm.

Only for external use It is for both external and internal use.

Records only external transactions. It records both external and internal

transactions.
It is historical in nature It is historical and futuristic as well
It is mandatory as per companies act and It is not mandatory for all the businesses
income tax act for all business (except few business)
undertakings
Single uniform format of presenting Cost accounting has different format of
information presenting information.

Charts or graphs are not used to present Charts or graphs are used to present the
the information information
It prepares and presents reports annually It prepares and presents reports whenever it
required. (i.e. daily, weekly, monthly,
quarterly, half yearly or annually)
It does not show profit or loss on each It show profit or loss on each product or job
product or job or order individually or order individually

Stock is valued at market price or cost Stock is valued at cost only

whichever is less

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Cost Accounting chapter - 1
Classification of Cost:
Classification into Direct and Indirect cost

 Direct cost: Direct cost are those cost which are incurred for and conveniently identified
with a particular cost units, process or department.

Ex.: Cost of Raw Materials used & wages of machine operator are common examples of
direct cost.
 Indirect cost: General cost and are incurred for the benefit of a number of cost units,
processes or departments. Indirect costs cannot be conveniently identified with a
particular cost unit or cost Centre.
Ex.: Depreciation of machinery, insurance, lighting, power, rent, managerial salary
etc…

Classification of fixed and variable cost

 Fixed cost: These are those costs which do not increase or decreases when the volume
of production changes.
Ex.: Building rent, managerial salaries etc…
 Variable cost: It tend to vary in direct proportion of output. In other words when the
volume of output increases the total volume of variable also increases, when the
volume of output decreases the total volume of variables also decreases.
Ex.: Direct materials, direct wages, power small tools, royalties.
 Semi variable cost: These costs include both fixed and variable cost that is these are
partly fixed and partly variable. A semi variable cost has often a fixed element below
which it cannot fall at any level of output, semi variable cost is also called semi fixed
cost or mixed cost.
Ex.: Telephone expenses

Classification into controllable and uncontrollable cost

 Controllable cost: They are the cost which may be directly regulated at a given level of
management authority. Variable cost generally controllable by department heads.
Ex.: Cost of raw material may be controlled by purchase in larger quantities.
 Non controllable cost: These are those costs which cannot be influenced by the action
of a specified member of an enterprise.
Ex: It is very difficult to control COSB like factory rent, managerial salaries etc.

Classification into Historical cost and Pre-determined cost

 Historical cost: these are past cost which are ascertained after these have been incurred.
Historical cost are thus nothing but actual costs. These costs are not available until after
the completion of manufacturing operations.
 Pre-determined: These are those future cost which are ascertained in advance of
production on the basis of a specialization of all the factors affecting cost. These costs
are extensively used for the purpose of planning and control.

Classification into Normal and Abnormal cost

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Cost Accounting chapter - 1
 Normal cost: It may be defined as cost which is normally incurred on expected lines at a
given level of output. This is a part of cost of production.
 Abnormal cost: Abnormal cost is that which is not normally incurred at a given level of
output. Such cost is over & above the normal cost and is not treated as a part of cost of
production. It is charged to costing profit and loss account.

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Cost Accounting chapter - 1
Classification of cost for decision making
Sunk cost
sunk cost is a cost that already been incurred and that cannot be changed by any decisions
made now or in the future. Sunk cost is also known as actual cost.

Differential cost (incremental cost)

differential cost is the increase or decrease in total cost that results from an alternative course of
action. Ex. Changing production process.

Marginal cost
marginal cost is the additional cost of producing one additional unit. Marginal cost is the same
thing as variable cost.

Opportunity cost
opportunity cost may be defined as the potential benefit that is lost or sacrificed when the
selection of one course of action makes it necessary to give up competing course of action.

Replacement cost
replacement cost is the current market cost of replacing an asset.

Out of pocket cost (Explicit cost and Implicit cost)

Out of pocket cost also known as Explicit costs, Out of pocket cost are those costs that involve
cash outlays or require the utilization of current resources.

In simple words for anything you paid from your pocket.

Other than out of pocket cost is depreciation for which you does not pay from your pocket.

Future cost
any cost which is going to incur in the future year.

Conversion cost
It is the cost of converting a raw material into finished product. This term is used to denote the
sum of direct labour and factory overheads cost in the production of a product.

Cost Centre and Cost Unit

Cost Centre: (for which cost is ascertained)
According to CIMA of UK defined cost centre as “A location, person, or item of equipment (or
group of these) for which cost may be ascertained and used for the purpose of control”.
Example. Cost may be ascertained for a person, department, sub branch, machine etc.

The main purpose of ascertaining the cost of a cost centre is to control the cost.

Two types of Cost Centre:

(a) Production cost center: These is the cost centre were actual production work take place.

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 Cost Accounting chapter - 1
Ex: Melting shop, machine department, welding department, finishing shops etc.
(b) Service cost center: This is the cost center which are ancillary to and render service to
production cost centers.
Ex: power house, tool room, stores department, repair shop, canteen etc.

Cost Unit (in terms of which cost is expressed)

It is a step further of cost center which breaks up the cost of a cost center into smaller sub-
divisions and helps in ascertaining the cost of saleable products & service. Ex: kilogram, tonne,
meter, liter, hour, km etc…

According to CIMA of UK cost unit refers to “Unit of product, service or time in relation to
which cost may be ascertained and expresses.

Cost Units may be classified into:

(1) Units of production:

Ex: A kilogram of a chemical, a ream of paper, a tone of steel, a meter of cable etc.
(2) Units of services:
Ex: A kilometer or a tone kilometer, a cinema seat, a consulting hour etc.

Cost

Direct Cost Indirect Cost

Direct material Indirect material

Direct Labour Indirect Labour
Direct Expenses Indirect Expenses

Over head

Factory Administration Selling overhead Distribution

overhead overhead overhead

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Cost Accounting chapter - 1
1) Material cost: It is cost of various items of materials used by an undertaking for
production and sale of product or service.
It can be classified into two types

a) Direct Material: The material which enter in to and forms part of the finished
product (or) it is used for primary packaging of products.
For Exp: cloth in garments, leather in hoses, timber in furniture, cartons, craft paper,
carriage octori etc.

b) Indirect material: The material which do not form part of the finished product
For Exp: Lubricants consumable stores, cotton waste etc.

2) Labour Cost: It is remuneration like wages, salary, commission, bonus etc.

It can be classified into two types:
a) Direct Labour: It is also known as called direct wages, the direct labour cost is the
cost of labour directly engaged in manufacturing.
b) Indirect Labour: The wages paid to workers who facilitate assisting indirectly to the
manufacturing process.
For Exp: wages of supervisor, foreman, inspector, watchman etc.

3) Expenses: The cost of service provided to an undertaking and the notional cost of the
use of owned assets. There are two types: a) Direct Expenses b) Indirect Expenses

a) Direct Expenses: The expenses which can be identified with or allocated to cost unit
or cost center. For Exp: excise duty, travelling expenses, relating to a job
experimental cost of job, cost of patent, royalty, cost of design etc.
b) Indirect Expenses: The expenses are those other than indirect material cost and
indirect Labour cost which cannot be directly identified with a particular job, process
or work order but are common to job or processes. For Exp: rent and tax,
depreciation, insurance, office and administration expenses, lighting etc.

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 Cost Accounting chapter - 1
Cost control and cost reduction

Definition of Cost Control

Cost Control is a process in which we focus on controlling the total cost through competitive analysis. It is a
practice which works to align the actual cost in agreement with the established norms.

It ensures that the cost incurred on production should not go beyond the pre-determined cost. Cost Control
involves a chain of various activities, which starts with the preparation of the budget in relation to production.

Definition of Cost Reduction

Cost Reduction is a process, which aims to lower the unit cost of a product manufactured or service rendered
without affecting its quality. It can be done by using new and improved methods and techniques. It ascertains
substitute ways to reduce the production cost of a unit.

Thus, cost reduction ensures savings in per unit cost and maximization of profits of the enterprise. Cost
Reduction aims at cutting off the unnecessary expenses which occur during the production Process, storage,
selling and distribution of the product. To identify cost reduction we should focus on the following major
elements:

Difference between Cost Control and Cost Reduction

The following are the main differences between Cost Control and Cost Reduction:

1. Cost Control focuses on decreasing the total cost of production while cost reduction focuses on decreasing
per unit cost of a product.

2. Cost Control is a temporary process in nature. Unlike Cost Reduction which is a permanent process.

3. The process of cost control will be completed when the specified target is achieved. Conversely, the
process of cost reduction is a continuous process. It has no visible end. It targets for eliminating wasteful
expenses.

4. Cost Control does not guarantee quality maintenance of products. However, cost reduction assured 100%
quality maintenance.

5. Cost Control is a preventive function because it ascertains the cost before its occurrence. Cost Reduction is
a corrective function.

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