Module 5

Lecturer – CA. Sonali Jagath Prasad

COST ACCOUNTING
 COST ACCOUNTING is the classifying,
recording and appropriate allocation of
expenditure for the determination of the costs
of products or services, and for the
presentation of suitably arranged data for the
purpose of control and guidance of
management.
 “Management Accountancy is the blending
together into a coherent whole, financial
accounting, cost accountancy and all aspects
of financial management.” -Batty
Basis of classification :

 Nature of expense
 Functions / activities
 Behaviour
 Management decision making
 Production Process
 Time period.

3
By Nature of expense:
 Costs should be gathered
together in their natural
groupings such as material,
labour and other expenses.
 The elements of cost can be
classified in the following three
categories : i) Material ii)
Labour iii) Expenses

4
MANUFACTURING COSTS
1. Direct Materials (DM)
 Materials that are consumed in the
manufacturing process and physically
incorporated in the finished product
 Materials whose cost is sufficiently large to
justify the record keeping expenses necessary
to trace the costs to individual products
MANUFACTURING COSTS
2. Direct Labor (DL)
 Labor time that is physically traceable to the
products being manufactured
 Labor time whose cost is sufficiently large to justify
the record keeping expenses necessary to trace the
costs to individual products
Example:
Direct labor for manufacturing Honda Accords
 Line workers, robot operators, painters, assembly
workers
Any labor probably not included in direct labor?
 Factory janitors, factory supervisors, factory
secretaries
MANUFACTURING COSTS
3. Manufacturing Overhead (OH)
All of costs of manufacturing excluding direct materials and
direct labor

a. Indirect Materials (IM) – Materials, used in the

manufacturing of products, which are difficult to trace to
particular products in an economical way
 Glue, nails, cleaning supplies

b. Indirect Labor (IL) – Labor, used in the manufacturing of

products, which is difficult to trace to particular products in
an economical way
 Wages for maintenance workers, factory supervisor’s
salary, idle time
MANUFACTURING COSTS
C. All other types of manufacturing
overhead
 Depreciation on machinery,
depreciation on factory building,
factory insurance, utilities for factory
By functions or activities
 Costs should be classified according to
the major functions for which the elements
are used into the following four major
functions :
 Production;
 Administration;
 Selling & Distribution; and
 Research & Development Expenditure.

9
NON-MANUFACTURING COSTS
1. Marketing or Selling Costs – Costs incurred in
securing orders from customers and providing
customers with the finished product
 Sales commissions, costs of shipping products to
customers, storage of finished goods,
depreciation of selling equipment (cash register)

2. Administrative Costs – Executive, organizational,

and clerical costs that are not related to
manufacturing or marketing
 CEO’s salary, cost of controller’s office,
depreciation on administrative building.
Nature of Costs
Categorization of Costs
Question
 Give examples of the following type of costs

Costs Fixed Variable

Direct Plant & Machinery 1. Hourly wages
2. Materials
3. Performance
linked bonuses
Indirect 1. Administration expns 1. Packaging
2. CEO salary 2. Power
3. Rent 3. Shipping costs
4. Insurance 4. Casual staff
Methods of Costing - Used to ascertain the cost of output -
Methods of Costing - Used to ascertain the cost of output -
Final output of intermediary output (i.e. Product, Service,
Final output of intermediary output (i.e. Product, Service,
Job, Contract, etc.) There are various methods of costing
Job, Contract, etc.) There are various methods of costing
such as - 1.Process Costing, 2.Job Costing, 3.Contract
such as - 1.Process Costing, 2.Job Costing, 3.Contract
Costing, 4.Service(Operations) Costing, 5.Batch Costing,
Costing, 4.Service(Operations) Costing, 5.Batch Costing,
6.Multiple Costing (Combination of two or more of the above
6.Multiple Costing (Combination of two or more of the above
methods in case of a complex production system.
methods in case of a complex production system.
Techniques of Costing - Used to control and reduce the cost
Techniques of Costing - Used to control and reduce the cost
of output - Final output of intermediary output (i.e.
of output - Final output of intermediary output (i.e.
Product, Service, Job, Contract, etc.) There are various
Product, Service, Job, Contract, etc.) There are various
techniques of costing such as - 1. Activity Based
techniques of costing such as - 1. Activity Based
Costing(ABC), 2.Marginal Costing, 3.Absorption Costing, 4.
Costing(ABC), 2.Marginal Costing, 3.Absorption Costing, 4.
Historical Costing, 5. Direct Costing 6. Standard Costing.
Historical Costing, 5. Direct Costing 6. Standard Costing.
Different company's may use different methods or techniques
Different company's may use different methods or techniques
with variations to suit their industry or business & other
with variations to suit their industry or business & other
practical considerations. The whole purpose of
practical considerations. The whole purpose of
use/application of any costing method or technique is to
use/application of any costing method or technique is to
ascertain the output cost on regular basis and strive for
ascertain the output cost on regular basis and strive for
control and reduction of cost with out hampering the quality
control and reduction of cost with out hampering the quality
of the product (It's endeavor of any company to improve the
of the product (It's endeavor of any company to improve the
quality & performance of their product/service on a
quality & performance of their product/service on a
continuous basis)
continuous basis)
Absorption Costing
 All costs incurred are allocated
to particular cost centres – direct costs, indirect
costs, semi variable costs and selling costs
 Allocates indirect costs to the point where the
cost occurred
 It is the costing system which treats all
manufacturing costs including both the fixed and
variable costs as product costs
Marginal Costing
 It is a costing system which treats only the
variable manufacturing costs as product
costs. The fixed manufacturing overheads
are regarded as period cost
INVENTORIABLE COSTS AND PERIOD
COSTS
 Inventoriable cost/ product cost is that cost which is regarded as
asset when incurred, but becomes a part of cost of goods sold when
the product is sold. For MUL, all manufacturing cost is inventoriable
cost. (Raw material to WIP to Finished goods) For a service sector
unit, absence of inventory means all are period costs.

 Period costs (non-product cost): all costs in P&L account except cost
of goods sold. So, in a mfg. sector unit, all non-manufacturing costs
are period costs. (Ex. Distribution cost, design cost, R&D costs,
Marketing costs, customer-service costs, etc.)
Variable and Absorption Costing
Variable and Absorption Costing
 Difference between Variable and
Absorption Costing
1) Both fixed and variable cost are considered for 1) Only variable cost is considered for product
product costing and inventory valuation. costing and inventory valuation.

2) The fixed cost is charged to cost of production. 2) Treatment of fixed overhead is different.
Each product is to bear a reasonable share of fixed Fixed cost is considered as a period cost. And
cost and profitability of product is thus influenced profitability of different product is judged by P/V
by subjective apportionment of fixed cost. ratio.

3) Presentation of cost is on conventional pattern. 3) Production of data is oriented to highlight the

Net profit of each product is determined after total contribution and contribution from each
deducting fixed overheads. product.

4) The difference in the magnitude of opening stock 4) The difference in the magnitude of opening stock
and closing stock affects the unit cost of production and closing stock does not affect the unit cost of
due to the impact of related fixed overheads. production.

Over and Under Absorbed Overheads

In absorption costing, fixed overheads can never be absorbed exactly because of difficulty in
forecasting costs and volume of output. If these balances of under or over absorbed/recovery are not
written off to costing profit and loss account, the actual amount incurred is not shown in it. In marginal
costing, however, the actual fixed overhead incurred is wholly charged against contribution and hence,
there will be some difference in net profits.
Limitations of Absorption Costing-
 1) In practice, this method employs highly arbitrary method of apportionment
of overhead. This reduces the practical utility of cost data for control
purposes.
2) Under absorption costing, fixed cost relating to closing stock is carried
forward to the next year. Similarly, fixed cost relating to opening stock is
charged to current year instead of previous year. Thus under this method,
all the fixed cost is not charged against the revenue of the year in which
they are incurred. It is an unsound practice.
3) Under the absorption costing collection of cost data is not very useful fir
decision making., because the process of assigning product cost a
reasonable share of fixed overhead obscures cost-volume-profit
relationship.
4) Under the absorption costing, behavior pattern of cost is not highlighted
and thus many s\situations which can be utilized under the marginal costing
are likely to go unnoticed under the absorption costing.
Advantage of Marginal Costing
 1) Variable cost remains constant per unit of output and fixed cost remain constant in
total during short period. Thus, control over the cost becomes more effective and
easier. Standards can be established for fixed cost in order to exercise full control
over the total activities.
2) Marginal costing brings out contribution and profit margin per unit of output and
clearly brings out the effect of the change in activity. If facilities making policy
decision in a number of managerial problems, such as, determining profitability of
products, introducing a new product, discontinuing a product, fixing selling price,
deciding whether to make or buy, utilizing spare capacity, profit planning.
3) The distinction between the product cost and period cost helps easy understanding
of marginal cost statements.
4) Closing inventory of work-in- progress and finished goods are valued at marginal
or variable cost only. This method leads to greater accuracy in arriving at profit as it
eliminates any carry over of fixed costs of the previous period through inventory
valuation.
5) As a corollary to above, since fixed cost do not enter in to product cost, it
eliminates the process of allocating, apportioning and absorbing overheads, and
adjusting under and over absorbed overheads. Therefore, the method is simpler to
operate.
Limitation of Marginal Costing
1) The technique is based on the segregation of costs in to fixed and variable ones, while
many expenses are neither totally fixed nor totally variable at various levels of activity. Thus
classifying all expenses in to two categories of either fixed or variable is a difficult task.

2) The assumption regarding behavior of cost such as fixed cost remains static , are often
not realistic.

3) Contribution is not only index to take future decision. Foe example, where fixed cost is
very high, selling price should not be fixed on the basis of contribution alone without
considering other key factors such as capital employed.

4) Marginal cost, if confused with total cost while fixing selling price may lead to a disaster.

5) Inventory valuation at marginal cost will understate profits and may not be acceptable by
the Tax authorities. Any claims based on cost will be very low. As it will not have share of
fixed cost.
APPLICATION OF MARGINAL
COSTING IN DECISION MAKING
 Decision making is one of the most important functions of the management.
Success of business planning highly depends on the Decision Making
capacity of the management.
 Decision Making means the process of choosing the best one among the
various alternative actions.
 For any business planning and control, the management is engaged in
search of the most appropriate course of action.
 Among the various alternatives feasible to the management, it has to
choose the best one from the point of view of the business concern.
 However, choosing the best alternative among the various options requires
an evaluation of all feasible alternatives for which relevant quantitative and
qualitative information are essentially available to the management.
 On the basis of these information, the management takes a decision on the
concerned issue which deals with the future. Such decision should also
affect the cost and other business factors.
COST CONCEPTS IN DECISION
MAKING…
 There are certain concepts of cost which are used in the process of cost
analysis for Decision Making, which are discussed as follows:
 Marginal Cost: Marginal Cost is the Variable Cost of producing a product. It
includes direct and indirect Variable Costs (i.e., prime cost and overheads)
incurred for the product, but it does not include any Fixed Cost. While
determining the cost of a product under Marginal Cost technique, only the
Variable Costs incurred for the product are taken into consideration and
Fixed Costs are ignored.
COST CONCEPTS IN DECISION
MAKING…
Differential Cost:
Differential Cost refers to the difference in the cost between various
alternative courses of action.
More clearly, it means changes in costs due to a change in the output level, a
change in the sales volume, a change in the product/sales mix, the make or
buy decision, an alternative method of production and so on. In case of such
change in cost due to a change in the output level, the change in cost due to
an increase in the output level is called ‘incremental cost’ and the change in
cost due to a decrease in the output level is called ‘decremental cost’.
Both incremental as well as decremental costs are called ‘Differential
Cost.’ For achieving business objectives to maximize the profit (or minimize
the loss), the management should evaluate these Differential Costs with the
differential revenues of the identified various alternatives to choose the best
alternative which will provide the maximum return to the business.
Most of the time, Differential Costs are considered by the management in the
course of Decision Making.

Relevant costing
 A relevant cost is a cost that differs between alternatives
 An avoidable cost is a cost that can be eliminated, in whole or in part, by
choosing one alternative over another.
 Avoidable costs are relevant costs. Unavoidable costs are irrelevant costs.
 Two broad categories of costs are never relevant in any decision. They
include:
 Sunk costs.
 Future costs that do not differ between the alternatives.
 Make or Buy Decision
 Make-or-buy decisions usually involve whether the company should
produce something itself or by it from outside
 If the cost to purchase the product from outside is lower that the
avoidable cost of internal production, the company should buy
the product from the outside.
 Relevant costs to be considered for analysis:
– Direct variable cost of in-house production
– Avoidable fixed costs saving
 Qualitative Issues to be considered
– Allows access to specialized knowledge or technology
– Benefit from economies of scale of the supplier
– Access to raw materials
– Quality control
– Supply chain management
Make or Buy Decision -
Example

$ 12.00 per unit

$ 1.50
 Special Orders
 Special orders revolve considers whether to accept a one-off order at
lower than normal selling price
 Key considerations for the decision:
– Difference in prices
– The opportunity cost of accepting the order
– Is the company operating at below or at full capacity
– Break-up of costs between variable and fixed costs
Special Orders - Example
Continue or Drop a Product
 Continue or drop a product
Factors which need to be considered long term:
•Is this a marketing tool?,
•does it draw people in who buy other products?,
•Does it help or hinder our long term image or reputation?
•What is the long run market for this product going to look like?
•Regular customer base buying these products- cannot upset them
Short run factors for consideration:
•Is this product profitable, and if it is not is this because of the way our
accountants have allocated fixed overhead to the product various
product lines?
•Is continuing this product the best available use of our resources?
•Is this product consuming a scarce resource which could be used to
make other things?
•Are our production resources a sunk cost?