Introduction to Cost Accounting PDF

Introduction to Cost Accounting Introduction 1.1 One important definition of accounting put forward by American Accounting Association reads as follows: ‘Accounting is the process of identi...

Introduction to Cost Accounting Introduction 1.1 One important definition of accounting put forward by American Accounting Association reads as follows: ‘Accounting is the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information’. From the above definition it is obvious that accounting is a process which as its end product, has information that is economically worthwhile for decision making. Further, accounting is concerned with providing both financial and non-financial information that will help decision-makers to make appropriate decisions based on informed judgements. This is pictorially represented as follows: Information Financial Information Non-Financial information Cost information Combination of financial and non financial information ‘Other’ Financial Information Figure 1.1: Types of Information From the above it is clear that cost information is a type of financial information that is related to the cost of the product or service. Cost Accounting, which is a branch of accounting, deals with the whole gamut of preparation and presentation of cost information. It is important to note that information provided by the cost accounting system1 is referred as cost information which particularly includes the following: a. The unit cost of a product, work or service b. Various elements of cost of a department or a factory or any other cost object. c. The volume of waste and the technological loses d. The costs related to the number of activities e. cost analysis (for decision making) 1. Cost accounting system is the discussed subsequently under ‘scope of cost accounting’ and also in module 6 of this study note. The Institute of Cost Accountants of India 5 Cost Accounting it is important to note that;  Users of financial information – Accounting is often referred as a language of the Business which helps the business to communicate with the stakeholders who are people who have an interest in an organization. Thus, the stakeholders of the business are the users of accounting information. These people are categorised as managers, shareholders and potential investors, employees, creditors and the government and each of these groups has its own requirements for information2. It is important to note that the stakeholders are either internal (managers, shareholders, employees, creditors) or external (potential investors and government). It is important to note that the management accounting is concerned with the provision of information to people within the organization (internal users) to help them make better decisions and improve the efficiency and effectiveness of existing operations, whereas financial accounting is concerned with the provision of information to external users. Thus, management accounting is often related to internal reporting while financial accounting is related to external reporting.  Quality of financial information – the success or failure of an organisation depends to a great extent on the effectiveness and efficiency of the decisions made. For example, during the early period of lockdown brought about by the COVID 19, Mr Keshubhai, a vegetable vendor adjusted to the new normal within few days and started online transactions and home delivery during 7 pm to 8 pm and 7 am to 8 am when lockdown was eased. While Mr Bikram, who sells vegetables in the same Bazar was undecided and waited for the lockdown to end. The decision made by the two vegetable vendors is being made on the basis of the information they possess at the time of making the decision3. Thus, one of the basic aspects of accounting is to generate quality financial information for the users such that they can make efficacious decision making which lead to successful business. From the above discussion it is apparent that the main purpose of accounting is to create financial information which is used by users (internal and external). There is specific information need of each individual user. While the internal users would require financial information, which would provide information to people within the organization to help them make better decisions and improve the efficiency and effectiveness of existing operations, ultimately leading to a successful business. This is the arena of management accounting and the financial information is referred as cost information for the purpose of this study note. While financial accounting is concerned with the provision of information to users external to the organization. It is of prime importance to point out that cost accounting and management accounting are often used interchangeably though there is significant difference between the two in respect of the purpose they serve and the scope of the two. Cost accounting discusses the nuances of the process of cost accumulation for fixation of sale price, valuation of inventory and taking other operating decisions. This is required for profit calculation and external reporting, as and when necessary. Whereas management accounting relates to the provision of appropriate information for decision- making, planning, control and performance evaluation. However, a study of the literature reveals that the distinction between cost accounting and management accounting is not clear cut and the two terms are often used synonymously4. 2. Students may note that in Para 9 of Framework for the Preparation and Presentation of Financial Statements in accordance with Indian Accounting Standards issued by ICAI, the users of financial statements and their information needs are mentioned with specificity and in Para 10, the financial information need of Investors are set as the most important information need as it is stated that their information need would suffice the information need of the other users. 3. This is, off course, a non-financial information, and is being used here for the sake of understanding the link between a decision and a success/ failure of a business. 4. For detailed discussion, readers may refer to chapter 1, Management and Cost Accounting, eighth edition by Colin Drury. 6 The Institute of Cost Accountants of India  Introduction to Cost Accounting 1.1.1 Evolution of Cost Accounting The double entry system of accounting was initiated in 1494. Since then, till the after period of Industrial Revolution cost accounting remained as a small branch of financial accounting. The need for information on internal operation and the competitive business environment ushered by the Industrial revolution acted as catalyst in the development cost accounting. Firms, such as textile mills and railroads, were compelled to devise internal administrative procedures to coordinate the various operations involved in the performance of the basic activity of conversion of raw materials into finished goods by textile mills and the transportation of passengers and freight by the railroads. During 1880s, the newly formed mass distribution and mass production enterprises adapted the internal accounting reporting systems of the railroads to their own organizations. But all these along with the adaptations were exclusively focussed on direct labour and direct material (prime costs). The scientific management movement provided a major impetus to the development of cost accounting practices. The period 1880 - 1925 saw the development of complex product designs and the emergence of multi activity diversified corporations like Du Pont, General Motors etc. It was during this period that scientific management was developed which led the accountants to convert physical standards into Cost Standards, the latter being used for variance analysis and control. During the World War I and II the social importance of Cost Accounting grew with the growth of each country’s defence expenditure. In the absence of competitive markets for most of the material required for war, the governments in several countries placed cost-plus contracts under which the price to be paid was cost of production plus an agreed rate of profit. The reliance on cost estimation by parties to defence contracts continued after World War II. In India, prior to independence, there were a few Cost Accountants, and they were qualified mainly from I.C.M.A. (now CIMA) London. During the World War II, the need for developing the profession in the country was felt, and the leadership of forming an Indian Institute was taken by some members of Defence Services employed at Kolkata. However, with the enactment of the Cost and Works Accountants of India Act, 1959, the Institute of Cost and Works Accountants of India (erstwhile The Institute of Cost Accountants of India) was established at Kolkata. The profession assumed further importance in 1968 when the Government of India introduced Cost Audit under section 233(B) of the Companies Act, 1956. At present it is under Section 148 of the Companies Act, 2013. Many times, we use Cost Accounting, Costing and Cost Accountancy interchangeably. But there are subtle differences among these terms. Though the terms are used interchangeably, it is important to know the precise meaning of the terms. 1.1.2. Three Basic Definitions From discussions in the previous section, it is obvious that cost accounting is a specific branch of the Accounting which caters to the financial (cost) information needs of the users. Cost and management accountancy primarily accommodates the financial information needs of the internal users8. But financial accountancy records and reports which culminates in the preparation of financial statements of an organisation is solely targeted towards the financial 5. Summa de arithmetica, geometria. Proportioni et proportionalita, a textbook for use in the schools of Northern Italy, was published in Venice in 1494. Though the book is basically on the synthesis of the mathematical knowledge of his time it is also notable for including one of the first published descriptions of the bookkeeping method that Venetian merchants used during the Italian Renaissance, known as the double- entry accounting system. 6. https://archive.org/details/scientificmanage00tayl 7. For a comprehensive understanding of the evolution of cost and management accounting, students are advised to refer The Evolution of Management Accounting by Robert S. Kaplan Source: The Accounting Review, Jul., 1984, Vol. 59, No. 3 (Jul., 1984), pp. 390-418, Published by: American Accounting Association. 8. Though in some specific cases, cost accounting records and reports are used by external users, management accounting is solely cater to the financial information needs of the internal users. The Institute of Cost Accountants of India 7 Cost Accounting information need of the external users. Thus, it would not be an exaggeration to highlight that cost and management accountancy is specifically aligned to the accomplishment of the strategic goal of an organisation as decision making is the epicentre of strategic success/failure. Before entering into the nuances of the academic discipline of cost accountancy it is essential to read into the three basic conceptual issues which are discussed in the following lines. 1. Cost Accountancy: - Cost Accountancy is the academic discipline of cost accounting and is defined as ‘the application of costing and cost accounting principles, methods and techniques to the science and art and practice of cost control and the ascertainment of profitability as well as presentation of information for the purpose of managerial decision making.’ Four particular points summarizes the above-mentioned definition. a. The application of the costing and cost accounting principles is encompassed in cost accountancy. b. This application is with specific purpose and that is for the purpose of cost control, ascertainment of profitability. c. Cost accounting is a combination of art and science; it is a science as it has well defined rules and regulations, it is an art as application of any science requires art and it is a practice as it has to be applied on continuous basis and is not a onetime exercise. d. Cost accountancy merely caters to the need of the cost information need of the management which facilitate decision making. 2. Cost accounting - CIMA Official Terminology defines cost accounting as the process of gathering of cost information and its attachment to cost objects, the establishment of budgets, standard costs and actual costs of operations, processes, activities or products; and the analysis of variances, profitability or the social use of funds. Thus, cost accounting encompasses the following; a. One of the main purposes of cost accounting is gathering of cost information related to cost objects. This cost information is then suitably presented to the management which aides them in their decision-making process. b. Nuances of cost accounting includes the process of cost accumulation through which the cost of operations, processes or activities or products is calculated. Establishment of standard cost and variance analysis are important aspects9. c. Computation profitability10 which pivots around fixation of selling price is an important aspect of cost accounting. 3. Costing - CIMA Official Terminology specifically states that the use of the term costing is not recommended except with a qualifying adjective, for example standard costing. The term is used in the following connotations; batch costing, continuous operation costing, contract costing, job costing, service costing, specific order costing, absorption costing and marginal costing. Thus, it is important to note that the term ‘costing’ is only to be used as a qualifying adjective 1.1.3. Objectives of Cost Accounting: It is reiterated that the very basic objective of Cost Accounting is preparation and presentation of cost information. The details of the basic objective are summarized in the following lines. 9. It is important to note that these are really aspects of management accounting as has been discussed previously. It has also been discussed that the arena of cost accounting and management are often blurred and is not specifically demarcated though the two covers comprehensively different aspects of dealing with cost information. 10. It is important to note that ‘social use of funds and ‘profitability’ have been synonymously used by The Document. 8 The Institute of Cost Accountants of India  Introduction to Cost Accounting 1. To ascertain the cost of production on per unit basis, for example, cost per kg, cost per meter, cost per litre, cost per ton etc. 2. Cost accounting helps in the fixation of selling price. Cost accounting enables to determine the cost of production which helps to fix the selling price. 3. Cost accounting helps in cost control and cost reduction. 4. Ascertainment of division wise, activity wise and unit wise profitability is analysed through cost accounting. 5. Cost accounting also helps in locating wastages, inefficiencies and other gaps in the production processes and services offered. 6. Cost accounting helps in presentation of relevant data to the management which helps in decision making. Decision making is the most important functions of Management which has specific linkages to the strategic success/failure of an organisation. 1.1.4. Scope of Cost Accounting The scope of cost accounting is broad and is directed into the operations of the organisation. Thus a proper functioning cost accounting system ensures the strategic success/ failure of the organisation.  Cost book-keeping11 - It involves maintenance of records of all costs incurred from their incurrence to their charge to departments, products and services. Such recording is done on the basis of double entry system.  Cost ascertainment - Ascertaining cost of products, processes, jobs, services, etc., is the important function of cost accounting. Cost ascertainment becomes the basis of managerial decision making such as pricing, planning and control.  Cost Analysis - It involves the process of finding out the causal factors of actual costs varying from the budgeted costs and fixation of responsibility for cost increases.  Cost Comparisons - Cost accounting also encompasses comparisons between cost from alternative courses of action such as use of technology for production, cost of making different products and activities, and cost of same product/ service over a period of time.  Cost Control - Cost accounting also includes the utilization of cost information for exercising control. It involves a detailed examination of each cost in the light of benefit derived from the incurrence of the cost. Thus, cost is analyzed to recognize whether the current level of costs is satisfactory in the light of standards set in advance.  Cost Reports - Presentation of cost is the ultimate function of cost accounting. These reports are primarily for use by the management at different levels. Cost Reports forms the basis for planning and control, performance appraisal and managerial decision making.  Cost Audit - Cost Audit is the verification of correctness of Cost Accounts and check on the adherence to the Cost Accounting plan. Its purpose is not only to ensure the arithmetic accuracy of cost records but also to see the principles and rules have been applied correctly. 1.1.5. Cost Accounting Systems Systems and procedures are devised for proper accounting for costs. Such a system is referred as a cost accounting system. The design of such a system varies significantly and depends on the type of the product/service of the organisation. As such six types of cost accounting system may be identified. These are listed as under. 11. This is covered in module 4 of this study note. The Institute of Cost Accountants of India 9 Cost Accounting 1. Historical Costing In this type of costing system, the costs are ascertained only after they have been incurred. The main objective of it is to ascertain costs that have been incurred in past. It is the process of accumulation of costs after they are incurred in a systematic manner. The historical costs are used only for post-mortem examination of actual costs incurred and it would be too late to control. The actual figures can be compared only when the standards of performance exist. 2. Absorption Costing12 Under the ‘absorption costing system’ all fixed and variable costs are allotted to cost units and total overheads are absorbed according to activity level. In absorption costing system, fixed manufacturing overheads are allocated to products, and these are included in stock valuation. Therefore, valuation of inventories of finished goods and work in progress includes manufacturing fixed cost and transferred to next period. Unlike manufacturing fixed overhead, the administrative overhead, selling and distribution overheads are treated as fixed cost and recorded only when they are incurred16. It is a traditional form of cost ascertainment. It is based on the principle that costs should be charged or absorbed to whatever is being costed – be it cost unit, cost centre – on the basis of the benefit received from these costs. 3. Direct Costing It is a method of costing in which the product is charged with only those costs which vary with volume. Variable or direct costs such as direct material, direct labour and variable manufacturing expenses are examples of costs charged to the product. All indirect costs are charged to profit and loss account of the period in which they arise. Indirect costs are disregarded in inventory valuation. This is similar to marginal cost accounting system where costs are classified into fixed and variable costs. Variable costs are charged to unit cost and the fixed costs attributable to the relevant period are written-off in full against the contribution for that period. Contribution margin indicates the recovery of fixed cost before contributing towards the operational profit. This technique is widely used for internal management purpose for decision making rather than for external reporting13. 4. Standard Costing14 Under standard costing system, the ascertainment and use of standard costs and the measurement and analysis of variances is done for control purpose. Standard cost is a predetermined cost which is computed in advance of production on the basis of a specification of all the factors affecting costs and used in Standard Costing. Its main purpose is to provide a base for control through Variance Accounting, for valuation of stock and work- in-progress and, in some cases, for fixing selling prices. 5. Uniform Costing It is not a distinct method of costing. It is the adoption of identical costing principles and procedures by several units of the same industry or several undertakings by mutual agreement. It facilitates valid comparisons between organizations and helps in elimination of inefficiencies. Essentials of a Cost Accounting System A company deploys the cost accounting system to track the raw materials even before the production process begins. Eventually, these raw materials convert into finished goods in real-time. Once the raw materials enter the production, the system tracks and record the use of the materials by crediting the raw material account and debiting 12. This is one of the frequently used cost accounting systems and is used for external reporting purpose, as well. 13. This is discussed in module 6.1 of this study note. 14. This is discussed in module 6.2 of this study note. 10 The Institute of Cost Accountants of India  Introduction to Cost Accounting the goods in the process account. Thus a suitable cost accounting system will vary according the to the operation of converting raw material into finished goods. But overall, a good cost accounting system should possess the following seven qualities. 1. Cost accounting system should be tailor made, practical, simple and capable of meeting the requirement of a business concern. 2. The data to be used by the cost accounting system should be accurate, otherwise it may distort the output of the system. 3. Necessary cooperation and participation of executives from various departments of the concern is essential for developing a good system of cost accounting. 4. The cost of installing and operating the system should not be too high and ultimately pass the cost-benefit analysis test. 5. The system of costing should not sacrifice the utility by introducing meticulous and unnecessary details. 6. A carefully phased programme should be prepared by using network analysis for the introduction of the system. 7. Management should have a faith in the costing system and should also provide a helping hand for its development and success. Installation of a Costing Accounting System Cost accounting system is a system that accumulates costs, assigns them to cost objects and reports cost information. In addition to this, a proper cost accounting system assists management in the planning and control of the business operations as well as in analyzing product profitability. There are several other advantages of a well-defined costing system in an organization like generating information for decision making, supplying information to the management for internal control, detailed analysis of costs. However, it is necessary that the cost accounting system is properly installed in an organization. The essential elements of such a system is discussed in the previous section. The following factors should be taken into consideration while designing a costing system. 1. Size of the firm - Size of the firm is an extremely important factor in designing a cost accounting system. As the size of the firm and its business grows, the volume and complexity of the cost data also grows. In such situation, the cost accounting system should be capable of supplying such information. 2. Manufacturing Process - Process of manufacturer changes from industry to industry. In some industries, there may be a continuous process of production while in some batch or job type of production may be in operation. A cost accounting system should be such that the manufacturing process is taken into consideration and cost data is collected accordingly. 3. Nature and Number of Products - If a single product is produced, all costs like material, labour and indirect expenses can be directly allocated to that product. But if more than one product is manufactured, the question of allocation and apportionment as well as absorption of indirect expenses (Overheads) arises and hence the cost accounting system should be designed accordingly as more complex data will be required. 4. Management Control Needs - The designing of a cost accounting system in a business organization is guided by the management control requirements. The costing system should supply data to persons at different levels in the organization to take suitable action in their respective areas. 5. Raw Materials - The designing of a cost accounting system in a business is also guided by the raw materials required for the production. The nature of raw materials and the degree of waste therein influence the designing of costing system. There are some materials which have a high degree of spoilage. The costing system should be such that identification of spoilage, keeping records of materials, pricing of the issues etc are taken into consideration. The Institute of Cost Accountants of India 11 Cost Accounting 6. Organization Structure - The structure of the organization also plays a vital role in designing a costing system. The system should correspond to the hierarchy of the organization. 7. External Factors - External factors are also important in designing of a costing system. For example, Cost Accounting Record Rules have been mandatory for certain types of industries. For the sake of compliance of the same, costing system should be designed. Limitations of Cost Accounting System Cost Accountancy is not an exact science but an art which has been developed through theories and accounting practices based on reasoning and common sense. The theories put to use in a particular organisation are often debatable. Conventions and accepted principles of Cost Accounting set the norm on which the cost accounting system are based. Some of the limitations of a cost accounting system are discussed in the following lines. 1. Installing a cost accounting system is expensive. It is argued that installation of a cost accounting system enhances cost of production. This is debatable as various cost reduction and cost control along with cost engineering (analysing alternative methods of production) helps in reducing cost. 2. The results shown by the financial accounts almost always differ from those shown by the cost accounts. Thus, there is a need for preparing reconciliation statements. 3. Differing views are put forward by cost accountants about the items to be included in cost accounting. 4. There is lack of exactness in the calculated costs as conventions, estimations and flexible factors are considered before they are calculated. Some of the aspects due to which the calculated costs cannot be said to be exact are as follows15: (a) Classification of costs into its elements. (b) Materials issue pricing based on average or standard costs. (c) Apportionment of overhead expenses and their allocation to cost units / centers. (d) Allocation of joint costs. (e) Segregation of semi variable overheads into fixed and variable. Cost Accounting lacks the uniform procedures and formats in preparing the cost information of a product / service. Keeping in view this limitation, all Cost Accounting results can be taken as mere estimates. 1.1.6. Financial Accounting, Cost Accounting and Management Accounting – a comparative study Accounting is the systematic recordation of the financial transactions of a business. The process includes systematic record keeping, tracking transactions, and aggregating the resulting information into a set of financial reports. Thus, the three aspects of accounting are Documentation (Record Keeping) The system of record keeping for accounting requires the use of a standard set of accounting policies and procedures, as well as standardized forms. The procedures should incorporate controls designed to ensure that assets are used as intended. Tracking of a transaction A separate procedure is needed to collect information about each type of business transaction. Transaction tracking occupies the bulk of the time of the accountant. 15. These are discussed vividly in different sections of the study note. Students are advised to note them whenever and wherever they come across these issues while proceeding with learning of this module. 12 The Institute of Cost Accountants of India  Introduction to Cost Accounting Financial Reporting16 Accounting frameworks are specified by generally accepted accounting principles (GAAP) and accounting standards of the respective countries. These mandates specific manner in which business transactions must be treated in the accounting records and aggregated into the financial statements. The result is an income statement, balance sheet, statement of cash flows, and supporting disclosures that describe the results of a reporting period and the financial position of the reporting entity at the end of that period. Accounting is classified as financial accounting, cost accounting and managements accounting. The classification is based on the specific function each of them performs and the nature of the accounting information they generate. This is pictorially represented below: Accounting Financial Cost Management Accounting Accounting Accounting Figure 1.2: Classification of Accounting Financial Accounting and Cost Accounting – A Comparison Financial accounting and cost accounting are complementary to each other. Financial accounting, as such, is the systematic procedure of recording, classifying, summarizing, analyzing, and reporting business transactions. The primary objective is to reveal the profits and losses of a business. Financial accounting provides a true and fair evaluation of a business. It, therefore, safeguards the interests of stakeholders. Cost Accounting, as such, is a subset of financial accounting, and is focussed on the process of conversion of raw material into finished goods. As such the cost accumulation process is the basic issue of cost accounting. The differences between cost accounting and financial accounting are presented in a tabular format. Basis of Financial Accounting Cost Accounting Comparison Purpose It is prepared for providing information The main purpose of Cost Accounting is to about the results of the business activities provide information to the management for as a whole for a particular period to the the proper planning, control and decision users. making. Need Financial Accounts are maintained as per Cost accounts are maintained to meet the the requirements of Companies Act and requirement of the Management. Income Tax Act. Recording Transactions are classified, recorded and In cost accounting, transactions are classified, analysed subjectively. recorded and analysed objectively according to the purpose for which costs are incurred. 16. This is specific to financial accounting as the users are external to the business in such case. Thus, reporting is crucial and needs standardization in case of financial accounting. Thus, financial reporting. The Institute of Cost Accountants of India 13 Cost Accounting Basis of Financial Accounting Cost Accounting Comparison Analysis of Financial accounting reveals the profit of a Cost Accounting shows the profit made on profit business as a whole. each product, job or process. Accounting Financial accounts are prepared for a Cost reports are prepared frequently and period definite period. submitted to the management according to their requirement which may be daily, weekly, etc. Stock In financial accounts, stocks are valued Cost accounting stocks are valued at cost valuation as per the relevant Accounting Standard (for example, AS 2 specifies that closing inventory should be valued at cost [carrying amount] or net realisable value whichever is lower. Relative Cost account provides information on the Financial accounts do not reveal the relative Efficiency relative efficiencies of various plant and efficiency of each department or section. Machinery Cost Accounting and Management Accounting - A Comparison Cost accounting is that branch of accounting which aims at generating information to control operations with the aim of maximizing profits and efficiency of the company. Conversely, management accounting is the type of accounting which assist management in planning and decision-making and thus is also referred as decision accounting. While cost accounting has a quantitative approach, management accounting gives emphasis on both quantitative and qualitative data. The two-accounting system plays a significant role, as the users are the internal management of the organization. Following is a tabular representation of the two accounting systems. Basis of Cost Accounting Management Accounting Comparison Meaning The recording, classifying and summarising The accounting in which the both financial of cost data of an organisation is known as and non-financial information are provided cost accounting. to managers is known as Management Accounting. Information Quantitative. Quantitative and Qualitative. Type Objective Ascertainment of cost of production. Providing information to managers to make decisions, and forecast strategies. Scope Concerned with ascertainment, allocation, Managerial decision making. distribution and accounting aspects of cost. 14 The Institute of Cost Accountants of India  Introduction to Cost Accounting Basis of Cost Accounting Management Accounting Comparison Specific Yes No. Thus the scope of management Procedure accounting is much broad. Target Recording of cost data (past and present). It gives more stress on the analysis of future projections. Interdependency Can be installed without management Cannot be installed without cost accounting. accounting. Financial Accounting and Management Accounting – A Comparison The key difference between financial accounting and management accounting is that financial accounting is the preparation of financial reports for the analysis by the external users interested in knowing the company’s financial position. In contrast, management accounting is the preparation of financial and non-financial information, which helps managers (internal user) make policies and strategies for the company. The distinguishing features of the two are presented in a tabular format in the next few lines. Basis for Financial Accounting Management Accounting Comparison Purpose Financial Accounting classifies, analyses, Management accounting helps management records, and summarizes the financial make effective decisions about the business. transactions of a particular period of the company. Application Financial accounting is prepared to reflect Management accounting helps management true and fair picture of financial affairs. to take meaningful steps and strategize. Scope The scope is pervasive, but not as much as The scope is much broader. the management accounting. Information Quantitative. Quantitative and qualitative. type Inter It is not dependent on management Management accounting is basically dependence accounting. decision-making accounting and depends on information created by Financial Accounting as well as Cost Accounting. Statutory It is legally mandatory to prepare financial Management accounting has no statutory requirement accounts of all companies. (for example, in requirement. the Indian Context Companies Act 2013, relevant rules of accounting standards furnish the statutory requirements) The Institute of Cost Accountants of India 15 Cost Accounting Format Financial accounting has specific formats There’s no set format for presenting for presenting and recording information. information in management accounting. Users Mainly for potential investors as well as all Only for management; stakeholders. Verifiable The information presented is predictive and The information presented is verifiable. not immediately verifiable. 16 The Institute of Cost Accountants of India  Introduction to Cost Accounting Important Cost Accounting 1.2 Terms In this section some of the cost accounting terms, which are of prime importance for conceptualising the subject of cost accounting. 1. Cost - Cost is defined as the expenditure (actual or notional) incurred on or attributable to a given product or service. It can also be described as the resources that have been sacrificed or must be sacrificed to attain a particular objective. In other words, cost is the amount of resources used for something which must be measured in terms of money. For example – Cost of preparing one cup of tea is the amount incurred on the elements like material, labour and other expenses. Similarly cost of offering any services like banking is the amount of expenditure for offering that service. Thus, cost of production or cost of service can be calculated by ascertaining the resources used for the production or services. CIMA Official Terminology17 defines cost either as a noun or as a verb. The following are the two-definition put forward in the official document The term ‘cost’ as a noun – The amount of cash or cash equivalent paid or the fair value of other consideration given to acquire an asset at the time of its acquisition or construction. The term ‘cost’ as a verb – To ascertain the cost of a specified thing or activity. The word cost can rarely stand alone and should be qualified as to its nature and limitations. From the above discussion it is clear that the usual connotation of the term cost is the historical cost which is used as a measurement basis for recording cost accounting transactions. But costs can also mean economic costs18 which are pertinent for decision making purpose. The Institute of Cost Accountants of India, previously known as The Institute of Cost and Works Accountants of India, was established in 1944 as a registered company under the Companies Act with the objects of promoting, regulating and developing the profession of Cost Accountancy. The Institute recognized the need for structured approach to the measurement of cost in manufacture or service sector and considered their responsibility to provide guidance to the stakeholders of the economy to achieve uniformity and consistency in classification, measurement and assignment of cost to product and services. They constituted the Cost Accounting Standards Board (CASB) in 2001 -2002, with the objective of formulating the Cost Accounting Standards (CAS19). 17. CIMA Official Terminology, 2005, The Chartered Institute of Management Accountants (CIMA Publishing, an imprint of Elsevier). 18. This includes opportunity cost which is pertinent for decision making purpose. This is taken up in later part of this module. 19. This are, thus, the guiding principles of cost accountancy. A comprehensive discussion is undertaken in Module III of this study note. The Institute of Cost Accountants of India 17 Cost Accounting Para 4.5 of CAS 1 states that cost is a measurement, in monetary terms, of the amount of resources used for the purpose of production of goods or rendering services. Thus ‘cost’ can be classified either as historical cost or as economic cost Historic Cost COST Economic Cost Figure 1.3: Types of Cost Historical cost is the factual cost incurred for the production of goods or services, encompassing direct material costs, direct labour costs, and manufacturing overhead costs. It emphasizes the retrospective nature of the cost, reflecting the real expenditures made in the past to produce a particular unit of output.  Out-of-Pocket Cost – this refers to the actual expenditures or payments made by an individual or a business for goods, services, or resources. These costs are tangible and represent real cash outlays. Out-of-pocket costs can include expenses such as direct payments for goods, services, wages, and other tangible items. It is often historical in nature but is pertinent to decision making. In the next few lines economic costs along with the other costs pertinent to the managerial decision-making process are discussed. Economic cost – This is also referred as opportunity cost. It is the value of the best alternative course of action that was not chosen. In other words, it is what could have been accomplished with the resources used in the course of action if they were employed in the next best alternative. It represents opportunities forgone. Example If a person has a job offer that pays Rs 25 for an hour’s work. But instead, he chooses to take a nap for an hour then the historical cost of the nap is zero as the person did not dash out any money in order to take the nap. However, the economic cost of the nap is Rs 25. This is what he could have been earned if he worked and did not take the nap. Thus, Rs 25 is a cost of the decision of taking the nap as it is the benefit foregone in taking the nap. Sunk Cost – Cost that has been irreversibly incurred or committed and cannot therefore be considered relevant to a decision. Sunk costs may also be termed irrecoverable costs. Imputed Costs – Imputed costs are hypothetical or notional costs, not involving cash outlay computed only for the purpose of decision making. In this respect, imputed costs are similar to opportunity costs. Interest on funds generated internally, payment for which is not actually made is an example of imputed cost. Relevant Costs: Relevant costs are costs which are relevant for a specific purpose or situation. In the context of decision making, only those costs are relevant which are pertinent to the decision at hand. Since we are concerned with future costs only while making a decision, historical costs, unless they remain unchanged in the future period are irrelevant to the decision-making process. Avoidable Costs & Unavoidable Costs – Avoidable Costs are those which under given conditions of performance efficiency should not have been incurred. Unavoidable Costs which are inescapable costs, which are essentially to be incurred, within the limits or norms provided for. It is the cost that must be incurred under a programme of business restriction. It is fixed in nature and inescapable Controllable and Non-Controllable Costs – Controllable Cost is that cost which is subject to direct control at some level of managerial supervision. Non-controllable Cost is the cost which is not subject to control at any level of managerial supervision. 18 The Institute of Cost Accountants of India  Introduction to Cost Accounting 2. Cost Object A cost object is any item for which cost measurement is required, for example, a product or a customer. Examples of cost objects include:  A product  A service to a hotel guest  A sales territory CIMA Official Terminology states, A cost object is, for example, a product, service, centre, activity, customer or distribution channel in relation to which costs are ascertained. GACAP20 defines a cost object as an activity, contract, cost centre, customer, process, product, project, service or any other object for which costs are ascertained. This definition is also corroborated in paragraph 4.7 of CAS 1. 3. Cost Unit: Cost Unit is a device for the purpose of breaking up or separating costs into smaller sub divisions attributable to products or services. CIMA official Terminology defines a cost unit as a unit of product or service in relation to which costs are ascertained. Cost unit should be appropriate to the type of business. It is important to note that once costs are traced to cost centres, they are further analysed in order to establish the cost per cost unit. Alternatively, some items of costs may be charged directly to a cost unit, for example direct materials and direct labour costs. GACAP23 defines a cost unit as a form of measurement of volume of production of a product or a service. Cost unit is generally adopted on the basis of convenience and practice in the industry concerned. This is also corroborated in paragraph 4.5 of CAS 1. Example of cost unit Business Appropriate Cost Unit Car manufacturer Particular brand of car Cigarette manufacturer Packet/ piece of cigarette Builder Particular building /Flat Audit company Audit File / Chargeable hour 4. Composite Cost Unit21 – The cost units for services are intangible and often comprise of two parts. Thus, they are referred as composite cost units. For example, if costs of a delivery service are being monitored and controlled by measuring the cost per tonne delivered then ‘tonne delivered’ is not an appropriate cost unit because it would not be valid to compare the cost per tonne delivered from place A to place B with the cost per tonne delivered from place M to place N. This is due to the simple fact that the distance is a major factor and delivering one tonne over a distance of one KM is not the same as delivering one tonne over a distance of 10 KM. Thus, Composite cost units. Composite cost units help to improve cost control in service organisations. Examples of composite cost units might be as follows: Business Composite Cost Unit Hospital Patient – Day Transport (Freight) Tonne – kilometre Transport (Passenger) Passenger -KM 20. The GACAP is the abbreviated form of Generally Accepted Generally Accepted Cost Accounting Principles. It is issued by the Institute of Cost Accountants of India. This document is like a preface to the Cost Accounting Standards. (https://icmai.in/upload/CASB/2015/GACAP-Final.pdf) 21. This is discussed in details in module 5 of this study note. The Institute of Cost Accountants of India 19 Cost Accounting 5. Cost Centre - Cost centres are collecting places for costs before they are further analysed. For cost accounting purposes, departments are termed cost centres and the product produced by an organisation is termed the cost unit. CIMA Official Terminology defines a cost centre as a production or service location, function, activity or item of equipment for which costs are accumulated. GACAP23 defines a cost unit as any unit of an entity selected with a view to accumulating all cost under that unit. The unit can be division, department, section, group of plant and machinery, group of employees or combination of several units. This definition is also corroborated in paragraph 4.6 of CAS 1. Cost Centre and Cost Object is the logical sub-unit for collection of cost. Cost Centre may be of two types personal and impersonal cost centres. Personal cost centre consists of a person or a group of persons. Cost centres which are not personal cost centres are impersonal cost centres. Again Cost centres may be divided into broad types i.e. Production Cost Centres and Service Cost Centres.  Production Cost Centres are those which are engaged in production like Machine shop, Welding shop, Assembly shop etc.  Service Cost centres22 are for rendering service to production cost centre like Power house, Maintenance, Stores, Purchase office etc. Cost centre is often referred as a responsibility centre whose managers are normally accountable for only those costs that are under their control, also known as expense centres. 6. Responsibility Centre - Responsibility Center refers to a particular segment or unit of an organization for which a particular manager, employee, or department is held responsible and accountable for its business goals and objectives. It refers to the part of the company where a manager has authority and responsibility. A responsibility center is a functional entity within a business that tends to have its own goals and objectives, policies, and procedures, thereby giving managers specific responsibility for revenues, expenses incurred, funds invested, etc. CIMA official terminology defines responsibility centre as departmental or organisational function whose performance is the direct responsibility of a specific manager. There are usually four types of responsibility center which are identified as under. (a) Cost Centre – Under the cost center , the manager is held responsible only for the costs, including a production department, maintenance department, human resource department, etc. this is discussed in previous section. (b) Profit Centre – Under the profit center the manager is responsible for all costs and revenues. Here the manager would have all of the responsibility to make decisions that would affect both the price and the revenue. CIMA official terminology defines profit centre as part of a business accountable for both costs and revenues. (c) Revenue Centre – This segment is primarily responsible for attaining sales revenue. The performance would be evaluated by comparing the actual revenue attained with the budgeted revenue. CIMA official terminology defines revenue centre as centre devoted to raising revenue with no responsibility for costs, for example a sales centre. Often used in not-for-profit organisations. 22. Service cost centre provide services to other cost centres. When the output of an organisation is a service, rather than goods, an alternative name is normally used, for example support cost centre or utility cost centre (CIMA Official Terminology, 2005). 20 The Institute of Cost Accountants of India  Introduction to Cost Accounting (d) Investment Centre – Apart from looking into the profits, this center looks into returns on the funds invested in the group’s operations during its time. CIMA official terminology defines investment centres as a profit centre with additional responsibilities for capital investment and possibly for financing, and whose performance is measured by its return on investment. 7. Cost of Production: To arrive at cost of production of goods, including those dispatched for captive consumption, adjustment for stock of work-in-process, finished goods, recoveries for sales of scrap, wastage and the like, shall be made. Cost of production of a service means cost of the service rendered. GACAP23 states, cost of production of a product or a service consists of cost of materials consumed, direct employee costs, direct expenses, production overheads, quality control costs, packing costs, research and development costs and administrative overheads relating to production. To arrive at cost of production of goods dispatched for captive consumption23, adjustment for Stock of work- in-Process, finished goods, recoveries for sales of scrap, wastage shall be made. Thus Cost of production (for captive consumption) = cost of materials consumed + direct employee costs + direct expenses + production overheads + quality control costs + packing costs + research and development costs + administrative overheads ± adjustment for stock of WIP and FG This definition is corroborated in paragraph 4.8 of CAS 1. 8. Conversion Cost: This term is defined as the sum of direct wages, direct expenses and overhead costs of converting raw material to the finished products or converting a material from one stage of production to another stage. CIMA official terminology defines conversion cost as cost of converting material into finished product, typically including direct labour, direct expense and production overhead. Para 4.4 of CAS 1 defines conversion cost is the production cost excluding the cost of direct materials. 9. Overhead Cost: An item of expense/cost which is not directly traceable to the product CIMA official terminology defines overhead cost as expenditure on labour, materials or services that cannot be economically identified with a specific saleable cost unit. GACAP23 defines Overheads comprise costs of indirect materials, indirect employees and indirect expenses. This defnition is also coroborated in paragraph 4.24 of CAS 1 From the above defnitions two important perspectives are noted regarding overhead cost24. 1. Overhead costs are not economically identifiable with the cost unit. Thus they are also referred as indirect costs. 2. Indirect costs comprise of indirect material, indirect labour25 and indirect expenses. The overhead expenditure is identified under a particular head based on the purpose of the expenditure based on the functions that are accomplished by the expenditure incurred. The functional classification26 overheads are given as under. 23. ‘Captive Consumption means the consumption of goods manufactured by one division or unit and consumed by another division or unit of the same entity or related undertaking for manufacturing another product(s)’. GACAP 24. A synonymous term ‘burden’ is in common use in the US and in subsidiaries of American companies. 25. CAS 7 specifies details about employee cost which is the connotation for the traditional term ‘labour’. Thus, whenever the term ‘labour’ is used, it implies ‘employee cost’ 26. In standard books only this is mentioned as factory (production) overhead, administrative overhead and selling and distribution overhead. Here the classification is as mentioned in CAS 1. The Institute of Cost Accountants of India 21 Cost Accounting 1. Production Overheads: Indirect costs involved in the production of a product or in rendering service. (as noted in Para 4.27, CAS 1) 2. Administrative Overheads: Cost of all activities relating to general management and administration of an entity. (as noted in Para 4.2, CAS 1) 3. Distribution Overheads: Distribution overheads, also known as distribution costs, are the costs incurred in handling a product or service from the time it is ready for dispatch or delivery until it reaches the ultimate consumer including the units receiving the product or service in an inter-unit transfer. (as noted in Para 4.15, CAS 1) 4. Selling Overheads: Selling overheads are the expenses related to sale of products or services and include all indirect expenses incurred in selling the products or services. (as noted in Para 4.29, CAS 1) 5. Marketing overheads: Marketing Overheads comprise of selling overheads and distribution overheads. (as noted in Para 4.21, CAS 1) The above classification is pictorially represented as follows: Overhead (para 4.24 of CAS 1) Production Overhead Administrative Overhead (para 4.27 of CAS 1) (para 4.2 of CAS 1) Distribution Overhead Selling Overhead (para 4.15 of CAS 1) (para 4.29 of CAS 1) Marketing Overhead (para 4.21 of CAS 1) Figure 1.4: Types of Overhead 10. Cost Accounting Standards27 The Institute of Cost Accountants of India, recognizing the need for structured approach to the measurement of cost in manufacture or service sector and to provide guidance to the user organizations, government bodies, regulators, research agencies and academic institutions to achieve uniformity and consistency in classification, measurement and assignment of cost to product and services, has constituted Cost Accounting Standards Board (CASB) with the objective of formulating the Cost Accounting Standards. Till date, the Board has issued 24 Cost Accounting Standards, Generally Accepted Cost Accounting Principles, 11 Guidance Notes28. 27. This is discussed in details in Module 3 of this study note. 28. Of the eleven guidance issued so far, nine is on Cost Accounting Standards and two on “Treatment of Costs Relating to Corporate Social Responsibility (CSR) Activities” and “Maintenance of Cost Accounting Records for Construction Industry Including Real Estate and Property Development Activity” respectively. (https://icmai.in/CASB/casb-about). 22 The Institute of Cost Accountants of India  Introduction to Cost Accounting 11. Cost Allocation - When items of cost (overheads) are identifiable directly with some products or departments such costs are charged to such cost centres. This process is known as cost allocation. Wages paid to workers of service department can be allocated to the particular department. Indirect materials used by a particular department can also be allocated to the department. Cost allocation calls for two basic factors – a. Concerned department/product should have caused the cost to be incurred, and b. Exact amount of cost should be computable. 12. Cost Apportionment – When items of cost (overheads) cannot be directly charged to or accurately identifiable with any cost centres, they are prorated or distributed amongst the cost centres on some predetermined basis. This method is known as cost apportionment. Thus, items of indirect costs residual to the process of cost allocation are covered by cost apportionment. The predetermination of suitable basis of apportionment is very important and usually following principles are adopted (in order to find suitable relation between the cost object and the cost to be apportioned). a. Service or use b. Survey method c. Ability to bear. The basis ultimately adopted should ensure an equitable share of common expenses for the cost centres and the basis once adopted should be reviewed at periodic intervals to improve upon the accuracy of apportionment. The term allocate is defined by the CIMA official terminology to assign a whole item of cost, or of revenue, to a single cost unit, centre, account or time period. In the US, “allocate” does not have this precise meaning, it is used more generally to refer to the whole process of overhead apportionment, allocation and absorption. 13. Cost Absorption29 - Ultimately the indirect costs or overhead as they are commonly known, will have to be distributed over the final products so that the charge is complete. This process is known as cost absorption, meaning thereby that the costs absorbed by the production during the period. Usually any of the following methods are adopted for cost absorption: 1. Percentage of direct material cost 2. Percentage of direct labour cost 3. Percentage of prime cost 4. Direct labour hour rate 5. Machine hour rate. The basis should be selected after careful maximum accuracy of cost distribution to various production units. The basis should be reviewed periodically and corrective action whatever needed should be taken for improving upon the accuracy of the absorption. CIMA official terminology defines overhead absorption rate (OAR) as a means of attributing overhead to a product or service, based for example on direct labour hours, direct labour cost or machine hours. 14. Under/over absorption of overhead30 - Costs, as such, are either direct costs which are traceable to the cost unit or are indirect costs (also referred as overheads) which are not traceable to the cost unit. Thus, in the cost accumulation process the direct costs can be added specifically to the cost unit as they directly attribute to the product. But the overheads or indirect cost cannot be directly added to the product cost. In this respect, absorption costing recommends the use of pre-determined rates for absorption of overhead cost to the products. 29. This is fundamental aspect of the absorption costing system. 30. This is discussed in details under the section ‘overheads’ in Module 2. The Institute of Cost Accountants of India 23 Cost Accounting Overhead absorption rates are usually predetermined, that is, they are calculated in advance of the period over which they will be used. The advantage of using predetermined rates is that managers have an overhead rate permanently available which they can use in product costing and fixation of sale price. But this gives rise to the problem of under/over absorption as the actual figures for overhead and for the absorption base are likely to be different from the estimates used in calculating the absorption rate. When this happens, the overhead will be either under absorbed or over absorbed. If the actual overhead incurred is higher than the overhead absorbed, then overhead is under absorbed and if the actual overhead incurred is lower than the overhead absorbed then the overhead is over absorbed. Illustration 1 Data for MNQ Company for a particular period is as under Particulars Machining Department Finishing Department Estimated/budget data Production overhead ` 3,40,000 ` 1,20,000 Machine hours 1,70,000 4,200 Direct labour hours 16,500 40,000 Actual results Production overhead incurred ` 36,000 ` 1,29,400 Machine hours 1,50,000 3,900 Direct labour hours 18,290 44,100 It is company policy to use machine hour rate to absorb production overhead in the machining department. The finishing department is more labour intensive and therefore labour hour rate is considered as more appropriate overhead absorption rate. Solution: The overhead absorption rates (OARs), the under and over absorbed overheads are calculated as follows; Particulars Machining Department Finishing Department OAR 340000 = `2 per machine hour 120000 = `3 per labour hour 170000 40000 Overheads absorbed ` 3,00,000 (` 2 × 150000 labour hour) ` 1,32,300 (`3 × 44100 machine hours) Actual overhead `3,60,000 `1,29,400 (incurred) ` 60,000 (absorbed overhead is less `2,900 (absorbed overhead is greater than Under/Over absorbed than actual overhead, thus under actual overhead, thus over absorbed) overhead absorbed) 24 The Institute of Cost Accountants of India  Introduction to Cost Accounting Elements of Cost 1.3 C osts are either direct (traceable to the cost unit) or indirect, referred as overheads (not traceable to the product) and thus has to be absorbed to the product on the basis of some pre-determined basis. This is briefly discussed in the previous section. The elements of cost along with the classification may be represented as follows. Cost Direct (traceable to product) Indirect (Overhead) Material (CAS 6) Administrative Overhead Production Ovehead Labour /Employee Selling Overhead Cost (CAS 7) Direct Expense (CAS 10) Distribution Overhead Figure 1.5: Elements of Cost Raw materials are converted into finished products by a manufacturing concern with the help of labour, plants etc. The elements that constitute the cost of manufacturing are known as elements of cost. The elements of cost include the following:  Material  Labour31  Expenses But as it is previously noted that each of the abobe element of cost includes both direct cost and indirect costs which are also referred as overheads. This is pictorially represented in the following diagram. 31. Labour cost is referred as employee cost as per CAS 7 The Institute of Cost Accountants of India 25 Cost Accounting Direct Material Indirect Material Material Cost Direct Labour Elements of Employee Indirect (Labour) Labour Cost Cost Direct Expenses Other Indirect Expenses Expenses Production/Factor Overhead OVERHEADS Administrative Overhead Selling and Distribution Overhead Figure 1.6: Classification of Elements of Cost into Direct and Indirect Costs It is important to note that all the traceable costs (direct material, direct labour and direct expenses) are grouped together and is referred as prime cost. Para 4.26 of CAS 1 define Prime cost is the aggregate of direct material cost, direct employee cost and direct expenses. Thus, Prime Cost = Direct Material + Direct Labour (Employee cost) + Direct Expenses It is previously noted in this study note that the traditional cost accounting system is the absorption costing system which is more frequently used. Under generally accepted accounting principles (GAAP), absorption costing is required for external reporting. This is an accounting method that captures all of the costs involved in manufacturing a product when valuing inventory. The method includes direct costs and indirect costs and is helpful in determining the cost to produce one unit of goods32. thus, absorption costing also referred as full costing or traditional costing is GAAP compliant. The following is a pictorial representation of the elements of cost and how the same builds up into cost of production and cost of sales under absorption costing system. 32. https://corporatefinanceinstitute.com/resources/knowledge/accounting/absorption-costing-guide/ 26 The Institute of Cost Accountants of India  Introduction to Cost Accounting Direct costs Overhead Materials Materials Labour Labour Expenses Expenses Prime cost Production Production Administration R&D Selling Distribution Production overhead Under/over Absorbed absorbed overhead overhead Production overhead Total cost Stock adjustment Cost of sales Sales PROFIT Figure 1.7: Elements of Cost under Absorption Costing System33 This representation is illustrated in the last section of this study note where statement of cost and profit is discussed in detail. This is also referred as cost sheet. Though this is recommended in the CIMA document it is important to note that almost all authors, in their books on Cost Accounting, includes selling and distribution overhead to cost of goods sold (Total cost in the above figure) to arrive at Cost of sales34. 33. The above chart is based on the absorption costing principle. The chart is adopted from CIMA Official Terminology, 2005, The Chartered Institute of Management Accountants (CIMA Publishing, an imprint of Elsevier 34. Discussion on cost sheets, as well as the illustrations on cost sheet, as given in the last part of the study note are presented on the basis of this classification of selling and distribution overhead. The Institute of Cost Accountants of India 27 Cost Accounting Classification of Cost 1.4 C ost Classification is the process of segregating the company’s costs into different categories that gives a fair idea to the decision-maker about the spending pattern. This bifurcation allows teams to efficiently use the data for accounting purposes and financial modelling, leading the management to decide which cost is more important than others. The Cost Accounting Standard (CAS) 1 (Revised 2015) issued by the Council of the Institute of Cost Accountants of India for determination of Classification of Cost. This section of the study note is in tandem with the provisions of the said document. Para 4.3 CAS 1 state that classification of cost is the arrangement of items of costs in logical groups having regard to their nature (subjective classification) and purpose (objective classification). Thus, two type of classification (logical groups) is recommended  Subjective classification (classification on the basis of nature) and  Objective classification (on the basis of purpose) A reading of para 6 of CAS 1 suggest five classifications along with some sub classifications, which is represented below: Cost By nature of By traceability By nature of By nature of expense to cost object behaviour production By function or operation process Employee Cost Fixed Cost Indirect Cost Variable Cost Direct Expense Semi Variable Cost Material Cost Direct Cost Figure 1.8: Types of Cost Classification 1. Classification by nature of expense (para 6.1) – on the basis of nature of the expense the elements of cost can be classified in the following three categories: 28 The Institute of Cost Accountants of India  Introduction to Cost Accounting a. Material – Material Costs are cost of materials used for the purpose of production of a product or rendering of a service, net of trade discounts, rebates, taxes and duties refundable that can be quantified with reasonable accuracy. b. Employee - Employee Costs are consideration, including benefits paid or payable to employees, permanent or temporary, for the purpose of production of a product or rendering of a service. c. Expenses - Expenses are costs other than material cost and employee cost for the purpose of production of a product or rendering of a service. (example - cost of utilities, payment for bought out services, job processing charge) 2. Classification by traceability of the cost to a cost object (para 6.2) – on the basis of traceability costs are either direct cost or indirect cost. a. Direct cost - If a cost can be assigned to a cost object in an economically feasible way, it shall be termed as direct to that cost object. These are of three types i. Direct material cost - Direct Material Costs are the cost of materials which can be assigned to a cost object in an economically feasible way. ii. Direct employee cost - Direct Employee Cost are employee costs, which can be assigned to a cost object in an economically feasible way. iii. Direct expenses - Direct Expenses are expenses except direct material and direct employee cost which can be assigned to a cost object. b. Indirect cost – if a cost is not identifiable as a direct cost then it is referred as indirect cost. It comprises of the following. i. Indirect material - Indirect Material Costs are cost of materials, which cannot be directly assigned to a particular cost object in an economically feasible way ii. Indirect employee cost - Indirect Employee costs are employee costs, which cannot be directly assigned to a particular cost object in an economically feasible way. iii. Indirect expenses - Indirect Expenses are expenses, which cannot be directly assigned to a particular cost object in an economically feasible way. 3. Classification by function (para 6.3) – costs can be classified according the functions which are a. Production; b. Administration; c. Selling; d. Distribution; e. Research; and f. Development 4. Classification by nature of behaviour of the cost (para 6.4) - Costs shall be classified based on behaviour in response to the changes in the activity levels such as, fixed cost, variable cost and semi-variable cost. Accordingly, costs are a. Fixed cost b. Variable cost c. Semi variable cost The Institute of Cost Accountants of India 29 Cost Accounting 5. Classification by nature of production or operation process (para 6.5) - Costs shall also be classified on the basis of nature of production or operation process. Operation Cost shall be the cost a specific operation involved in production of goods or rendering of services. Accordingly, costs are a. Job cost b. Batch cost c. Contract cost d. Process cost e. Joint costs are the costs of common resources used for producing two or more products or rendering two or more services simultaneously A diagram regarding the types of classification is presented for easy comprehension. 1.4.1. Cost Behaviour Analysis It is discussed in the previous section that costs can be classified according to its behaviour. Cost behavior analysis refers to management’s attempt to understand how operating costs change in relation to a change in an organization’s level of activity. These costs may include direct materials, direct labour, and overhead costs that are incurred in developing a product. Management typically performs cost behavior analysis through mathematical cost functions. Cost functions are descriptions of how a cost (e.g., material, labour, or overhead) changes with changes in the level of activity relating to that cost. For example, total variable costs will change in relation to increased activity, while fixed costs will remain the same. Cost functions may come in various forms. CIMA Official Terminology states that cost behaviour is the Variability of input costs with activity undertaken. Cost may increase proportionately with increasing activity (a variable cost), or it may not change with increased activity (a fixed cost). Some costs (semi-variable) may have both variable and fixed elements. Other behaviour is possible; costs may increase more or less than in direct proportion, and there may be step changes in cost, for example. To a large extent, cost behaviour will be dependent on the timescale assumed. The level of activity refers to the amount of work done, or the number of events that have occurred. Depending on circumstances, the level of activity may refer to the volume of production in a period or the number of units sold. From the above discussion it is obvious that, in general, three types of costs is noticed. It is very important to understand the nature of the cost. As the treatment of fixed cost and variable cost is different in the two most important cost accounting systems: absorption costing and marginal costing. And as such semi –variable cost cannot be allowed to remain and should be segregated into fixed and semi –variable cost. 1. Fixed cost – fixed cost is referred as period and refers to a cost which is incurred for a particular period. It remains fixed over a relevant range35. GACAP defines fixed costs as costs which do not vary with the change in the volume of activity. Fixed indirect costs are termed fixed overheads. CIMA Official Terminology defines a fixed cost as a cost incurred for an accounting period, that, within certain output or turnover limits, tends to be unaffected by fluctuations in the levels of activity (output or turnover). Total fixed cost remains while per unit fixed cost reduces as number of units increases (a diagrammatic representation is shown below) 2. Variable cost – the variable cost is often referred as the product cost. The per unit variable cost remains fixed over the relevant range. GACAP defines variable Costs are the cost which tend to directly vary with the volume of activity. CIMA official terminology defines variable cost as a cost that varies with a measure of activity. 35. The relevant range is Activity levels within which assumptions about cost behaviour in breakeven analysis remain valid. This is discussed in details in Module 6 of this study note. 30 The Institute of Cost Accountants of India  Introduction to Cost Accounting 3. Semi-variable cost – this are dual natured. A part of these cost remains fixed while the other part behaves as a variable cost. CIMA official terminology defines a semi-variable cost as a cost containing both fixed and variable components and thus partly affected by a change in the level of activity. The following five figures (1 -5) is a pictorial representation of the costs discussed above. Per Unit Cost Total Cost Total Fixed Number of units Number of units (i) : Total Fixed Cost (ii) : Fixed Cost per unit Fixed Per Unit Cost Total Cost Total Fixed Number of units Number of units (iii) : Total Variable Cost (iv) : Variable Cost Per unit Total variable Total Cost Total Fixed Number of units (v) : Total Cost Figure 1.9: Graphical Representation of Different Total Costs and per unit costs under Cost Behaviour Analysis Figure (i): total fixed cost remains fixed and does not change as number of units is increased. This holds good within the relevant range. Figure (ii): the per unit fixed cost curve is a rectangular hyperbola and reduces as number of units produced increases. Figure (iii): total variable cost increases at a steady rate as units produced increases. Figure (iv): the per unit variable cost is a straight line parallel to the X axis. This is one basic assumption which shall have to hold good during the relevant range. The Institute of Cost Accountants of India 31 Cost Accounting Figure (v): total cost curve comprising of fixed cost and variable cost is represented in this figure. This may be also represented as a straight-line curve where the fixed cost is the Y – intercept and the variable cost per unit is the m (slope of the total cost function). 1.4.2 Segregation of Semi Variable Costs In both absorption costing system and marginal costing system costs must be identified as fixed cost or variable cost as their treatment differs because their nature differs. Thus semi –variable costs are not allowed to remain as they are. These costs are to be segregated into its component parts; fixed portion and variable portion. When managers have identified a semi-variable cost they will need to know how much of it is fixed and how much is variable. Only when they have determined this will they be able to estimate the cost to be incurred at relevant activity levels. Past records of costs and their associated activity levels are usually used to carry out the analysis. Before segregation of semi-variable costs, managers need to identify the same semi variable cost. The below illustration would clarify the issue. Illustration 2 Let us assume that a company identified two sets of costs for two consequent months which are as follows. January 2022, 60 tables are produced with total cost of ` 1,700 February 2022, 70 tables are produced with total cost of ` 1,900 It is a given fact that total fixed costs don’t change within the relevant range with increase in units produced. So, the increase in total cost of ` 200 (` 1,900 - ` 1,700) during January –February is caused by an increase of 10 units (70 tables – 60 tables) This is given as ` 1,900 – ` 1,700 = ` 200 (change in costs) (increase). 70 tables – 60 tables = 10 (changes in tables) (increase) ` 200 Thus, variable cost per unit = 10 units = ` 20 per table Thus, the total cost is semi variable in nature as there are both fixed and variable element in the total cost of producing table. If the total cost is variable, then in January the total cost would be ` 1,200 (60 × 20) and in February the total cost would be ` 1,400 (70 × 20), which they are not. The TC in January is Rs 1700 and in February it is ` 1,900. Given, total cost = total variable costs + total fixed costs For January (60 tables) TC = TVC + TFC = Variable cost per unit × number of units + TFC ⇒ 1700 = 20 × 60 + TFC ⇒ TFC = 1700 -1200 = 500 Check (for February) (70 tables) TC = TVC + TFC = Variable cost per unit × number of units + TFC ⇒ 1900 = 20 × 70 + 500 ⇒ LHS = RHS 32 The Institute of Cost Accountants of India  Introduction to Cost Accounting In other words, the cost function is given as TC = TVC + TFC = Variable cost per unit × number of units + TFC Y= m × x + C Where Y = TC, m = slope of the cost function (variable cost per unit) and C = y intercept (total fixed cost) Where, Rise y2 - y1 Change in TC m= = x - x = Change in output Run 2 1 The four most common methods36 used to separate the fixed and variable elements are as follows 1. Graphical Method – This method takes account of all available historical data and it is very simple to use. However, it is very prone to inaccuracies that arise due to subjectivity and the likelihood of human error. a. First a scatter graph is drawn which plots all available pairs of data on a graph. b. Then a line of best fit is drawn by eye. This is the line which, in the judgement of the user, appears to be the best representation of the gradient of the sets of points on the graph. c. The point where the extrapolation of this line cuts the vertical axis (the intercept) is then read off as the total fixed cost element. The variable cost per unit is given by the gradient of the line 2. High and Low Method – The highest and lowest levels of output and costs are taken and the differential is found. This difference arises only due to variable costs. The remaining portion will be fixed costs. Under this method the variable cost per unit will be computed first and then the fixed cost will be derived. Variable cost per unit is computed by dividing the difference in cost at highest level and lowest level with the difference in volume between highest and lowest level. CIMA official terminology defines the high low method as a method of estimating cost behaviour by comparing the total costs associated with two different levels of output. The difference in costs is assumed to be caused by variable costs increasing, allowing unit variable cost to be calculated. Following from this, since total cost is known, the fixed cost can be derived. 3. Linear Equation Method – This uses the straight-line equation of y = m x + c where y represents total cost, m is variable cost per unit, x is the level of output and c is fixed costs. The total costs at two different volumes are put into these equations which are solved for the values of m and c. 4. Least Square Method – This statistical tool uses straight line equation and finds the line of best fit to solve the equations. Also known as Simple Regression Method. Under this method first the mean of volume and mean of costs are computed. The deviations in volume (X) from the mean and deviation in cost (Y) from mean are computed. 36. These are discussed in details in later part of the study note. The Institute of Cost Accountants of India 33 Cost Accounting Illustration 3 (Segregation of Semi-Variable Cost (High/Low Method and linear equation method) The costs of operating the maintenance department of a computer manufacturer, XYZ Company, for the last four months have been as follows. Month Cost (`) Production volume (Units) 1 1,10,000 7,000 2 1,15,000 8,000 3 1,11,000 7,700 4 97,000 6,000 High/low method Change in Total Cost Variable cost P.U. = (consider only the highest and the lowest points) Change in output therefore High 8000 units ` 1,15,000