Cost Analysis, Concepts & Classifications

COST ANALYSIS, CONCEPTS & CLASSIFICATIONS

CONCEPT OF COST 1. Cost means the total of all expenses. 3. Cost is defined as the amount of expenditure( actual or notional) incurred on or attributable to a given thing or to ascertain the cost of a given thing. 4. The cost of an article consists of actual outgoings or ascertained charges incurred in its production and sale.

ELEMENTS OF COST For proper control and managerial decisions, the total cost is analysed by elements of cost. i.e,by the nature of expenses. The elements of cost are 1. Materials 2. Labour 3. Other expenses These elements of cost are further analysed into different elements as

Elements of cost Labour

Materials Direct

Indirect

Direct

Indirect

Other expenses Direct

Indirect

Overheads

Production or Works Overhead

Administration Overhead

Selling Overheads

Distribution Overheads

By grouping the above elements of cost, the following divisions of cost are obtained. 1.

Prime cost

2.

Work or Factory cost = Prime cost + Works or Factory Overheads

3.

Cost of Production

4. Total cost or Cost of sales

= Direct Materials + Direct Labour + Direct Expenses

= Works Cost + Administration Overheads = Cost of production+ Selling & Distribution Overheads

DIRECT MATERIAL Those materials which can be identified in the product and can be conveniently measured and directly charged to the product. Eg: cloth of dress making, bricks for building

5. 6. 7. 8.

The following are normally classified as direct materials: All raw materials Materials specifically purchased for a specific job, process or order Parts or components purchased or produced Primary Packing materials

Certain materials which are parts of finished products but used in small quantities are treated as indirect material Thus the ease and the feasibility with which a material can be traced into the composition of a finished product will determine what is to be treated as direct material.

DIRECT LABOUR All labour expended in altering the construction, composition, confirmation or condition of the product. It is that labour which can be conveniently identified or attributed wholly to a particular job, product or process or expended in converting raw materials into finished goods.

Direct labour includes payment made to 3. Labour engaged on the actual production of the product or in carrying out of an operation or process. 4. Labour engaged in aiding the manufacture by way of supervision, maintenance, tools setting, transportation of material etc., 5. Inspectors, analysts etc., specially required for such production

DIRECT OR CHARGEABLE EXPENSES All expenditures other than direct material or direct labour that are specifically incurred for a particular product or process. Such expense is charged directly to the particular cost centre as part of the prime cost. Eg: Excise duty, Royalty on production, surveyor’s fees, designing or drawing expenses etc

OVERHEADS The aggregate of the cost of indirect materials, indirect labour and such other expenses including services as cannot conveniently be charged direct to specific cost units. All expenses other than direct expenses The cost of operating supplies and services used by the undertaking and including the maintenance of capital assets.

The main groups into which overheads may be sub-divided are 3. 4. 5. 6.

Manufacturing overheads Administration overheads Selling overheads Research and Development overheads

Overheads can also be classified as 9. Indirect materials 10. Indirect labour 11. Indirect expenses

EXPENSES EXCLUDED FROM COSTS Total cost of a product should include only those items of expenses which are a charge against profit. Items of expenses which are relating to capital assets, capital losses, payments by way of distribution of profits and matters of pure finance should not form a part of the costs Eg: Dividend, abnormal wastage of material, abnormal idle time, interest on capital, loss on sale of assets etc

COST SHEET OR STATEMENT OF COST Cost sheet is a statement designed to show the output of a particular accounting period along with break-up of costs. 2. It is a memorandum statement 3. It does not form part of double entry cost accounting records. 4. But derives its data for financial accounting

ADVANTAGES OF COST SHEET 1. It discloses the total cost and the cost per unit of the units produced during the given period. 2. It enables a manufacturer to keep a close watch and control over the cost of production. 3. By providing a comparative study of the various elements of current cost with the past results and standard costs, it is possible to find out the causes of variations in costs and to eliminate the adverse factors and conditions which go to increase the cost.

1. It acts as a guide to the manufacturer and helps him in formulating a definite useful production policy. 2. It helps in fixing up the selling price more accurately 3. It helps the businessman to minimise the cost of production when there is a cut throat competition 4. It helps the businessman to submit quotations with reasonable degree of accuracy against tenders for the supply of goods.

Prepare a cost sheet from the following particulars Rs. Direct materials 1,00,000 Direct wages 25,000 Direct expenses 5,000 Wages of foreman 2,500 Electric power 500 Lighting: factory 1,500 Office 500 Depreciation: Factory plant 500 Office premises 1,250

Consumable stores Manager’s salary Director’s fees Office stationery Storekeeper’s wages Oil & water Rent: Factory Office Repairs and renewals: Factory plant Office premises Carriage outward Transfer to reserves Discount on shares written off

2,500 5,000 1,250 500 1,000 500 5,000 2,500 3,500 500 375 1,000 500

Telephone charges Postage Salesmen’s salaries Travelling expenses Advertising Warehouse charges Sales Income tax Dividend

125 250 1,250 500 1,250 500 1,89,500 10,000 2,000

COST SHEET OR STATEMENT OF COST Rs. Direct material Direct wages Direct expenses Prime cost Add: Factory overheads: Wages of foreman 2500 Electric power 500 Storekeeper’s wages 1000 Oil and water 500 Factory rent 5000 Repairs and renewals Factory 3500 Factory lighting 1500 Depreciation- factory 500 Consumable stores 2500 Factory cost

Rs. 100000 25000 5000 130000

17500 147500

Rs. Add: Admn overheads: Office rent Repairs and renewals Office Office lighting Depreciation-office Manager’s salary Director’s fees Office stationery Telephone Postage Cost of production

Rs.

2500 500 500 1250 5000 1250 500 125 250

11875 159375

Rs. Rs. Add: Selling & Dist. overheads: Carriage outwards 375 Salesmen’s salaries 1250 Travelling expenses 500 Advertising 1250 Ware house expenses 500 3875 Cost of Sales 163250

Cost of Sales Profit Sales

:

Rs. 163250 Rs. 26250 Rs. 189500

TREATMENT OF STOCK 1. Stock of Raw materials If the opening stock of raw materials, purchases and closing stock of raw materials are given then the cost of raw materials consumed must be calculated as Cost of raw materials consumed = Opening stock of raw materials + purchases during the year – closing stock or raw materials

1. Stock of Work in progress Work in progress is valued at prime cost or works cost. If is valued at works cost then the adjustment will be Factory or Manufacturing or Works cost =Prime Cost + Factory overheads+ opening WIP- Closing WIP

3. Stock of Finished Goods If the opening and closing stocks of finished goods are also given, then these must be adjusted before calculating cost of goods sold as under: Cost of goods sold = Cost of production + Opening stock of Finished goods – Closing stock of Finished goods.

COST CENTRE It is the smallest segment of activity or area or responsibility for which costs are accumulated. These cost centres are departments or sub departments of an organisation with reference to which cost is collected for cost ascertainment and cost control. The cost centres may be product centre or service centre Eg: In engineering industry, cost centres may be machine shop, welding shop, assembly shop, maintenance dept etc.,

PROFIT CENTRE It is that segment of activity of a business which is responsible for both revenue and expenses and discloses the profit of a particular segment of activity. Profit centres are created to delegate responsibility to individuals and measure their performance

CONVERSION COST It is the sum of direct wages, direct expenses and overhead costs of converting raw material from one stage of production to the next. Conversion cost = Works cost – Cost of direct materials

ORDERING COST & DEVELOPMENT COST Ordering cost: Costs incurred each time an order for the purchase of material is placed and are expressed as rupee cost per order and include cost of getting an item into the firm’s inventory Development cost: It is the cost of process which begins with the implementation of the decision to produce a new or improved method and ends with the commencement of formal production of the product by that method

CONTRIBUTION MARGIN & CARRYING COST Contribution margin: This is the excess of sales price over variable costs. This can be expressed as total or ratio of sales or percentage of sales. Carrying cost: It is basically the costs incurred on the maintenance of inventory and include cost of the money locked up in the inventory, inventory obsolescence, storage space, rent and cost of stores operations. It is also known as holding cost.

POLICY COST & DISCRETIONARY COSTS Policy cost: It is the cost which is in addition to normal requirement, incurred in accordance with the policy of an undertaking. Discretionary costs: Include fixed costs that arise from periodic appropriate decision that directly reflected top management policies. It is also known as managed cost or programmed costs.

CLASSIFICATION OF COST Cost classification is the process of grouping costs according to their common characteristics. A suitable classification of costs is important, in order to identify the cost with cost centres or cost units The same cost figures are classified according to different ways of costing depending upon the purpose to be achieved and requirements of a particular concern.

The important ways of classification are: •

•

By nature or Element: The costs are divided into three categories, Materials, Labour and Expenses. Materials can be further classified as raw material, spare parts, consumable stores, packing material etc. This classification is important as it helps to find out the total cost and valuation of WIP. By Functions: The costs are divided on the basis of managerial activities involved in the operation of a business undertaking. Eg; Production, Administration, Selling and Distribution

3.As Direct or Indirect: Total cost is divided into direct costs and indirect costs. Direct costs are those costs which are incurred for and may be conveniently identified with a particular cost centre or cost unit. Indirect costs are those costs which are incurred for the benefit of number of cost centres or cost units and cannot be conveniently identified with a particular cost centre or cost unit. Eg: rent of building, management salaries

•

By variability: Costs are classified according to their behaviour in relation to changes in the level of activity or volume of production. On this basis, costs are classified into three groups namely fixed, variable and semi-variable Fixed costs: Those which remain fixed in total amount with increase or decrease in the volume of output or productive activity for a given period of time. Eg; rent, insurance Fixed cost per unit decreases as production increases and increases as production declines.

Variable costs: Costs which vary in total in direct proportion to the volume of output. These costs per unit remain relatively constant with changes in production. They are also known as product costs as they depend on the quantum of out put rather than time. Eg: Direct material, direct labour, power, repairs etc. Semi variable costs: Costs which are partly fixed and partly variable. Eg: Telephone expenses include a fixed portion of annual charge plus variable charge according to calls.

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By controllability: The costs are classified according to whether or not they are influenced by the actions of a given member of the undertaking. On this it is classified as controllable costs and uncontrollable costs. Controllable costs: Costs which can be influenced by the action of a specified member of an undertaking. i.e. costs which are at least partly within the control of management Uncontrollable costs: costs which cannot be influenced by the action of a specified member of an undertaking.

•

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By normality: Costs are classified according to whether these are costs which are normally incurred at a given level of output in the conditions in which that level of activity is normally attained. On this basis costs are classified as normal cost and Abnormal cost. Abnormal costs are not a part of cost of production and are charged to Costing P&L a/c. By Capital and Revenue (Financial Accounting Classification): The costs which are incurred in purchasing assets used to generate income or to increase income earning capacity is called capital cost. The benefit of such costs are spread over a number of years.

Expenditure incurred to maintain the earning capacity or to run the business is called revenue expenditure. •

By time: Costs are classified as 1. Historical costs: The costs which are ascertained after their incurrence are called historical costs. The basic characteristics of such costs are (a) They are based on recorded facts. (b) They can be verified (c) They are mostly objective 2. Predetermined costs: Costs are estimated costs. Computed in advance of production taking into consideration the previous periods’ costs and the factors affecting such costs. Such costs determined on scientific methods become standard cost.

9. According to planning and control: Budgeted costs: An estimate of expenditure for different phases of business operations, coordinated in a well conceived framework for a period of time in future which becomes a managerial targets to achieve. Standard costs: It is the predetermined cost based on a technical estimate for materials, labour and overhead for a selected period of time and for a prescribed set of working conditions.

•

For managerial decisions: On this basis costs are classified as 1.Marginal costs: It is the total of variable costs. i.e., prime cost plus variable overheads. It is based on the distinction between fixed and variable cost. 2.Out of pocket costs: It is that portion of the cost which involves payment to outsiders. 3.Differential costs: The change in cost due to change in level of activity or pattern or method of production. 4.Sunk costs: It is an irrecoverable cost and is caused by complete abandonment of a plant. i.e., costs which are not relevant for decision making. 5.Imputed costs: Costs which appear in cost accounts only. These costs are also known as notional costs, which are considered for decision making.

6.Opportunity cost: It is the advantage, in measurable terms, which has been foregone due to not using the facility in the manner originally planned. 7.Replacement cost: It is the cost at which an asset or material identical to that which is being replaced or revalued, can be purchased. 8.Avoidable and unavoidable cost: Avoidable costs are those which can be eliminated if a particular product or department with which they are directly related is discontinued. Un avoidable costs are those which will cannot be eliminated with the discontinuation of a product or department.