introduction to cost accounting

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Cost Accounting

Introduction- Meaning Cost accounting is concerned with

recording, classifying and summarizing costs for determination of costs of products or services, planning, controlling and reducing such costs and furnishing of information to management for decision making

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COST ACCOUNTING

The Institute of Cost and Management Accountant, England (ICMA) has defined Cost Accounting as –

“the process of accounting for the costs from the point at which expenditure incurred, to the establishment of its ultimate relationship with cost centers and cost units. In its widest sense, it embraces the preparation of statistical data, the application of cost control methods and the ascertainment of the profitability of activities carried out or planned”.

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Cost Accounting = Costing + Cost Reporting + Cost Control.

Cost Accounting and Accountancy

Cost Accountancy means : “the application of costing and cost

accounting principles, methods and techniques to the science, art and practice of cost control”

It includes the presentation of information derived therefrom for the purpose of managerial decision making.

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Cost Accountancy includes… Cost Accounting Cost Control Cost Reduction Cost Audit

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Objectives of Cost Accounting Ascertainment of cost Estimation of cost Cost Control Cost reduction Determination of selling price Facilitating preparation of financial

and other statements Providing basis for operating policy

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Functions of managerial accounting Determining the cost Providing relevant information for

better decision-making Providing information for planning,

control, decision-making and application

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Application Cost accounting has extended

from manufacturing operations to a variety of service industries such as hotels, bands, airline, etc

Cost accounting system should be flexible and adaptable to meet the new business environment and the changing nature of the company

Cost - Concept Cost refers to the amount of resources

given up in exchange for some of goods or services

The resources given up are always expressed in terms of money.

CIMA defines “ the amount of expenditure (actual or notional) incurred on or attributable to a given thing or activity”.

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Important concepts Cost object Cost Cost unit Cost centre

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Cost object It is an activity or item or operation

for which a separate measurement of costs is desired

E.g. the cost of operating the personnel department of a company, the cost of a repair machine, and the cost for control

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Cost It is the amount of expenditure

incurred on a specific cost object Total cost = quantity used * cost

per unit (unit cost)

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Cost unit It is a quantitative unit of product

or service in which costs are ascertained, e.g. cost per table made, cost per metre of cloth

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Cost centre It is a location or function of an

organisation in respect of which costs are ascertained

E.g. the rent, rates and maintenance of buildings; the wages and salaries of strorekeepers

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Main Elements of Cost Material Labour Expenses

Material The substance from which the product

is made is known as material. It may be in raw, semi- manufactured

or a manufactured state. It can be Direct as well as Indirect.

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Direct materials All material which becomes an integral part of the

finished product and which can be conveniently assigned to specific physical unit is called as ‘direct material’.

The cost of materials – the cost of materials used entering into and becoming the elements of a product or service

E.g. fabrics in garments, crude oil in refinery, bricks, iron and cement in Building.

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Indirect materials All material which is used for purpose

ancillary to the business and which cannot be conveniently assigned to specific physical unit is termed as ‘indirect material’.

Such as stationery, consumable supplies, spare parts for machine that assist to the production of final products.

Labour For conversion of materials into

finished goods, human effort is needed

Such human effort is called Labour. Labour can be direct labour as well

indirect labour.

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Direct labour Labour which takes an active and direct part in

the production of a particular commodity or rendering service is called direct labour.

Direct labour costs are, therefore, specifically and conveniently traceable to specific product or service.

The cost of remuneration for working time E.g. assembly workers’ wages in toy assembly. It is also known as process labour, productive

labour, operating labour etc.

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Indirect labour Labour employed for the purpose of carrying out

tasks incidental to goods or service provided, is indirect labour.

Such labour does not alter the construction, composition or conditions of the product. It cannot be particularly traced to specific units of output.

Such as salaries of factory supervision and office staff that do not directly involve in production of the final product.

Indirect labour may relate to the factory, the office or the selling and distribution divisions

Expenses Any other cost, beside material

and labour cost, is termed as expense.

Expenses may be direct or indirect.

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Direct expenses These expenses which can be directly,

conveniently and wholly allocated to specific cost centres or cost units.

Such expenses are also described as ‘chargeable expenses’

Other costs which are incurred for a specific product or service

E.g. royalties Hiring of some special machinery, required for a

particular construct; cost of defective work etc.

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Indirect expenses Such as rent, rates, depreciation,

maintenance expenses that do not have instant relationships with the manufacturing processes

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Direct cost Cost that can be identified

specifically with or traced to a given cost object

The direct costs consist of the following three elements: Direct materials Direct labour Direct expenses

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Indirect cost (overhead) Cost that cannot be identified

specifically with or traced to a given cost object

They are identified with cost centres as overheads Indirect materials Indirect labour Indirect expenses

Overhead Factory or Works where production

is done Indirect material used in factory such

as oil, lubricants and consumables. Indirect labour such as gatekeeper

salary and works’ manager’s salary Indirect exp. such as factory rent,

insurance and factory lighting

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Office and Administration Overheads Indirect material used in office such as

printing & stationary Indirect labour such as salaries to

office managers, Director, CFO, CEO etc.

Indirect exp. such as insurance, ret and lighting of office

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Selling and Distribution overheads Indirect material used such as packing

material, printing and stationary material

Indirect labour such as salaries of salesman and sales manager

Indirect expenses such as rent insurance and advertising exp.

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Cost accumulation

•Prime cost = direct materials + direct labour + direct expenses

•Production cost = Prime cost + factory overheadAlso known as Factory Cost

•Total cost = Prime cost + Overheads (admin, selling,distribution cost)OR

= Production cost + period cost (administrative, selling, distribution and finance cost)

•Period cost is treated as expenses and matched against sales for calculating profit, e.g. office rental

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Cost Sheet Costs sheet is a document which

provides for the assembly of the estimated detailed cost in respect of a cost centre or a cost unit.

It analyses and classifies in a tabular form, the expenses incurred on different items for a particular period.

COST SHEET 

DIRECT MATERIALDIRECT LABOURDIRECT EXPENSES 

PRIME COSTFACTORY OVERHEADS 

FACTORY COSTOFFICE OVERHEADS 

COST OF PRODUCTIONSELL & DIST OVERHEADS 

COST OF SALESPROFIT  SALES

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Example.. From the following particulars compute the cost of production of

product:Amount

Material Used 12,000

Labour Employed 8,000

Salary of inspector engaged in the product 1,000

Propionate lighting and heating (factory and office 3:2)

500

Proportionate of deprecation, repairs and rent (50% is related to factory)

1,000

Municipal tax and insurance (40% related to office) 800

Trade subscription 100

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Cost Sheet..Particulars Amount

Direct Material: Material Consumed 12,000

Direct Labour: Labour Employed 8,000

Direct Exp: Salary of inspector engaged in the product

1,000

PRIME COST 21,000

Add: Factory overheads lighting and heating deprecation, repairs and rentMunicipal tax and insurance

300500480

FACTORY COST (Prime cost + Factory overheads)

22,280

Add: Office and Administrative overheads lighting and heating deprecation, repairs and rentMunicipal tax and insurance Trade subscription

200500320100

Total Cost of Production (Factory cost+ office exp)

23,400

Exercise.. Calculate total cost Material Used in manufacturing: 5,500 Material Used in packing: 1,000 Material Used in selling the product: 150 Material Used in factory: 75 Material Used in office: 125 Labour required in producing: 1,000 Labour required for supervision of mgt. of factory: 200 Expenses- Direct- Factory: 500 Expenses- Indirect- Factory:100 Expenses- office: 125 Deprecation- office building and equipment: 75 Depreciation- factory: 175 Selling expense: 350 Freight : 500 Advertising : 125

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Classification of Cost Fixed Variable Semi-variable and Step cost

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Variable cost It increases or decreases in direct

proportion to levels of activity, but the unit variable cost remains constant

E.g. cost of food served in a restaurant, raw material, labor (per unit paid)

Also known as product cost. Wages of labour, power and material

cost are example of variable cost.

Variable cost- Total and per unit

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Fixed cost Total fixed cost remains constant

over a relevant range of activity level but unit fixed cost falls with an increase in activity volume.

Salary, rent, insurance are example of fixed cost

Fixed cost- Total and Per unit

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Semi-variable cost It processes characteristics of both

fixed and variable cost It increases or decreases with

activity level but not in direct proportion

Semi- Variable Cost

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Step cost It remains constant for a range of

activity levels, then, on further increase in activity, the cost jumps to a new level and remains constant over a certain range until the next jump occurs

Step costs

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Product cost Product cost are related to the goods

purchased or produced for resale. If the products are sold, the product cost

will be included in the cost of goods sold and recorded as expenses in current period

If the products are unsold, the product costs will be included in the closing stock and recorded as assets in the balance sheet

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Period cost Period cost related to the

operation of a business They are treated as fixed cost and

charged as expenses when they are incurred

They should not be included in the stock valuation

Relevant and Irrelevant Cost

Relevant cots are those costs which would be changed by the managerial decision.

For example, if a company is considering to close unprofitable retail sales shop, wages, salaries payable to the shop workers are relevant in this decision as they will disappear on closing of shop.

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These costs wages, salaries, electricity are relevant for decision making.

On the other hand, prepaid rent, insurance or any other uncovered cost of any equipment which will have to be scarped are irrelevant cost which must be ignored.

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Shutdown and Sunk Costs Shutdown costs are those costs which will

gave to be incurred when plant is closed due to temporary non availability of material, labour or any other key ingredients.

Some fixed cots like deprecation of building, rent, maintenance will have to incur during that period and are called Shutdown cost.

Thus cost which have to incur even if there is no production are called Shutdown costs

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Sunk costs are historical or past costs. These costs are costs which have been

created or incurred by a decision that was taken in past that cannot be changed by any decision that will be made in future.

Investment in plant, machinery, building etc are prime example of such costs.

Since sunk cost cannot be altered by later decision, they are irrelevant for decision making

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Controllable and Uncontrollable cots

Controllable costs are those can be influenced by the action of a specified member of the company.

Cost which can't be so influenced are uncontrollable costs.

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Imputed or Hypothetical costs Costs which don’t involve any cash

outlay . They are not included in the cost

accounts but are important for consideration while making management decisions.

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Differential, Incremental cost The cost difference between two

alternatives is termed as differential cost

Incremental is increase in the cost if increase the production by x number of units.

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Out of pocket costs Present or future cash expenditure

regarding a certain decision which varies depending upon on the nature of decision made.

Own truck verus taking transport company .

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Comparison of cost, management and financial accounting

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Meanings Financial accounting Cost accounting Management accounting

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Financial accounting Provides information to users who

are external to the business It reports on past transactions to

draw up financial statements The format are governed by law

and accounting standards established by the professional accounting policies

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Cost accounting Is concerned with internal users of

accounting information, such as operation managers

The generated reports are specific to the requirement of the management

The reporting can be in any format which suits the user

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Management accounting Comprises all cost accounting

functions The accounting for product and

service costs, management accounting extends to use various internal accounting reports for planning, control and decision making

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Cost and management accounting

Vs.Financial accounting

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Management (cost)accounting

Financial accounting

Nature Records material, labour and overhead costs in product or jobReports produced are for internal management and contol

Records company transaction eventsExternal financial statements are produced

Accounting system

Not based on the double entry system

Follows the double entry system

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Management (cost)accounting

Financial accounting

Accounting principles

No need to use accounting principlesAdopt any accounting techniques that generates useful accounting information

Use Generally Accepted Accounting Principles for recording transactions

Users of information

Used by different levels of management or departments responsible for respective activities

Used by external parties: shareholders, creditors, government, etc

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Management (cost)accounting

Financial accounting

Operation guidelines or standards

Based on management instructions and requirements

Conforms to company Ordinances, stock exchange rules, SEBI , MCA rules etc.

Time span

Reports are prepared whenever neededThey may be prepared on a weekly or daily basis

Reports are prepared for a definite period, usually yearly and half yearly

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Management (cost)accounting

Financial accounting

Time focus

Future orientation: forecasts, estimates and historic data for management actions

Past orientation: use of historic data for reporting and evaluation

Perspective

Detailed analysis of parts of the entity, products, regions, etc

Financial summary of the whole orgainisation

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Cost accountingvs.

Management accounting

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Management accounting

Cost accounting

Objective To provide information for planning and decision making by the management

To ascertain and control cost

Basic of recording

Concerned with transactions related to the future

Based on both present and future transactions for cost ascertainment

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Management accounting

Cost accounting

Coverage Covers a wider area: financial accounts, cost accounts, taxation, etc.

Covers matters relating to ascertainment and control of cost of product or service

Utility Only the needs of internal management

The needs of both internal and external interested groups

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Management accounting

Cost accounting

Types of transactions

Deals with both monetary any non-monetary transactions, covering both quantitative and qualitative aspects

Deals only with monetary transactions, covering only quantitative aspect

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Methods of Costing Costing is “the technique and

process of ascertaining cost”. There are various methods of

costing: Job Costing Contract Costing Batch Costing Process Costing Operation Costing Operating Costing

Job Costing Job costing is used when the production is not

highly repetitive and, in addition, consists of distinct jobs or lots .

Each product produced in the job are identified by order number.

This method is followed by these concerns when work is carried on by the customers request.

Commercial foundry, printing press, specialized industrial equipments are example where job costing is applied.

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Contract Costing

Contract  costing is applied for contract work like construction of dams, buildings, roads, civil engineering contract etc. each contract or job is treated as separate cost unit for the cost ascertainment and control.

A contract costing in principle differ from job costing, A contract is a big job while a job is a small contract.

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Batch costing A batch is a group of identical products.

Under batch costing a batch of similar products is treated as a separate unit for the purpose of ascertaining cost.

The total costs of a batch is divided by the total number of units in a batch to arrive at the costs per unit.

This type of costing is generally used in industries like bakery, toy manufacturing, pharmaceutical etc.

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Process Costing This method is used in industries where

production is carried on through different stages or processes before becoming a finished product.

Costs are determined separately for each process. The main feature of process costing is that output of one process becomes the raw materials of another process until final product is obtained.

This type of costing is generally used in industries like textile, chemical  paper, oil refining etc.

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Service (Operating) Costing

This method is used in those industries which rendered services instead of producing goods. Under this method cost of providing a service is also determined.

It is also called service costing. The organisation like water supply department, hotels, Railway, transportation, electricity department etc. are the examples of using operating costing.

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Operation Costing This is suitable for industries where

production is continuous and units are exactly identical to each other.

This method is applied in industries like mines or drilling, cement works etc.

Under this system cost sheet is prepared to find out cost per unit and profits or loss on production.

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Techniques of Costing

Following types of techniques are used by management only for controlling costs and making some important managerial decisions. Marginal Costing Direct Costing Absorption or Full Costing Uniform Costing Standard Costing

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Marginal Costing It is a technique of costing in which allocation of

expenditure to production is restricted to those costs which arise as a result of production i.e. costs which vary with production (material, labour and direct expenses-variable only and variable overheads)

Fixed costs are excluded on the ground that in cases where production varies, the inclusion of fixed costs may give misleading results.

It is the ascertainment of marginal cost by differentiating between fixed and variable cost. It is used to ascertain the effect of changes in volume or type of output on profit. 79

Direct Costing It is the practice of charging all direct costs,

variable and some fixed costs relating to operations, processes or products leaving all other costs to be written off against profits in which they arise.

This technique is different from marginal because some fixed costs can be considered as direct costs in appropriate circumstances.

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Absorption or Full Costing It is the practice of charging all costs,

both variable and fixed to operations, processes or products.

This differs from marginal costing where fixed costs are exclude.

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Uniform Costing It is the use of same costing

principles and practices by several undertakings for common control or comparison of costs.

This facilitates inter firm comparison, establishing of realistic pricing policies etc.

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Standard Costing A comparison is made of the actual cost

with a pre-arranged standard cost and the cost of any deviation (called variances) is analyzed by causes.

This permits the management to investigate the reasons for these variances and to take suitable corrective action.

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Historical Costing It is ascertainment of costs after they

have been incurred. It aims at ascertaining costs actually

incurred on work done in the past. It has a limited utility, though

comparisons of costs over different periods may yield good results.

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