Unit 2 Components of Costing 2.1 Objectives of Costing The objectives of costing are broadly d 1. Ascertainment of Cost Ascertainment of cost is the first and most important objective of costing, + The aim is to determine the cost of each product, process, or operation, and to ensure that all expenses are absorbed into the cost of the products, the techniques, and the process of costing use + Toascertain the cost of management, with the help of the costing department, to make preliminary investigations and introduce a system for recording costs. + A proper and complete record is maintained for materials, labor, and other expenses. Thus, the management periodically collects cost data, which is used as the basis for determining the selling price. As such, the costs and sales are matched, This matching process helps to determine and improve the profitability of the product. 4 Significantly, costing not only enables managers to ascertain costs, but it also provides a basis for ascertaining the profitability of the product being produced or any services rendered. 2. Cost Control 4 Ascertaining costs alone is not sufficient. Naturally, it is not enough because it is the cost that determines the selling price and, in turn, the profitability, As such, the norm that everyone attempts to follow is “the lower the cost, the greater to profit.” 4 To fulfill the underlying idea behind this norm, itis important to control the cost so as to reduce the cost of a product or service. 4% Budgetsare prepared, standardsare established, actualsare ascertained, and thena comparison is made. If any deviation between the actuals and the budget and the standards is identified, corrective measures are taken. 4 This helps to control the cost and enables managers to earn more or reduce the selling price. In turn, this allows the customer to benefit from better quality, which can build goodwill for the product and firm. 3. Guidelines for Management © Costing is a faithful servant for managers within an organization. It aids managerial decision- jaking from all practical points of view. led into the following three areas. is worthwhile 13 Scanned with CamScannerComponents of Costing / : tained from costing enable managers to strive toward efficiency for the Cost data provide organizational guidelines for various managerial deci, cost data can guide the introduction of anew product line, leag fa or highlight expansion opportunities, thy Unit 2 & Cost data obt organization. For example, the use of identification of unused capacity, stiny ms By Le ea ofthe term‘cost’ may also be understood by having knowledge a, «clas eate of cost. The following i the brief description of these elements of cost: m base cere ter Direct material is material that can be directly identified with each unt oy * otk Direct material can be conveniently measured and directly charged to the product, aris raw cotton in textile manufactures, sugarcane in sugar industry and leather for sh, making industry. . ‘The cost of direct material includes the following: ‘& Alltype of raw materials issued from the store, . x Raw materials specifically purchased for the specific job or project, Raw materials transferred from one cost centre to another cost centre, ‘4 Primary packing material, like cartons, cardboard boxes etc. 2. Indirect Material: They are those materials which do not normally form a part of the finisheg product. thas been defined as “materials which cannot be allocated but which can be portioned to or absorbed by cost centres or cost units”. These are: ‘& Stores used in maintenance of machinery, buildings, etc., like lubricants, cotton waste, bricks and cements. 4 Stores used by the service departments ie, non-productive departments like Power house, Boiler house and Canteen, etc. & Materials which due to their cost being small, are not considered worth while to be treated as direct materials. 3. Direct Labour: Direct labour is labour that can be identified directly with a unit of finished product, Allthe labour charges expended in altering the construction, composition, confirmation or condition of the product is included in it. It includes the payment of direct wages made to the following groups of direct labour: .ct labour engaged on the actual production of the product. ‘Direct labour engaged in adding this manufacture by way of supervision, maintenance and tool setting, etc. 4 Inspectors, analysts, etc. specially required for such production. 4, Indirect Labour: The wages of that labour which cannot be allocated but which can be apportioned to or absorbed by, cost centres or cost units is known as indirect labour. In other words, wages paid to labour which are employed other than or production constitute indirect labour costs. Examples of indirect labour are: charge hands and supervisors, maintenance workers, labour employed in service departments, material handling and internal transport, apprentices, trainees and instructors, factory clerical staff and labour employed in time and security office, etc. Direct or Chargeable Expenses: They include all expenditures other than direct material and direct labour that are specifically incurred fora particular product or job. Such expenses are charged directly to the particular cost account concerned as part of the prime cost. Examples of direct expenses are excise duty, royalty, surveyor's fees, cost of rectifying defective work, travelling expenses to the jo’ experimental expenses of projects, expenses of designing or drawings, repairs and maintenance of plant obtained on hire and hire of special equipment obtained for a contract. 6. Indirect Expenses: Indirect expenses are expenses which cannot be allocated but which can be apportioned to or absorbed by cost centres or cost units as rent, insurance, municipal taxes, salary! manager, canteen and welfare expenses, power and fuel, cost of training for new employees, lighting and heating, telephone expenses, etc. 14 Scanned with CamScannerUnit2 — Components of Costing 7, Overheads: Overheads may be defined as the cost of indirect materials, indirect labour and such other expenses including services as cannot conveniently be charged direct to specific cost units. Thus, overheads are all expenses other than direct expenses. Overheads may be divided into following categories: a. Factory or works overheads cover all indirect expenditure incurred by the undertaking from the receipt of the order until its completion is ready for dispatch either to the customer or to the finished goods store, The overheads also include: depreciation on plant and machinery, buildings and equipments, insurance charges on fixed assets, repairs and maintenance of fixed assets, electricity charges, coal and other fuel charges, rent, rates and taxes of works, etc b. Office and administrative overhead consists of all expenses incurred in the direction, control and administration of a factory. Examples are the expenses in running the general office eg, office rent, light, heat, salaries, salary to secretaries and accountants, general managers, directors, executives, investigations and experiments and miscellaneous fixed charges. ¢. Selling overheads comprise the cost of products or distributors of soliciting and recurring orders for the articles of commodities dealt in and of efforts to find and retain customers. It includes sales office expenses, salesmen's salaries and commission, showroom expenses, advertisement charges, fancy packing, samples and free gifts, after sales service expenses and demonstration and technical advice to potential customers. 4. Distribution overheads comprise all expenditure incurred from the time the product is completed in the work until it reaches its destination. It includes warehouse rent, warehouse staff salaries, insurance, expenses on delivery vans and trucks, expenses on special packing for bulk transport, losses in warehouse stocks and finished goods damaged in transit and cost of repairing, etc. 2.3 Cost Sheet A Cost Sheet or Cost Statement is “a document which provides a detailed cost information. In a typical cost sheet, cost information are presented on the basis of functional classification. However, other classification may also be adopted as per the requirements of users of the information. 2.3.1 Functional Classification of Elements of Cost Under this classification, costs are divided according to the function for which they have been incurred. The following are the classification of costs based on functions: ero eene Direct Material Cost Direct Employee (labour) Cost Direct Expenses Production/ Manufacturing Overheads Administration Overheads Selling Overheads Distribution Overheads Research and Development costs ete. 2.3.2 Cost Heads ina Cost Sheet "The costs as classified on the basis of functions are grouped into the following cost heads in a cost sheet: Prime Cost: expenses. The total of cost for each element has to be calculated separately. Prime cost represents the total of direct materials costs, direct employee (labour) costs and direct Direct Material Cost 300 Direct Employees (labour) Cost 100 Direct Expenses 7008 Prime Cost: XXXX 15 Scanned with CamScannerComponents of Costing i bie ata Cost Itis the costof direct material consumed. The cost of direct material cong, is calculated as follows: Opening Stock of Material 008 ‘Add: Additions/ Purchases 3008 Less: Closing stock of Material | _ (20%) Direct materials consumed | _xxxx is purchased and issued for production shall be done as per meq, 2 Material Cost”. Few examples are: Noy ‘The valuation of material discussed in the ‘Chapter- a. Costof material b. Freight inwards ; aire veand other expenditure directly attributable to procurement 4. Trade discounts or rebates (to be deducted) ; ©. Duties & Taxes (if input tax credit is not available/ availed) etc. ii. Direct Employee (labour) Cost: Itis the total of payment made to the employees who are engayy, in the production of goods and provision of services. Employee cost is also known as labour co includes the following: a. Wages and salary ». Allowances and incentives cc. Payment for overtimes d, Bonus/ ex-gratia fe. Employer's contribution to welfare funds such as Provident fund and other similar funds; £ Other benefits (medical, leave with pay, free or subsidised food, leave travel concession ang provisions for retirement benefits) etc. ii, Direct Expenses: Expenses other than direct material cost and direct employee cost, which are incurred to manufacture a product or for provision of service and can be directly traced in an economically feasible manner to a cost object. The following costs are examples for direc expenses: a. Cost of utilities such as power & fuel, steam et b. Royalty paid/ payable for production or pro\ Hire charges paid for hiring specific equipment d,_ Fee for technical assistance and know-how e. Amortised cost of moulds, patterns, patents etc, f. Cost for product/ service specific design or drawing g Cost of product/ service specific software h, Other expenses which are directly related with the production of goods or provision of service. Cost of Production: Ina conventional cost sheet, this item of cost can be seen, Its the total of prime cost and factory related costs and overheads. ion of service Prime Cost 70K Add : Factory Overheads 20004 Gross Works Costs 0x ‘Adil: Opening stock of Work-in-process oo Less: Closing stock of Work-in-process (x) Factory or Works Costs 200 ‘Add: Quality Control Cost 0 ‘Add: Research & Development cost (Process related) ox ‘Add: Administrative Overheads related with production vox Less: Credit for recoveries (miscellaneous income) (ox) ‘Add: Packing Cost (Primary packing) 10% Cost of Production x00 16 Scanned with CamScannerUnit2 Components of Costing 4, Factory Overheads: It is also known as works/production/manufacturing overheads. [t includes the following indirect costs: a. Consumable stores and spares Depreciation of plant and machinery, factory building ete. & Lease rent of production assets Repalr and maintenance of plant and machinery, factory building ete. e. Indirect employees cost related with production activities Drawing and Designing department cost 8. Insurance of plant and machinery, factory building, stock of raw material & WIP etc. h. Amortized cost of jigs, fixtures, tooling etc. i Service department cost such as Tool Room, Engineering & Maintenance, Pollution Control ii, Stock of Work-in-process: The cost of opening and closing stock of work-in-process (WIP) is adjusted to arrive at factory/works cost. The WIP stock is valued on the basis of percentage of completion in respect of each element of cost. Students may refer the ‘Chapter Process & Operation | Costing’ to know the WIP valuation methods. iti, Quality Control Cost: This is the cost of resources consumed towards quality control procedures. iv. Research & Development cost: It includes only those research and development related cost which is incurred for the improvement of process, system, product or services. v. Administrative Overheads: It includes only those administration overheads which are related to production. The general administration overhead is not included in production cost. vi, Credit for recoveries: The realised or realisable value of scrap or waste is deducted as it reduces the cost of production, vii. Joint products and By-products: Joint costs are allocated between/among the products on a rational and consistent basis. In case of by- products, the net realisable value of by-products is deducted from the cost of production. viiiPacking Cost (primary); Packing material which is essential to hold and preserve the product for its use by the customer, Cost of Goods Sold: Itis the cost of production for goods sold. [tis calculated after adjusting the values of opening and closing stocks of finished goods. It can be calculated as belo Cost of Production Xxx, ‘ost of Opening stock of finished goods 2x Less: Cost of Closing stock of finished goods (xxx) Cost of Goods Sold XXX Cost of Sales: Itis the total cost of product incurred to make the product available to the customer or consumer. Itincludes Cost of goods sold, administration and marketing expenses. Itis calculated as below: Cost of Goods Sold 70K ‘Add: Administrative Overheads (General) XxX ‘Add: Selling Overheads ony ‘Add: Packing Cost (secondary) xn ‘Add: Distribution Overheads xx Cost of Sales XKXX, ‘Administrative Overheads: It is the cost related with general administration of the entity. It includes the followings: ‘a. Depreciation and maintenance of, building, furniture etc. of corporate or general management. b,. Salary of administrative employees, accountants, directors, secretaries etc. a7 Scanned with CamScannerCosting t2 Components of| on lighting, office expenses etc. stationery, office supplies etc. ice expenses lke directors siting fees, remungay, mH Rent, rates & taxes, insurance, 4. Indirect materials- printing am f, Legal charges, audit fees, corporate ol and commission, meeting expenses ete. ii Selling Overheads: Itis the cot related with sale of products or services. It Includes the folly, |. Sel z costs: a. Salary and wages related with s. ods. . b. Rent depreciation, maintenance and other cost related with sales department. \psite for online sales, market research ete, Cost of advertisement, maintenance of wel s tu, Packing cost (secondary): Packing material that enables to store, transport, inform the custo, * promote and otherwise make the product marketable, : Distribution Overheads: It includes the cost related with making the goods avallable to ty customers. The costs are : a. Salary and wages of employees engaged in distribution of goods. b. ‘Transportation and insurance costs related with distribution. / ¢. Depreciation, hire charges, maintenance and other operating costs related with distributoy vehicles ete 2.3.3 Preparation of Cost Sheet/Statement A cost sheet isa statement of al costs incurred or expected to be incurred during a given period, in relation to the product/cost unit/cost center /department/operation/process/service, and analysed accordingto the various elements of cost. Itis prepared at convenientintervals such as, weekly, fortnight, monthly, quarterly, half-yearly or annually or as and when required by the management. “The cost sheet is usually presented both in totals and unit cost. Sometimes, percentage of each item to total cost is also shown, When the particulars of a cost sheet are presented in the form of an account, the same will be called a production account. If a cost sheet shows the total cost and cost per unit, production account shows profit or loss, b 2.3.3.1 Method of Preparation of Cost Sheet ‘An organization needs to bear multiple types of overheads while carrying out business operations Ina cost sheet, the following overheads or expenditure are presented systematically: 1. Prime Cost The initial cost made for manufacturing a product, ie, raw material, labour wages and other production-related expenses, is termed as prime cost. Following is the equation for computing the prime cost: Prime cost = Direct Material + Direct Labour + Direct Expense ‘Where direct material is calculated with the help of the following formula: Direct Material = Material Purchased + Op. Stock of Raw Material - Cl. Stock of Raw Material 2. Works Cost or Factory Cost The works cost is calculated by summing up the prime cost with the factory overheads and simultaneously adjusting the opening and closing stocks of work in progress. It can be denoted as: Works Cost = Prime Cost + Factory Overhead + Op. Stock of WIP - Cl. Stock of WIP ‘The various indirect overheads incurred at the factory premises can be computed with the help of the following formula: Factory Overhead = Indirect Material + Indirect labour + Indirect Expenses Let us now go through each of the indirect overheads in detail below: + Indirect Material: The indirect material includesall the additionalitemsused for manufacturing products, but not directly contribute as a raw material for the finished goods. Itcan be anything luke the oil, fuel, coal, stationery items and other factory utilities. Also, the items which are though directly used for making a product, but are inexpensive and small, are considered 2 indirect material. These include thread, pins, cello tape, nails, nuts, etc. ales department and employees directly related with sling Ms, 18 Scanned with CamScannerUnit2 Components of Costing 4 Indirect Labour: The labour or human resource engaged in all the activities other than ‘manufacturing of goods or services which are essential to carry out the business and assist the production operations is called indirect labour. It includes salary paid to managers, cleaning staff, security staff, drivers, etc * Indirect Expens I the other overheads which are neither directly contributing to the production operations, nor they can be termed as labour or material expense, are called indirect expenses. These are the expenses made for running the business operations smoothly. These include advertisements, depreciation, rent, electricity, insurance, taxes, repairs and maintenance, etc, 3. Cost of Production ‘The cost of production includes all the direct and indirect cost, including the material, labour and other expenses, ie, production cost, factory cost and office or administration cost. The following formula denotes the computation of cost of production: Cost of Production = Works Cost + Administration Overhead After making an adjustment of the opening finished goods and the closing finished goods to the cost of production, we acquire the cost of production of goods sold. Further, to calculate the cost of production of goods sold, the opening and closing stocks of finished products are adjusted with the cost of production. Its formula is: Cost of Production of Goods Sold = Works Cost + Administration Overhead + Finished Goods (Opening) - Finished Goods (Closing) 4. Total Cost (Cost of Sales) ‘The final value ofa product or service can be determined after adding all the selling and distribution expenses to the cost of production of goods sold. The formula to find out the total cost or cost of sales is: Total Cost = Cost of Production of Goods Sold + Selling and Distribution Overhead Ifthe sales price of the products or service is known, the following method can be used to determine the profit: Profit = Sales - Total Cost 2.3.3.2 Specimen Format of Cost Sheet for a Manufacturing Entity Particulars Total Cost|Cost per (Rs)__| unit (Rs) 1__[Direct materials consumed: Opening Stock of Raw Material ‘Add: Additions/ Purchases Less: Closing stock of Raw Material Direct employee (labour) cost 2 3__| Direct expenses 4 _| Prime Cost (1+2+3) 5 _| Add: Works/ Factory Overheads 6 + 8 9 Gross Works Cost (4#5) Add: Opening Work in Process Less: Closing Work in Process Works/ Factory Cost (6+7-8) 10 |Add: Quality Control Cost 11__[ Add: Research and Development Cost SISIBIEIS IRIS IB EIEIEIEIEIE 19 Scanned with CamScannerUnit2 Components of Costing 72 [Add: Administrative Overheads (relating to} xx production activity) 13 | Less:CreditforRecoveries/Scrap/By-Products/] (xxx) misc. income. 14 | Add: Packing cost (primary) x00 d 15_| Cost of Production (9+10+11+12-13+14) xxx 16 | Add: Opening stock of finished goods 200 17_| Less: Closing stock of finished goods 2X 18 | Cost of Goods Sold (15+16-17) 3x 19 _| Add: Administrative Overheads (General) 20x 20_| Add: Marketing Overheads : Selling Overheads 2x Distribution Overheads xxx 21_| Cost of Sales (18+19+20) xxx Formulas: 1. Prime Cost is the aggregate of Direct materials, Direct Labour and Direct Expenses. Prime Cost = Direct Materials + Direct Labour + Direct Expenses 2, Works Cost is the aggregate of prime cost and works overhead. It consists of the total of all ite cost incurred in the manufacturing of a product. Works Cost = Prime Cost + Works Overhead 3, Cost of production includes works cost and administration overheads. Production is not deemed ty be complete without the managerial and office expenses. Cost of production = Works Cost + Office and Administration Overheads 4. Cost of Sales (Total Cost) is the aggregate of all expenses attributable to it. It comprises cost of production plus selling and distribution overheads. Cost of Sales = Cost of production + Selling and Distribution overheads 2.3.4 Treatment of various items of cost in Cost Sheet/Statement i, Abnormal costs: Any abnormal cost, where itis material and quantifiable, shall not form part of cost of production or acquisition or supply of goods or provision of service. Examples of abnormal costs are: a. Cost pertaining to or arising out of a pandemic e.g. COVID-19 b. Cost associated with employees due to sudden lockdown. li, Subsidy/ Grant/ Incentives: Any such type of payment received/ receivable are reduced from the cost objects to which such amount pertains. Penalty, fine, damages, and demurrage: These types of expenses are not form part of cost. Interest and other finance costs: interest, including any payment in the nature of interest for uuse of non- equity funds and incidental cost that an entity incurs in arranging those funds. Interest and finance charges are not included in cost of production. Interest and Financing Charges shall be presented in the cost statement as a separate item of cost of sales, 2.3.5 Advantages of Cost sheet ‘The main advantages of a Cost Sheet are as follows: Itprovides the total cost figure as well as cost per unit of production. Ithelps in cost comparison, It facilitates the preparation of cost estimates required for submitting tenders. It provides sufficient help in arriving at the figure of selling price. Itfaclitates cost control by disclosing operational efficiency. MS of + + * * * 20 Scanned with CamScannerUnit2 — Components of Costing 2.3.6 Illustrations Illustration 1; ‘The following data relates to the manufacture ofa standard product during the month of June, 2021: Raw materials Rs, 1,80,000 Direct wages Rs, 90,000 Machine hours worked (hours) 10,000 Machine hour rate (per hour) Rs.6 Administration overheads (general) Rs. 35,000 Selling overheads (per unit) Rs.5 Units produced 4,000 Units sold 3,600 Selling price per unit Rs. 125 You are required to prepare a cost sheet in respect of the above showing: i. Cost per unit ii, Profit for the month Solutio i. Cost Sheet Output: 4,000 units Particulars Total Cost (Rs) | Cost per Unit (Rs.) Raw materials 1,80,000 45.00 Direct wages 90,000 22.50 Prime cost 2,70,000 67.50 ‘Add: Factory overheads (10,000 hrs = Rs. 8 per hour) 80,000 20.00 Cost of Production 3,50,000 87.50 Less: Closing Stock of finished goods (4,000- Ly 97.5% 400 3,600units) Yoo 87.5 =35,000 (35,000) |= ~ Cost of Goods Sold 3,15,000 87.50 ‘Add: Administration overheads (general) 35,000 9.72 Add: Selling Overheads (3,600 units Rs. 5 per unit) 18,000 5.00 Cost of sales (total Cost) 3,68,000 102.22 fi, Statement of Profit Particulars ‘Total Cost (Rs.) Sales revenue (3,600 units @ Rs.125) 4,50,000 Less: Cost of sales 3,68,000 Profit 82,000 21 Scanned with CamScannerUnit2 Components of Costing Illustration 2: ‘The following information has been obtained from the records of Manya Industries for the Devig from April 1 to April 30, 2021. On April 1, 2021 | On April 30,2021 (Rs) (Rs) Cost of raw materials 60,000 50,000 Cost of work-in-process 12,000 15,000 Cost of stock of finished goods 90,000 1,10,000 Purchase of raw materials during April 2021 4,80,000 Wages paid 2,40,000 Factory overheads 1,00,000, ‘Administration overheads (related to production) 50,000 Selling & distribution overheads 25,000 Sales 10,00,000 Prepare a statement giving the following information: a, Raw materials consumed b. Prime cost c. Factory cast d. Cost of goods sold e. Net profit Solution: Statement of Cost & Profit (for the month of April 2021) ‘Amount (Rs:) Opening stock of raw materials 60,000 ‘Add: Purchase of raw materials during April 2021 4,80,000 Less: Closing stock of raw materials (50,000) {a) Raw materials consumed 4,90,000 Add: Direct wages 2,40,000 (b) Prime cost 7,30,000 Add: Factory overheads 1,00,000 Works cost 8,30,000 ‘Add: Opening work-in-process 12,000 Less: Closing work-in-process (25,000) (Factory cost 8,27,000 ‘Add: Administration overheads 50,000 Cost of production 8,77,000 ‘Add: Opening stock of finished goods 90,000 Less: Closing stock of finished goods (2,10,000) (a) Cost of goods sold 857,000 Add: Selling & distribution overheads 25,000 Cost of sales 882,000 (c) Net Profit 1,18,000 Sales 10,00,000 22 _ d Scanned with CamScanner