Prof: Ankita .

Rohatgi Management Accounting for Engineers

CONCEPTS IN COST ACCOUNTING

Meaning of Cost accounting: If a concern is manufacturing number of project, its Profit and
Loss Account shows the lump sum amount of net profit or loss from all products taken together.
The profits from some products are set off against losses, if any from other products and only the
net result is shown in the Profit and Loss Account. Financial Account thus fail to give a product-
wise break –up of profit or loss .In case of a construction company, the Profit and Loss Account
shows the net profit or loss from all contracts taken together. The Financial Account do not
indicate the profit or loss made on each contract separately. Similarly, if a concern has a number
of processes, divisions or branches, the Profit and Loss Account shows the net profit or loss from
all process, divisions or branches taken together. Financial Accounts do not show the profit or
loss made by each process, division or branch separately.

Financial Accounts fail to ascertain the individual cost/ profitability of each product or contract
or process etc.separately.Cost Accounting grew out of this serious limitation of Financial
Accounting. The management of any concern is identifying products which are profitable so that
it can concentrate upon the profitable activities and discontinue the loss-making products. Each
product, contract, process, division or branch is known as a ‘cost centre’. Cost Accounting fulfils
this objective by ascertaining the individual cost of each product, contract, process or division.

FINANCIAL ACCOUNTING .VS. COST ACCOUNTING

Feature Financial Accounting (FA) Cost Accounting (CA)

1. Nature FA records, report and analyses CA records, report and analyses
financial transactions of a concern. cost of each cost centre (product,
contract, process etc.)
2. Use FA is used even by outside entities e.g. CA is used only the management
investors, creditors, banks etc. of the concern
3. System FA uses the double-entry system for CA does not use the double-entry
recording financial data. system for collecting cost data.
4. Period FA is for specific period e.g. a financial CA concentrates on cost centers
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Prof: Ankita . Rohatgi Management Accounting for Engineers

year. and not on period.

5. Reports FA results are shown in P & L A/c and CA results are shown in Cost
Balance Sheet. Sheets / Costing Profit & Loss
A/c. Contract A/c. Process A/c.
6. Data FA discloses past data. It is a post – CA discloses current data or
mortem. future estimates.
7. Decisions FA cannot be used for managerial CA is used for making decisions-
decisions. pricing, product-mix, how much
to produce etc.
ITEMS EXCLUDED IN COST ACCOUNTS

Cost Account mainly helps to determine the cost of a cost centre or a cost unit. It further
helps in ascertaining the profit or loss in respect of a cost center or a cost unit. Thus Cost
Accounting exclusively concentrates upon the Cost and Income of a centre or Unit. Hence
the following items appearing in the Financial Accounts are excluded from Cost Accounting:
(a) Financial Charges (b) Financial Losses (c) Financial Income, and (d) Appropriations of
Profit. Let us study these items in detail.

FINANCIAL CHARGES
These are the expenses for financing or raising capital for the concern. Since these have no
effect on the cost of an particular cost center or cost unit, they are ignored in Cost Account.
Financial Charges cover the following items :
(1) Interest on loans, debentures, fixed Deposits etc.
(2) Shares issue expenses, discount on issue, underwriting commission, share Transfer
expenses etc.
(3) Fines and penalties
(4) Cash discount.

FINANCIAL LOSSESS

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Prof: Ankita . Rohatgi Management Accounting for Engineers

Theses are capital losses like loss on sale of fixed assets, loss by fire etc. having no relation
with the cost of a center or unit. These too are excluded in Cost Account. Financial Losses
mean the following items.
(i) Loss on sale of fixed assets, investment, property etc.
(2) Compensation or damages paid as ordered by Court,
(3) Loss by fire, theft or any natural calamity
(4) Bad Debts written off.
FINANCIAL INCOME
Since a Cost Sheet is concerned with only the income from sale of a product items of
purely financial nature not attributable to the product are ignored in Cost Accounting
Financial Income means the following items :
(1) Rent from property
(2) Profit on sale of fixed assets, investments etc.
(3) Interest and Dividends earned on investments, deposits
(4) Damages received under order of Court
(5) Discount Received.
(6) Windfall Gains, Capital Gains etc.

APPROPRIATIONS OF PROFIT
Cost Accounting is not concerned with the appropriation or application of profit e.g. payment of
taxes, dividends etc. These cover the following items :
(1) Income Tax
(2) Write offs relating to intangible assets such as Goodwill, Preliminary Expenses, Discount on
Issue of Share etc.
(3) Charities and Donations
(4) Dividends
(5) Transfers to Reserves and Sinking funds etc.

Elements of Cost

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Prof: Ankita . Rohatgi Management Accounting for Engineers

COST CLASSIFICATION

COST CLASSIFICATION

BEHAVIOUR TIME FOR MANAGEMENT ELEMENTS

1. Fixed Cost 1. Historical Cost 1. Marginal Cost. 1. Material Cost

2. Variable Cost 2. Pre-determined Cost 2. Opportunity Cost. 2. Labour Cost

a) Standard Cost 3. Replacement Cost. 3. Expenses

b) Estimated Cost 4. Sunk cost. Cost Centre/

Cost Unit Wise
5. Notional cost Elements

6. Controllable cost

and uncontrollable cost

1. Prime/Direct Cost
Direct Material Cost

Direct Labour Cost

`Direct Expenses

2. Overheads/Indirect Cost
Factory Overheads

Office/Administrative

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Prof: Ankita . Rohatgi Management Accounting for Engineers

Overheads

Sale/Distribution

Overheads

CLASSIFICATION ON BASIS OF BEHAVIOUR

Cost are classified, on the basis of behavior into Fixed Cost, Variable Cost.
 FIXED COST
Fixed costs means a cost which tends to be unaffected by variations in volume of output. Fixed
Costs depend mainly on effluxion (passage) of time and so not vary directly with volume or rate
of output. Fixed Costs are sometimes referred to as period costs. These costs remain fixed
whatever the quantity of output. These costs do not increase when the output increases and do
not decrease when the output is lower. Rent, depreciation, insurance of factory building are some
examples of fixed costs.
 VARIABLE COSTS
Variable Cost means a cost which tends to vary directly with volume of output. Variable costs
are sometimes referred to as Direct Cost. These costs vary according to the quantity produced.
These costs increase when the output increases and decrease when the output is lower. Direct
Material Cost, Direct Wages, Direct expenses are some examples of variable costs.
CLASSIFICATION ON BASIS OF TIME

Costs are classified, on the basis of time, (1) Historical Costs, and (2) Pre-determined costs.

 HISTORICAL COSTS
Historical Costs are the actual costs as per the past records. These are used in Unit Costing to
ascertain the cost of a product; in Contract Costing to ascertain the cost of contract and in
Process Costing to ascertain the cost of a process.

 PRE-DETERMINED COSTS
Pre-determined costs are Future Costs determined in advance on the basis of standards or
Estimates. Thus, per-determined costs are of two types – (1) Standard Cost, and (2) Estimated
Cost.
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Prof: Ankita . Rohatgi Management Accounting for Engineers

1) Standard Cost: Standard Costs is a pre - determined cost calculated on the basis of
standards of efficient operations and relevant necessary expenses. Standard Costs are
used as a basis of fixing prices and for cost control through analysis of variances.
2) Estimated Cost: Estimated costs are calculated in advance of production or even before
accepting sales order. These may be based on past data. These, however, are not
scientifically calculated and hence are less reliable than Standard Costs.

CLASSIFICATION FOR MANAGEMENT

Costs may be classified according to the information required by the management for making
various decisions. Such costs are classified as follows.

 MARGINAL COST
Marginal Cost is the amount by which the costs change, if the output is changed by one unit.
Marginal cost is based on the classification of costs into fixed Costs and Variable Costs
explained above. These costs help the management in taking decisions about volume of
output, fixing prices etc.The marginal cost refers to variable cost.

 OPPORTUNITY COST
Opportunity Cost is the cost of the alternative use of an asset. Thus, if deposits in Bank are
withdrawn for purchase of machinery, the opportunity cost would be the loss of interest on
bank deposits. It should be noted that opportunity cost is not formally recorded in accounts or
cost records. It is specially computed only for the purpose of decision – taking by
management, whenever required.

 REPLACEMENT COST
Replacement Cost is the cost at which an existing asset or material can be replaced at current
market price. For many managerial decisions, replacement cost or current market price is
more relevant than the historical cost or book value of the asset or material.

 IMPUTED COST
Imputed Cost is hypothetical or notional cost not involving any actual cash payment. Interest
on owner’s capital or rent on own property are examples of imputed costs.

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Prof: Ankita . Rohatgi Management Accounting for Engineers

 SUNK COST
Sunk Cost is historical cost not relevant to the decision required to be made by the
management at present. Thus, the written down value of machinery is a sunk cost which is
not relevant for deciding whether to buy a new machinery for expansion or not. Sunk costs
are not affected by increase or decrease in the volume of output.

 CONTROLLABLE AND UNCONTROLLABLE COST

Controllable Cost, on the other hand, is the cost which cannot be influenced or controlled by
the concerned cost center or responsibility center. Thus overhead expenses incurred by Head
Office, but shared by all branches, cannot be controlled by individual branches. The share of
such Head Office Expenses borne by each branch is an Uncontrollable cost.

A cost may be uncontrollable for a particular cost center, but may be controllable for another
cost center or the management as a whole. For example, Rent for factory may be beyond
control for the production department but can be controlled by the administration department
by negotiations etc. A cost which is uncontrollable in the immediate future may become
controllable over a long period. Thus controllable cost is a relative term depending upon the
circumstances.

CLASSIFICATION ON BASIS OF ELEMENTS

The Total Cost of a manufactured product is made up of various elements such as material,
Labour and Expenses. Hence, costs can be classified according to the different elements of
expenses i.e. Material, Labour and Expenses.

The main elements of Cost are Material Cost, Labour Cost and Expenses.

1) Material Cost: Material Cost is the cost of raw material supplied to the company..
2) Labour Cost: Labour Cost is the cost of remuneration of the employees of the company
3) Expenses : Expenses mean the cost of services provided to an undertaking.
CLASSIFICATION OF ELEMENTS BASED ON COST CENTRE/UNIT

Each of the above costs may be classified on the basis of their relationship with a cost center
or a cost unit – direct or indirect.

1) Direct Costs are the costs identified with and allocated to cost centers or cost units.

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Prof: Ankita . Rohatgi Management Accounting for Engineers

2) Indirect Cost are the costs which cannot be identified which and allocated to cost
centers or cost units. Therefore, Indirect Costs are apportioned to cost centers or cost
units on some suitable basis. The terms Cost Allocation, Cost Apportionment, Cost
Centers and Cost Units are explained below.
PRIME/DIRECT COSTS

Prime or Direct Costs mean the cost of Material, Labour or Expenses which can be directly
identified with or attributed to a cost center or a cost unit. Direct Costs can be Direct Material
Costs, Direct Labour or Direct Expenses.

1) Direct Material Cost means the material cost which can be wholly identified with and
allocated to a particulars cost center or cost unit.
2) Direct Labour Cost means the labour cost or wages which can be wholly identified with
and allocated to a particular cost center or cost unit.
3) Direct Expenses mean the expenses which can be wholly identified with and allocated to
a particular cost center or cost unit.
Prime Cost means the total Direct Costs of a cost center or cost unit. Thus.

Prime Cost = Direct Material + Direct Labour + Direct Expenses

OVERHEADS/INDIRECT COSTS

Overheads means the aggregate of indirect costs such as indirect material cost, indirect wages
and indirect expenses. Indirect Costs denote the cost of Material, Labour or Expenses which
cannot be directly identified with or attributed to a cost centre . However, these are apportioned
to cost centers or cost unit on a suitable basis. Total Indirect Costs are made up of Indirect
material costs + Indirect Labour Costs + Indirect Expenses.

1) Indirect Material Cost means the material cost which cannot be identified with or
allocated to a particular cost center or cost unit. However, this is apportioned to or absorbed by
cost centers or cost units on a suitable basis.
2) Indirect Labour Cost means the labour cost which cannot be identified with or allocated
to a particular cost center or cost unit. However, these are apportioned to or absorbed by cost
centers or cost units on a suitable basis.

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Prof: Ankita . Rohatgi Management Accounting for Engineers

Overheads mean the total Indirect Costs apportioned to or absorbed by all cost centers or cost
units. Thus,

Overheads = Indirect Material + Indirect Labour + Indirect Expenses