Chapter 1

INTRODUCTION TO COST ACCOUNTING

number of products, is interested to know the cost per unit of

A manufacturer, producing a
It is easy to find out
each commodity. This information will help him in fixing the prices judiciously.
from financial accounting. But it is
the aggregate cost of production of total output of all categories
unit of each class of commodity from financial accounting.
very difficult to calculate the cosi per
is to allocate the aggregate
For finding out the cost per unit of each category of output, it necessary
cost among the different classes of products. This
function is performed by Cost Accounting. Cost.
in the 17th Century.
Accounting was first introduced in France by the Royal Wallpaper Manufactory
But it has its own
Financial Accounting is considered to be the father of accounting systems.
limitations.
Limitations of Financial Accounting
The following are the important limitations of financial accounting:

provides only past data (historical). It is simply post-mortem of the past events.
a
. It
etc.
2. It does not show profit or loss of each product, job, process
3. It fails to exercise control over resources.

4. It does not measure organisational efficiency.

fixation.
. I t fails to provide adequate data for price
6. It does not provide data for comparison of
cost.

7. It fails to take into account the impact of price level changes.

8. It cannot disclose controllable and uncontrollable costs.

9. It provides only limited information to management for decision making.
It is these limitations which gave birth to costing and cost accounting.

Meaning and Definition of Costing

method or technique.
Costing simply means finding out the cost of a product or service by any
(ICMA, London defines costing as, "the technique and process of ascertaining the cost" 'The
 technique of costing refers to principles and rules for ascertaining the cost. The process of costina
ing
costs.
refers to the procedure (routine work) of ascertaining
defined as follows:
The term 'costing' is mathematically
costs + Process of ascertaining costs.
Costing= Technique of ascertaining
the procedure to m e a s u r e the cost.
In short, costing is
of Cost Accounting
Meaning and Definition
Cost accounting is the process of accounting for costs lt is the process of classifying, recording
allocating and reporting expenditure for determining the costs of products or services It is the
accounting for cost that aims at providing cost data and preparing statements and reports for the
purpose of managerial decision making.
Cost accounting is mathematically defined as follows:
Cost Accounting = Costing + Application of cost control methods + Ascertainment of

profitability.
Thus, cost accounting may be defined as a formal accounting system set up for recording
costs. It is the process ofaccounting for costs with the object of ascertain ing and controlling costs,
In short, cost accounting is the art and science of recording, analysing and estimatingcosts.
Difference Between Costing and Cost Accounting

The differences between costing and cost accounting are as below:

Costing Cost Accounting

1.It has narrow scope. 1. It has broader scope.
2. It is concerned with recording of cost.
2. It is concerned with ascertainment of cost.
3. It begins where costing ends.
3. It begins where cost accountancy ends.
4. It is done by cost clerks.
. It is done by cost accountant.
In short, costing is merely finding cost of a product/ service by any technique or method, but
cost accounting means costing by using double entry system.
Meaning and Definition of Cost Accountancy
Cost accountancy is an essential part of accountancy. Cost accountancy has been developed
to meet the managerial needs of business and other organisations which incur cost.
ICMA, London defines cost accountancy as the application of costing and çost accounting.
principles, methods and techniques to the science, artand practice of cost control and the ascertainment
ofprofitability as well as presentation of information for the purpose ofmanagerial decision making
Cost accountancy is mathematically defined as follows:
Cost Accountancy = Cost Accounting + Presentation of information to managemenmt
fo
decision making.
In short, cost accountancy is the sciene, art and practice of cost accounting
 Nature or Features of Cost Accounting
The following features of cost accounting indicate its natu

Cost accounting provides cost date

2Like financial accounting, cost accounting follows doubleentry system
Cost accounting is particularly useful for manufacturing enterprises.
A. Cest+-accounting is a science, art and practice of cost accountànt.
5 Cost accountingissupplementary to financialaccounting.
&determines the total and per unit cost of products and services.
T. It provides datafor fixing the selling price of products and services.
8 It provides data to management for exercising effective control over costs.
9 Itisaprofession.
Scope of Cost Accounting
included in that subject. Cost
The scope of any subject refers to the various areas of study
accounting has a very wide scope. It includes the following:
Cost Recording or (Cost Book-keeping) : Cost recording refers to recording of cost
transactions in the various books. These transactions are then posted into thevarious ledgers
maintained under the cost accounting system.
2 Cost Allocation: Cost allocation means distribution of costs to various departments or products
or cost centres.
on pre-determined basis. It is the charging of specificcosts to cost units
Cost Ascertainment: The major function of cost accounting is the ascertainment of cost of
Froducts/ jobs/processes etc.
Cost Analysis It involves detailed investigation into the çauses of actual costs yarying
increase in cost.
from the budgeted costs and assigning responsibility for
Cost Comparisons : Cost accounting includes comparisons between cost of different
products and activities, and costof sameproduct or service over a period oftime.
Cost control
6. Cost Control: Cost control is the regulation of costs of products or operations.
is exercised through a variety of techniques. Important techniques are inventory control,

productcontrol, quality control, budgetary control, standard costing

ete

Cost Audit: Cost audit is the verification ofcostaccounts. The aim of cost audit is to highlight
the shortcomings inherent in the cost accounting system:

8. Cost Reporting:This involves presentationofcost informationto managementfor decision makmg.

Objectives (Purposes) of Cost Accounting
The main objectives of cost accounting are outlined as follows:
1. To ascertain cost
2. To control cost.
 33. To determineselling price.
To ascertainthe profit of
cach activity.
44. statements.
5. To prepare financial
decision-making.
6. To assistmanagementin
profitab of different products.jobs or workorders.
7.
T. Toascertain the
efficiency.
8. To measure
to improve
performance.
9. To suggest steps
wastages.
10. To control and reduce
poliçies.
1 Toformulatebusiness
Functions of Cost Accounting
are summarised as follows:
The functions of cost accounting
Ascertaining actual cost
of each product, job or process.
1.
formulation, decision-makingetc.
Providing cost data for the purpose pricing, policy
of
2. actuals.
setting standards and comparing them with the
3 Controlling costs by
or department.
4. Measuring efficiency of each product, process
5. Serving as a toolfor planningand budgeting.
6. Helping in theselling price fixation.
. Helping in the preparation oftendersorquotations.
8. Protecting theinterests of investors.
9. Reportingtothegovernment.
its duties or functions through the following
According to Wilmot, cost accounting discharges
process: (i) analysing, (b) recording, (c) standardising,
(d) forecasting, (e) comparing, (f) reporting,
and(g) recommending costs and results.
Merits / Importance / Advantages of Cost Accounting
A good costing system is an invaluable aid to management. Peter Drucker says, "Profitability
is the sovereign criterion ofthe enterprise, and cost accounting greatly promotes it". Cost accounting
helps the management in discharging their functions efficiently. It helps in maximising profit. It
also benefits employees, creditors, government and society in general.
A. Advantages to Management
1. Cost accounting system identifies profitable and unprofitable activities. This helps to reduce
or eliminate
unprofitable activities. In this way it helps to improve overall profitability.
2. Cost accounts
furnish cost data to management for decision making such as make or buy,
continue or shut down,
accept or reject etc.
3 Cost
accounting system helps to exercise control on
through standard costing, budgetary control material, labour and overhead cOStS
etc.
 4 Cost accounting system helps in minimising losses and wastages relating to materias, idle
time, idle capacity etc.
5. Cost accounting helps the management in fixing thesellingprice. It assists in the preparation
of estimates and tenders.
6. Cost accounting system enables to measureorganisationalefficiency.
7. Cost accounting helps in appraisingtheperformance of each division, department etc. on the
basis of cost
comparisons.
8. Cost data help management in
determining future production policy.
9. Determination ofcost centre helps management to define and fix responsibilities upon individuals.
10. Cost of closing stock ofmaterial, work-in-progress and finished goods can be easily obtained
from cost records. This facilitates the
preparation of final accounts whenever required.
B Advantages to Employees
1. Cost accounting facilitates the introduction of incentive schemes.and bonus plans. In this
way it offers better wages to employees.
2. Cost accounting helps in introducing a good wagesystem.
3. A good costing system helps in increasing the productivity. profitability and prosperity of
firms. On account of this, workers get better wages, job security etc,
4. Cost accounting minimizs the possibilities of mi_understanding between workers and
employers.
C Advantages to Creditors
1. Cost data helps the creditors to ascertain the solvency, profitability and future prosperity of
an enterprise before they lend.
2 Cost accounting enables the creditors to ascertain whether the capitalemployed iseffectively
utilised in the business.
3 Cost accounts help creditors to understand about thecreditworthiness andfinancialsoundness
of firms.
D Advantages to Government

Cost accounting helps government in formulating policies relating toexport, import, taxation,
price control measures, wage fixation etc.
2 Cost information helps in preparingnationalplans and budgets
3 Cost accounting helps in levying excise duty,salestax etc.
Government can run public sector enterprises efficiently with the help of cost accounts
4
E Advantages to Society
1. Cost accounting conducts a war against all kinds of waste. Therefore, consumers get quality
products at reasonable prices.
 Cotrttrig
2. Cost accounting brings stability by improving managerial and operating efficiency.
3. Cost saving and cost reduction cfforts carried out by various organisations help in curbing
inflationarytendencies in the economy.
4. Costa ccounting provides continuous employment opportunitis to various sections of societu
Demerits / Disadvantages of Cost Accounting
Cost accounting is a normative science. Even though cost accounting is highly useful. it
suffers from the following limitations:
Cost accounting lacks uniformity. Different organisations prepare cost records and reports
in different methods and forms.
2. Cost accounting has only a limited useinprojectingfuture costs. It provides data for arriving at
decisions. It does not offer solutions to a problem.

3. It requires heavy expenditure.

4. Cost computed for one purpose may not be suitable for some other purposes.
5. Cost accounting is not suitabletotrading concerns. It is not applicable to small enterprises.

6 Cost accounting system is more complex because a number of steps are involved in ascertaining
costs.

7. Cost accounting is based on assumptions and presumptions. Hence, it is notan accurate or an

exact science.

Criticisms or Objections Against Cost Accounting

Despite several benefits offered by cost accounting, some objections are raised against it.
Arguments against cost accounting are outlined as below:
1. Cost accountingis expensive. Only large organisations can afford.
2. Cost accounting is unnecessary.
3. Cost accounting is notsuitable for alltypes ofindustries, e.g., rice mills. It is unnecessary for
trading concerns.
4. Cost accounting is a failure as regards bringing desired results.
5. Cost accounting is merely a system ofestimates and probabilities.
6. Cost accounting is stereotyped and mechanical.
Relationship Between Financial Accounting and Cost Accounting
Both cost accounting and financial accounting are branches of accounting. In fact, cost
accounting is complementary to financial acounting. This means that cost accounts make financial
accounts complete. It can be seen that where financial accounts end, cost accounts begin. BOn
are similar in some respects. But in some other respects they differ from one another.
Similarities
The points of similarities are outlined as follows:
 1. Both are branches of accounting.
2. Both record transactions relating to business and non-business entities.
3. Principles of double entry are applicable in both systems.
4. Both provide valuable information for the use of management and others.

5. Both provide a measure of control.

Differences
The following are the main differences between financial accountingand cost accounting
Financial Accounting Cost Accounting
1. Financial accounts are accounts of the 1. Cost accounts are only a part of the wholee
whole business. accounts.

2. Financial disclosethe net

accounts 2. Cost accounts disclose the net profit or net
results of the busjness as a whole. loss of each department, job, product etc.
3. Financial accounts deal with all 3. Cost accounts deal with transactions relating
to manufacturing and sale of products and
commercialtransactipns.
serviceS.
-4. Financial accountsrecord only actual 4. ( st accounts record both actual costs and
(historical) costsS. estimated costs.
5 Financial accounts deal with externaltran-| 5. Cost accounts deal with internaltransactions.
sactions (between business and outsiders)
6. The main object of financial account is to 6.. The main object of cost account is to ascertain
ascertain correct profit/loss of the business the true cost of production.
and to show a true and fair view of the
state of affairs of business.
7. Generally, financial accounts provide 7. Cost accounting furnishes cost data at fre-
financial information once a year. quent intervals, i.e., daily, weekly or monthly.
8. Financial accounts are guided by generally| 8. Cost accounts aretailor-made to suit needs of
accepted accounting principles. specific.organisation, division, department etc.
9. Financial accounting informationisnot 9. The cost data are helpful in evaluating the
sufficient to evaluate the efficiency of the efficiency of the business.
business.
10. Emphasis in financial accounting is on 10.Emphasis in cost accounts is on control on

reporting, not on control. material, labour and overhead.

11. Financial account does not guidethe 11.Cost accounting provides adequate data for
formulationof pricing policy. formulatingpricingpolicy.
12. In financial accounts, stock is valued at cost 12.In cost accounts, stock is always valued at

price or market price whichever is less. cost price.

 Methods of Costing
costs (or cost per unit of product/
the method of finding
Method of costing simply means
are known as methods of
calculation of cost per unit of output
service). The methods used for the costs. The method to be
used differ from
to ascertain
costing. Different methods can be applied depends upon the
nature of product, service

industry to industry. The choice of a method of costing and process

two methods of costing, namely, job costing
and industry. Basically, there are only
these two basic methods. Following are the
costing. All other methods of costing are variation of
main methods of costing:
Costing: Under job costing costs are collected and accumulated for each job or work
(1. Job Each job is distinct and cach is different from
Each job is a separate cost unit.
order separately., Job costing is applicable to printing
the other. Therefore, each job is to be separately costed.
machine tools, ship building, furniture making
work, repair shops, foundries, engineering works,
-

etc.
a number of small orders
(2. Batch batch represents a group of similar products or
costing: A
Each batch is produced
processed or manufactured together as a single group (i.e., batch).
Costs are collected for the batch
according to specific instructions and is to be costed.separately?
as a whole and cost per unit is ascertained by dividing the total cost of batch by the number of units
biscuit
produced in that batch. Batch costing is generally followed in spare parts manufacturing,
factories, pharmaceutical companies, readymade garments, packed food, watch manufacturing,
toys,cosmetics etc.

(3. Contract costings A contract is a bigjob. Hence it takes a longer time to complete. Like jobs,
eachcontract is different from the other. Costs are collected,accumulated and ascertainedfor
eachcontract separately. So a separate account is maintained for each individual contract. This
method is used in construction type of industries such as building, roads, bridges, dams etc.
4. Process costing: This basic method of costing is suitable to industries where production is
undertaken on mass scaleand on continuous basis and raw materials are passed through two or
more distinct processes before completion)Thus output of one process becomes the input for the
néxt process(A separate account for each process is opened and all expenditure is charged thereon.
Thus the cost
ofthe product at each stage is calculated
5. Single or unit costing: This method of costing is used when a company produces only one
product (or a few grades of the same product) in large number on a continuous basis and when the
units are identical. The production is costed as a single
process. That is why this method is also
called 'single operation costing'. The object of unit
costing is to find out the cost per unit of output.
Unit costing is also called single costing or This is used in
output
costing. industries like
mines,
quarries, cement works, steel works, brick works etc. In all these cases there is a natural or
standard cost unit.
6. Operating costing: This method is applied to the enterprises which are engaged in rendering
services such as transport
undertakings, railways, airways, hospitals, electricity,hotels etc. This
method aims at ascertaining the cost
of services rendered. Operating costing is also known as
service costing.
 7. Operation costing: A manufacturing process may sometimes be subdivided into a number

ofparts.
Each part is For example, production ofa steel almirah is divided
knownasan operation.
into operations such as cutting a steel sheet, welding the body, welding compartments, fixing the
door and the handle and polishing. In this case operation costing is appliedlOperation costing
refers to the determination ofcost.of operations. The cost unit is the 'operation' instead of the
is used in industries
process. This method is also called detailed process costing. This method
like toy making,leather,engineering goods etc.
8. Multiple costing: When two or moremethods ofcosting are applied in respect of the samg
This method is used in industries where
product, it is called multiple costing or composite costing,
a large number of components are separately produced and assembled into a final product. For
example, in bicycle manufacturing industries batch costing may be used to ascertain the costs of
various component parts. After having assembled these parts unit costing may be used in ascertaining
the cost of a single bicycle. Other examples of industries which use multiple costing are radio

manufacturing, television manufacturing, refrigeration industries, aeroplanes, automobiles, machine

tools, electric motors, computers etc.
Types or Techniques of Costing
In addition to the methods of costing, theré are some techniques or types of costing also. Types
and decision
ortechniques of costing refer to the manner of ascertaining costs for cost control
for
making purposes. They are the ways in which cost information is presented to the management
cost control and decision making. The following are the various types or techniques of costing:

1. Absorption Costing: It is the process of charging all costs (both variable and fixed) to

products, services, jobs or processes. It is also called full costing.

2. Marginal Costing: It is the process of chargingonly variable costs to products, operations
and process. It is also known as variable costing8
costs and
3. Direct Costing: It is the process of charging all direct costs (all variable some

fixed costs) to products, services, jobs etc. The indirect costs are excluded and written off

againstthe profit of the period in which they arise.

for the purpose
4. Differential Costing: It is the technique of comparing cost of two alternatives
of deciding which alternative isthe best.
several
5. Uniform Costing: It is the use of same costing principles, practices and methods by
undertakings for a common control orcomparison of costs.
been incurred.
6. Historical Costing: It is the ascertainment of costs after they have
analysing
7. Standard Costing: It is a system of comparing actual cost with standard cost,
variances and taking remedial action, if necessary.
for apportionment of overheads.
8. Activity Based Costing: This is a technique basically used is the
each Each activity acts as cost driver. Cost driver
Overheads are identified with activity. stores
be purcahse order,
reason for the incurrence of overhead costs. Cost drivers may
 requisition. power consumed ete. Having determined the overhead costs with each cost centre
cost per unit of each cost driver can be ascertained. The overhead cost is then assigned to jobs
on the basis of number of activities required for their completion.
9. Life Cycle Costing: This is a technique for evaluation of total cost of the product over its
economic life. Thus, it takes into consideration the entire life of the product from beginning to
end.

10. Target Costing: This is a technique to control the cost in competitive environment of a
product. In this type of costing, a firm focuses on whatitwill sell atwhich price and then it
plansto produce the product.
 Chapter 2

COSTCLASSIFICATION&ELEMENTS OFCOST
and decision making. To
The three important functions ofmanagement are planning, controlling of information
needs information. One very important type
perfome these füunctions effectively, management
related to costs. The costs which are collected should be classified to suit particular purposes. The
is
decision making etc.
purposes may be cost ascertainment, inventory valuation, cost control,
Meaning and Definition of Cost
differently. In the
The term 'cost' hasvariety of meanings. It is defined by different people
It means anything which is given
Oxford Dictionary cost means "the price paid for something".
But in cost accounting, it has a specific meaning. A cost is
or sacrificed to obtain something.
when a business enterprise
incurred when a resource is used for some purpose. In other words,
the term cost refers
sells goods or services, it incurs costs. Thus, in cost accounting,
produces or

or service.
to the resources consumed to produce a product
"ameasurement in monetary
The Institute of Management Accountants, U.S.A. defines cost as
ICMA London defines cost as the
terms of the amount of resources used for some purpose".
cost is the expenditure incurred to secure
amount of expenditure incurred on a given thing. Thus,
to the total expenses incurred on the production and
sale
an economic benefit. In short, cost refers

of products and services.

Expense
benefit. If the benefit is received immediately, then the cost becomes
an
Cost provides a
future benefits, then the cost is known as asset
expense, such as salary expense. If the cost gives
or such as machinery. As the asset is used, an expense such as depreciation arises.
expenditure,
.Thus, cost includes expense and expenditure.
In
The AICPA defines expense as all expired cost which is deductible from revenue",
short, expense is an expired cost with a matching economic benefit.
Classification of Cost (or Types of Costs)
Cost classification is the process of grouping costs according to their common characteristics.
There various ways of classifying costs. Each classification
are serves a different purpose. The
following are the various bases of cost classification:
 1. assincation According to Functions: On the hasis of function, costs are classilicd int,

five categories. They are

anufacturing cost (Production cost): This is the cost associated with the production of
goods.
(b) Administrative cost: This is the cost incurred in the administration of thebusiness. This is
not related to manufacturingorselling functions.
stimulating demand for products. In short, selling
(C)Selling cost: This the cost for creating and
cost is the cost incurred inmarketing the producis.
the goods from the factory to the
(a) Distribution cost: This is the cost incurred in moving
consumers (or market).
and usingcapital.
e) Financing cost: This is the cost incurred for raising
2. According to Behaviour or Variability:
Classification
the basis
On of variability, costs
are classified into fixed, variable, semi-variable
and step costs.

Fixed cost: Fixed costs are those costs which do not change with changes in the level_of
(a) will remain fixed.
When production increases or decreases, the fixed cost (total)
activity.
to time. Hence, fixed cost is also called Lime cost or period
However, it may vary according
cost. It should be noted that fixed remain fixed only upto acertain levelof activity (i.e.,
costs
also be noted that fixed cost
fixed only in the short period). It may varyin the longrun. It may
in volume of output. Fixed cost per unit decreases with
per unit will change with change
increase in output and increases with decrease in output. Rent and rates, salaries and wages
etc. examples of
of permanent staff, insurance, municipal taxes, depreciation of building
are

fixed costs. The behaviour of fixed cost is shown below:

Fixed cost Total fixed cost Fixed cost

Fixed cost
per
unit

(Production(Units) (Production(Units)
(b) Variable cost: Variable costs are those costs which vary directly with changein volume of
production or volume of output. This means that when volume of output increases, total
variable cost also increases
proportionately. Similarly, when the volume of output decreases,
total variable cost also decreases
proportionately. But the variable cost per unit remains
fixed. Examples variable cost include direct material, direct labour, direct expenses,
of
commission of salesmen and other variable
overheads. These are direct costs. Variable
costs are also
known as product costs. The behaviour of variable cost is shown below
 Totalvariablecost

Cost () Cost () Variable cost per unit

(Production(Units) (Production(Units)
(c)Semi-variable cost: These costs are partly fixed and partly variable. Telephone charges,
of
repairs and maintenance, power charges, depreciation, supervision cost etc. are examples
semi-variable cost. These are also called mixed costs or semi-fixed cosis.
The behaviour of semi -variable cost is shown below:

Variable portion
Cost )

Fixed portion

(Production(Units)
These remain fixed over a
(d) Step costs: Step costs are those costs which increase in steps.
increasesbeyond a
rangeof activity and then jumps to ahigher leyel when level of activity variant of semi-
known as chunk cost. Step cost is a
certain point. Step cost is also etc. are examples of
canteen staff wages
variable cost. Inspection costs, supervisor's salary,
on a graph, it gets the shape of steps. It is shownbelow
step cost. When step cost is plotted

Step cost

Cost ()

(Production(Units)
 On the basis of identifiabilit
3. Classification According to Identifiability or Traceability:
indircct.
Or
chargeability, costs are classified into direct and
identificd with a particular Cost centrc (ar
Direct costs: All costs which be conveniently
can
are directly chargeableto a product,
activity cr r
Cost unit are known as direct costs. These
in manufacturing a product arc comm
department. Material used and labour employed
examples of direct costs. be identified with a particular cost
which cannot conveniently
(b) Indirect costs: Those costs are c o m m o n to a number of cost units
known as indirect costs. These
unit or cost centre are basis. The total of indirect i
cost 1
on a suitable
or cost centres.They are to be apportioned
of machinery etc. arc
factory rent, depreciation
called overhead. Factory manager's salary,
costs.
ypical examples of indirect also be classified on the
with Time and Period: Costs can
4. Classification by Association into historical cost, product
to this, costs can be classified
basis of time and period. According
costs.
cost, period cost, and pre-determined place. They
incurred after the event takes
Historical costs: These are the costs which are
(a)
are nothing but actual costs.
are the costs which are directly
associated with the product. These
b) These,
Product costs:
costs are direct material,
are the costs of making
the finished products. Examples of product
These costs are
overheads. Thus, these are manufacturing costs.
direct labour and factory
also called inventoriable costs.
of the
Period costs: These are the costs charged as an expense in the
profit and loss account
c) on the basis of time. Generaly, expenses
periodin which they areincurred. They
are incurred
insurance etc. are treated as period costs. In
of fixed nature like depreciation, rent, salaries,
It should be noted that rent paid on office
short, period cost is the çost incurredin the period,
is a product cost.
building is a period cost, while rent paid on a factory building
Pre-determined cost: It is the cost which is computed in advance of production.
5. Classification on the Basis of Managerial Decisions: On the basis
of managerial decision-

making, costs are classified into the following categories:

Sunk costs: Sunk costs are historical or past costs. These are the costs which have already
been incurred as a result of a decision made in the past. Such costs cannot be reversed or
revised by a future decision. These are not relevant for decision-making. Investment in plant
and machinery is an example ofsunk cost. As soon as a fixed asset is purchased, its cost is
sunk. This is so because the amount invested in plant and machinery is sunk in the sense that
the amount is irrecoverable or the decision is irreversible.
(6) Opportunity costs: Opportunity is the cost
value of abenefit sacrificed favour of an
in
alternative cOurse ofaction. It is the cost of the best alternative foregone. Ítisthe value of
benefits foregone when one decision alternative is selected over another. To be more
clearly,
when one alternative is chosen over the
other, the possible benefit lost from the rejected
alternative is the opportunity cost
ofthe alternative chosen. For example, if an owned building
 is proposed to be uscd for a new project, the likely rent of the building if it is rented out is the
opportunity cost. To conclude, we can think of oppotunity cost as the opportunity lost
(cDifferetial costs: The differencein totalcosts betweentwo alternativey is called differential
cost. In the words of the AAA Committec, "differential cost is the increase or decrease in
total costs, or the changes in the specific elements of cost that results from any variation in

operation". It is the increase or decrease in total cost that results from alternative course
an

of action. If a decision results in an increasein cost, the differential cost is called incremental
cost. Ifa decisionresults jn a decreaseincost, the differential cost is called decrementalcos
These notional costs. These computed for decision-
(d) Imputed costs: are hypothetical or are

making purposes. These costs are not actually incurred. These are expenses which an
considered
entrepreneurpays to himself. These are not recorded in the books. Imputed costs are
while making a decision. Examples of imputed costs are rent on owned building, salary of
owner, interest on owned capital, loss ofasset value due to inflation etc.
(e) Out-ofpocket costs: Out of pocket costs are those coststhatinvolvecashoutflowimmediately
orinfuture. Material costs, labour costs, repairs, rent, insurance premium etc. are the examples
on fixed assets and amortisation of intangible assets do
of outof pocketcosts. Depreciation
not involve any cash outflow. Therefore, they are not out-of-pocket costs.

( Shut down costs: These are the costs (fixed) which will be incurred even if the plant is
closeddowntemporarily due toraw material shortage, labour problem,fall in demandetc.
Examples are rent, rates, depreciation, maintenance of plant, insurance of plant and machiney,
interest on borrowed capital, salary of permanent staff etc.
gMarginal cost: It is the additional costofproducing an additionalupit.
a) Conversion cost: It is the cost ofconvertingrawmaterialsinto finished products. Thus, it is
tze ictal of direct labour cost, direct expenses and manufacturing (factory) overheads. It may
be noted that conversion cost excludes the cost of direct materials.
Relevant costs: Costs which have directinfluenceon the decision-making are called relevant
costs. These are future costs that will change dueto managerialdecision. For each decision,
the management must decide which costs are relevant.
Importance of Cost Classification
Theneed for cost classification arises due to the fact that cost data are ised ior a variety of
purposes. It may be noted that for different purposes, different types of cost information. are required.
Hence, costs must be arranged and classified in such a way that they can be combined in different
ways to serve different purposes. The importance ofcost classification may be outlined as below:
i t helps in formulation ofpricingpolicy.
2 lt is useful in break even analysis.
3 It is useful in planning process and budgetary control.
4 It helps to ascertain profits.
5. It is useful in cost control.
 Elements of Cost
Elements of cost are broad heads of cost involved in a product or service. There
There are
are three
three
elcments of cost - material, labour and expenses. The analysis of total cost into materials, labour
and expenses is called elements of cost. The following chart shows the various elements of cost

Cost

Material Labour Expenses

1
Indirect Direct Indirect Direct Indirect
Direct

Factory oh. Office oh. Selling oh. Distribution oh.

Elements of Cost Chart

The various elements of cost are briefly explained as follows:

Materials
CThe matter or substance from which the product is made is called material It may be in raw
or processed form. Material is of two types - direct materials and indirect materials.

Direct materials: Direct materials are those materials which can conveniently be identified
with and allocated to a particular job. product or process. In other words, mâterials that become
part of the finished goods are called direct materials. In short, the materials which are present in
the finished products are called direct materials. Examples are cotton in textile mill, clay in
bricks, leather in shoes, steel in machine, cloth in garment, timber in furniture, gold or silver in
jewellery etc.
Indirect materials: Indirect materials are those materials which cannot conveniently be identified
with a particular product, job, or process. Therefore, they cannot be allocated to ajob or prOcess.
Generally, these do not form a part of the finished product. Examples of indirect material are oil,
grease, lubricants, consumable stores, cleaning materials, cotton waste, coal, printing and
materials etc.
stationery
 Labour
CEorthe conversion of raw material into finished goods, human cffort is required. Such human
effort is called labour Remuneration on labour is called wages. Labour is further divided into
direct and indirect.

Direct labour: Direct labour is the labour which can conveniently beindentified witha particuar
the wages
product,job or process. Direct labour is directly engaged on production. It represents
paid to workers directly engaged in converting the raw materials into finished products.
Indirect labour: It is the labour which is notdirectly engagedon production. Itcannotconveniently
to
beidentified with a particular product,job or process. Hence it cannot be directly chargea
production. Indirect labour cost includes the wages paid to cleaners, inspectors, foremen,
storekeepers, supervisors, peon, watchmen, salesmen, directors. Indirect labour costs form a part

of the manufacturing overhead.

Expenses
CAll costs other than material and labour are termed as expenses) Expenses are of two
types direct expenses and indirect expenses.
Direct expenses: Direct expenses are those expenses which are neither direct materials nor
direct labour but are directly chareed to productor johor process. These are specially incurred in
production of a particular product, job, or process. The utility of such expenses is exhausted on
completion of job or process. Direct expenses are also called chargeable expenses or prime cost
expenses or product expenses. Examples of direct expenses are cost of special drawings, designs,
patterns, models etc., experimental cost, cost ofpatents and royalties, travelling expenses to the site,
cost of rectification of defective work, hire charges of special machinery for a particular job, excise

duty etc. The latest trend in cost accounting is that these expenses are not taken into account.
Indirect expenses: Indirect expenses are those which cannotbe identified witha particular product
or job. They are apportionedto or absorbed by cost centres or costunits. They include all indirect
costs other than indirect material and indirect labour. Examples of indirect expenses are rent, rates,
taxes, insurance, depreciation, repairs and maintenance, carriage, advertising. power and lighting etc.
Overheads
Overheads are indirect charges. These are the aggregate of indirect material cost, indirect
labour cost and indirect expenses. These are operating expenses. Overheads cannot be conveniently
and directly charged to specificcostcentre or cost unit. These are to be
apportioned or absorbed.
Overheads are also called oncost. They are sometimes called "burden'.
There is a difference between indirect expenses and overheads. Indirect expenses are
expenses actually incurred. Overhead refersto the estimated expenses. But both cannot be allocated
to a cost centre or cost unit.

According to function, overheads can be classified into four, namely, factory overheads,
office overheads, selling overheads and distribution overheads.
 Factory overheads: These are indirect charges incurred in connection with production in t .
C
factory. These include indirect material, indirect labour and indirect expenses in producing . the
enses in
or services in the factory. Factory overheads are also called works overhead. Examnles
producing
goods
Examples of
factory overhead are consumable stores, factory rent, plant depreciation, repairs to machinery and
factory building, factoryinsurance, drawing office salaries, coal, gas, power etc.
Office overheads: These are indirect expenses incurred in formulating policies, planning, control:lling,
directing and motivating the personnel ofan organisation. In short, these are costs incurred
in
onnection with the management and administration or an enterprise. Office overheads are called
administrative overheads. Examples of office overheads include office rent, office salaries. postaaae,
printing and stationery, legal charges, audit fees, accountant's salary, office lighting and heating
depreciation of furniture, telephone charges, directors fees etc.
Selling overheads: These are indirect expenses incurred for the purposeof promoting sales,creating
and stimulating demand and retaining the customers. Examples of such expenses are advertising
salesmen salary and commission, bad debts, market research, traveller's salaries, sales office and
showroom expenses, sales manager's salary, samples, free gifts, after sales service expenses etc.
Distribution overheads: These are indirect expenses incurred from the time the products are
completed in the factory till they reach their destination. These are costs of moving the goods
from factory to the places of consumers. Examples of distribution overhead are godown rent,
warehouse staff salary, packing expenses, delivery van expenses, carriage outward, insurance of
stock of finished goods etc.
Divisions or Components of Cost
By grouping the various elements of cost, we get the following divisions or components of cost:
O Prime cost
Factory cost.
Ciio Cost of production
(iv) Total cost
Prime cost: Prime cost refers to the total of three important elements of cost- direct
material,
direct labour and direct expenses. Thus, prime cost is the
aggregate of all direct elements of cost.
It is also called by other names such as first cost, basic cost and
foundation cost. Prime cost is
calculated as below:
Prime cost =Direct material+ Direct labour + Direct expenses
Factory cost: This is the total of prime cost and factory overheads. It is the actual expenses that
are incurred in
converting raw materials into finished products. It is also known as works cost. It
is expressed as follows:

Factory cost or Works cost =

Prime cost +
Factory or Works overhead
Cost of production: This is the
aggregateof factory cost and office and administrative overheads.
It is also known as office cost. It is
computed as follows:
Cost of production or office cost
Factory cost +office and administration overheads
=
Total cost: When selling and distribution overheads are added to cost of production, it is called
total cost or cost of sales. It serves the purpose of fixing the selling price by adding a margin of
profit to the total cost. It is calculated as follows:
overheads
Total cost or cost of sales =
Cost of production + selling and distribution
The following chart summarises the various divisions oftotal cost:

Direct mat
+
Direct lab Prime cost
+ + = Factory cost

Direct exp Factory oh + Cost of prod

+ Cost of sale
Office & adm oh
Sell& dist oh or
Total Cost