Chapter -1 Introduction to Cost Accounting

Meaning and Definition of Cost

Meaning of Cost
Cost is the amount of resources used for something which must be measured in
terms of money. For example: - Cost of preparing one Silk Saree is the amount
incurred on the elements like material, labour and other expenses; similarly cost
of offering any services like banking is the amount of expenditure for offering
that service.
Definition of Cost
Cost can be defined as “The expenditure incurred on or attributable to a given
thing.” It can also be described as the resources that have been sacrificed or
must be sacrificed to attain a particular objective.
Definition of Costing
The costing terminology of C.I.M.A. (Charted Institute of Management
Accounts) London defines costing as the “The techniques and processes of
ascertaining costs”. These techniques consist of principles and rules which
govern the procedure of ascertaining cost of products or services.
Definition of Cost Accounting
The Costing terminology of C.I.M.A. (Charted Institute of Management
Accounts) London defines cost accounting as “The establishment of budgets,
standard costs and actual costs of operations, processes, activities or products,
and the analysis of variances, profitability or the social use of funds."
Wheldon defines cost accounting as “The classifying, recording and
appropriate allocation of expenditure for determination of costs of products or
services. The relation of these costs to sales value and ascertainment of
Profitability.”
Cost Accounting primarily deals with collection, analysis of relevant of cost
data for interpretation and presentation for various problems of management.
Cost accounting accounts for the cost of products, service or an operation.
Meaning and Definition of Cost Accountancy
Cost Accountancy is the widest of all the terms and includes not only costing
and Cost Accounting but also cost control and cost audit.
Cost Accountancy is defined by C.I.M.A. as “ The application of
costing and cost accounting principles, methods and techniques to the science,
art and practice of cost control and the ascertainment of profitability. It includes
the presentation of information derived there from for the purpose of managerial
decision making”.
OBJECTIVES OF COST ACCOUNTING
Information regarding cost of each product or service would enable the
management to know where to economies on costs, how to fix prices, how to
maximize profits and so on. Thus, the main objects of cost accounting are the
following:
1) To Ascertaining cost: This is the Primary objective of Cost Accounting. It
ascertains the cost of production of every unit, job, process, department or
service and to develop cost standard.
2) Measuring and increasing efficiency: - It helps in measuring the efficiency
of the organization as a whole as well as of the departments. It increases
efficiency by providing the guidance how to overcome inefficiency.
3) To Provide Data: To Provide data for periodical profit and loss accounts and
Balance sheets at such intervals, e.g., weekly, monthly or quarterly, as may be
desired by the management during the financial year.
4) To Determine Selling Price: After ascertaining the cost of product while
fixing selling price it is required to add certain percentage of profits to cost to
determining selling price.
5) To control cost and reduce cost: - Cost Accounting assists in cost control. It
uses techniques like budgetary control, standard costing etc, for controlling cost.
Cost is reduced by constant research and development activities without
compromising with quality of goods and service.
5) To Provide guidance in the development of business.
To present comparative cost data for different periods and various volumes of
output and to provide guidance in the development of business. This is also
helpful in budgetary control.
6) To provide a perpetual inventory (maintenance of detailed inventory
records in the accounting system).
Perpetual inventory system provides the basis for production planning and helps
to avoiding unnecessary wastages or losses of materials and stores.
7) It provides information to make decisions: - It enables management to
make short-term decisions of various types, such as quotation of price to special
customers or to make or buy decision, assigning priorities to various products,
etc.

Importance and Uses of Cost Accounting

1. Elimination of Wastes, Losses and Inefficiencies

A good cost accounting system eliminates wastes, losses and inefficiencies by
fixing standard for everything.
2. Cost Reduction
New and improved methods of production are followed under cost accounting
system. It leads to cost reduction.
3. Identify the reasons for Profit or Loss
A good cost accounting system highlights the reasons for increasing or
decreasing profit. If so, the management can take remedial action to maintain
profitability of the concern.
4. Advises on Make or Buy Decision
On the basis of cost information, the management can decide whether make or
buy a product in open market.
5. Price Fixation
The total cost of a product is available in the costing records. It is highly useful
for price fixation of a product.
6. Cost Control
Budgets are prepared and standards are fixed under cost accounting system. The
expenses are not permitted beyond the budget amount. The actual performance
is compared with standard to find the variation. If there is any variation, reasons
are find out and the management can exercise control. Period to period cost
comparison also helps cost control.
7. Assist the Government
Government can collect reasonable tax from the company and exercise price
control.

Differences between Financial Accounting and Cost Accounting

Basis Financial Accounting Cost Accounting

1.Purpose Main Purpose of FA is to Main Purpose of CA is to
prepare profit and Loss provide detailed cost
Account and Balance information to
Sheet management.
2.StatutoryRequirement Financial Accounts are Cost Accounting is
required to be kept as per voluntarily kept to serve
the requirement of the management in the
companies Act & Income discharge of its functions.
Tax Act.
3.Reporting FA reports (P&L A/C and CA Provides Continuous
Balance Sheet) are flow of data information
prepared at the end of the of cost report to the
Accounting Year. management. (Like Daily,
weekly, monthly etc,.)
4.Analysis FA reveals the profit of CA shows the profits
the Business as a whole. result of each operation
process and product.
5.Control FA related to recording CA provides for a detailed
aspects but did not system of Cost control
consider the Cost Control. with the help of standard
costing and budgetary
control.
6.Audit Audit of FA is Statutory. Audit of CA is not
Compulsory.
7.Nature FA is concerned mainly CA is concerned not only
on historical records. with historical cost but
also with predetermined
cost.
8.Pricing It fails to guide the It Provides adequate data
formation of pricing for formulating pricing
policy. policy.

Various Elements of Cost

The following are the Elements of Cost in Cost Accounting:
1. Material Cost
Material costs are a key factor in production expenses, including all materials
needed for manufacturing. These costs are divided into Direct and Indirect
Materials based on their traceability and significance in the production process.
Direct Material
Direct materials are raw materials that can be easily traced to the production
process and make up a large part of the total cost. They are essential and
identifiable parts of the finished product.
Example:
In making wooden furniture, timber, nails, and glue are direct materials. Their
costs can be directly linked to the finished table.
Indirect Material
Indirect materials are used in the production process but cannot be directly
traced to the final product. They are necessary for production but do not form
part of the finished product.
Example:
Indirect materials include cleaning supplies, machine lubricants, or small
amounts of glue or nails used to maintain equipment in a furniture factory.
These costs are distributed across multiple output units or different production
departments.
2. Labor
Labor costs are a key aspect of cost accounting, covering the expenses of the
workforce involved in the production process. These costs are divided into Direct
Labor and Indirect Labor based on how easily they can be linked to the final
product.
Direct Labor
Direct labour includes the workers who are directly involved in manufacturing
goods or providing services. The costs associated with direct labor can be
directly traced to specific products or services.
Example:
In a car assembly line, the workers who assemble the cars are considered direct
labour. Their wages are direct costs linked to each vehicle’s production.
Indirect Labor
Indirect labour involves the personnel who support the production process but
do not directly contribute to the creation of goods or services. These costs are
distributed across multiple output units or departments.
Example:
In a car assembly plant, the salaries of maintenance staff, supervisors, and quality
control inspectors are considered indirect labour costs. These expenses are
essential for production but cannot be assigned to a specific vehicle.
3. Overhead Cost
Overhead costs play a vital role in cost accounting, covering all expenses not
directly linked to making a product or providing a service. These costs are divided
into direct and indirect overheads based on how easily they can be traced to
specific cost centres or products.
Direct Overheads
Direct overheads are costs that can be directly assigned to a particular cost
centre or product. They are closely related to specific departments or products,
making them easier to allocate precisely.
Example:
In a furniture factory, the electricity used by machinery in the production
department is a direct overhead cost.
Indirect Overheads
Indirect overheads are costs that cannot be directly traced to a specific cost
centre or product. These expenses are distributed across multiple departments or
products, needing a method for allocation.
Example:
The salaries of administrative staff, general factory maintenance, and rent for the
entire manufacturing facility are indirect overheads. These costs are essential for
overall operations but can’t be directly linked to a single product or department.
Classification of Costs

1] Classification by Nature

This is the analytical classification of costs. Let us divide as per their natures. So
basically, there are three broad categories as per this classification, namely Labor
Cost, Materials Cost and Expenses.

2] Classification by Functions

The grouping of costs is according to the broad divisions of functions such as

production, administration, selling etc.

• Production Costs: All costs concerned with actual manufacturing or

construction of the goods
• Commercial Costs: Total costs of the operation of an enterprise other
than the manufacturing costs. It includes the admin costs, selling and
distribution costs etc.

3] Classification by Traceability

• Direct Costs: So, these are the costs which are easily identified with a
specific cost unit or cost centres. Some of the most basic examples are
the materials used in the manufacturing of a product or the labour
involved with the production process.
• Indirect Costs: These costs are incurred for many purposes, i.e.
between many cost centres or units. So we cannot easily identify them
to one particular cost centre. Take for example the rent of the building
or the salary of the manager. We will not be able to accurately
determine how to ascertain such costs to a particular cost unit.

4] Classification by Normality

• Normal Costs: This is a part of the cost of production and a part of the
costing profit and loss. These are the costs that the firm incurs at the
normal level of output in standard conditions.
• Abnormal Costs: These costs are not normally incurred at a given
level of output in conditions in which normal levels of output occur.
These costs are charged to the profit and loss account, they are not a
part of the cost of production.
5)Cost Object:

Cost Object is the method of measuring the cost of the product, segment,
customer, etc., separately so as to determine the exact cost along with the
determination of the selling price.
6)Cost Unit: Cost unit is a unit of quantity in terms of which costs may be
computed. Or CIMA defined Cost unit as “A quantitative unit or Product or
service in relation to which costs are ascertained.” Ex:

Industry/ product Cost unit

Automobile Number
Hospital Patient –per day
Steel manufacturing Per ton
Transport Passenger- Kilo meter
7)Cost Driver:
Cost drivers are the direct cause of a business expense.
An example of this could be how the amount of water your office uses in a
month determines the price of your water bill.

8)Cost centre
A cost centre is nothing but a location, person or an item of equipment for
which cost may be ascertained and used for the purpose of cost control. For
example, a production department, stores department, sales department can be
cost centres.
Or a cost centre can be: 1. a location i.e. an area such as Department &Sales
area. 2. An item of equipment i.e. Machine, delivery vehicle or 3) A Person e.g.,
salesman, foreman.

Definition of Cost Reduction

Cost Reduction is a process, which aims to lower the unit cost of a product
manufactured or service rendered without affecting its quality. It can be done by
using new and improved methods and techniques. It ascertains substitute ways to
reduce the production cost of a unit.

Definition of Cost Control

Cost Control is a process in which we focus on controlling the total cost through
competitive analysis. It is a practice which works to align the actual cost in
agreement with the established norms.
It ensures that the cost incurred on production should not go beyond the pre-
determined cost. Cost Control involves a chain of various activities, which starts
with the preparation of the budget in relation to production.

Methods of Costing

A METHOD is a target plan or set of orderly procedures that are based on a

credible approach. It reveals what needs to be done in a systematic way and
how to focus on achieving those goals.
Job Costing
It refers to a system of costing in which costs are ascertained in terms of
specific jobs or orders which are not comparable with each other. Industries
where this method of costing is generally applied are printing press, automobile
garage, repair shop, ship-building, house building, engine and machine
construction, etc.
Contract Costing
The aggregated costs relative to a single contract designated a cost unit. The
contract costing method is used mostly by builders, civil contractors, ship
builders, and construction and mechanical engineering firms.
Batch Costing
This method is also a type of job costing. A batch of similar products is
regarded as one job and the cost of this complete batch is ascertained. It is then
used to determine the unit cost of the articles produced. It should, however, be
noted that the articles produced should not lose their identity in manufacturing
operations.
Operating Costing
Operating costing is a process and technique of accumulating and ascertainment
of cost for providing a standardized service to the public or to an undertaking.
This method is employed in railways, road transport, water supply undertakings,
telephone services, electricity companies, hospital services, municipal services,
etc.
Process Costing
Where a product passes through distinct stages or processes, the output of one
process being the input of the subsequent process, it is frequently desired to
ascertain the cost of each stage or process of production. This is known as
process costing.
Process costing is generally adopted in textile industries, chemical industries, oil
refineries, soap manufacturing, paper manufacturing, tanneries, etc.
Multiple or Composite Costing:
Some products are so complex that no single system of costing is applicable. It
is used where there are a variety of components separately produced and
subsequently assembled in a complex production. Total cost is ascertained by
computing component costs which are collected by job or process costing and
then aggregating the costs through use of the single or output costing system.
This method is applicable to manufacturing concerns producing motor cars,
aero planes, machine tools, cycles, sewing machines, etc.
Departmental Costing
When costs are ascertained department by department, the method is called
“Departmental Costing”. Usually, for ascertaining the cost of various goods or
services produced by the department, the total costs will have to be analysed,
say, by the use of job costing or unit costing.
Techniques of Costing
A technique is a precise strategy, concrete trick or a tested and trusted tip that's
designed to help you reach your goals.
The following techniques of costing are used by the management for controlling
costs and making managerial decisions:
1. Historical or conventional costing
It refers to the determination of costs after they have been actually incurred. It
means that cost of a product can be calculated only after its production. This
system is useful only for determining costs, but not useful for exercising any
control over costs.
2. Standard Costing
It refers to the preparation of standard costs and applying them to measure the
variations from standard costs and analysing the variations with a view to
maintain maximum efficiency in production. Then actual costs are compared
with the pre-determined costs and deviations known as variances are noted
down. Thereafter, the reasons for the variances are ascertained and necessary
steps are taken to prevent their recurrence.
3.Marginal Costing
It refers to the ascertainment of marginal costs by differentiating between fixed
costs and variable costs and the effect on profit of the changes in volume or type
of output. In this case, only the variable costs are charged to products or
operations while fixed costs are charged to profit and loss account of the period
in which they arise.
4. Uniform Costing
A technique where standardized principles and methods of cost accounting are
employed by a number of different companies and firms is termed as uniform
costing. This helps in comparing performance of one firm with that of another.
5. Direct Costing
The practice of charging all direct costs to operations, process or products
leaving all indirect costs to be written off against profits in the period in which
they arise, is termed as direct costing.
6. Absorption Costing
The practice of charging all costs both variable and fixed to operation, process
or products or process is termed as absorption costing.

Disadvantages or Limitations of Cost Accounting

The Disadvantages or Limitations of Cost Accounting are listed below:
1. It depends mainly on past performances.
2. It is expensive.
3. The system is more complex.
4. Inapplicability.
5. Not suitable for small organization.
6. Lack of Social Accounting.