Accounting For Managerial

Decisions
Unit 3
Costing :

Costing is defined as the technique and process of ascertaining costs.

The technique in costing consists of the body of principles and rules for ascertaining the costs of
products and services. The technique is dynamic and changes with the change of time.

It is popularly known as an arithmetic process.

For example, If the cost of producing a product say Rs. 200/-, then we have to refer material, labour and
expenses accounting and arrive the above cost as follows:
 Cost Accounting
Cost Accountancy is defined 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 is a science because it is a systematic body of knowledge having certain principles

(b) It is an art as it requires the ability and skill to apply the principles of Cost
Accountancy to various managerial problems.

It begins with the recording of expenditure and ends with the preparation of periodical
statement and reports of ascertaining and controlling the cost.
 Objectives
(a) To ascertain the Costs under different situations using different techniques and systems of costing
(b) To determine the selling prices under different circumstances
(c) To determine and control efficiency by setting standards for Materials, Labour and Overheads
(d) To determine the value of closing inventory for preparing financial statements of the concern
(e) To provide a basis for operating policies which may be determination of Cost Volume relationship,
whether to close or operate at a loss, whether to manufacture or buy from market, whether
to continue the existing method of production or to replace it by a more improved method of
production....etc.
(f) To achieve real and permanent reduction in the unit cost of goods manufactured or services
rendered without impairing their suitability for the use intended or diminution in the quality of the product.
 Cost Objects, Cost Centers and Cost Units –
Elements of Cost

Direct Material + Direct Labour + Direct Expenses = Prime Cost

Indirect Material+ Indirect Labour + Indirect Expenses = Overheads
 Direct Material Cost
Direct material cost can be defined as ‘The Cost of material which can be attributed to a cost object
in an economically feasible way’. For example, timber in furniture making, cloth in dress making,
bricks in building a house.

(i) All raw materials, like jute in the manufacture of gunny bags, pig iron in foundry and fruits in
canning industry
(ii) Materials specifically purchased for a specific job, process or order, like glue for book binding,
starch powder for dressing yarn
(iii) Parts or components purchased or produced, like batteries for transistor-radios
(iv) Primary packing materials like cartons, wrappings, card-board boxes, etc.
 Indirect Material Cost
Indirect Material
Indirect materials are those materials which do not normally form a part of the finished product. It has
been defined as “materials which cannot be allocated but which can be apportioned to or absorbed
by cost centres or cost units”.
These are:

(i) Stores used in maintenance of machinery, buildings, etc., like lubricants, cotton waste, bricks and
cements
(ii) Stores used by the service departments, i.e., non-productive departments like Powerhouse, Boiler
House and Canteen, etc., and
(iii) Materials which due to their cost being small, are not considered worthwhile to be treated as
direct materials.
Direct Labour / Employee Cost

The cost of employees can be attributed to a cost object in an economically feasible way.
In simple words, it is that labour which can be conveniently identified or attributed wholly to a
particular job, product or process or expended in converting raw materials into finished goods.
Wages of such labour are known as direct wages.
Thus, it includes payment made to the following groups of labour:

(i) Labour engaged on the actual production of the product or in carrying out of an operation or
process
(ii) Labour engaged in adding the manufacture by way of supervision, maintenance, tool setting,
transportation of material etc.
(iii) Inspectors, analysts etc., specially required for such production
 Indirect Labour/ Employee Cost

The labour / employee cost cannot be directly attributed to a particular cost object.

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.

Example of such labour are:

charge-hands and supervisors;
maintenance workers;
men employed in service departments, material handling and internal transport;
apprentices, trainees and instructors;
clerical staff and labour employed in time office and security office.
 Direct or Chargeable Expenses
• Direct expenses are expenses relating to manufacture of a product or rendering a service which can
be identified or linked with the cost object other than direct material cost and direct employee cost.

• Direct expenses include all expenditure other than direct material or direct labour that is specifically
incurred for a particular product or process.

• Such expenses are charged directly to the particular cost account concerned as part of the prime
cost. Examples of direct expenses are:

(i) GST; (ii) Royalty; (iii) Architect or Supervisor’s fees; (iv) Cost of rectifying defective work; (v)
Travelling
expenses to the city; (vi) Experimental expenses of pilot projects; (vii) Expenses of designing or
drawings
of patterns or models; (viii) Repairs and maintenance of plant obtained on hire; and (ix) Hire of
special
equipment obtained for a contract.
 Overhead/Prime Cost
• Overheads comprise of indirect materials, indirect employee cost and indirect expenses which are
not directly identifiable or allocable to a cost object.

• Overheads may be defined as the aggregate of the cost of indirect material, indirect labour and such
other expenses including services as cannot conveniently be charged directly to specific cost units.

• Thus, overheads are all expenses other than direct expenses.

• In general terms, overheads comprise all expenses incurred for or in connection with,
• the general organization of the whole or part of the undertaking, i.e., the cost of operating supplies
and services used by the undertaking and includes the maintenance of capital assets.

• Prime Cost
• The aggregate of Direct Material, Direct Labour and Direct Expenses is called Prime Cost.

• Generally, it constitutes 50% to 80% of the total cost of the product, as such, as it is primary to the
cost of the product and called Prime Cost.
Relevant Costs:

Relevant costs are costs which are relevant for a specific purpose or situation.
In the context of decision making, only those costs are relevant which are pertinent to
the decision at hand.
Since we are concerned with future costs only while making a decision, historical costs,
unless they remain unchanged in the future period are irrelevant to the decision-making
process.
Sunk Costs:

Sunk costs are historical costs which are incurred i.e. sunk in the past and are not
relevant to the particular decision-making problem being considered.
Sunk costs are those that have been incurred for a project and which will not be
recovered if the project is terminated.
While considering the replacement of a plant, the depreciated book value of the old
asset is irrelevant as the amount is sunk cost which is to be written-off at the time of
replacement.
 Cost Object
• Cost object is the technical name for a product or a service, a project, a
department or any activity to which a cost relates.
• Therefore, the term cost should always be linked with a cost object to be
more meaningful.
• Establishing a relevant cost object is very crucial for a sound costing
system.
• The Cost object could be defined broadly or narrowly.
• At a broader level a cost object may be named as a Cost Centre, whereas
at a lowermost level it may be called as a Cost Unit.
 Cost Driver
• CIMA terminology defines a Cost Driver as “the factor influencing the level of cost, often used in the
context of ABC to denote the factor which links activity resource consumption to produce outputs,
• for example, the number of purchase orders would be a Cost Driver for procurement cost”.

• In other words, we can say that, the Cost Driver is an activity which is responsible for cost incurrence.

• An activity may be an event, unit of work etc.

• Examples of the Cost Drivers are

• number of machine set−ups,
• number of purchase orders,
• hours spent on product inspection,
• number of tests performed etc.
Cost Sheet or the cost statement is a document which provides a detailed cost
information
Cost heads in a Cost Sheet
Prime Cost

Cost of Production

Cost of Goods Sold

Cost of Sales
Prime Cost i) Material Cost

ii) Direct Employee

(Labor) Cost iii) Direct Expenses
• Wages and salary • Cost of utilities
• Allowances and incentives • Royalty paid/payable for production of
• Payment for overtime service
• Bonus/Ex-Gratia • Hire charges for specific equipment
• Employees contribution to PPF and other • Fee for technical assistance and know-how
similar funds • cost of moulds, patterns
• Other benefits (medical, leave with pay, • Cost of design/drawings
free or subsidized food, LTC, and • Cost of softwares
retirement benefits
Production Cost
Prime Cost Xxx
Add: Factory Overheads Xxx

Gross Works Cost XXXX

Add: Opening Stock of Work in Progress (WIP) xxx
Less: Closing Stock of Work in Progress (WIP) (xxx)
Factory or Work Cost XXXX
Add: Quality Control Cost xxx
Add: R& D Cost xxx
Add: Administrative Overheads related with production xxx
Less: Credit with recoveries (Misc. Income) (xxx)
Add: Packing Cost xxx
Cost of Production XXXX
Factory Overheads
• Consumable stores and spares
• Depreciation of plant and machinery, factory building
• Lease rent of production assets
• Repair and maintenance of plant and machinery, factory building
• Indirect employee costs related with production activities
• Drawing and designing department cost
• Insurance of plant and machinery, factory and building, stock of raw
material and WIP
• Amortized cost of jigs, fixtures and tooling etc
• Service department costs
Stock of WIP/Quality
Control/R&D/Admin/Other
• The WIP stock is valued on the basis of the percentage of of completion
in respect of each element of cost.
• Quality control cost is the cost of resources consumed towards quality
control procedures
• R&D cost includes only R&D related work related to improvement of
process, system, product or services
• Administrative overheads are the admin cost only related to
production. General admin is not added to this cost.
• Credit for recoveries are the realized or realisable value of scrap or
waste deducted as it reduces the cost of production
• Packing cost which are essentially to hold and preserve the products
for its use by the customer.
Cost of Goods Sold

Cost of Production Xxx

Add: Cost of opening stock of Finished Goods Xxx
Less: Cost of closing stock of Finished Goods (xxx)
Costs of Goods Sold xxxx
Cost of Sales
Administrative O/H
 Particulars Total Cost ₹ Cost per Unit ₹
1. Direct Material Consumed:
Opening stock of raw material xxx
Add: Additions/Purchases xxx
Less: Closing stock of Raw Material xxx
xxx
2. Direct Employee Cost xxx
3. Direct Expenses xxx
4. Prime Cost (1+2+3) xxx
5 Add: Factory Overheads xxx
6. Gross Works (4+5) xxx
7. Add Opening Work in Progress (WIP) xxx
8 Less Closing Work in Progress (WIP) xxx
9. Works/Factory Cost (6+7+8) xxx
10. Add: Quality Control Cost xxx
11. Add: R&D Cost xxx
12. Add: Admin Overheads (related to production) xxx
13. Less: Credit for recoveries/Scrap by-products xxx
 Particulars Total Cost ₹ Cost per Unit ₹
14. Add: Packing cost(primary) xxx
15 Cost of Production (9+10+11+12+13+14) xxx
16. Add: Opening stock of finished goods xxx
17 Less: Closing stock of finished goods xxx
18. Cost of Goods Sold xxx
19. Add: Administrative Overheads (General) xxx
20 Add: Marketing Overheads xxx
Selling Overheads xxx
Distribution Overheads xxx
21. Cost of Sales(18+19+20) xxx
The following data relates to the manufacture of a standard costing during the month of April
Output is 4,000 units. Prepare a cost sheet with cost per unit and profit for the month.

Particulars Amount
Raw Materials ₹1,80,000
Direct Wages ₹90,000
Machine hours worked 10,000
Machine hour rate(Per hour) ₹8
Administration overheads (general) ₹35,000
Selling Overheads (per unit) ₹5
Units produced 4,000
Units sold 3,600
Selling price per unit ₹125
Relevant Costs:
• Relevant costs are costs which are relevant for a specific purpose or situation.
• In the context of decision making, only those costs are relevant which are pertinent
to the decision at hand.
• Since we are concerned with future costs only while making a decision, historical
costs, unless they remain unchanged in the future period are irrelevant to the
decision-making process.

Sunk Costs:
• Sunk costs are historical costs which are incurred i.e. sunk in the past and are not
relevant to the particular decision-making problem being considered.
• Sunk costs are those that have been incurred for a project and which will not be
recovered if the project is terminated.
• While considering the replacement of a plant, the depreciated book value of the old
asset is irrelevant as the amount is sunk cost which is to be written-off at the time of
replacement.
• Normal Cost & Abnormal Cost:

• Normal Cost is a cost that is normally incurred at a given level of output in the
conditions in which that level of output is achieved.
• Abnormal Cost is an unusual and typical cost whose occurrence is usually irregular
and unexpected and due to some abnormal situation of the production.

Differential Cost:

• Differential cost is the change in the cost due to change in activity from one level to
another.
Opportunity Cost:
• Opportunity cost is the value of alternatives foregone by adopting a particular strategy or employing
resources in specific manner.
• It is the return expected from an investment other than the present one.
• These refer to costs which result from the use or application of material, labour or other facilities in a
particular manner which has been foregone due to not using the facilities in the manner originally planned.
• Resources (or input) like men, materials, plant and machinery, finance etc., when utilized in one
particulars way, yield a particular return (or output).
• If the same input is utilized in another way, yielding the same or a different return, the original return on the
forsaken alternative that is no longer obtainable is the opportunity cost.
• For example, if fixed deposits in the bank are proposed to be withdrawn for financing project, the
opportunity cost would be the loss of interest on the deposits.
• Similarly, when a building leased out on rent to a party is got vacated for own purpose or a vacant space is
not leased out but used internally, say, for expansion of the production Programme, the rent so forgone is
the opportunity cost.
Marginal costing is a technique of costing where costs are divided into two groups
based on their behavior: Variable cost and fixed cost. Total Variable costs vary
proportionately with volume (level of activity, production or sales). Total Fixed costs
remain unchanged with volume. Fixed costs are often called period costs.
 Marginal Cost Equation
There are two equations in marginal costing.
The first equation is: Contribution = sales – variable costs.

Here all the components being variable, the ratios of any two components are always
constant.

The second equation is: Profit = contribution – fixed costs.

As fixed costs are constant with respect to volume, when contribution varies with
volume, profit changes disproportionately with volume.

Example, Variable cost = ₹50,000, Fixed Cost = ₹20,000, and Selling Price = ₹80,000
Calculate Contribution and Profit.
 Marginal Cost Equation And P/V Ratio

Based on the first equation we may say, sales = variable cost + contribution………..(A)

Dividing (A) by sales, we get: 1 = variable cost/ sales + contribution/sales……..(B)

Here, the ratio of variable cost/ sales is called variable cost to sales ratio and
contribution/sales is called P/V ratio (profit-volume ratio, where contribution
represents profit and sales represent volume).
P/V Ratio
 C-V-P Analysis
Cost-volume-profit (C-V-P) analysis is basically the application of marginal costing
technique in
(a) analysis of costs based on their behavior with the volume and
(b) analysis of profits, in two steps: step one, contribution, which is sale -
variable costs, and step two: profits, which is contribution less fixed costs.

The analysis shows how with change in volume, contribution changes

proportionately and profit changes disproportionately.

C-V-P analysis is useful for planning and decision making in regard volume, cost
and profits
 Break Even Analysis
Break-even analysis is a part of C-V-P analysis.

BEPChart.xlsx
As the sales revenue grows from zero, the
contribution also grows until it just covers the fixed
costs.

This is the break even point where neither profit nor

losses are made.
Hence it is obvious that to break even, the amount of
contribution must be exactly equal to the fixed costs.
Thus,
Example
Margin of Safety
Examples

Find: (a) P/V ratio; (b) Contribution per unit; (c)

BEP (Rs., units); (d) MOS (Rs., units); (e)
Additional profits if sales increase to Rs.
1,10,000.

Find: (a) P/V ratio; (b) Monthly Fixed Costs; (c)

BEP; (d) MOS in the month of August; (e)
Additional profits if sales increase to Rs.
1,10,000 in September.
Examples