COST ACCOUNTING

INTRODUCTION

Prof. Rishi Chourasia

ACCOUNTING INFORMATION SYSTEM
 The overall objective of an accounting information
system is to provide information to users.
 This system is divided into two major subsystems:

1. The financial information system.

2. The cost management information system.
THE FINANCIAL ACCOUNTING INFORMATION
SYSTEM
 Primarily concerned with providing outputs for external users,
namely, investors, government authorities, tax authorities,
bankers, insurers etc.
 Financial accounting statements are prepared according to
well known rules and conventions.
 Such rules and conventions are defined and governed by the
respective Accounting Standards Boards and the Securities
Exchange Commission/Board of the countries concerned.
 Financial statements normally consist of Balance sheets,
Income statements, and statement of Cash Flows.
 Financial accounting information is used for investment
decisions, stewardship evaluation, monitoring activity, and
regulatory measures.
THE COST MANAGEMENT INFORMATION
SYSTEM
 This system is primarily concerned with producing outputs for
internal users for satisfying management objectives.
 Such a system is not bound by any formal rules and
conventions, unlike the financial accounting system. Instead
such criteria are set internally.

 This system has the following three broad objectives:

1. To provide information for costing out services, products
and other objects of interest to management.
2. To provide information for Planning and Control.
3. To provide information for Decision making.
COST MANAGEMENT INFORMATION
SUBSYSTEMS
 This system has two major subsystems:
1. The Cost Accounting Information system.
2. The Operational Control Information system.

 The objectives of these two systems correspond to the

Costing and Control objectives mentioned earlier for
the cost management information system.
 The output of the two cost systems satisfies the third

objective (Decision making).

COST ACCOUNTING INFORMATION SYSTEM

 Designed to assign costs to individual products and

services and other objects as specified by
management.
 For external financial reporting, the cost accounting

system helps to assign costs to products in order to

value inventories and determine cost of sales as per
the rules and conventions set by the respective
Accounting Standards Boards of the respective
countries.
THE OPERATIONAL CONTROL SYSTEM
 This subsystem is designed to provide, accurate and
timely feedback concerning the performance of
managers and others relative to their planning and
control of activities.
 Operational control is concerned with what activities
should be performed and assessing how well they are
performed.
 A good operational control information system
provides information that helps managers engage in a
program of continuous improvement of all aspects of
the business.
THE OPERATIONAL CONTROL SYSTEM
 The system should be in a position to provide information not
only with respect to product costs but also with respect to all
activities along the length of the organizations value chain
with a view to improving the value received by the customer.

 Such value is however to be provided only at returns that are

acceptable to the owners of the company.

 Thus this system should be in a position to provide cost

information concerning quality, different product designs, and
post- purchase customer needs all of which are vital for
managerial planning and control.
 COST - MEANING
Cost means the amount of expenditure
( actual or notional) incurred on, or
attributable to, a given thing.
COST ACCOUNTING - MEANING

Cost accounting is concerned with recording,

classifying and summarizing costs for
determination of costs of products or
services, planning, controlling and reducing
such costs and furnishing of information to
management for decision making
 ELEMENTS COST
OF
COST

OTHER EXPENSES
MATERIALS LABOUR

DIRECT INDIRECT
DIRECT INDIRECT INDIRECT
DIRECT

OVERHEADS

SOH DOH
FOH AOH
MATERIAL: The substance from which the
finished product is made is known as material.

Direct material is one which can be directly or

easily identified in the product Eg: Timber in
furniture, Cloth in dress, etc.

Indirect material is one which cannot be easily

identified in the product.
Examples of Indirect material
 At factory level – lubricants, oil,
consumables, etc.
 At office level – Printing & stationery,

Brooms, Dusters, etc.

 At selling & dist. level – Packing

materials, printing & stationery, etc.

LABOUR: The human effort required to convert the
materials into finished product is called labour.

DIRECT LABOUR is one which can be

conveniently identified or attributed wholly to a
particular job, product or process.
Eg:wages paid to carpenter, fees paid to tailor,etc.

INDIRECT LABOUR is one which cannot be

conveniently identified or attributed wholly to a
particular job, product or process.
Examples of Indirect labour
 At factory level – foremen’s salary, works
manager’s salary, gate keeper’s salary etc
 At office level – Accountant’s salary, GM’s
salary, Manager’s salary, etc.
 At selling and dist.level – salesmen salaries,
Logistics manager salary, etc.
OTHER EXPENSES are those expenses
other than materials and labour.

DIRECT EXPENSES are those expenses

which can be directly allocated to
particular job, process or product. Eg :
Excise duty, royalty, special hire
charges,etc.

INDIRECT EXPENSES are those expenses

which cannot be directly allocated to
particular job, process or product.
Examples of other expenses
 At factory level – factory rent, factory insurance,
lighting, etc.
 At office level – office rent, office insurance, office

lighting, etc.
 At sales & dist.level – advertising, show room

expenses like rent, insurance, etc.

COST CLASSIFICATION – ON THE BASIS OF

 Nature
 Function
 Direct & indirect
 Variability
 Controllability
 Normality
 Financial accounting classification
 Time
 Planning and control
 Managerial decision making
ON THE BASIS OF NATURE
 MATERIALS

 LABOUR

 EXPENSES
ON THE BASIS OF FUNCTION
 MANUFACTURING COSTS

 COMMERCIAL COSTS – ADM AND S&D COSTS

ON THE BASIS OF DIRECT AND
INDIRECT

 DIRECT COSTS

 INDIRECT COSTS
ON THE BASIS OF VARIABILITY
 FIXED COSTS

 VARIABLE COSTS

 SEMI VARIABLE COSTS

ON THE BASIS OF CONTROLLABILITY

 CONTROLLABLE COSTS

 UNCONTROLLABLE COSTS
ON THE BASIS OF NORMALITY

 NORMAL COSTS

 ABNORMAL COSTS
ON THE BASIS OF FIN. ACC
 CAPITAL COSTS

 REVENUE COSTS

 DEFERRED REVENUE COSTS

ON THE BASIS OF TIME
 HISTORICAL COSTS

 PRE DETERMINED COSTS

ON THE BASIS OF PLANNING AND
CONTROL

 BUDGETED COSTS

 STANDARD COSTS
ON THE BASIS OF MANAGERIAL DECISION MAKING

 MARGINAL COSTS
 OUT OF POCKET COSTS
 SUNK COSTS
 IMPUTED COSTS
 OPPORTUNITY COSTS
 REPLACEMENT COSTS
 AVOIDABLE COSTS
 UNAVOIDABLE COSTS
 RELEVANT AND IRRELEVANT COSTS
 DIFFERENTIAL COSTS
TERMS IN COST ACCOUNTING
 COST UNIT
 COST CENTRE
 COST ESTIMATION
 COST ASCERTAINMENT
 COST ALLOCATION
 COST APPORTIONMENT
 COST REDUCTION
 COST CONTROL
METHODS OF COSTING
 JOB COSTING
 CONTRACT COSTING
 BATCH COSTING
 PROCESS COSTING
 UNIT COSTING
 OPERATING COSTING
 OPERATION COSTING
 MULTIPLE COSTING
TYPES OF COSTING

 UNIFORM COSTING
 MARGINAL COSTING
 STANDARD COSTING
 HISTORICAL COSTING
 DIRECT COSTING
 ABSORBTION COSTING
COST ASSIGNMENT
 Cost assignment is one of the key processes of the cost
accounting system.
 Improving the cost assignment process has been one of the
major developments in the cost management field in recent
years.
 ACCURACY OF ASSIGNMENTS:
Assigning costs accurately to cost objects is crucial.
However the term accurate is a relative concept having more
to do with the reasonableness and logic of the cost assignment
method used, rather than on our knowledge of some
underlying “TRUE COST”.
COST ASSIGNMENT
 The objective is to measure and assign as accurately as
possible the cost of resources used by the cost object.
 In this process some cost assignment methods are clearly more
accurate than others.
 Example: Two friends dining at a restaurant, one drinking only
coffee costing Rs 25, whereas the other having a meal costing
Rs 200. One method of assigning costs would be to divide the
total costs by 2 which would mean each is assigned Rs112.50.
However this would not be as accurate as assigning costs on
the basis of the items actually consumed by each of them.
COST ASSIGNMENT
 Distorted cost assignments can produce erroneous
decisions which can prove to be very costly.
 Example: The decision on whether to outsource a
component, presently being produced in house,
would depend on how accurately the costs of
producing internally is obtained. If the cost of
internal manufacture is overstated, the decision may
erroneously be made in favour of outsourcing,
whereas an accurate assessment of costs of internal
manufacture may suggest the opposite,
TRACEABILITY
 The relationship of costs to cost objects can be exploited to
help increase the accuracy of cost assignments.

DIRECT AND INDIRECT COSTS.

 Costs are directly or indirectly associated with cost objects.
 Indirect costs are those costs that cannot be traced “easily and
accurately” to a cost object.
 Direct costs are those costs that can be traced “easily and
accurately” to a cost object.
 The term easily means in a cost effective way and the term
accurately means that the costs are traced using a “causal”
relationship.
 Thus Traceability is simply the ability to assign a cost
directly to a cost object in an economically feasible
way by means of a causal relationship. The more costs
that can be traced to the object, the greater the accuracy
of the cost assignments.
 Establishing traceability is therefore a key element in
building accurate cost assignments.
 Another important point that needs to be emphasized
is that a cost can be classified both as an indirect cost
as well as a direct cost, depending upon the cost
object which is the point of reference.
 For example, if the plant is the cost object, then the

cost of heating and cooling the plant is a direct cost;

however if the cost objects are products produced in
the plant, then this utility cost is an indirect cost.
METHODS OF TRACING:
Tracing costs can occur in two ways:

1. Direct tracing.
2. Driver tracing.

 Direct tracing: is the process of identifying and assigning costs

to a cost object that are specifically and or physically
associated with the cost object. Identifying such costs is most
often accomplished by physical observation.
 Example: If the power department is the cost object, then the
salary of the power department supervisor and the fuel used to
produce power are examples of costs that are directly
traceable by physical observation.
METHODS OF TRACING:
Driver Tracing:

 Ideally all costs should be charged to cost objects using Direct

Tracing. However, it is not often possible to physically
observe the exact amount of resources being consumed by a
cost object.
 The next best approach is to use “cause – and – effect”
reasoning to identify factors called “Drivers” that can be
observed and which measure a cost objects resource
consumption.
 Drivers are factors that cause changes in resource usage,
activity usage, costs and revenues.
 Driver tracing uses two types of drivers for tracing
costs to cost objects:

1. Resource drivers, and

2. Activity drivers.
 Resource drivers measure the demands placed on
resources by activities and are used to assign costs of
resources to activities.
 Consider the activity of maintaining equipment. This activity
consumes resources such as parts, equipment, tools, labour, and
energy (power to run the equipment and tools).
 Some of these resources such as equipment, tools, materials are
directly traceable to the activity.
 Others such as power and labour may not be directly traceable to
the activity. Thus unless power is metered, it may not be possible
to physically observe how much power is used. Metering may not
be practical.
 Thus a resource driver such as machine hours may be used to
assign the cost of power.
 Example: If the cost of power is Rs. .50p per machine hour, and
the activity, maintaining equipment uses 2000 machine hours,
then Rs. 1000 of the power cost would be assigned to the activity.
 The total cost of the activity would be the sum of the
directly traceable resource costs and the resource
driver assigned costs.
 Activity Drivers:
 Once the total cost of maintaining equipment is
determined, then the cost of this activity can be
assigned to the cost objects that consume this activity
by using activity drivers.
 Activity drivers are measures of the demand placed
on activities by cost objects and are used to assign the
cost of activities to cost objects.
 ASSIGNING INDIRECT COSTS:
 Indirect costs cannot be traced to cost objects as no
causal relationship exists between the cost and the cost
object. It can also mean that tracing is not economically
feasible.
 Assignment of indirect costs to cost objects is called
allocation, and is based on convenience or some
assumed linkage.
 Example: The cost of the personnel dept in a concern
manufacturing 5 products cannot be assigned to the
products using either direct tracing or driver tracing, as
no causal relationship exists between the products and
the incurrence of the costs. It could therefore be
assigned using some convenient linkage, like number
of products manufactured or number of labour hours
etc.
 Any such method of allocation used would at best be
arbitrary, and would reduce the accuracy of the cost
assignments.
 COST ASSIGNMENT SUMMARIZED.
 Direct Tracing is the most precise as costs are

assigned using direct physical observation.

 Driver tracing follows direct tracing in terms of cost

assignment accuracy, and relies on causal factors

called drivers to assign costs.
 The precision of driver tracing depends on the quality
of the causal relationship described by the driver.
 Allocation is the most simple of the assignment

methods described but it is the least accurate and

should be avoided wherever possible.
PRODUCT AND SERVICE COSTS
One of the most important of cost objects is the output
of organizations.

There are two types of outputs:

A. Tangible products and,
B. Services.
 Services differ from tangible products on three
important dimensions:
1. Intangibility
2. Perishability and,
3. Inseparability.
 Manufacturing organizations produce tangible
products.
 Service organizations produce intangible products.
DIFFERENT COSTS FOR DIFFERENT PURPOSES

 A fundamental cost management principle is different

costs for different purposes.
 The meaning of product cost would therefore depend

on the management objective being served.

PRODUCT COSTS AND EXTERNAL
FINANCIAL REPORTING
 An important objective of the cost management
system, is the calculation of product costs for external
financial reporting.
 Costs are subdivided into two major functional
categories:
 A. Production costs are those costs associated with
the manufacture of goods or the provision of services.
 B. Non production costs are those associated with
the functions of selling and administration.
PRODUCTION COSTS
 Production costs can be further classified as, Direct
materials, Direct labour and Overheads.
 1. Direct materials are those materials that can be

directly charged to the products by physical

observation.
 Examples: Steel in automobiles, wood in furniture, etc,
 B. Direct Labour: is labour that is traceable to the
goods or services being produced by direct
observation. Employees who convert raw materials
into a product or who provide a service to customers
are classified as direct labour.
 Example: Workers on an assembly line, chef in a

restaurant, project leader in a software concern, a

pilot of a commercial airline etc.
 Overhead: consists of all costs other than direct
costs, and in a manufacturing concern are also
referred to as manufacturing overhead.
 Example: Depreciation on buildings and equipment,

maintenance, supplies, supervision, material

handling, power, property taxes, landscaping of
factory grounds, plant security, finance dept
expenses, personnel dept expenses, etc.
 Marketing and Administrative costs:
 These are two categories of non manufacturing costs,
which are not included for the valuation of
inventories, but are expensed in the period they are
incurred.
 Such costs can be very substantial in manufacturing
organizations often greater than 25% of sales
revenues.
 For service organizations the relative importance of
these costs depends on the nature of the service being
produced.
 Example: Physicians and dentists, generally do very
little marketing and hence have very low selling costs.
An airline on the other hand may incur substantial
marketing costs.
 Marketing costs are necessary to market and distribute
a product and are often referred to as order- getting and
order- filling costs.
 Examples: Salaries and commissions of sales
personnel, advertising, warehousing, shipping, and
customer service. The first two are order getting costs
and the last three can be classified as order filling.
 Administrative costs are those which cannot be

assigned as either production or marketing and

consist of top executive salaries, legal fees, annual
report printing, R & D, etc.
 Prime and Conversion costs.
 The manufacturing and non manufacturing cost

classifications give rise to the above related cost

concepts, which are nothing but combinations of
different production costs.
 Prime costs is the sum of direct materials and direct

labour cost.
 Conversion cost is the sum of direct labour and

overhead cost.
EXTERNAL FINANCIAL STATEMENTS

 For external financial reporting, costs are classified

on the basis of whether they pertain to the Production
function or not.
 The reason for this separation is that production costs
are inventoriable and non production costs are
viewed as period costs.
 Thus production costs attached to units sold are
recognized as an expense (cost of goods sold) on the
income statement.
 Production costs attached to unsold units are reported
in the Balance sheet as inventory.
 PROFARMA OF COST SHEET
PARTICULARS Rs.
Direct Material ***
Direct Labour ***
Direct Expenses ***
PRIME COST ***
ADD: WORKS /FACTORY OVERHEAD ***
WORKS COST ***
ADD: OFFICE & ADMINISTRATION EXPENSES ***
COST OF PRODUCTION ***
ADD: Opening Stock of Finished Goods ****
LESS: Closing Stock of Finished Goods (***)
COST OF GOODS SOLD ***
ADD: SALES /DISTRIBUTION OVERHEAD ***
COST OF SALES ****
ADD: PROFIT / (LOSS) ***
SALES ****
 PROFORMA OF COST SHEET
PARTICULARS Rs. Rs.
A DIRECT MATERIAL
Op. STOCK OF RAW MATERIAL ****
Add. Purchase of raw material ****
Expenses on Freight , etc…. ****
****
Less: CI. Stock of Raw Material (***) ****
B Direct Labour ***
C Direct Expenses ***
PRIME COST( A+B+C) ***
ADD: WORKS/FACTORY OVERHAED ***
Less : Sale of Scrap/ Waste (***)
****
Add: Op. Stock of work in Progress ****
****
Less: CI. Stock of Work in Progress (***)
WORKS COST ***
ADD: OFFICE & ADMINISTRATIVE EXPENSES ***
COST OF PRODUCTION ***
ADD: Opening Stock of finished Goods ***
****
LESS: Closing Stock of Finished Goods (***)
COST OF GOODS SOLD ****
SALES /DISTRIBUTION OVERHEAD ***
COST OF SALES ****
PROFIT/(LOSS) ****
SALES ****
 PROFORMA OF COST SHEET
PARTICULARS Rs. Rs.
A DIRECT MATERIAL
Op. STOCK OF RAW MATERIAL ****
Add. Purchase of raw material ****
Expenses on Freight , etc…. ****
****
Less: CI. Stock of Raw Material (***) ****
B Direct Labour
Productive Wages / Direct Wages
C Direct Expenses ***
PRIME COST( A+B+C) ****
ADD: WORKS/FACTORY OVERHAED
Unproductive Wages / Indirect Wages ***
Factory Manager’s Salary ***
Fuel, Electricity ,Rent ,Rates , Taxes, Repairs ***
Depreciation on Plant & Machinery ***
Depreciation on Factory Building ***
****
Less : Sale of Scrap/ Waste (***)
****
Add: Op. Stock of work in Progress ***
****
Less: CI. Stock of Work in Progress (***)
WORKS COST/FACTORY COST ****
ADD: OFFICE & ADMINISTRATIVE EXPENSES
Salaries , Electricity , Depreciation on Office Building ****
Depreciation on Office Furniture , Directors Fees ****
Manager’s Salaries , Bonus , Staff Welfare….. ****
BAD DEBTS ****
COST OF PRODUCTION ****
ADD: Opening Stock of finished Goods ***
****
LESS: Closing Stock of Finished Goods (***)
COST OF GOODS SOLD ****
ADD: SALES /DISTRIBUTION OVERHEAD
Salesman salaries, Commission Advertisement ***
Depreciation on Delivery Van, Show room ***
BAD DEBTS
Rent of Showroom , Distribution Expenses *** ****
COST OF SALES ****
PROFIT/(LOSS) ***
SALES ****