"COST" IN COST /
ACCOUNT/ ING
Generally speaking by cost we mean the total amount of money or other resources foregone of sacrificed to procure something or to achieve seine objective. Word expense is also used to denote almost the same meaning the difference between these two is that when benefit of resources given up can be realized in future, we refer to them as cost. But where resources given up have no future potential benefit we call them as expense. "A cost is an unexpired expense and an expense is an expired cost" is a simple and common way to distinguish between these two. This distinction between cost and expense is most commonly applied in financial accounting What does the term cost means in cost accounting and in management accounting is explained in the following page-In cost and management accounting the word cost is used in such a variety of ways that it has become extremely difficult to give it a precise meaning without some adjective or qualifying phrase. We speak of direct cost, prime cost, fixed cost, controllable cost, joint cost, standard cost, marginal cost etc. etc. Keeping in view such diverse uses of the word cost. The Committee on Cost Concepts and Standards of American Accounting Association has given a broad definition of cost, so that it may cover all of the various types of costs as arc used by the accountants. The committee defines cost as follow:
CLASSIFIC ATTON OF COST
Product costs or manufacturing costs
Cost is foregoing, measured m monetary terms, incurred or potentially to be incurred to achieve a specific Cost object or Cost objective.
What docs this definition implies is that the expression cost has meaning only when it is related to an object. The cost object may be a product or service. It may be an activity or operation; cost object may be a department or process and so on. Cost object or Cost objective means an item of activity or division for which we make a separate measurement of costs. Cost objectives are developed to guide the decision makers and to form the basis of classification of cost e.g. manufacturing costs of a product, or direct and indirect costs of a department.
The system of cost accounting serves the decision makers In providing quantitative data for diverse purposes That is why the costs are classified in a number of ways; There are different measures of costs for different purposes An organization does not record costs be all possible classifications However, in this modern age. Computers have made it possible to record costs on multiple classification bases without much additional clerical work and expense. This has facilitated ready availability of cost data for all decision making situations following are the principal classifications:
Product costs are the costs incurred for manufacturing or. As the case may be. For purchasing goods In case of manufacturing business product costs consist of direct materials, direct labour and factory overhead in ease of trading business, these costs involve purchase price plus transportation in plus other costs associated with receiving.
Product costs are said to be "attached to" the units produced. These are also called inventorial costs these costs are. In the first instance, recorded as assets in inventory accounts as raw materials or parts or stores then transformed through work in process into finished goods inventory. These are treated as expense when the goods are sold (i.e. cost of goods sold) following is a brief description of three main product costs.
Direct materials : Various substances that become an integral part of finished product and that can be economically identified with it are called direct materials Examples of direct materials include cloth for a shut, paper for a book, rubber for a tire etc
Direct labour: Direct labour is the labour cost of workers working or materials to convert them into finished product and the cost can he traced with units of output without undue cost or inconvenience Examples: include labour cost of workers working on a production conveyer, labour cost of carpenter or tailor.
Factory overhead: All manufacturing costs other than direct materials and direct labour are collective!} Termed as factor, overhead. These costs are also described by such names as manufacturing overhead, indirect manufacturing expenses, factory burden. This classification includes costs such as indirect materials, indirect labour, power, light, depreciation, repairs, cleaning and maintenance 'etc
The term indirect materials are used for those items of materials which may become a part of finished product but may be traceable into the product only at unreasonably high cost or inconvenience. For example welding material used in the production of a bicycle or the cost of thread used for binding this book.
Similarly, labour costs which either cannot he directly associated with units of finished goods or which can be so associated only at unreasonably high cost and inconvenience are termed as indirect labour Examples include labour cost of security guards, material handlers, cleaners, supervisors, engineers etc.
As direct relationship exists between finished product and direct materials and direct labor, these two costs are jointly called as Prime Cost.
Similarly, as direct labor and factor) overhead costs an e incurred to convert raw materials into finished products, these two costs are jointly called as conversion cost.
Period costs or manufacturing, costs
Costs which are not related to production and are matched against revenues on a time period basis are called period costs, non-manufacturing costs or non-inventorial costs these costs include marketing or selling costs and administrative costs
Total cost of a manufacturing concern
Marketing or selling costs: Marketing or selling costs include all costs of marketing research, getting orders and distribution of finished products to consumers. Advertising, sales travel, sales commission and salaries, cost of warehousing the finished goods and distribution expenses arc examples of these costs...
Administrative costs: All those costs which cannot be logically included under either production or marketing costs are grouped as administrative costs. Administrative costs include costs of planning, policy making and controlling the operations of enterprise. Examples of these costs include fess of board of directors, general accounting, public relation and other similar
Total cost of a trading concern
Direct and indirect costs
This classification of direct cost is one that covertly with a cost objective Particularly Related to cost objective, an erectly and economically identified associated with a particular segment under consideration.
An indirect cost is one that cannot he conveniently and economically identified with cost objective and must he apportioned to the cost objective or segment under consideration on some equitable basis.
From the above it is clear that the terms direct and indirect costs are meaningless, unless we have identified the segment for which the cost is being calculated. For example direct departmental costs or direct costs of a product arc the terms to give clear meanings.
A cost may be direct and indirect at the same time depending upon its object. For example, salary of a production supervisor and depreciation of machinery are Indirect costs with reference to the product and is classification factory overhead. But the same salary and depreciation are direct costs when our cost object is the department where the supervisor is working a machine is installed
This classification, based on cost behavior, is. One of the most classifications for the purposes of cost planning and control. Cost here means how a cost will react or respond to changes in the level of bus, activity.
Fixed costs: Fixed costs are cost is which do not respond to changes in activity level within a limited range called the relevant range. Those remain constant in total regardless of changes in activity. Therefore, measured on per unit basis they will react inversely to changes in ac Depreciation of factor} building, salary of plant manager, insurance and machinery are examples of fixed cost.
Units of Output Units of Output
Following table illustrates this idea Assume that annual depreciation of factor) building of an automobile manufacturer is Rs 100.000 and he can produce 10,006 automobiles per year.
As the production increases, average fixed cost per unit decreases because the same total amount now spread over more units-;
Variable costs: Variable costs arc costs which change in total in direct proportion to changes in activity level if production increases by 10 per cent total variable costs will also increase by 10 per cent. It is important to note that the total amount of variable costs will increase or decrease with activity level, but per unit variable cost is a constant amount Direct materials and direct labor are good examples of variable costs
Units of Output Units of Output
Behavior of Total variable costs & per unit variable costs
This idea is illustrated by following table. Assume that production one bag of flour requires 20 kg of wheat costing Rs 100. Total and per unit cost of wheat under various output levels is as below:
Variable cost per unit is a fixed amount, therefore, when activity level increase or decreases, the total variable cost also increase or decreases accordingly
Semi variable: Semi variable costs are composed of both fixed costs; variable costs these costs respond to changes in activity level, but due the presence of fixed costs they do not change in direct proportion production volume.
Cost of electricity consumed in a factory is an example of semi variable cost. Cost of electricity consumed for lighting and air conditioning purpose?
Units of Output Units of Output
Behavior of Total semi variable costs & per unit semi variable costs
Represents fixed portion of total cost of. Electricity... Electricity consumed lot driving machines is variable component as it changes with the changes in activity level.
With an increase in the level of output semi variable cost per unit decreases hut the negative slop of unit cost curve is not as steep as in is in case of variable costs.
This is a cost concept primarily designed to fix responsibility of cost control for various levels of management, therefore, it is always associated with a designated level in the organizational hierarchy.
Controllability of a cost means the degree of influence that a specific manager can exert over the cost item. As we move upwards in organizational hierarchy more and more costs become controllable, and for the chief executive there is no uncontrollable cost. Whereas, for the managers at lower levels there are few controllable costs
A controllable cost for the specified manager is one. Over which he has the influence as the power to authorize it is vested in him. An Uncontrollable costs is one which is out of the sphere of influence of a specified manager by virtue of limited authority given to him. For example, for a production supervisor costs of direct materials and direct labor used in his department are controllable costs but cost of depreciation of plant is uncontrollable for him. For production manager who authorizes purchase of plant and equipments, depreciation of plant is' a controllable cost.
There are number of other cost concepts used for planning control and other decision making purposes. Following is a brief description of some of the more important among them.
Differential costs: While making a choice between different alternatives a decision maker is also assisted by quantitative data provided in the form of differential costs. Differential costs are those items of total costs of two or more alternatives which have different magnitude under each alternative. Items of differential costs may be variable cost items or may be fixed cost items. Following table illustrates the concept of differential costs in case of a decision to choose between two alternative methods of production.
| | | Capital | Labour | |
| Cost Items | Nature of | Intensive | Intensive | Differential |
| | Cost | Method | Method | Costs |
| - | | Rs. (000) | Rs. (000) | Rs. (000) |
| Direct Materials | Variable | 2.000 | 2.000 | — |
| Direct Labour | Variable | X25 | . 1.750 | + 925 |
| Superintendence | Fixed | 150 | 250 | + 100 |
| Plant Depreciation | Fixed | 600 | 350 | - 250 |
| Light + air-conditioning | Fixed | 25 | 25 | |
| Power | Variable | 450 | 325 | - 125 |
| Net Differential Cost | | | | + 650 |
For evaluation of alternatives on the basis of cost data only the differential costs are important for consideration, therefore, these are also called relevant costs. Net differential cost represents the extra cast of the rejected alternative; therefore, it is also referred to as incremental cost.
Opportunity cost: Opportunity cost is a concept, used for evaluation of alternative uses of resources Decision makers select that alternative* use of resources from which they expect the maximum net return Opportunity cost is the net return that could he obtained from the second best alternative that has been rejected.
Suppose a trader of agricultural inputs has one million rupees to invest. Different avenues of investment available to him are as under Alternative I Investment in the purchase of pesticides, expected
Return Rs. 250.000 Alternative 2: Investment in the purchase of fertilizers, expected
Return Rs. 200.000. Alternative 3 Lend out the money to a fellow trader, expected return
Rs 100.000. .
He will choose the alternative 1 as its expected return is maximum. His opportunity cost will be Rs. 200.000 i.e. the expected revenues from second best alternative.
Now suppose, due to some emergency he is unable to invest the money in alternative 1 or 2 and has lent it out for a return of Rs. 100.000 the difference of net returns between the best alternative and the alternative chosen is called an opportunity loss. In this ease Rs 150.000 (i.e. Rs, 250.000 - Rs. 100.000)
A well know example of opportunity cost is interest on capital debited in profit and loss account. Most of the times opportunity cost is not recorded in books of accounts but it is always relevant to decisions
Standard cost: Standard cost means what the cost should he. Standard cost "is predetermined cost (if a unit of product or an operation or a department or a process. Standard cost is mainly used for evaluation of actual performance. Standard cost is the cost target to be achieved. Such cost targets are scientifically determined after consultation with engineer1-', production supervisors other front line managers, purchase people etc Historical cost data after due adjustments for changes in products, production efficiency and technology etc. is also used for setting standard cost
Actual cost incurred is compared against the predetermined standard cost and investigation into deviations is made by means of variance analysis Standard cost also forms the basis of budgets and sales price determination decisions
Sunk cost: Sunk cost is the term used for a cost that has already been incurred and now cannot he avoided or changed and consequently n is irrelevant for the current decision making situation For example, a company has bought a building for its showroom at a cost of five million rupees. The company is considering a change in its product mix. The cost of building and its depreciation will be the same whatever may be the composition of company's product mix So this cost being unavoidable has no relevance to the current decision making situation and is referred to as a sunk cost.
