Cost Accounting

Definition, Scope, Objectives and Significance of Cost Accounting

Way back to 15th Century, no accounting system was there and it was the barter system prevailed. It was in the last years of
15th century Luca Pacioli, an Italian found out the double entry system of accounting in the year 1494. Later it was
developed in England and all over the world upto 20th Century. During these 400 years, the purpose of Cost Accounting
needs are served as a small branch of Financial Accounting except a few like Royal wallpaper manufactory in France (17th
Century), and some iron masters & potters (18th century).

The period 1880 AD- 1925 AD saw the development of complex product designs and the emergence of multi activity
diversified corporations like Du Pont, General Motors etc. It was during this period that scientific management was
developed which led the accountants to convert physical standards into Cost Standards, the latter being used for variance
analysis and control.

During the World War I and II the social importance of Cost Accounting grew with the growth of each country’s defence
expenditure. In the absence of competitive markets for most of the material required for war, the governments in several
countries placed cost-plus contracts under which the price to be paid was cost of production plus an agreed rate of profit.
The reliance on cost estimation by parties to defence contracts continued after World War II.

In addition to the above, the following factors have made accountants to find new techniques to

serve the industry :-

 Limitations placed on financial accounting

 Improved cost consciousness

 Rapid industrial development after industrial revolution and world wars

 Growing competition among the manufacturers

 To control galloping price rise, the cost of computing the precise cost of product / service

 To control cost several legislations passed throughout the world and India too such as Essential Commodities Act,
Industrial Development and Regulation Act etc
Due to the above factors, the Cost Accounting has emerged as a specialized discipline from the initial years of 20th century
i.e after World War I and II.

In India, prior to independence, there were a few Cost Accountants, and they were qualified mainly from I.C.M.A. (now
CIMA) London. During the Second World War, the need for developing the profession in the country was felt, and the
leadership of forming an Indian Institute was taken by some members of Defence Services employed at Kolkata. However,
with the enactment of the Cost and Works Accountants of India Act, 1959, the Institute of Cost and Works Accountants of
India (Now called as The Institute of Cost Accountants of India) was established at Kolkata. The profession assumed further
importance in 1968 when the Government of India introduced Cost Audit under section 233(B) of the Companies Act, 1956.
At present it is under Section 148 of the Companies Act, 2013.

Many times we use Cost Accounting, Costing and Cost Accountancy interchangeably. But there are differences among these
terms. As a professional, though we use interchangeably we must know the meaning of each term precisely.

Cost Accounting

Cost Accounting may be defined as “Accounting for costs classification and analysis of expenditure as will enable the
total cost of any particular unit of production to be ascertained with reasonable degree of accuracy and at the same
time to disclose exactly how such total cost is constituted”. Thus Cost Accounting is classifying, recording an appropriate
allocation of expenditure for the determination of the costs of products or services, and for the presentation of suitably
arranged data for the purpose of control and guidance of management.

Cost Accounting can be explained as follows:-

Cost Accounting is the process of accounting for cost which begins with recording of income and expenditure and ends with
the preparation of statistical data.

It is the formal mechanism by means of which cost of products or services are ascertained and controlled.

Cost Accounting provides analysis and classification of expenditure as will enable the total cost of any particular unit of
product / service to be ascertained with reasonable degree of accuracy and at the same time to disclose exactly how such total
cost is constituted. For example it is not sufficient to know that the cost of one pen is ` 25/- but the management is also
interested to know the cost of material used, the amount of labour and other expenses incurred so as to control and reduce its
cost.

It establishes budgets and standard costs and actual cost of operations, processes, departments or

products and the analysis of variances, profitability and social use of funds.

Thus Cost Accounting is a quantitative method that collects, classifies, summarises and interprets

information for product costing, operation planning and control and decision making.

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. The process of costing is the day to day routine of ascertaining
costs. It is popularly known as an arithmetic process. For example If the cost of producing a product say ` 200/-, then we
have to refer material, labour and expenses accounting and arrive the above cost as follows:

Material ` 100
Labour ` 40
Expenses ` 60
Total ` 200

Finding out the breakup of the total cost from the recorded data is a daily process. That is why it is called arithmetic
process/daily routine. In this process we are classifying the recorded costs and summarizing at each element and total is
called technique.

Cost Accountancy:

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 includes the presentation of
information derived there from for the purposes of managerial decision making. Thus, Cost Accountancy is the science, art
and practice of a Cost Accountant.

It is a science because it is a systematic body of knowledge having certain principles which a cost accountant should possess
for proper discharge of his responsibilities.

It is an art as it requires the ability and skill with which a Cost Accountant is able to apply the principles of Cost
Accountancy to various managerial problems.

Practice includes the continuous efforts of a Cost Accountant in the field of Cost Accountancy.

Such efforts of a Cost Accountant also include the presentation of information for the purpose of managerial decision making
and keeping statistical records.

Objectives of Cost Accounting

The following are the main objectives of Cost Accounting :-

 To ascertain the Costs under different situations using different techniques and systems of costing

 To determine the selling prices under different circumstances

 To determine and control efficiency by setting standards for Materials, Labour and Overheads

 To determine the value of closing inventory for preparing financial statements of the concern
  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

Scope of Cost Accountancy

The scope of Cost Accountancy is very wide and includes the following:-

Cost Ascertainment:

The main objective of Cost Accounting is to find out the Cost of product /services rendered with reasonable degree of
accuracy.

Cost Accounting: It is the process of Accounting for Cost which begins with recording of expenditure and ends with
preparation of statistical data.

Cost Control: It is the process of regulating the action so as to keep the element of cost within the set parameters.

Cost Reports: This is the ultimate function of Cost Accounting. These reports are primarily prepared for use by the
management at different levels. Cost reports helps in planning and control, performance appraisal and managerial decision
making.

Cost Audit: Cost Audit is the verification of correctness of Cost Accounts and check on the adherence to the Cost
Accounting plan. Its purpose is not only to ensure the arithmetic accuracy of cost records but also to see the principles and
rules have been applied correctly.

To appreciate fully the objectives and scope of Cost Accounting, it would be useful to examine the position of Cost
Accounting in the broader field of general accounting and other sciences. i.e Financial Accounting, Management
Accounting, Engineering and Service Industry.

Financial Accounting and Cost Accounting:

Financial Accounting is primarily concerned with the preparation of financial statements, which summarise the results of
operations for selected period of time and show the financial position of the company at particular dates. In other words
Financial Accounting reports on the resources available (Balance Sheet) and what has been accomplished with these
resources (Profit and Loss Account). Financial Accounting is mainly concerned with requirements of creditors, shareholders,
government, prospective investors and persons outside the management. Financial Accounting is mostly concerned with
external reporting.

Cost Accounting, as the name implies, is primarily concerned with determination of cost of something, which may be a
product, service, a process or an operation according to costing objective of management. A Cost Accountant is primarily
charged with the responsibility of providing cost data for whatever purposes they may be required for.
The main differences between Financial and Cost Accounting are as follows:

Financial Accounting Cost Accounting

(a) It provides the information about the business (a) It provides information to the management for
in a general way. i.e Profit and Loss Account, proper planning, operation, control and decision
Balance Sheet of the business to owners and other making.
outside partners.
(b) It classifies, records and analyses the (b) It records the expenditure in an objective
transactions in a subjective manner, i.e according manner, i.e according to the purpose for which the
to the nature of expense. costs are incurred.
(c) It lays emphasis on recording aspect without (c) It provides a detailed system of control for
attaching any importance to control. materials, labour and overhead costs with the help
of standard costing and budgetary control.
(d) It reports operating results and financial (d) It gives information through cost reports to
management as and when desired.
position usually at the end of the year.
(e) Financial Accounts are accounts of the whole (e) Cost Accounting is only a part of the financial
business. They are independent in nature. accounts and discloses profit or loss of each
product, job or service.
(f) Financial Accounts records all the commercial (f) Cost Accounting relates to transactions
transactions of the business and include all connected with Manufacturing of goods and
expenses i.e Manufacturing, Office, Selling etc. services, means expenses which enter into
production.
(g) Financial Accounts are concerned with (g) Cost Accounts are concerned with internal
external transactions i.e. transactions between transactions, which do not involve any cash
business concern and third party. payment or receipt.
(h) Only transactions which can be measured in (h) Non-Monetary information likes No of Units /
monetary terms are recorded.
Hours etc are used.
(i) Financial Accounting deals with actual (i) Cost Accounting deals with partly facts
and
figures and facts only.
figures and partly estimates / standards.
(j) Financial Accounting do not provide(j) Cost Accounts provide valuable information on
 information on efficiencies of various workers/ the efficiencies of employees and Plant &
Plant & Machinery. Machinery.
(k) Stocks are valued at Cost or Market price (k) Stocks are valued at Cost only.

Whichever is lower.
(l) Financial Accounting is a positive science as it (l) Cost Accounting is not only positive science
is subject to legal rigidity with regarding to but also normative because it includes techniques
preparation of financial statements. of budgetary control and standard costing.
(m) These accounts are kept in such away to meet (m) Generally Cost Accounts are kept voluntarily
the requirements of Companies Act 2013 as per to meet the requirements of the management, only
Sec 128 & Income Tax Act, 1961 Sec 44AA. in some industries Cost Accounting records are
kept as per the Companies Act.

Cost Accounting and Management Accounting:

Management Accounting is primarily concerned with management. It involves application of appropriate techniques and
concepts, which help management in establishing a plan for reasonable economic objective. It helps in making rational
decisions for accomplishment of these objectives. Any workable concept or techniques whether it is drawn from Cost
Accounting, Financial Accounting, Economics, Mathematics and Statistics, can be used in Management Accountancy. The
data used in Management Accountancy should satisfy only one broad test. It should serve the purpose that it is intended for.
A Management Accountant accumulates, summarizes and analysis the available data and presents it in relation to specific
problems, decisions and day-to-day task of management. A Management Accountant reviews all the decisions and analysis
from management’s point of view to determine how these decisions and analysis contribute to overall organizational
objectives. A Management Accountant judges the relevance and adequacy of available data from management’s point of
view.

The scope of Management Accounting is broader than the scope of Cost Accountancy. In Cost Accounting, primary
emphasis is on cost and it deals with its collection analysis relevance interpretation and presentation for various problems of
management. Management Accountancy utilizes the principles and practices of Financial Accounting and Cost Accounting
in addition to other management techniques for efficient operations of a company. It widely uses different techniques from
various branches of knowledge like Statistics, Mathematics, Economics, Laws and Psychology to assist the management in
its task of maximising profits or minimising losses. The main thrust in Management Accountancy is towards determining
policy and formulating plans to achieve desired objective of management. Management Accounting makes corporate
planning and strategy effective.
From the above discussion we may conclude that the Cost Accounting and Management Accounting are interdependent,
greatly related and inseparable.

Advantages of Cost Accounting

Cost Accounting has manifold advantages, a summary of which is given below. It is not suggested that having installed a
system of Cost Accounting, a concern will expect to derive all the benefits stated here, the nature and the extent of the
advantages obtained will depend upon the type, adequacy and efficiency of the cost system installed and the extent to which
the various levels of management are prepared to accept and act upon the advice rendered by the cost system.

The Cost Accounting System has the following advantages:-

 A cost system reveals unprofitable activities, losses or inefficiencies occurring in any form such as

 Wastage of man power, idle time and lost time.

 Wastage of material in the form of spoilage, excessive scrap etc., and

 Wastage of resources, e.g. inadequate utilization of plant, machinery and other facilities.

 Cost Accounting locates the exact causes for decrease or increase in the profit or loss of the business. It identifies the
unprofitable products or product lines so that these may be eliminated or alternative measures may be taken.

 Cost Accounts furnish suitable data and information to the management to serve as guides in making decisions
involving financial considerations.

 Cost Accounting is useful for price fixation purposes. Although sale price is generally related more to economic
conditions prevailing in the market than to cost, the latter serves as a guide to test the adequacy of selling prices.

 With the application of Standard Costing and Budgetary Control methods, the optimum level of efficiency is set.

 Cost comparison helps in cost control. Comparison may be period to period, of the figures in respect of the same unit
or factory or of several units in an industry by employing Uniform Costs and Inter- Firm Comparison methods.
Comparison may be made in respect of cost of jobs, process or cost centres.

 A cost system provides ready figures for use by the Government, wage tribunals and boards, and labour and trade
unions.

 When a concern is not working to full capacity due to various reasons such as shortage of demands or bottlenecks in
production, the cost of idle capacity can readily worked out and repealed to the management.

 Introduction of a cost reduction programme combined with operations research and value analysis techniques leads to
economy.

 Marginal Costing is employed for suggesting courses of action to be taken. It is a useful tool for the management for
making decisions.
  Determination of cost centres or responsibility centres to meet the needs of a Cost Accounting system, ensures that
the organizational structure of the concern has been properly laid responsibility can be properly defined and fixed on
individuals.

 Perpetual inventory system which includes a procedure for continuous stock taking is an essential feature of a cost
system.

 The operation of a system of cost audit in the organization prevents manipulation and fraud and assists in furnishing
correct and reliable cost data to the management as well as to outside parties like shareholders, the consumers and the
Government.

Limitations of Cost Accounting system

Like any other system of accounting, Cost Accountancy is not an exact science but an art which has developed through
theories and accounting practices based on reasoning and commonsense. Many of the theories cannot be proved nor can they
be disproved. They grownup in course of time to become conventions and accepted principles of Cost Accounting. These
principles are by no means static, they are changing from day to day and what is correct today may not hold true in the
circumstances tomorrow.

 Large number of Conventions, Estimates and Flexible factors: No cost can be said to be exact as they

 incorporate a large number of conventions, estimations and flexible factors such as :-

 Classification of costs into its elements.

 Materials issue pricing based on average or standard costs.

 Apportionment of overhead expenses and their allocation to cost units/centres.

 Arbitrary allocation of joint costs.

 Division of overheads into fixed and variable.

 Cost Accounting lacks the uniform procedures and formats in preparing the cost information of a product/ service.
Keeping in view this limitation, all Cost Accounting results can be taken as mere estimates.

Installation of Cost System or Cost Accounting System

From what has been stated in the preceding sections, it will be seen that there cannot be a readymade cost system suitable for
a business. Such system has to be specially designed for an undertaking to meet its specific needs. Before installing a cost
system proper care should be taken to study and taken into account all the aspects involved as otherwise the system will be a
misfit and full advantages will not be realized from it. The following points should be looked into and the prerequisites
satisfied before installing a cost system:-

The nature, method and stages of production, the number of varieties and the quantity of each product and such other
technical aspects should be examined. It is to be seen how complex or how simple the production methods are and what is
the degree of control exercised over them.

 The size, layout and organisation of the factory should be studied.

 The methods of purchase, receipt, storage and issue of materials should be examined and modified wherever
considered necessary.

 The wage payment methods should be studied.

 The requirements of the management and the policy adopted by them towards cost control should be kept in view.

 The cost of the system to be installed should be considered. It is needless to emphasize that the installation and
operation of system should be economic.

 The system should be simple and easy to operate.

 The system can be effectively run if it is appropriate and properly suited to the organisation.

 Forms and records of original entry should be so designed and to involve minimum clerical work and expenditure.

 The system should be so designed that cost control can be effectively exercised.

 The system should incorporate suitable procedure for reporting to the various levels of management. This should be
based on the principles of exception.
Cost:

Cost is a measurement, in monetary terms, of the amount of resources used for the purpose of production of goods or
rendering services.

Cost in simple, words, means the total of all expenses. Cost is also defined as the amount of expenditure (actual or notional)
incurred on or attributable to a given thing or to ascertain the cost of a given thing. Thus it is that which is given or in
sacrificed to obtain something. The cost of an article consists of actual outgoings or ascertained charges incurred in its
production and sale. Cost is a generic term and it is always advisable to qualify the word cost to show exactly what it meant,
e.g., prime cost, factory cost, etc. Cost is also different from value as cost is measured in terms of money whereas value in
terms of usefulness or utility of an article.
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’. Direct materials are those materials which can be identified in the product and can be conveniently
measured and directly charged to the product. Thus, these materials directly enter the product and form a part of the finished
product. For example, timber in furniture making, cloth in dress making, bricks in building a house. The following are
normally classified as direct materials:-

All raw materials, like jute in the manufacture of gunny bags, pig iron in foundry and fruits in canning industry.
Materials specifically purchased for a specific job, process or order, like glue for book binding, starch powder for dressing
yarn.

Parts or components purchased or produced, like batteries for transistor-radios.

Primary packing materials like cartons, wrappings, card-board boxes, etc.

Indirect Material Cost

Materials, the costs of which cannot be directly attributed to a particular cost object. 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 apportioned to or absorbed by cost centres or cost units”. These are: Stores used in maintenance of machinery,
buildings, etc., like lubricants, cotton waste, bricks and cements.

Stores used by the service departments, i.e., non-productive departments like Power House, Boiler House and Canteen, etc.,
and 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 which 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:

Labour engaged on the actual production of the product or in carrying out of an operation or process.

Labour engaged in adding the manufacture by way of supervision, maintenance, tool setting, transportation of material etc.

Inspectors, analysts etc., specially required for such production.

Indirect Labour/ Employee Cost

The labour / employee cost which 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. In
other words paid to labour which are employed other than on production constitute indirect labour costs. 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) Excise duty; (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

Overheads comprise of indirect materials, indirect employee cost and indirect expenses which are not directly identifiable or
allocable to a cost object. Overheads may 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. 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.

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, where as at a lowermost level it may be called as a Cost Unit.

Cost Centre

CIMA defines a cost centre as “a location, a person, or an item of equipment (or a group of them) in or connected with
an undertaking, in relation to which costs ascertained and used for the purpose of cost control”. The determination of
suitable cost centres as well as analysis of cost under cost centres is very helpful for periodical comparison and control of
cost. In order to obtain the cost of product or service, expenses should be suitably segregated to cost centre. The manager of a
cost centre is held responsible for control of cost of his cost centre. The selection of suitable cost centres or cost units for
which costs are to be ascertained in an undertaking depends upon a number of factors such as organization of a factory,
condition of incidence of cost, availability of information, requirements of costing and management policy regarding
selecting a method from various choices. Cost centre may be production cost centres operating cost centres or process cost
centres depending upon the situation and classification.

Cost centres are of two types-Personal and Impersonal Cost Centre. A personal cost centre consists of person or group of
persons. An impersonal cost centre consists of a location or item of equipment or group of equipments.

In a manufacturing concern, the cost centres generally follow the pattern or layout of the departments or sections of the
factory and accordingly, there are two main types of cost centres as below :-

Production Cost Centre: These centres are engaged in production work i.e engaged in converting

the raw material into finished product, for example Machine shop, welding shops...etc

Service Cost Centre: These centres are ancillary to and render service to production cost centres,

for example Plant Maintenance, Administration...etc

The number of cost centres and the size of each vary from one undertaking to another and are dependent upon the
expenditure involved and the requirements of the management for the purpose of control.

Responsibility Centre

A responsibility centre in Cost Accounting denotes a segment of a business organization for the activities of which
responsibility is assigned to a specific person. Thus a factory may be split into a number of centres and a supervisor is
assigned with the responsibility of each centre. All costs relating to the centre are collected and the Manager responsible for
such a cost centres judged by reference to the activity levels achieved in relation to costs. Even an individual machine may
be treated as responsibility centre for cost control and cost reduction.

Profit Centre

Profit centre is a segment of a business that is responsible for all the activities involved in the production and sales of
products, systems and services. Thus a profit centre encompasses both costs that it incurs and revenue that it generates. Profit
centres are created to delegate responsibility to individuals and measure their performance. In the concept of responsibility
accounting, profit centres are sometimes also responsible for the investment made for the centre. The profit is related to the
invested capital. Such a profit centre may also be termed as investment centre.

Cost Unit

Cost Unit is a device for the purpose of breaking up or separating costs into smaller sub divisions attributable to products or
services. Cost unit can be defined as a ‘Unit of product or service in relation to which costs are ascertained’. The cost unit is
the narrowest possible level of cost object.
It is the unit of quantity of product, service of time (or combination of these) in relation to which costs may be ascertained or
expressed. We may, for instance, determine service cost per tonne of steel, per tonne-kilometre of a transport service or per
machine hour. Sometimes, a single order or contract constitutes a cost unit which is known as a job. A batch which consists
of a group of identical items and maintains its identity through one or more stages or production may also be taken as a cost
unit.

A few examples of cost units are given below:

Industry / Product Cost Unit

Automobile Number of vehicles
Cable Metres / kilometres
Cement Tonne
Chemicals / Fertilizers Litre / Kilogram / tonne
Gas Cubic Metre
Power - Electricity Kilowatt Hour
Transport Tonne-Kilometre, Passenger-Kilometre
Hospital Patient Day
Hotel Bed Night
Education Student year
Telecom Number of Calls
BPO Service Accounts handled
Professional Service Chargeable Hours

Cost Allocation

When items of cost are identifiable directly with some products or departments such costs are charged to such cost centres.
This process is known as cost allocation. Wages paid to workers of service department can be allocated to the particular
department. Indirect materials used by a particular department can also be allocated to the department. Cost allocation calls
for two basic factors - (i) Concerned department/product should have caused the cost to be incurred, and (ii) exact amount of
cost should be computable.

Cost Apportionment
When items of cost cannot directly charge to or accurately identifiable with any cost centres, they are prorated or distributed
amongst the cost centres on some predetermined basis. This method is known as cost apportionment. Thus we see that items
of indirect costs residual to the process of cost allocation are covered by cost apportionment. The predetermination of
suitable basis of apportionment is very important and usually following principles are adopted - (i) Service or use (ii) Survey
method (iii) Ability to bear. The basis ultimately adopted should ensure an equitable share of common expenses for the cost
centres and the basis once adopted should be reviewed at periodic intervals to improve upon the accuracy of apportionment.

Cost Absorption

Ultimately the indirect costs or overhead as they are commonly known, will have to be distributed over the final products so
that the charge is complete. This process is known as cost absorption, meaning thereby that the costs absorbed by the
production during the period. Usually any of the following methods are adopted for cost absorption –

(i) Direct Material Cost Percentage

(ii) Direct Labour Cost Percentage

(iii) Prime Cost Percentage

(iv) Direct Labour Hour Rate Method

(v) Machine Hour Rate, etc.

The basis should be selected after careful maximum accuracy of Cost Distribution to various production units. The basis should be
reviewed periodically and corrective action whatever needed should be taken for improving upon the accuracy of the absorption.

Conversion Cost

This term is defined as the sum of direct wages, direct expenses and overhead costs of converting raw material to the finished
products or converting a material from one stage of production to another stage. In other words, it means the total cost of
producing an article less the cost of direct materials used. The cost of indirect materials and consumable stores are included
in such cost. The compilation of conversion cost is useful in a number of cases. Where cost of direct materials is of
fluctuating nature, conversion cost is used to cost control purpose or for any other decision making. In contracts/jobs where
raw materials are on account of the buyers conversion cost takes the place of total cost in the books of the producer. Periodic
comparison/review of the conversion cost may give sufficient insight as to the level of efficiency with which the production
unit is operating.

Cost Control

Cost Control is defined as the regulation by executive action of the costs of operating an undertaking, particularly where such
action is guided by Cost Accounting.

Cost control involves the following steps and covers the various facets of the management:
Planning: First step in cost control is establishing plans / targets. The plan/target may be in the form of budgets, standards,
estimates and even past actual may be expressed in physical as well as monetary terms. These serves as yardsticks by which
the planned objective can be assessed.

Communication: The plan and the policy laid down by the management are made known to all those responsible for
carrying them out. Communication is established in two directions; directives are issued by higher level of management to
the lower level for compliance and the lower level executives report performances to the higher level.

Motivation: The plan is given effect to and performances starts. The performance is evaluated, costs are ascertained and
information about results achieved are collected and reported. The fact that costs are being complied for measuring
performances acts as a motivating force and makes individuals endeavor to better their performances.

Appraisal and Reporting: The actual performance is compared with the predetermined plan and variances, i.e deviations
from the plan are analyzed as to their causes. The variances are reported to the proper level of management.

Decision Making: The variances are reviewed and decisions taken. Corrective actions and remedial measures or revision of
the target, as required, are taken.

Advantages of Cost Control

The advantages of cost control are mainly as follows

 Achieving the expected return on capital employed by maximising or optimizing profit

 Increase in productivity of the available resources

 Reasonable price of the customers

 Continued employment and job opportunity for the workers

 Economic use of limited resources of production

 Increased credit worthiness

 Prosperity and economic stability of the industry

Cost Reduction

Profit is the resultant of two varying factors, viz., sales and cost. The wider the gap between these two factors, the larger is
the profit. Thus, profit can be maximised either by increasing sales or by reducing costs. In a competition less market or in
case of monopoly products, it may perhaps be possible to increase price to earn more profits and the need for reducing costs
may not be felt. Such conditions cannot, however, exist paramount and when competition comes into play, it may not be
possible to increase the sale price without having its adverse effect on the sale volume, which, in turn, reduces profit.
Besides, increase in price of products has the ultimate effect of pushing up the raw material prices, wages of employees and
other expenses- all of which tend to increase costs. In the long run, substitute products may come up in the market, resulting
in loss of business. Avenues have, therefore, to be explored and method devised to cut down expenditure and thereby reduce
the cost of products. In short, cost reduction would mean maximization of profits by reducing cost through economics and
savings in costs of manufacture, administration, selling and distribution.

Cost reduction may be defined as the real and permanent reduction in the unit costs of goods manufactured or services
rendered without impairing their suitability for the use intended. As will be seen from the definition, the reduction in costs
should be real and permanent. Reductions due to windfalls, fortuities receipts, changes in government policy like reduction
in taxes or duties, or due to temporary measures taken for tiding over the financial difficulties do not strictly come under the
purview of cost reduction. At the same time a programme of cost reduction should in no way affect the quality of the
products nor should it lower the standards of performance of the business.

Broadly speaking reduction in cost per unit of production may be affected in two ways viz.,

 By reducing expenditure, the volume of output remaining constant, and

 By increasing productivity, i.e., by increasing volume of output and the level of expenditure remains unchanged.
These aspects of cost reduction are closely linked and they act together - there may be a reduction in the expenditure and the
same time, an increase in productivity.

Cost Control vs. Cost Reduction: Both Cost Reduction and Cost Control are efficient tools of management

but their concepts and procedure are widely different. The differences are summarised below:

Cost Control Cost Reduction

(a) Cost Control represents efforts made towards (a) Cost Reduction represents the achievement in
achieving target or goal. reduction of cost.
(b) The process of Cost Control is to set up a (b) Cost Reduction is not concern with
target, ascertain the actual performance and maintenance of performance according to
compare it with the target, investigate the standard.
variances, and take remedial measures.
(c) Cost Control assumes the existence of (c) Cost Reduction assumes the existence of
standards or norms which are not challenged. concealed potential savings in standards or
norms which are therefore subjected to a
constant challenge with a view to improvement by
bringing out savings.
 (d) Cost Control is a preventive function. Costs are (d) Cost Reduction is a corrective function. It
optimized before they are incurred. operates even when an efficient cost control
system exists. There is room for reduction in the
achieved costs under controlled conditions.
(e) Cost Control lacks dynamic approach. (e) Cost Reduction is a continuous process of
analysis by various methods of all the factors
affecting costs, efforts and functions in an
organization. The main stress is upon the why of a
thing and the aim is to have continual economy in
costs.
Types of costing have been designed to suit the needs of individual business conditions. The basic principles underlying all
these methods are the same i.e. to collect and analyze the expenditure according to the elements of costs and to determine the
cost of each Cost Centre and or Cost Unit. Classification of cost is the arrangement of items of costs in logical groups having
regard to their nature or purpose. Items should be classified by one characteristic for a specific purpose without ambiguity.
Scheme of classification should be such that every item of cost can be classified. In view of the above, cost classification
may be explained as below:

As per Cost Accounting Standard 1 (CAS-1), the basis for cost classification is as follows:

 Nature of expense

 Relation to Object – Traceability

 Functions / Activities

 Behaviour – Fixed, Semi-variable or Variable

 Management decision making

 Production Process

 Time Period
Classification of cost is the process of grouping the components of cost under a common designation on the basis of
similarities of nature, attributes or relations. It is the process of identification of each item and the systematic placement of
like items together according to their common features. Classification by Nature of Expense

Costs should be gathered together in their natural grouping such as Material, Labour and Other Direct expenses. Items of
costs differ on the basis of their nature. The elements of cost can be classified in the following three categories.

1. Material

2. Labour
3. Expenses

Material Cost:

Material cost is the cost of material of any nature used for the purpose of production of a product or a service. It includes
cost of materials, freight inwards, taxes & duties, insurance ...etc directly attributable to acquisition, but excluding the trade
discounts, duty drawbacks and refunds on account of excise duty and vat.

Labour Cost:

Labour cost means the payment made to the employees, permanent or temporary for their services. Labour cost includes
salaries and wages paid to permanent employees, temporary employees and also to the employees of the contractor. Here
salaries and wages include all the benefits like provident fund, gratuity, ESI, overtime, incentives...etc

Expenses:

Expenses are other than material cost or labour cost which are involved in an activity.

Classification by Relation to Cost Centre or Cost Unit:

If expenditure can be allocated to a cost centre or cost object in an economically feasible way then it is called direct
otherwise the cost component will be termed as indirect. According to this criteria for classification, material cost is divided
into direct material cost and indirect material cost, Labour cost is divided into direct labour and indirect labour cost and
expenses into direct expenses and indirect expenses. Indirect cost is also known as overhead.

Direct Material Cost: Cost of material which can be directly allocated to a cost centre or a cost object in an economically
feasible way.

Direct labour Cost: Cost of wages of those workers who are readily identified or linked with a cost centre

or cost object.

Direct Expenses: Expenses other than direct material and direct labour which can be identified or

linked with cost centre or cost object.

Direct Material + Direct labour + Direct Expenses = Prime Cost

Indirect Material: Cost of material which cannot be directly allocable to a particular cost centre or cost object.

Indirect Labour: Cost of wages of employees which are not directly allocable to a particular cost centre.

Indirect expenses: Expenses other than of the nature of material or labour and cannot be directly allocable to a particular
cost centre.

Indirect Material + Indirect Labour + Indirect Expenses = Overheads

Classification by Functions:

A business enterprise performs a number of functions like manufacturing, selling, research etc.

Costs may be required to be determined for each of these functions and on this basis functional costs may be classified into
the following types:-

 Production or Manufacturing Costs

 Administration Costs

 Selling & Distribution cost

 Research & Development cost
Production or Manufacturing Costs:
Production cost is the cost of all items involved in the production of a product or service. These
refer to the costs of operating the manufacturing division of an undertaking and include all costs
incurred by the factory from the receipt of raw materials and supply of labour and services until
production is completed and the finished product is packed with the primary packing.
The followings are considered as Production or Manufacturing Costs:-

 Direct Material

 Direct Labour

 Direct Expenses and

 Factory overhead, i.e., aggregate of factory indirect material, indirect labour and indirect
expenses.
Manufacturing cost can also be referred to as the aggregate of prime cost and factory overhead.

Administration Costs:

Administration costs are expenses incurred for general management of an organization. These
are in the nature of indirect costs and are also termed as administrative overheads. For
understanding administration cost, it is necessary to know the scope of administrative function.
Administrative function in any organization primarily concerned with following activities :-

Formulation of policy

Directing the organization and

Controlling the operations of an organization. But administrative function will not include
control activities concerned with production, selling and distribution and research and
development.

Therefore, administration cost is the cost of administrative function, i.e., the cost of formulating
policy, directing, organizing and controlling the operations of an undertaking (Administrative
cost will include the cost of only those control operations which are not related to production,
selling and distribution and research and development). In most of the cases, administration cost
includes indirect expenses of following types:
  Salaries of office staff, accountants, directors

 Rent, rates and depreciation of office building

 Postage, stationery and telephone

 Office supplies and expenses

 General administration expenses.

Selling & Distribution Costs:

Selling costs are indirect costs related to selling of products are services and include all indirect
costs in sales management for the organization. Distribution costs are the costs incurred in
handling a product from the time it is completed in the works until it reaches the ultimate
consumer.

Selling function includes activities directed to create and stimulate demand of company’s
product and secure orders. Distribution costs are incurred to make the saleable goods available in
the hands of the customer.

Following are the examples of selling and distribution costs:

Salaries and commission of salesmen and sales managers.

Expenses of advertisement, insurance.

Rent, rates, depreciation and insurance of sales office and warehouses.

Cost of insurance, freight, export, duty, packing, shipping, etc.,

Maintenance of Delivery vans.

Research & Development Costs:

Research & development costs are the cost for undertaking research to improve quality of a
present product or improve process of manufacture, develop a new product, market research etc.
and commercialization thereof.
R&D Costs comprises of the following:-

 Development of new product.

 Improvement of existing products.

 Finding new uses for known products.

 Solving technical problem arising in manufacture and application of products.

Development cost includes the costs incurred for commercialization / implementation of research

findings.

Pre-Production Costs:

These are costs incurred when a new factory is in the process of establishment, a new project is
undertaken, or a new product line or product is taken up but there is no established or formal
production to which such costs may be charged. Preproduction costs are normally treated as
deferred revenue expenditure and charged to the costs of future production.

Classification based on Behaviour – Fixed, Semi-variable or Variable

Costs are classified based on behaviour as fixed cost, variable cost and semi-variable cost
depending upon response to the changes in the activity levels.

Cost classification by behaviour

Fixed Variable Semi-variable

Fixed Cost:

Fixed cost is the cost which does not vary with the change in the volume of activity in the short
run. These costs are not affected by temporary fluctuation in activity of an enterprise. These are
also known as period costs. Example: Rent, Depreciation...etc.

Variable Cost:
Variable cost is the cost of elements which tends to directly vary with the volume of activity.
Variable cost has two parts (i) Variable direct cost (ii) Variable indirect costs. Variable indirect
costs are termed as variable overheads. Example: Direct labour, Outward Freight...etc.

Semi-Variable Costs:

Semi variable costs contain both fixed and variable elements. They are partly affected by
fluctuation in the level of activity. These are partly fixed and partly variable costs and vice versa.
Example: Factory supervision, Maintenance...etc.

Classification based on Costs for Management Decision Making

Ascertainment of cost is essential for making managerial decisions. On this basis costing may be

classified into the following types.

Marginal Costing:

Marginal Cost is the aggregate of variable costs, i.e. prime cost plus variable overhead. Marginal
cost per unit is the change in the amount at any given volume of output by which the aggregate
cost changes if the volume of output is increased or decreased by one unit. Marginal Costing
system is based on the system of classification of costs into fixed and variable. The fixed costs
are excluded and only the marginal costs, i.e. the variable costs are taken into consideration for
determining the cost of products and the inventory of work-in-progress and completed products.

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.

Replacement Cost:

Replacement cost is the cost of an asset in the current market for the purpose of replacement.
Replacement cost is used for determining the optimum time of replacement of an equipment or
machine in consideration of maintenance cost of the existing one and its productive capacity.
This is the cost in the current market of replacing an asset. For example, when replacement cost
of material or an asset is being considered, it means that the cost that would be incurred if the
material or the asset was to be purchased at the current market price and not the cost, at which it
was actually purchased earlier, should be take into account.

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.

Imputed Costs:

Imputed costs are hypothetical or notional costs, not involving cash outlay computed only for
the purpose of decision making. In this respect, imputed costs are similar to opportunity costs.
Interest on funds generated internally, payment for which is not actually made is an example of
imputed cost. When alternative capital investment projects are being considered out of which one
or more are to be financed from internal funds, it is necessary to take into account the imputed
interest on own funds before a decision is arrived at. 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.

Avoidable Costs & Unavoidable Costs:

Avoidable Costs are those which under given conditions of performance efficiency should not
have been incurred. Unavoidable Costs which are inescapable costs, which are essentially to be
incurred, within the limits or norms provided for. It is the cost that must be incurred under a
programme of business restriction. It is fixed in nature and inescapable.

Uniform Costing:

This is not a distinct system of costing. The term applies to the costing principles and procedures
which are adopted in common by a number of undertakings which desire to have the benefits of
a uniform system. The methods of Uniform Costing may be extended so as to be useful in inter-
firm comparison.

Engineered Cost:

Engineered Cost relates to an item where the input has an explicit physical relationship with the
output. For instance in the manufacture of a product, there is a definite relationship between the
units of raw material and labour time consumed and the amount of variable manufacturing
overhead on the one hand and units of the products produced on the other. The input-output
relationship can be established the form of standards by engineering analysis or by an analysis of
the historical data. It should be noted that the variable costs are not engineered cost but some
administration and selling expenses may be categorized as engineered cost.

Out-of-Pocket Cost:
This is the portion of the cost associated with an activity that involve cash payment to other
parties, as opposed to costs which do not require any cash outlay, such as depreciation and
certain allocated costs. Out-of-Pocket Costs are very much relevant in the consideration of price
fixation during trade recession or when a make-or-buy decision is to be made.

Managed Cost: Managed (Programmed or Discretionary) Costs all opposed to engineering costs,
relate to such items where no accurate relationship between the amount spent on input and the
output can be established and sometimes it is difficult to measure the output. Examples are
advertisement cost, research and development costs, etc.,

Common Costs:

These are costs which are incurred collectively for a number of cost centres and are required to
be suitably apportioned for determining the cost of individual cost centres. Examples are:
Combined purchase cost of several materials in one consignment, and overhead expenses
incurred for the factory as a whole.

Controllable and Non-Controllable Costs:

Controllable Cost is that cost which is subject to direct control at some level of managerial
supervision. Non-controllable Cost is the cost which is not subject to control at any level of
managerial supervision.

The objectives of the CASB are to develop high quality Cost Accounting Standards to enable the
management to take informed decisions and to enable regulators to function more effectively by
integrating, harmonizing and standardizing Cost Accounting Principles and Practices.

The following will be the functions of the CASB :-

 To issue the framework for the Cost Accounting Standards.

 To equip the Cost & Management Accounting professionals with better guide lines on
cost

 Accounting Principles.

 To assists the members in preparation of uniform cost statements under various statutes.

 To provide from time to time interpretations on Cost Accounting Standards.

  To issue application guidance relating to particular standard.

 To propagate the Cost Accounting Standards and to persuade the users to adopt them in
thevpreparation and presentation of general purpose Cost Statement.

 To persuade the government and appropriate authorities to enforce Cost Accounting

Standards, to facilitate the adoption thereof, by industry and corporate entities in order to
achieve the desired objectives of standardization of Cost Accounting Practices.

 To educate the users about the utility and the need for compliance of Cost Accounting
Standards.

Overview of Cost Accounting Standards issued till date are as follows:

CAS No Title Objective

CAS 1 Classification of Cost For preparation of Cost Statements.
CAS 2 Capacity Determination To bring uniformity and consistency in the principles and methods
of determination of capacity with reasonable accuracy.
CAS 3 Production and Operation To bring uniformity and consistency in the principles and methods
Overheads of determining the Production or Operation Overheads with
reasonable accuracy.
CAS 4 Cost of Production for Captive To determine the assessable value of excisable goods used for
consumption
captive consumption.
CAS 5 Average (Equalized) Cost To determine averaged / equalized transportation cost.
of Transportation
CAS 6 Material Cost To bring uniformity and consistency in the principles and methods
of determining the Material Cost with reasonable accuracy in an
economically feasible manner.
CAS 7 Employee Cost To bring uniformity and consistency in the principles and methods
of determining the Employee Cost with reasonable accuracy.
CAS 8 Cost of Utilities To bring uniformity and consistency in the principles and methods
 of determining the Cost of Utilities with reasonable accuracy.
CAS 9 Packing Material Cost To bring uniformity and consistency in the principles and methods
of determining the Packing Material Cost with reasonable
accuracy.

CAS 10 Direct Expenses To bring uniformity and consistency in the principles and methods of
determining the Direct Expenses with reasonable accuracy.
CAS 11 Administrative Overheads To bring uniformity and consistency in the principles and methods of
determining the Administrative Overheads with reasonable accuracy.
CAS 12 Repairs and Maintenance To bring uniformity and consistency in the principles and methods of
determining the Repairs and Maintenance Cost with reasonable
Cost
accuracy.
CAS 13 Cost of Service To bring uniformity and consistency in the principles and methods of
Cost Centre determining the Cost of Service Cost Centre with reasonable
accuracy.
CAS 14 Pollution Control Cost To bring uniformity and consistency in the principles and methods of
determining the Pollution Control Costs with reasonable accuracy.
CAS 15 Selling and Distribution To bring uniformity and consistency in the principles and methods of
overheads determining the selling and Distribution over- heads with reasonable
accuracy
CAS 16 Depreciation and Amortisation To bring uniformity and consistency in the principles and methods of
determining the Depreciation and Amortisation with reasonable
accuracy.
CAS 17 Interest and Financing To bring uniformity and consistency in the principles, methods of
determining and assigning the Interest and Financing Charges with
Charges.
reasonable accuracy.
CAS 18 Research and To bring uniformity and consistency in the principles and methods of
determining the Research, and Development Costs with reasonable
Development Costs
accuracy and presentation of the same.
CAS 19 Joint Costs To bring uniformity and consistency in the principles and
 methods of determining the Joint Costs.
CAS 20 Cost Accounting Standard on To bring uniformity and consistency in the principles and methods of
Royalty and Technical Know- determining the amount of Royalty and Technical Know-how Fee
How Fee with reasonable accuracy.
CAS 21 Cost Accounting Standard on To bring uniformity, consistency in the principles, methods of
Quality Control determining and assigning Quality Control cost with reasonable
accuracy.
CAS 22 Cost Accounting Standard on To bring uniformity and consistency in the principles and methods of
Manufacturing Cost determining the Manufacturing Cost of excisable goods
CAS 23 Cost Accounting Standard on To bring uniformity and consistency in the principles and methods of
Overburden Removal Cost determining and assigning Overburden Removal Cost including those
requiring attestation.
CAS 24 Cost Accounting Standard on To bring uniformity and consistency in the principles and methods for
Treatment of Revenue in Cost treatment of revenue in cost statements with reasonable accuracy.
Statements
This standard deals with the principles of Classification of Cost for determining the cost of a
product or service.

Objective

The objective of this standard is to bring uniformity and consistency in the principles of
Classification of Cost for disclosure and presentation in the cost statements of a product or
service.

Scope

This standard shall be applied to cost statements, which require classification, presentation and
disclosure of cost including those requiring attestation.

Principles of Classification of Costs

Costs shall be classified by the process of grouping the components of cost under a common
designation on the basis of similarities of nature, attributes or relations. Items grouped together
under common heads shall be further classified according to their fundamental differences.
Scheme of classification shall be such that every item of cost is classified.

Classification of Costs

 By Nature of expenses

 By nature of traceability to a cost object

 By function

 By nature of behaviour

 By nature of production or operation process