COST CONCEPT AND COST OBJECT

COST CONCEPT AND COST OBJECT

The dictionary meaning of cost is “a loss or sacrifice”, or “an amount paid or required in

payment for a purchase or for the production or upkeep of something, often measured in terms of effort or time expended”. C I M A Terminology defines cost as ‘resources sacrificed or forgone to achieve a specific objective’. Cost is generally measured in monetary terms.

Basics of Cost Accounting

Cost is the amount of expenditure (actual or notional) incurred on or attributable to, a specified thing or activity. Thus, material cost of a product will mean the expenses incurred in procuring, storing and using materials in the product. Similarly, labour cost will represent that part of payment made to the workmen for time spent on the product during its manufacture. Again, the term ‘cost’ can hardly be meaningful without using a suffix or a prefix. The cost is always ascertained with reference to some object, such as, material, Iabour, direct, indirect, fixed, variable, job, process, etc. Thus, each suffix or prefix implies certain attribute which will explain its nature and limitations.

Cost object is defined by Charles T. Horngren as ‘any activity for which a separate measurement of cost is desired’. It may be an activity, or operation in which resources, like materials, labour, etc. are consumed. The cost object may be a product or service, a project or a department, or even a program like eradication of illiteracy. Again, the same cost may pertain to more than one cost objects simultaneously. For example, material cost may be a part of product cost as well as production department cost.

COST MANAGEMENT

The techniques and process of ascertaining cost involve three steps, viz.

(i) Collection of expenditure or cost data,

(iii) Classification of expenditure as per cost elements, function, etc. and

(iii) Allocation and apportionment of expenditure to the cost centres and cost units.

The system accumulates and classifies expenditure according to the elements of costs, and then, the accumulated expenditure is allocated and apportioned to cost objects i.e. cost centres and cost units. We should, therefore, know what are cost elements, cost centres and cost units.

Elements of Cost

For the purpose of identification, accounting and control, breakup of cost into its elements is essential. Elements are related to the process of manufacture i.e. the conversion of raw materials into finished products. Costs are normally broken down into three basic elements, namely, material, labour and expense. Material cost includes all materials consumed in the process of manufacture up to the primary packing. Labour cost includes all remuneration paid to the staff and workmen for conversion of raw materials into finished products. Expenses consist of the cost of utilities and services used for the conversion process including notional cost for the use of owned assets.

Each of the cost elements can be further divided into direct and indirect cost. Direct costs are those which can be identified with or related to the product or services, so much so that an increase or decrease of an unit of product or service will affect the cost proportionately. Indirect cost, on the other hand, cannot be identified or traced to a given cost object in economical way and are related to the expenses incurred for maintaining facilities for such production or services. Thus, the elements of cost may be summarised as follows – (a) Direct materials and indirect materials, (b) Direct wages and indirect wages, (c) Direct expense and indirect expense

Cost and Management Accounting

The aggregate of direct materials cost, direct wages and direct expense is called Prime cost, while indirect materials cost, indirect wages and indirect expenses are collectively called overhead cost.

Overheads are classified into production overheads i.e. indirect costs relating to manufacturing activities, administration overheads i.e. costs relating to formulating the policy, directing the organisation and controlling operations and selling and distribution overheads i.e. indirect costs relating to the activity of creating and stimulating demand and securing orders as well as operations relating to distribution of goods from factory warehouse to customers. Factory cost, cost of production and cost of sales are arrived at by adding respective overheads to prime cost, factory cost and cost of production as indicated in the chart below :–

Rs.

Direct materials cost x

Direct wages x

Direct expenses x

PRIME COST

Factory overhead x

FACTORY COST x

Administration overhead x

COST OF PRODUCTION x

Selling and distribution overhead x

COST OF SALES x

Allocated and Apportioned Cost

Cost allocation is the allotment of the whole items of costs to cost centres or cost units. Cost apportionment refers to the allotment of proportions of item of cost to cost centres or cost units. A cost which is allocated to a cost centre is a direct cost of that cost centre, whereas the cost which is apportioned to different cost centres on suitable basis is an indirect cost of that cost centre. Thus, direct costs are allocated, since they can be directly identified with a cost centre or cost unit, and indirect costs are apportioned expenditure. The concept of direct and indirect cost is very important for costing purposes.

Cost Centre

Cost centre is defined as a location, person or item of equipment (or group of them) in respect of which costs may be ascertained and related to cost units for the purposes of cost control. It is the smallest segment of activity or area of responsibility for which costs are accumulated.

Thus cost centres can be of two kinds, viz.

(a) Impersonal cost centre consisting of a location or item of equipment (or group of

these) such as machine shop, and

(b) Personal cost centre consisting of a person or a group of persons such as factory

manager, sales manager, etc.

Cost centres are also classified in manufacturing concerns into production and service cost centres. Production cost centres relate to those centres where production or manufacturing

activities take place. Service cost centres are those, which are ancillary and render services to the production cost centres, so that manufacturing activities can take place. In a biscuit manufacturing company, making, baking and packing are production cost centres while personnel, purchase, stores, canteen, accounts are service cost centres.

The main purpose of cost centre is two fold :–

(i) Recovery of cost: Costs are collected, classified and accumulated in respect of a location, person or an item of equipment and then the costs are distributed over the products for recovery of incurred cost, and

(ii) Cost control: Cost centres assist in making a person responsible for the control of expenditure incurred by the cost centre. Manager of each cost centre shall control costs incurred in his area of responsibility.

The size of the cost centre depends on the activity and operation, and feasibility of cost

control. Sub-cost centres are created if the size of the cost centres become too big from

control point of view.

Cost Unit

While cost centres assist in ascertaining costs by location, person, equipment, operation or process, cost unit is a unit of product, service or a combination of them in relation to which costs are ascertained or expressed.

The selection of suitable cost unit depends upon several factors, such as, nature of business, process of information, requirements of costing system, etc. but usually relates to the natural unit of the product or service. For example, in steel and cement industry, the cost unit is ‘tonne’, while in transportation services, the unit may be passenger-kilometre or tonne-km, etc. It may be noted that while the former is a single cost unit, the latter is a composite unit, i.e. a combination of two units. A few examples of cost units are given below :–

lndustry or product Cost unit

Automobile Number

Biscuit Kilogram

Bread Thousand loaves

Breweries Barrel

Bricks Thousand bricks

Cigarettes Thousand cigarettes

Chemical Litre, gallon, kilogram

Coal, cement Tonne

Cotton textile K.G. of yarn or metre of cloth

Gas Cubic foot or cubic metre

Hospital Patient day

Hotel Guest-day, guest room, etc.

Power and electricity Kilowatt-hour

Steel Tonne

Transport Passenger kilometre, Tonne-kilometre

COST CLASSIFICATION

Cost classification refers to the process of grouping costs according to their common

characteristics, such as nature of expense, function, variability, controllability and normality.

Cost classification can be done on the basis of time, their relation with the product and accounting period. Cost classification is also made for planning and control and decision making. Thus, classification is essential for identifying costs with cost centres or cost units for the purpose

of determination and control of cost :

(a) By nature of expenses: Costs can be classified into material, labour and expenses as explained earlier.

(b) By function: Costs are classified, as explained earlier, into production or manufacturing cost, administration cost, selling and distribution cost, research and development cost.

— Production cost begins with the process of supplying material labour and services and ends with primary packing of the finished product.

— Administration cost is the aggregate of the costs of formulating the policy, directing the organisation and controlling the operations of an undertaking, which is not related directly to production, selling, distribution, research and development activity or function.

— Selling cost refers to the expenditure incurred in promoting sales and retaining customers.

— Distribution cost begins with the process of making the packed product available for despatch and ends with making the reconditioned returned empty package available for reuse.

— Research and development cost relates to the costs of researching for new or improved products, new application of materials, or new or improved methods, processes, system or services, and also the cost of implementation of the decision including the commencement of commercial production of that product or by that process or method.

— Pre-production cost refers to the part of development cost incurred in making trial production run preliminary to formal production, either in a new or a running factory. In a running factory, this cost often represents research and development cost also. Pre-production costs are normally considered as deferred revenue expenditure and are charged to the cost of future production.

(c) By variability: Costs are classified into fixed, variable and semi-fixed / semi-variable

costs according to their tendency to vary with the volume of output.

— Fixed costs tend to remain unaffected by the variation or change in the volume of output, such as supervisory salary, rent, taxes, etc.

— Variable costs tend to vary directly with volume of output, such as direct material, direct labour and direct expense.

— Semi-fixed/semi-variable cost is partly fixed and partly variable, such as telephone expense, electricity charges, etc.

 (d) By controllability: Costs can be classified under controllable cost and uncontrollable cost.

— Controllable cost can be influenced by the action of a specified member of an undertaking.

— Uncontrollable cost cannot be influenced by the action of a specified member of an undertaking.

(e) By normality : Costs can be divided into normal cost and abnormal cost. — Normal cost refers to the cost, at a given level of output in the conditions in which that level of output is normally attained.

— Abnormal cost is a cost which is not normally incurred at a given level of output in the conditions in which that level of output is normally attained.

(f) On the basis of time : Costs, may be classified into historical or actual cost and

predetermined or future cost.

— Historical cost relates to the usual method of determining actual cost of operation based on actual expenses incurred during the period. Such evaluation of costs takes longer time, till the accounts are closed and finalised, and figures are ready for use in cost calculations.

— Predetermined cost as the name signifies is prepared in advance before the actual operation starts on the basis of specifications and historical cost data of the earlier period and all factors affecting cost. Predetermined cost is the cost determined in advance and may be either estimated or standard.

— Estimated cost is prepared before accepting an order for submitting price quotation. It is also used for comparing actual performance.

— Standard cost is scientifically predetermined cost of a product or service applicable during a specific period of immediate future under current or anticipated operating conditions. The method consists of setting standards for each elements of cost, comparing actual cost incurred with the standard cost, evaluating the variance from standard cost and finding reasons for such variance, so that remedial steps can be taken promptly to check inefficient performances.

(9) In relation to the product : Costs may be classified into direct and indirect costs.

— Direct costs are those which are incurred for a particular cost unit and can be conveniently linked with that cost unit. Direct costs are termed as product cost.

— Indirect costs are those which are incurred for a number of cost units and also include costs which though incurred for a particular cost unit are not linked with the cost unit. Since such costs are incurred over a period and the benefit is mostly derived within the same period, they are called period costs.

(h) Cost analysis for decision making: Here costs are classified under relevant costs

(e.g. marginal cost, additional fixed cost, incremental cost, opportunity cost) and irrelevant costs (e.g. sunk cost, committed costs, etc.)

METHODS OF COSTING

Various methods of ascertaining costs are available to suit the business need. But the basic principles are the same in every method. The choice of a particular method of costing depends on the nature of business of the concern.

There are two basic methods of costing viz. – (a) Specific order or job costing (b) Continuous operation or process costing

All other methods are either variation of job or process costing or are just techniques used for particular purpose under specific conditions. Brief description of each of the methods are as follows:

Job Costing

Job costing is the basic costing method applicable to those industries where the work consist of separate contracts, jobs, or batches, each of which is authorised by a specific order or contract. The most important feature is that each job or order can be identified at each stage of production and therefore, costs which can be directly identified with a job or order is charged to that job or order. A share of indirect expenses is also charged to the same. Variation of job costing are contracts costing and batch costing.

— Contract costing is the form of specific order costing, generally applicable where work is undertaken to customer’s special requirements and each order is of long duration, such as building construction, ship building, structurals for bridge, civil construction, etc. The work is usually done outside the factory.

— Batch costing is that form of specific order costing which applies where similar articles are manufactured in batches either for sale or for use within the undertaking. Costs are collected according to batch order number and total costs are divided by total numbers in a batch to arrive at unit cost of each job. The method is applicable in aircraft, toy making, printing industries, etc.

Operation Costing – Process and Services

Process costing method is applicable where goods or services result from a sequence

of continuous or repetitive operations or processes and products are identical and cannot be segregated. Costs are charged to processes and averaged over the units produced during the period. Examples are food processing, chemical, dairies, paints, flour, biscuit making, etc. Variations of process costing are found in single or output costing, operation costing, departmental costing as explained below:

— Single or output costing is used when the production is uniform and identical and a

single article is produced. The total production cost is divided by the number of units produced to get unit or output cost. Examples are mining, breweries, brick making, etc. — Operation costing refers to the methods where each operation in each stage of production or process is separately costed. Thereafter, the cost of finished unit is determined. This is suitable to industries dealing with mass production of repetitive nature — for example, motor cars, cycles, toys, etc.

— Departmental costing refers to the method of ascertaining the cost of operating a department or cost centre. Total cost of each department is ascertained and divided by total units produced in that department to arrive at unit cost. If one product passes through a number of departments for completion, cost of each department will be picked up and the total unit cost will be the aggregate of unit cost of the departments through which the product passes.

Service or Operating Costing

Operating costing is applicable to service organisation that do not make or sell tangible goods but render services. Examples are transportation companies, hotels, hospitals, schools, electric and gas generation and distribution, etc. Cost of providing and operating a service is ascertained and unit cost is found out by dividing total cost of units of services rendered. Composite units, such as tonne-mile, passenger-kilometre, KWH, etc. are generally used.

Composite or multiple costing: The manufacture of certain products involve a lot of

complexities and therefore, any one of the basic methods of job or process costing cannot be used for collecting and presenting product cost. In fact, industries making complex products such as cycles, automobiles, aeroplanes, radios, etc. use combination of various costing methods and the methods are known as composite or multiple costing.

TECHNIQUES OF COSTING

In each of the costing methods, various techniques may be used to ascertain cost, depending on the management requirement. These techniques may be grouped as follows :

A. Absorption costing : It refers to the ascertainment of costs after they have been actually incurred. As per this system, fixed as well as variable costs are allotted to cost units and total overheads are absorbed by actual activity level. Absorption costing is termed as total costing, since total costs are ultimately allotted to cost units. It is also termed as  historical or traditional costing. However, since costs are ascertained after they have been incurred, and substantial time-gap exists between occurrence of expenditure and reporting off cost information, it does not help to exercise cost control.

B. Marginal costing : It refers to a principle whereby variable costs are charged to cost

units and the fixed costs attributable to the relevant period is written off in full against  the contribution for that period. Contribution is the difference between sales and variable

or marginal cost of sales. Marginal costing is also known as direct or variable costing. It is a valuable aid to management in taking important policy decisions, such as product

pricing, choosing product mix, decision to make or to buy, etc.

C. Standard costing: It refers to the technique which uses standards for costs and revenues for the purpose of control through variance analysis. Standards are established for each cost element on a scientific basis for immediate future period, and actuals are compared against the standard. Variances from standards are analysed, reasons established and corrective action taken to stop recurrence of inefficient operation. Thus, standard costing is extremely helpful for cost control. Standard costing is normally used along with budgetary control, which refers to the establishment of budgets relating to responsibilities of executive to the requirements of a policy and the continuous comparison of actual with budgeted results, either to secure by individual action the objective of that policy or to provide a basis for its revision .Absorption costing system and marginal or direct costing system can be used in conjunction with standard costing system.

D. Differential costing: It is defined as a technique used in the preparation of adhoc information in which only costs and income differences between alternative courses of

action are taken into consideration. It considers only the additional costs and additional

revenues arising out of the decision regarding addition of a project. Similarly, incremental costing technique considers incremental costs and incremental revenue arising out of a decision to change the level of nature of activity.

E. Uniform costing: It refers to the use by several undertakings of the same costing system i.e. the same basic methods, principles and techniques. This is not a distinct method of costing. The system is applied by a number of units of the same undertaking

or several undertakings within the same industry with a view to promote operating efficiency by comparing inter-unit or interfirm performance data. Trade associations and multinational companies often use this system.

Concept And Meaning Of Cost Control

Cost Control

Control is function that make sure that actual work is done to fulfill the original intention. It is a widely accepted notion that the actual costs for each cost element should be within the budget. Like hospitality and entertainment, expenses in a marketing department should not exceed the budget allowed for that head for the given period. Cost control is thought of as a managerial effort to attain cost goals within a particular environment.

Cost control is not a specific program. Rather, it is a routine activity to be frequently carried out. Cost must be controlled, otherwise, there will be wastage, misappropriation and embezzlement. Checking such wastage and misappropriation of resources is a continuous activity. A firm exercising a better control last year does not mean that it has now been relaxed from the cost control function. Cost control relies heavily on accounting techniques. Some of the key cost control techniques are responsibility accounting control system, standard costing, budgetary control and cost management ratios.
Therefore, cost control includes the routine management of the organizational activities, such as controlling of wastage, misappropriation, loss of work time, set up time etc.

Concept And Meaning Of Cost Reduction

Cost reduction means conducting some innovations in the way of working in a new style, so that the excess costs of production and operation could be eliminated. Cost reduction programs are directed toward specific efforts to reduce costs by improving methods work arrangements and products. Cost reduction can be made in different areas and stages of production, storing and distribution process by applying more advanced and scientific techniques of operation. So, a cost reduction program needs a research and development activity.

Cost reduction programs may require a bulk amount of research and development budget, but once a new technique is introduced, it gives competitive advantages for the long period.

The aim of cost reduction is to see whether there is any possibility of bringing about a saving in the costs incurred on materials, labor, overheads etc.

Cost reduction is possible through the following improvements:

* Obtaining more outputs from the same inputs and facilities.

* Using a lesser quantity of inputs to obtain the same output .

* Simplifying the methods of distribution.

* Improving the location and layout of plant, warehouse and other resources.

Differences Between Cost Control And Cost Reduction

Following are the main differences between cost control and cost reduction:
1. Focus

Cost control focuses on the minimization of wastage than the reduction of cost. Cost reduction focuses on minimization of cost through new production process, improved plant layout, scientific material handling etc.

2. Basis Of Application

Cost control is routinely applied on a continuous basis. Cost reduction is applied when an opportunity for cost reduction is identified which offers a competitive advantage for a longer time.

3. Use Of Accounting Techniques

Cost control heavily relies on accounting techniques. Cost reduction may not involve the use of accounting technique.

Tools And Techniques Of Cost Reduction

The following are the widely used techniques of cost reduction:

1. Just-In-Time (JIT) System

The main aim of JIT is to produce the required items, at the required quality and quantity, at the precise time they are required. JITpurchasing requires for the items where too much carrying costs associated with holding high inventory levels. purchasing system reduces the investment in inventories because of frequent order of small quantities.

2. Target Costing

Target costing refers to the design of product, and the processes used to produce it, so that ultimately the product can be manufactured at a cost that will enable the firm to make profit when the product is sold at an estimated market-driven price. This estimated price is called target price.

3.Activity Based Management(ABM)

Activity based management is the use of activity based costing to improve operations and to eliminate non-value added cost. The main goal of ABM is to identify and eliminate non-value added activities and costs.

4.Life Cycle Costing

Life cycle costing estimates and accumulates costs over a product's entire life cycle in order to determine whether the profits earned during the manufacturing phase will cover the costs incurred during the pre-and-post manufacturing stage.

5. Kaizen Costing
Kaizen costing is the process of cost reduction during the manufacturing phase of an existing product. The Japanese word 'Kaizen' refers to continual and gradual improvement through small activities, rather than large or radical improvement through innovation or large investment technology.

6.Business Process-re-engineering

Re-engineering is a complete redesign of process with an emphasis on finding creative new ways to accomplish an objective.The aim of business process re-engineering is to improve the key business process in an organization by focusing on simplification, cost reduction, improved quality and enhanced customer satisfaction.

7.Total Quality Management(TQM)

Under the TQM approach, all business functions are involved in a process of continuous quality improvement.

8. Value chain

Value chain analysis is a means of achieving higher customer satisfaction and managing costs more effectively. The value chain is the linked set of value creating activities all the way from basic raw materials' sources, component suppliers, to the ultimate end-use product or service delivered to the customer.

9. Bench Marketing

Bench marketing is a continual search for the most effective method of accomplishing a task by comparing the existing methods and performance levels with those of other organizations or other sub-units within the same organization.

10. Management Audits
Management audits, also known as performance audits, can be used to facilitate cost reduction in both profit and non-profit organizations. Management audits are intended to help management to do a better job by identifying waste and inefficiency and recommending a corrective action