Study Note - 8

Elements of Cost & Management Accounting

This Study Note includes

Introduction Definitions Evolution of Cost and Management Accounting Concepts : Cost and Cost Objects Classification of Costs Cost Organisations Costing System Cost Determination

8.0 Introduction:
In the previous study note, the students would have learnt the basic accounting concepts, the rules of accounting and their applications in different business transactions as well as different forms of business organisations. It was also clear that the financial statements are used as a conduit of information to the outside world i.e. various stakeholders of the business. In short, whatever may be the form of business organisation; financial accounting is 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 business as of a particular date. Over years financial accounting has developed into a very effective tool at the hands of all stakeholders to enable them to broadly understand the business results. It has become a very structured mechanism with advent of professional accounting bodies that emerged all over the world. Existence of research based accounting standards ensures uniformity of accounting treatment. The disclosure requirements of accounting standards make the financial statements more vivid and stakeholders get complete information about business activity. But still there are certain limitations like: It offers information late i.e. after the end of accounting year. For certain organisations (companies listed on stock exchanges) publishing of quarterly financials is compulsory. But still it is after a time gap and the information is only summarised. Stakeholders will understand what has happened during an accounting period, wont know why it has happened. Financial statement may show a loss and very broadly bring out the details thereof, but there is absence of further information which could help them understand the qualitative aspects thereof. It could be seen that the financial statements i.e. P & L account and balance sheet portray the overall results of the business. Even if the firm is engaged in manufacturing of more than one type of product; these statements exhibit the business in totality. A balance sheet, for example, does not give financial position of Television division, B1

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DVD division, and audio products division for an electronics manufacturing company. For listed companies, although reporting for business segment-wise results is mandatory, the disclosure requirement is very superfluous. If the business is doing well, how to better the performance? If it is not doing well, what can be done to improve the results? This is the domain of internal management of the organisation. Financial statements are meant for those people who are external to the organisation or for those people who are not part of day to day decision making within the organisation.

Can the business be run without making decisions? Even doing nothing is a decision! Decision is making a choice from among the available alternative courses of action. How is this choice made? Why a particular alternative is chosen and the others are not? What is the basis for this choice? The most obvious basis is an economic evaluation of the alternatives available. Economic evaluation means comparing benefits with costs. The alternative that brings more benefit than the cost will be the obvious choice. As such measurement of both, benefits and costs, becomes very crucial. Managers must evaluate the financial implications of decisions that require trade-offs between costs and benefits of different alternatives. A decision maker will definitely need information to be able to decide. This information is both quantitative as well as qualitative. The financial accounting information will not serve this purpose as it talks about how to deal with transaction when they occur. The information needed will be more specific and relevant to the decision to be made. Let us consider some decisions taken in managing or running a business: a) b) c) d) e) f) g) h) How much quantity should be produced during the coming year? At what price should the product be sold in various markets? In what quantities should the material be procured? How much should be paid to the workers and how to control their performance? What level of capacity should be used? Whether a particular order should be taken or not? Whether to expand or close a particular line of business? Assessing the performance of different divisions

The information based on which such decisions are made cannot always come through financial statements. As stated earlier, the information should be the most relevant and specific to the decision making. Financial implications are important when considering the decisions for the above named situations. The basic aim of business is to make profit. In other words, it must ensure that the business transactions are profitable. This would mean that decision to do a business transaction must be as accurate as possible. It is therefore logical that the decisions must be taken on the basis of correct and timely information pertaining only to the issue under consideration. A very basic definition of profit is the difference between revenue (i.e. selling price) and costs. In todays market driven world economy, selling price is almost decided by the market forces

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viz. demand and supply. If that be so, how does one increase profits? Theres only one way and that is to keep costs to absolute minimum possible. Knowledge of costs therefore is imperative. Costs and information do go hand in hand. The art and science of Cost and Management accounting provides knowledge to effective decisions for cost control, enhancement of profitability and internal reporting. Cost and management accounting is internal to the business. It is a very potent tool in the hands of management to achieve goals by making effective decisions with the aid of well developed cost accounting techniques and management accounting tools. These enable the management to answer why than merely understanding what. The evolution of cost & management accounting is as old as the business activity in the world. Let us get a perspective of the same. Remember, cost and management accounting has developed on the platform of very strong science of financial accounting.

8.1 Definitions
Before embarking on the journey into the world of cost and management accounting, it is helpful for a student to understand some basic definitions. a) Cost It is a measurement, in monetary terms, of resources used for some purpose. The resources may be tangible (material or machinery) or intangible (wages, power, time spent). The use of resources is implicit in the term cost. The measurement is in monetary terms obviously because money is common denominator. One cannot measure the combined effect of using 500 kg of material and 50 hours of labour unless they are expressed in terms of money. Further, cost always relates to a purpose. The purpose could be products, departments, projects, services or any activity for which monetary measurement of resources is needed. Purpose here also could mean a context, without which cost does not convey anything. The word cost cannot be used in isolation and has to be always with a reference to a context. With change in context, the interpretation of cost will change. Hence, probably there are many definitions of this term available, each of them linking cost to a reference or context. In coming sessions, all such cost terms are explained in depth. b) Costing It is defined as the process of ascertainment of cost. The cost may have to be ascertained for a product or service or a department or any activity carried out by the business. The word costing here is used as a form of verb to cost. It denotes accumulating all such expenses incurred for producing a product or rendering a service or carrying out business activity. These expenses are mainly in the form of material, labour and other expenses. Many methods of costing exist depending on the nature or product, type of business. These are job costing, contract costing, process costing, service costing etc. These are explained in the coming sections. c) Cost Accounting - It involves the process of classifying, identifying and recording of expenditure with the intention of ascertaining cost of a cost centre or cost unit for the purpose of cost control. Rather than viewing the organisation as a whole, cost accounting attempts to look at individual components of the organisation like a

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department, a job, or a process etc. It tries to compare the cost of these individual components vis--vis the benefits they offer in order to determine the efficiency and effectiveness of each resource used in the business. The main purpose of costing is to determine a unit cost. It may be a historical cost or an estimated cost. The broad process of costing or cost accounting comprises of: Cost book-keeping is recording of costs according to preset classification. As will be seen later, cost classification is done on the basis of nature of organisation, nature of product or service it deals in and requirements of management. At present, cost book keeping is done concurrently with financial accounting. ERP accounting systems provide facility of recording financial as well as costing aspect of a transaction. This is called an integrated accounting. A transaction is recorded with respect not only to the double entry effects, but also as per classification of costs and link with the respective cost centre or cost object. The costing provides basis for certain aspects of reporting in financial statements. The most crucial item in financial statements which is not transaction based, is valuation of inventories. Accounting principles define it as lower of the cost or market price. The valuation of cost of stock is the domain of costing. The maintenance of cost data presupposes very strong database for other quantitative information. For example, recording of material cost incurred is not sufficient, but also the quantity of material used assumes equal importance, like-wise labour cost & labour hours, machine costs & machine hours etc. This quantitative dimension makes costing a very potent tool in ascertainment of a unit cost. This will better understood as we go along. Cost Control is evaluating what level of cost is the most ideal for a given activity. It provides mechanism to keep costs within those predetermined limits. The word control is not used with its restrictive meaning, but also to ensure to maintain cost to the levels what ought to be. Organisations can sustain competition only if they understand the cost structure very well. Based on this understanding, companies are able to innovate to offer more value to the customer. For example, when offering machinery to the customer, they could effectively explain how the cost of production could be reduced. So the control ideology is not based on the restrictive aspect but more on value proposition. To facilitate this, cost data is to be pre-classified and entries are made accordingly. Cost Analysis tries to link costs with their determinants or drivers and also provides tools to measure reasons of why costs are out of sync and fix responsibility there for. It comprises of techniques of standardizing costs or estimating costs which could be effectively used to take managerial decisions. Hence, the primary emphasis is cost and its determination, analysis, interpretation and reporting.

d) Cost Accountancy This is a broader and comprehensive term. The Chartered Institute of Management Accountants (CIMA) London defines it as the application of costing

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and cost accounting principles, methods and techniques to the science, art and practice of a cost accountant for the purpose of cost control and ascertainment of profitability as well as presentation of information for the purpose of managerial decision making. As a science it tries to establish a relationship between costs and the cost drivers. As an art it demands a very high level of analytical mindset, good logic and judgmental capability to interpret these relationships. As a practice, it sets a very high standard of professional integrity so that correct information could be made available in the most relevant manner, which will strengthen the decision making process in an organisation. Although art and science of costing has an internal focus, it helps take decisions that improve its customer service by offering product or service in the most cost effective manner. Companies that achieve cost leadership within their industry scale greater heights. During the time of recession, companies can operate by improving efficiency and effectiveness by making decisions that are based on sound cost e) Management Accountancy It is an integral part of management that is concerned with identifying, presenting and interpreting information for formulating strategy, planning & controlling activities, decision making, optimizing use of resources, and reporting to external and internal stakeholders. It is application of appropriate techniques and concepts in processing historical and projected economic data of an entity to assist management in establishing plans for reasonable economic objectives and in the making of rational decisions with a view to achieve these objectives. It is the process of analysis and interpretation of financial data collected with the help of financial accounting and cost accounting, with the intention to draw inferences there from, in order to assist management in the process of decision making. Management Accounting is a relatively younger field. The main facets of management accounting are: 1) The focus is on analysis of information. It is done with the help of concepts or techniques that emerge from financial accounting, cost accounting, economics, mathematics, statistics and more importantly information technology. 2) Accumulation, synthesis and analysis of the quantitative and qualitative data are an integral part of management accounting. The qualitative data used could be from various angles such as legal, commercial, manpower, environment in which the business entity conducts itself, the socio-economic events and political factors all over the world. 3) The thrust is measuring performance of various facets of business and comparing it with the targets set to enable management to take corrective actions in time to meet the objectives. There is a continuous monitoring of deviations from the standards or plans. 4) It equips management for strategy formulation by providing decision making tools for short term and long term. 5) Business needs to acquire and use resources (financial and otherwise). Management accounting helps in optimizing the resource mobilization and utilization. Remember resources are limited and the uses to which they could be put are unlimited. Effective resource utilization is important for a consistent and profitable running of business.
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8.2 Evolution of Cost and Management Accounting

As mentioned in the preceding paragraphs, the emergence of cost and management accounting dates back to the history of business in the world. It owes its existence, among other reasons, to the platform of financial accounting that have evolved over centuries now. The evolution and growth of cost and management accounting systems are corresponding to that of changes in the business activity. When business was relatively simpler and the need for information was limited, the systems were primitive and suited the purpose. Further, the management and ownership was in the hands of the owner for a very larger period of history of the business, more so till the industrial revolution began in the Europe in the 17th century. As owner themselves used to be decision-makers, they could decide on their own, without having to depend on system vending out information. World over the socio-economic conditions underwent changes over the last couple of centuries. In some parts of world capitalism flourished whereas in the other parts the kingdoms ruled people. The business activity, in whatever form it existed, had not yet gone beyond the country borders. They just meant to serve the customers by distributing the products they made. With industrial revolution the world saw many changes in the manner of conducting business. The customer base expanded, the production got automated, transportation revolutionized the market and the business activities started becoming more complex. The competition added a different flavour as companies started to use newer techniques of producing and marketing. Research and development activities were in full swing and the most exciting innovations and inventions in the later part of 18th century and entire 19th century changed the whole business world. New forms of business organisations saw a shift from sole proprietorships to limited companies which meant separation of ownership and management. This period saw business activities coming under regulation through statutes and laws of various countries. Trade organisations and bodies for commerce were developed to foster changing needs of business. In the background of this development, the art and science of accounting also was changing. The double entry accounting dates back to 1491, but the history of cost and management accounting is more recent than this. The First World War and the great depression that followed were responsible for emergence of costing and cost accounting techniques. The innovations in costing were brought about around this time. The whole world went through the crisis of cutting costs. But the knowledge of ascertaining cost was very primitive. The economists kept on researching rigorously to find out ways to standardize the process of ascertaining cost. The concept of cost existed more from an economic point of view. The techniques application of the concept of cost to various business situations got developed during this period. The period between 1850 and 1920 saw emergence of costing and cost accounting. The focus was more on product costs and operating efficiencies. The application was limited to industrial organisations which were relatively big in size and complex in nature. Then onwards

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till 1950s when matching concept got evolved, the focus shifted to cost determination and financial control. This period also witnessed development of accounting bodies and the process of professionalizing of accounting began around this period. The management accounting innovations during 1950s to through the eighties focused on information for management. It is during this time that use of information technology started developing at a much faster pace. Use of quantitative techniques and their application in the area of accounting started in this period. These techniques were transportation & assignment, queuing theory, probability, linear programming, simulation, PERT and CPM. Application of these techniques using accounting and costing data added a completely new dimension to the decision making process, which became future oriented. These tools then started getting integrated with development of financial models for effective decisions. As manufacturing technologies got revolutionized especially the post 2nd world war in Japan and the US, the management accounting also progressed to align to those changes. The manufacturing became CAD based; robotics became integral and Japanese techniques of Total Quality Management (TQM), Just in Time (JIT), Kaizen, lean management etc started ruling the business world. The management accounting responded very well with development of tools such as Activity Based Costing (ABC), Balanced Scorecard (BS), Product Lifecycle Management (PLM), and target costing. Robert D. Kaplan was responsible for most of the innovations in management accounting tools and techniques after 1980. The various tools of management accounting developed and used very effectively by organisations world over are: a) b) c) d) e) f) g) h) Material Requirement Planning (MRP) Enterprise Resource Planning (ERP) Customer Relationship Management (CRM) Supply Chain Management (SCM) Earned Value Management (EVM) Economic Value Addition (EVA) Balance Score Card (BSC) Enterprise-wide Risk Management (ERM)

The newer concepts that are quite widely used and have become part & parcel of management accounting profession are: 1) 2) 3) 4) 5) Activity Based Management (ABM) Theory of Constraints (TC) Throughput Accounting (TA) Direct Product Profitability (DPP) Life Cycle Costing (LCC)

The post 1990 period witnessed the emergence of internet and web based technologies that totally revolutionized the management accounting profession. The focus has now clearly shifted from transaction management to enhancement of stakeholders value, from supplying a product or service to customer relations, from vendor management to business partnerships
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and so on. Todays management accounting function helps management to assess the value of business by continuously comparing various performance parameters with the benchmarks set by the organisation. Regardless of the size of the organisation, these tools are used quite commonly. The developers of these tools have configured them to suit and affordable even to smaller companies. These tools act as excellent Decision Support System (DSS) and assist management in business restructuring, mergers and acquisitions, shared services etc. The application of management accounting in its present form is expanded to cover service sector as BPO, KPO, shared services etc. The fast emergence of banking, insurance & financial services sector has thrown open entirely new fields of application of management accounting concepts. Experts have been able to customize these concepts to suit the needs of these sectors. Even in manufacturing segment, contemporary management accounting focuses more on process management than a traditional push production flow system. The credit of the most modern pull systems like JIT and Back flush accounting goes to Toyota Corporation of Japan. For beginner of the Management Accounting course, therefore, it is necessary to grasp not only the basic of financial, cost and management accounting concepts; but also various aspects of business encompassing other functions such as R & D, procurement, production, marketing, human resources etc. in order to play an effective and contributory role as a Management Accountant. Over years the Management Accounting Profession has become more formalized. Structured training in this profession is available from professional bodies. Some of the important professional bodies are Chartered Institute of Management Accountants (CIMA), London, The Institute of Certified Management Accountants (CMA), US. In India, The Institute of Cost and Works Accountants of India (ICWAI) is doing a commendable work in this area. The scope of management Accounting covers both financial & cost accounting, Controllers function, taxation, management audit, systems and procedures, corporate governance etc. As it is not a pure science, its highly subjective. The information supplied for decision making must be relevant, accurate and timely.

8.3 Concepts: Cost and Cost Object

Commonly understood cost is expenditure incurred for creation of a value. However, cost can very rarely stand alone and should always be qualified as to its nature and limitations. A number indicated as cost would mean differently under different circumstances. Further this number may be an approximation. It may not necessarily be an actual cost, but may be estimation. Cost may always have to be used together with an adjective to convey the meaning that was intended. If we say cost of a pen is Rs 15 it does not convey the full meaning. In order to make it meaningful the term cost is always preceded by a phrase which explains it further. It is very important that the purpose or a context is known, so that the decision taken based on the cost information is as correct as possible. When it is said cost of the pen is Rs 15; does it mean total cost? Estimated cost? Actual cost? Material cost? It could be any of these or anything else! So unless specified, the meaning will not be complete. B8
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The term cost may denote: an expense that is related to a product or service e.g. cost of material used to produce a TV set or an expense that may be related to time i.e. deferred cost, the benefit from which is yet to be received. an expense that is lost i.e. there wont be a benefit accruing out of the incurrence of the cost e.g. cost of stock damaged in a fire

A cost accountant must be able to differentiate cost with respect to product or service, time and the benefit related to it. The purpose it to identify cost with a thing to which it is related to. Therefore the term cost should always be linked with a cost object to be more meaningful. Cost object is the technical name for a product or a service, a project, a department or any activity to which a cost relates. In oil exploration company a barrel is the cost object. In a hospital, cost object could be different wards, dispensary, various services such as x-ray, ECG etc. relating to which costs are accumulated. The integrated accounting packages do provide for having a very comprehensive system for setting up and using such cost objects. Without any duplication, a cost is booked to its object simultaneously when passing the basic accounting entry. The cost object could be defined broadly or narrowly. In a broader sense, for a CTV manufacturing company, a TV set may be a broad cost object. To narrow it down, it could be an LCD panel or a flat screen TV. To make it narrower, it could be 42 TV, 32 TV and so on. Depending on the need and purpose the cost objects are to be defined. There is no standard list of cost object and every oragnisation has to build them on merit basis. Establishing relevant cost object is very crucial for a sound cost accounting system. When costs are accounted for, they are to be booked (i.e. entered under) to a correct cost object. If at this first level of cost data collection, the entry is not made to correct cost object, it will affect the whole process of cost ascertainment and will not aid business decisions. For example, if the need is to ascertain cost of a flat screen TV and LCD TV, both of them must be established as valid cost objects. Material bought in for Flat Screen TV must be entered to the cost object related to it, whereas material bought in for LCD TVs must be booked under its relevant cost object. Similarly, cost of wages paid to workers who are assembling the TV sets must be booked under the relevant cost object. At a broader level a cost object may be named as a cost centre, whereas at a lowermost level it may be called as a cost unit. Cost Centre: Commonly understood, cost centers are sub-units of an organisation. We use the terms such as departments, divisions, regions, and zones etc. that convey the same meaning of cost

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centre. Correct identification of these sub-units is essential for implementing cost accounting system as the costs are ascertained and controlled with respect to the cost centers. It also facilitates assigning responsibility to operating managers who are in charge of various cost centers. There is no standard number or size of cost centers. It will depend on nature and size of the organisation, the expenditure involved ( you wont be having a separate cost centre if the yearly cost involved is only Rs 100), and requirements of management to control. Cost centers are sometimes called as centers that add to costs of the organisation and only indirectly add to the profit of the organisation. The official terminology of 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. This definition clearly brings out a very wide connotation of the term. It can be explained as follows: a) A cost centre could be a location or locations like a branch, a region or zone of sales, etc. b) It could be identified as a person such as Chairmans office or MDs office c) It could be equipment or a group thereof such as lathe machines, Computers, etc. d) It may be a department carrying out a certain activity e.g. production departments like turning, fitting, welding, blending, assembly etc. The activity could be a service activity as well like a stores department, labour office, accounts department etc. Consider a case of an educational institution that imparts various courses to undergraduates, graduates and post graduate levels. What could be the cost centers there? We may consider having the following: a) Office of the managing committee they lay down policies & decide on which courses to offer b) Faculty department - they are actual imparters of training c) Office they take care of fees collection, scholarships, examinations, results, certification etc. d) Laboratory responsible for maintaining lab equipments & materials e) Library looks after reading material, internet & web facilities f) Canteen and recreation looks after daily provisions of facilities g) Hostel and Campus development take care of student accommodation h) Students coordination department liaison of students with teachers & university officials Such a demarcation of an education institute into organizational sub-units will act as a sound basis for cost collection. Cost centers act as a collecting place for costs.

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In a typical manufacturing company, the broad classification of cost centers could be production departments and service departments. Production departments are directly engaged in the production activity whereas the service departments provide support services to aid the production departments to run their function smoothly. The production departments convert the raw material into a finished product with the help of support functions. In an automobile manufacturing company, there could be following cost centers: a) Production departments: Engine shop, machine shop, forging shop, Paint shop, components manufacturing, and Fitting & Assembly b) Service departments: Quality assurance & control, Stores, purchases, plant maintenance, boiler house, marketing, accounts &finance, Human resources, administration & industrial relations, IT services, research & development etc. A hospital may have following cost centers: a) Outpatient department (OPD) b) Inpatient department which may be further sub-divided depending on specialty of diseases like heart related, cancer, paediatric, etc c) Tests like x-ray, ECG, MRI, pathology laboratory d) Utilities housekeeping, canteen e) Dispensary f) Medical & paramedical services g) Accounts and administration When different responsibility centers are properly set up, cost collection and use of cost information for control purposes can be done effectively. Cost Unit The cost unit is the narrowest possible level of a cost object for which costs are collected. Usually it represents the unit used to express the quantity in which the product or service offered by an organisation is measured. This is a normal selling unit or output for which costs are calculated. The CIMA official terminology defines cost unit as a unit of product or service in relation to which costs are ascertained. Every business offers either a product or a service to its customers. The customers can be external to the organisation or internal to the organisation. For example, a car manufacturing company will sell cars to the external customers. Also, the engine shop will supply completed engines to the assembly for fitting. In such case there could be multiple cost units in relation to which costs are computed. Let us see some of the common examples of cost units in the following table.
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Business Automobile Pharmaceuticals

Cost unit A car, a scooter, a motor bike etc. A strip or a pack or a bottle of medicine

Expressed as Number / each Number of strips of tablets or capsules of various potencies, a crate of bottles of different sizes Number Number of sofas, beds, chairs etc. Number of Kwh Number of hours Number / each Number of calls Number of accounts Number

Sugar, fertilizer, chemicals Furniture Power Professional service Construction Tele marketing BPO service Gas

Kg / liters / tonnes Article Kilowatt hour Chargeable hours A job or a contract Customer calls made Accounts handled Cubic foot or cu mtr

For service industry, the cost unit is usually a composite cost unit i.e. its a combination of more than one cost unit. Consider a state bus transport company that provides a service of carrying passengers. Here there are two dimensions. One the distance carried and second the number of passengers carried. The appropriate cost unit here will be passenger-kilometers. Examples of such composite units are shown below:

Business Goods carrying company Hospital Hotel Education Railways

Composite Cost unit Tonne-miles / tonnekilometers Patient day Bed night Student year Passenger kilometers

8.4 Classification of costs

As we have seen meaning of costs vary with purpose for which it is incurred. There may be many adjectives with which costs could be explained. There has to be a logical way to group the different types of costs in order to devise an efficient system collecting and analyzing costs. Remember that collection is only the starting point. These costs are to be further analysed and interpreted so that the objective for which they are collected can be served in a better way. The CIMA official terminology defines classification as the arrangement of items in logical groups having regard to their nature (subjective classification) or purpose (objective classification).
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This definition is a little restrictive as it takes into account only nature and purpose as the two logical categories. In fact, however, costs can be classified in many ways that would be helpful. More the number of ways to classify more will be complexities. But thats how it is. If a cost accountant wants to understand costs, he must dig deeper into it. The cost classification can be done in the following ways:

Basis Nature of expenses i.e. element

Traceability to object Functional

Behavioural

Production process

Decision making

Cost types Material costs Labour costs Other expenses Direct costs Indirect costs Production cost Administration costs Selling costs Distribution costs Research & development costs Fixed costs Variable costs Semi-fixed or semi-variable or mixed costs Job / contract costs Process costs Operation costs Service costs Relevant costs Opportunity costs Target costs Standard costs Marginal costs Budgeted costs

The list given above is not exhaustive and as one progresses with the study of costs, one will find many other adjectives that could be used to explain some other cost types which will convey special meaning valid for the context under consideration. An item of cost may fit into each of the above types even at the same time. But each will convey different meaning and will require different treatment for planning and control purpose. A cost accountant must grasp these different types of costs thoroughly in order to apply them in pursuit of the objectives of cost and management accounting. Again the explanations provided below regarding the above types do not mean a standard way of defining them. The line of demarcation between these types is very thin.

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Element-wise classification: According to elements or nature of expenses costs can be classified as material costs, labour costs and other expenses. Any item of expense can fit into one of these three. Material costs are costs of physical commodities used to make a final product. They obviously exist in case of manufacturing companies invariably and also in case of some service industries like restaurants. The material could be basic raw material, components, consumables, spares, packing material etc. The raw material could be further sub-divided according to their types like steel, plastic, metals, paints, gases etc. In case of a car, the metal body, engine, accessories, tyres are all examples of material cost. Consumables used like oil, grease etc will also form part of material cost. For manufactured items material cost constitutes higher proportion between 50% - 60% of the total costs. Naturally this element attracts maximum attention for cost control purpose. This material could either be purchased from outside or manufactured within the factory. Labour Costs comprise of expenses in relation to salaries, wages, bonuses, expenses on staff welfare, statutory benefits like provident fund, gratuity etc. This is an intangible source of cost and one cannot physically see this element into the final product. Usually, it comes next to material cost with regard to its proportion to total costs. In case of service providing organisations, of course, labour costs will constitute greater proportion. Further, as they are related to human beings who run the business they are probably more important to ensure that maximum benefit is obtained by use of manpower efficiently. Other expenses are those which are not pertaining to material or labour. These expenses are incurred either to provide support to manufacturing or service activity or to ensure smooth running of business. For example, crane hire charges or a consulting engineers fees may be necessary for manufacturing activity. Rent paid for office, insurance charges paid, electricity and water charges, advertising, transportation are among other examples that help smooth running of business. All elements put together are called as Total cost or Full cost. Labour and other expenses put together may be called as conversion costs. They help the conversion of raw material into finished product. Classification based on traceability to cost object The word traceability here means the connectivity of an item of cost to the cost object which could be either a cost centre or a cost unit. Its very important to know to what extent there is a direct relationship between costs and cost objects. On this basis costs can be classified into: Direct costs are costs that can be easily identified with the unit of output. An engine in the car can be easily identified with the car assembled. A worker working on the assembly line can be directly identified. For a project execution company, site expenses can be directly
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identified with the project under execution. The meaning here is these cost owe their existence directly to the unit s produced. If nothing is produced, these costs will most probably not be incurred. The direct costs could be direct material costs, direct labour costs or direct expenses. Hence all elements of costs could fit in as direct costs as the test is whether there is a direct linkage of them to the unit produced or service rendered. The direct costs (material plus labour plus expenses) together make a prime cost. Indirect costs are those which are not easily directly connected with the cost unit or cost centre. Please mark the word easily here. What it means is theoretically establishing the link may be possible, but the cost of linkage itself is more than the cost of such expense. For example, maintenance material used to clean machines cannot be identified with the final unit of output. Can we identify the salary of an accountant with each unit produced? Is it possible to link each rupee of rent paid with the product produced? The answer is no. This is what makes these costs as indirect costs. Here again one may see indirect material costs or indirect labour costs or indirect expenses. All indirect costs (material plus labour plus expenses) together are termed as overheads. As there is no direct linkage with cost unit, such costs are either allocated or apportioned to the final product on some suitable basis. This is explained later in this study material. Functional classification The business activities, by and large, can be sub-divided into groups as production activities, administration activities, selling & distribution activities. Mostly any organisation will have these functions as cost centers. Non-manufacturing companies may not have factory or production, but they may use other functions. As such costs incurred in furtherance of each function are called by the name of that function. Factory or production costs comprise of items of expenses related directly to the factory or production activity. These could include all elements viz. material, labour and expenses. Administrative or office costs are those incurred for overall administration of the organisation. This may includes items like stationery, office supplies, building maintenance, salaries of office people etc. This category may include material, labour & other expenses. Selling and distribution costs are costs incurred after the production is over. These are related to efforts for selling and distributing the products. It may involve advertising, free samples, distribution van expenses, secondary packing material, carriage outwards, discounts and schemes offered to customers. Thus these costs also may include material, labour and expenses. Research & Development costs are costs associated with efforts undertaken by the organisation to innovate new products, new designs, and new processes. These costs cannot be related to the ultimate cost unit. Hence they are normally not included in the total cost. There may be various research projects going on simultaneously. Some of them may be commercially successful while the other may not. The cost of non-successful projects may be written off to the P & L a/c in the year in which they are incurred.

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Elements of Cost & Management COST-VOLUME-PROFIT ANALYSIS Accounting

Behavioural classification of costs The word behaviour, here, denotes the relativity or variability of change in the cost with respect to change in the level of business activity. The level of business activity may be indicated in terms of volume of output, hours utilised, capacity operated etc. A relationship is tried to be established between the changes of activity level with the rate of change of costs incurred for those activities. It is in this connection that the costs are classified into fixed, variable and semi-variable costs. This classification is a very powerful tool in the hands of management for the purpose of short term decision making as will be discussed in the topic on marginal costing. Fixed costs are those cost which do not change with change in the level of activity within the relevant range (installed capacity). Consider the item of rent for factory. The rent payment is associated with time period. Once an organisation makes a rent agreement, the cost is payable irrespective of whether there is any activity or not. The rent cost of Rs 10000 per month will not vary even if production jumps from 100 units to 1000 units. An interesting aspect about fixed costs is that while the total fixed costs remain constant, per unit fixed cost will go on decreasing. In our example, rent in totality will remain as Rs 10000. But if output is 100 units, per unit rent will be (10000 / 100) i.e. Rs 1000 and if production goes up to 1000 units then per unit rent will be (10000 / 1000) i.e. Rs 100. It is clear that this concept helps management to understand the importance of capacity utilization. However, these costs will remain same within the installed capacity only. If the capacity increase necessitates having another factory to be hired, then rent may increase. But again at that level it will remain constant in totality. Such costs are related more to time than to product. It may be found that in non-manufacturing type of business, the proportion of fixed costs is generally more. Other examples of such costs are salaries to managers, insurance, maintenance, advertising, travel and other discretionary expenses. Variable costs are costs that vary in direct proportion to the level of output. Any increase in the production volume will result in corresponding increase in these costs. Consider one unit of a standard size table requires 130 cu ft of wood. So if one table is made, the consumption of wood will be 130 cu ft. for 20 tables it will be 20 times 130 i.e. 2600 cu ft. For 100 tables it will be 100 times i.e. 13000 cu ft of wood. Thus total variable costs will increase exactly in the same proportion of the volume of activity. The most common examples of such cost are material costs and costs of labour directly working on production. An interesting aspect about variable costs is that while total variable cost changes with production level, per unit cost remains the same. Semi-fixed or semi-variable costs are those which change with change in activity level but not in the same proportion. In practice, the line of demarcation between fixed and variable is so thin that most of the cost items fall under this category. There cannot be exact linear relationship between most of the cost items and the levels of activity. Various statistical tools are used to establish a correlation and the degree of variability is measured. There may a cost item which is 60% variable and 40% fixed.
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The following example shows how perfectly variable or perfectly fixed cost would behave. Please understand these relations very well as it lays the foundation of a very popular technique of marginal costing which studies the cost-volume- profit relationship.

a)

Level of activity Variable cost (say b) materials) c) Fixed costs (say rent) d) Per unit variable cost e) Per unit fixed cost

1000 60000 30000 60 30

1500

2000

(b a) (c a)

90000 120000 30000 30000 60 60 20 15

This can also be shown as chart as follows:

C O S T S

T o tal fixed U n it fixed

0 1000 1500 2000

From the view point of managerial decision making especially in the short term this classification acts as a very potent tool. It can help take decisions such as by how much should the production be increased or decreased or what will be the effect of volume changes on costs or vice versa. But as we know, there cannot be a linear relationship as depicted in the above chart, there is a need for segregation of semi-fixed or semi-variable costs into individual components of fixed costs and variable costs. Statistical tools are available to segregate such costs. Classification by production process Based on the method of producing a product, the costs also need to be accumulated with regard thereto. Production method based classification of costs can be done as follows: Job or Contract costs are associated with industries where the end product is a unique, nonstandard item which is produced or built as per customer specification. Repeat production

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Elements of Cost & Management COST-VOLUME-PROFIT ANALYSIS Accounting

of the same item is highly unlikely. These costs are directly associated to a job or a contract which is the cost unit in these industries. The application of this method is seen in construction industry, ship building, machinery construction and projects. Most of the costs relate with an individual production order. It can be applied even in service industry. Consider the case of an automobile service station, where vehicles are brought for servicing or repairs. In each case the job to be done is different and will require different material, different skill set of labour etc. Hence costs are accumulated against specific jobs. Process costs are related to production processes in industries like chemical, pharmaceuticals, fruit processing, cosmetics etc wherein raw material is input in a series of processes where different treatments are made to convert the form of raw material into a finished product. Output of one process becomes input for the next in the series. There is no individual identity of each unit being processed. Consider fruits are cut in process of crushing then forwarded to blending with preservatives and then passed through process of removing impurities & other wastes before a final product in the form of fruit pulp or juice is made. Here a certain quantity of fruits is input, the costs cannot be associated with each kg of the fruit. Thus the costs are ascertained for each process separately and then averaged out to the total quantity processed. In this example, if 100 kg of fruit pass through blending process during a production run and the cost of blending process is Rs 1200, the cost per kg is averaged as Rs 12/Operation costs are pertaining to performing an operation at each stage in the production process. This is a variant of process costing and finds its application in industries where large number of similar items is produced or also in industries where sub-assemblies are produced. Take case of bearing manufacturing which is assembly of inner rings, outer rings, balls and other components. Each component is produced in large quantities and then assembled to get a ball bearing. Service costing is used in the service industries and the costs are ascertained for generating services. The intention is to show cost of appropriate cost unit of a service e.g. passengerkilometer for railways, KWH for power etc. This is generally used in hospitability, hospitals, etc. At times the business case may require application of more than one methods of costing simultaneously. This is because of existence of production methods for different components which are to be assembled into a final product. This is called multiple costing or composite costing and is applied in case of audio and video manufacturing, aero planes, textiles etc. Classification for decision making The purpose of ascertaining costs is to help management in decision making process. As it involves evaluation of costs & benefits of various alternatives, costs which are relevant for a

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particular decision only should be considered. There are numerous concepts of costs other than those listed above. Let us see some of them. Relevant Costs are those which are relevant for situation under consideration. Costs which are future costs, involved a cash outflow and which differ between the various alternatives are called relevant costs. Consider that a company has to make a choice between making a product in house or outsourcing it. In this case the cost of machinery already acquired is not relevant as it is already imputed or sunk. Here only variable cost of producing in house should be compared with the price offered by subcontractor to arrive at a correct decision. Opportunity cost is the benefit forgone as a result of pursuing one course of action rather than pursuing the best alternative course of action. The opportunity costs are always relevant. For, they reflect the choice of alternatives to arrive at a decision. For each alternative course of action, one needs to study the net relevant cost or benefit before making a recommendation. Its an imputed cost reflecting the greatest benefit forgone as a result of using a particular alternative course of action. If the net benefits of 3 different alternative courses of action are Rs 5000, Rs 7500 and Rs 3500. If the alternative 2 is chosen, it means the benefit of the next best alternative (Rs 5000 in this case) is forgone. Thus the opportunity cost of selecting 2nd alternative is Rs 5000. Although notional in nature, it helps management to decide a course of action more conservatively. Target cost is a product cost estimate derived from a competitive market price. The intention of target cost is to bring about continuous improvement in the cost. Consider a product the price of which is given by market. If the company wants to earn a desired profit on the product, theres no alternative but to produce it within the target cost calculated as (selling price desired profit). It may sound simple, but achieving the results is very difficult. Standard cost is a pre-determined cost which is calculated from managements standard of efficient operations and the relevant necessary expenditure. It is a normal cost under ideal circumstances. The standards are set for quantities of material and labour hours and also for the rates of material and labour. The standards are set for other expenses assuming operating under ideal circumstances. The standard cost once established, acts as a benchmark against which the actual costs are compared. The deviation from the standard are measured, analysed and corrective actions are taken. Standards are based on scientific computations based on time & motion study, industrial engineering and other techniques. As the name suggests, it can be applied only in those industries where the products processes and operations are standardised. Marginal Cost is an amount by which aggregate costs change if volume of output is increased or decreased by one unit. It follows from this that the marginal cost resembles to a variable cost. If only one additional unit is to be produced, it is necessary to incur only variable costs as fixed costs do not change with the change in output levels. Thus marginal cost

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Elements of Cost & Management COST-VOLUME-PROFIT ANALYSIS Accounting

is also defined as cost of producing one additional unit. This is explained later in this study material. Budgeted Cost is also a pre-determined cost like standard cost; but the later is set for a long term, whereas budgeted cost is usually for a year. The basic purpose of budgeted cost is to provide a benchmark for comparison of actual performance. The budgeted cost is like a target within which to operate. Standard costing, budgetary controls and marginal costing are techniques used by management accountants as integral part of any performance management system in an organisation. These different categories of cost can be interlinked. Costs could fall into more than one category simultaneously. There may be an overlapping when one tries to categorise cost as per one or more types as mentioned in preceding sections. A raw material cost is a) b) c) d) e) f) Material cost by elemental classification, Direct cost by traceability Production cost by function Variable cost by behaviour Relevant cost for decision making. Could fall into any of the types based on production process.

Illustration 1 Classify the following items of costs using different classification criteria. a) Repairs to machinery b) Factory rent c) Freight inward d) Directors fees e) Direct wages f) Free samples g) Office stationery

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Answer:

Item Repairs to machinery Factory rent Freight inward Directors fees Direct wages Free samples Office stationery

Element Expense Expense Material Expense Labour Material Expense

Function Production Production Production Administrative Production Selling Administrative

Traceability Indirect Indirect Direct Indirect Direct Indirect Indirect

Behaviour Semi-fixed Fixed Variable Fixed Variable Fixed fixed

8.5 Cost Organisation

In smaller organisations costing may not be a separate department. The financial controller himself may look after this function. In larger and complex organisations, theres definitely a separate role for a cost and management accountant. Although in most of the organisations costing is primarily an integral part of accounts department, the managements are now preferring an independent set up. They are attaching increasing importance to the function of management accountant as a value enhancer. The management Accountant normally reports to the CEO or MD of the company as he is supposed to assist him in taking business decisions. This department is manned with the required number of professionals. The basic job profile is: a) To set up and maintain a sound cost and management accounting system. Many times it an integrated accounting system b) To generate reports on various performance parameters of all the functions of management, compare the results with benchmarks set & report on variances. c) To communicate with different departmental heads in their quest of achieving better performance by providing them with management accounting information. d) To identify areas of weakness and constantly update heads of various functions on them e) To be an integral part of budgeting process in the organisation. The costing department is an important player in the entire value chain of the organisation. It has to help the CEO in bringing about improvements in processes, cost reductions, and value enhancement. As the function encompasses all functional areas of the organisation, a cost and management accountant has work along with these departments as a facilitator and not only as a critique. The involvement of this department with others can be explained with an example:

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Department MDs or CEOs office Areas contributed Preparation of strategic plan Reporting on key variances Reporting on value additions Analysis of product or SBU wise results Capacity expansion or diversification Management audit Internal control Set up costing system Generate costing reports Inventory valuation Wastage reporting & monitoring Labour time utilisation Production budgets Make or buy decisions Product pricing Sales budgets & forecasts Cash flow estimations Impact of sales promotion Competition analysis Bidding for tenders Accept or reject an order Purchase budgets Vendor analysis Economic ordering quantity Stock levels Price variances Cost information ERP implementation

Production

Sales and Marketing

Procurement

Information technology

While the above list is only illustrative, it will be quite clear that the role of a cost & management accounting department is there in almost all business functions. In addition to the above, the costing department also looks after cost audit in those organisations where cost audit is compulsory. It is also evident that the role of this department is functional as well as strategic.

8.6 Costing system

We have seen that the concept of cost is very complex and subjective. It may have different connotation depending on the context and purpose. To determine costs correctly, an organisation must install proper system of costing. There is no standard system that can suit every organisation, but it will depend on the nature of business, the nature of product or service, the managements need for costing information and cost control. Typically a costing system is comprised of the following characteristics: B 22
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a) It lays down basic procedures and functional routines. In its traditional form, costing process aligns itself with the flow of business activity. Hence a clearly defined logical flow of business activities will make the system stronger. b) It starts with a proper classification of costs, determination of cost centers and cost units. This base level activity is many times ignored which may create problems at a future date. c) It provides basic guidelines for segregation of fixed and variable costs. d) It will include the logic for allocation and apportionment of indirect costs. e) It also provides standard reports vending out regular flow of costing information to various levels of management. f) The system should provide for a cost accounting manual explaining how different items of costs will be treated in an organisation. g) It needs to take into consideration the cost audit record rules and cost audit report rules if applicable. h) The system should not be closed ended, but scalable to take care of future changes in the business requirement. If not taken care of in time, this will increase the cost of system itself. i) These days, the system is mostly an integrated system which takes care of financial and cost accounting simultaneously as the process is automated.

8.7 Cost Determination

A costing and cost accounting system should form a sound basis to enable management to analyse, interpret the cost information from various angles in order to take correct decisions. The historical cost data could also serve as platform for estimating future costs. In the coming sections, we will learn in depth various element of costs. Determination of cost is embodied in a costing method within the costing system. Cost is always determined for a cost unit. Whatever may be the cost unit, costs are accumulated and attributed to that cost unit to ascertain the total cost. In Job costing, for example, all elements of costs are identified with a job. In case of costs that cannot be directly so identified, they are allocated or apportioned using a suitable basis. In a service organisation, the composition of cost is dominated by indirect costs. The proportion of allocated costs in the total cost in such industries is higher. The primary record of cost is done with respect to the element and cost centre. The secondary record relates to allocation of indirect costs. The next level is to relate it to the actual cost unit. In case the cost unit is not singular, the costs are averaged out. For example, if chocolates are made in batches of a particular quantity, cost unit is normally a batch and costs are ascertained for the batch. These costs are then divided by the number of chocolate in the batch to find out cost per chocolate. The process of determination of cost of a pre-determined cost unit can be seen in the following chart:

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Elements of Cost & Management COST-VOLUME-PROFIT ANALYSIS Accounting

Production departments Basis of stage Final Final Stage 1 Stage 2 Stage identification Stage 1 2 stage Elements Direct material Direct labour Direct expenses -----direct -----identification ------------------------------------

Service departments Dept dept dept Dept 1 Dept 2 Dept 3 1 2 3 ----------------------------------------------

Primary distribution of indirect costs Indirect material -----direct or Indirect labour -----allocated Indirect expenses ------

----------------

----------------

---------------------

---------------------

--------------------

Secondary distribution of indirect costs Apportionment of service service department costs to rendered production departments Total Cost of production (a) Quantity of cost units (b) Per (a b) unit cost

------

------

------

This is not a standard chart but only illustrative. Each organisation will form its own format depending on the need. The attempt here is to only explain the cost flow.

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Miscellaneous Examples Q1 Specify the method of determination of costs and the cost units for the following industries. Oil Chemicals Canteen Aerated water Printing Hospital Telephone service House-building Insurance Ready- made garments Answer 1: Oil Process costing method a liter or a barrel Chemicals Process costing kg for solids, liters for liquids or cu ft for gases Canteen operating costing a meal Aerated water unit or batch costing a bottle or a barrel Printing job costing a printing job Hospital operating costing a patient bed Telephone service multiple costing a call per unit of time House building contract costing a dwelling unit or a building Insurance operations costing a claim Ready-made garments batch costing a batch of shirts or clothing

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Elements of Cost & Management COST-VOLUME-PROFIT ANALYSIS Accounting

Q2 A company manufactures and retails clothing. Classify the following costs into Direct material Direct labour Direct expenses Indirect production expenses Research and development costs Administration costs Selling & distribution costs Finance costs 1) Lubricant for sewing machines 2) CD for office computer 3) Maintenance contract for office photocopier 4) Telephone rental & metered calls 5) Interest on bank overdraft 6) Performing rights societys charge for broadcasting in factory 7) Market research for product launch 8) Wages of security guards at factory 9) Carriage on basic raw material purchased 10) Royalty payable on number of products produced 11) Road license fees for delivery vans 12) Parcels sent to customers 13) Cost of advertising products on television 14) Audit fees 15) Chief accountants salary 16) Wages of operators in cutting department 17) Cost of painting slogans on delivery vans 18) Wages of storekeeper in material stores 19) Wages of fork-lift truck driver 20) Developing a new product in laboratory Answer 2: Direct material 9 Direct labour 16 Direct expenses 10 Indirect production costs 1, 6, 8, 18, 19 Research & development 20 Selling & distribution 7, 11, 12, 13, 17 Administration costs 2, 3, 4, 14, 15 Finance costs 5 B 26
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