Cost concepts

Fixed Costs (FC). The costs which dont vary with changing output. Fixed costs might
include the cost of building a factory, insurance and legal bills. Even if your output changes
or you dont produce anything, your fixed costs stay the same. In the above example, fixed
costs are always 1,000.
Variable Costs (VC). Costs which depend on the output produced. For example, if you
produce more cars, you have to use more raw materials such as metal. This is a variable cost.
Semi-Variable Cost. Labour might be a semi-variable cost. If you produce more cars, you
need to employ more workers; this is a variable cost. However, even if you didnt produce
any cars, you may still need some workers to look after empty factory.
Total Costs (TC) Fixed + Variable Costs
Marginal Costs Marginal cost is the cost of producing an extra unit. If the total cost of 3
units is 1550, and the total cost of 4 units is 1900. The marginal cost of the 4th unit is 350.
Opportunity cost Opportunity cost is the next best alternative foregone. If you invest
1million in developing a cure for pancreatic cancer, the opportunity cost is that you cant use
that money to invest in developing a cure for skin cancer.
Economic Cost. Economic cost includes both the actual direct costs (accounting costs) plus
the opportunity cost. For example, if you take time off work to a training scheme. You may
lose a weeks pay 350, plus also have to pay the direct cost of 200. Thus the total economic
cost = 550.
Accounting Costs this is the monetary outlay for producing a certain good. Accounting
costs will include your variable and fixed costs you have to pay.
Sunk Costs. These are costs that have been incurred and cannot be recouped. If you left the
industry you cannot reclaim sunk costs. For example, if you spend money on advertising to
enter an industry, you can never claim these costs back. If you buy a machine, you might be
able to sell if you leave the industry.
Avoidable Costs. Costs that can be avoided. If you stop producing cars, you dont have to
pay for extra raw materials and electricity. Sometimes known as an escapable cost.

ELEMENTS OF COST
There are broadly three elements of cost - (1) material, (2) labour and (3) expenses.:
The substance from which the product is made is known as material. It may be in a raw stateraw material, e.g., timber for furniture and leather for shoe, etc. It may j also be in
manufactured state-components, e.g., battery for car, speaker for radio, etc, Materials can be
direct and indirect.
Direct Material: All materials which become an integral part of the finished j product, the
cost of which are directly and completely assigned to the specific physical units and charged
to the prime cost, are known as direct material. The following are some of the materials that
fall under this category:
(a) Materials which are specifically purchased; acquired or produced for a particular job,
order or process.
(b) Primary packing material (e.g. carton, wrapping, cardboard, etc.)
(c) Materials passing from one process to another as inputs.
In order to calculate the cost of material, expenses such as import duties, dock charges,
transport cost of materials are added to the invoice price.
Material considered direct at one time may be indirect on other occasion. Nail used in
manufacturing wooden box is treated as direct material, but treated as indirect material when
used to repair the factory building.
Indirect Material: All materials, which cannot be conveniently assigned to specific physical
units, are termed as 'indirect material'. Such commodities do not form part of the finished
products. Consumable stores, lubrication oil, stationery and spare parts for the machinery are
termed as indirect materials.

Labour
Human efforts used for conversion of materials into finished products or doing various jobs
in the business are known as labour. Payment made towards the labour is called labour cost. It
can also be direct and indirect.
Direct Labour: Direct labour is all labour expended and directly involved in altering the
condition, composition or construction of the product. The wages paid to skilled and
unskilled workers for manual work or mechanical work for operating machinery, which can
be specifically allocated to a particular unit of production, is known as direct wages or direct
labour cost. Hence, 'direct wage' may be defined as the measure of direct labour in terms of
money. It is specifically and conveniently traceable to the specific products Wages paid to the
goldsmith for making gold ornament is an example of direct labour.
Indirect Labour: Labour employed to perform work incidental to production of goods or
those engaged for office work, selling and distribution activities are known as 'indirect
labour'. The wages paid to such workers are known as 'indirect wages' or indirect labour cost.
Example: Salary paid to the driver of the delivery van used for distribution of the product.
Expenses
All expenditures other than material and labour incurred for manufacturing a product or
rendering service are termed as 'expenses'. Expenses may be direct or indirect.
Direct Expenses: Expenses which are specifically incurred and can be directly and wholly
allocated to a particular product, job or service are termed as 'direct expenses'. Examples of
such expense are: hire charges of special machinery hired for the fob, carriage inward,
royalty, cost of special and specific drawings, etc. These are also known as 'chargeable
expenses'.
Indirect Expenses: All expenses excluding indirect material and indirect labour, which cannot
be directly and wholly attributed to a particular product, job or service, are termed as 'indirect
expenses'. Some examples of such expenses are: repairs to machinery, insurance, lighting and
rent of the buildings.

Job costing
It involves the detailed accumulation of production costs attributable to specific units or
groups of units. For example, the construction of a custom-designed piece of furniture would
be accounted for with a job costing system. The costs of all labour worked on that specific
item of furniture would be recorded on a time sheet and then compiled on a cost sheet for that
job. Similarly, any wood or other parts used in the construction of the furniture would be
charged to the production job linked to that piece of furniture. This information may then be
used to bill the customer for work performed and materials used, or to track the extent of the
company's profits on the production job associated with that specific item of furniture.

Process costing
It is used when there is mass production of similar products, where the costs associated with
individual units of output cannot be differentiated from each other. In other words, the cost of
each product produced is assumed to be the same as the cost of every other product. Under
this concept, costs are accumulated over a fixed period of time, summarized, and then
allocated to all of the units produced during that period of time on a consistent basis. When
products are instead being manufactured on an individual basis, job costing is used to
accumulate costs and assign the costs to products. When a production process contains some
mass manufacturing and some customized elements, then a hybrid costing system is used.

Unit - III

Break-Even Analysis
The study of cost-volume-profit relationship is often referred as BEA. The term BEA is
interpreted in two senses. In its narrow sense, it is concerned with finding out BEP; BEP is
the point at which total revenue is equal to total cost. It is the point of no profit, no loss. In its
broad determine the probable profit at any level of production.
Assumptions:
1.
2.
3.
4.

All costs are classified into two fixed and variable.

Fixed costs remain constant at all levels of output.
Variable costs vary proportionally with the volume of output.
Selling price per unit remains constant in spite of competition or change in the volume
of production.
5. There will be no change in operating efficiency.
6. There will be no change in the general price level.
7. Volume of production is the only factor affecting the cost.
8. Volume of sales and volume of production are equal. Hence there is no unsold stock.
9. There is only one product or in the case of multiple products. Sales mix remains
constant.
Merits:
1. Information provided by the Break Even Chart can be understood more easily then
those contained in the profit and Loss Account and the cost statement.
2. Break Even Chart discloses the relationship between cost, volume and profit. It
reveals how changes in profit. So, it helps management in decision-making.
3. It is very useful for forecasting costs and profits long term planning and growth
4. The chart discloses profits at various levels of production.
5. It serves as a useful tool for cost control.
6. It can also be used to study the comparative plant efficiencies of the industry.
7. Analytical Break-even chart present the different elements, in the costs direct
material, direct labour, fixed and variable overheads.
Demerits:
1. Break-even chart presents only cost volume profits. It ignores other considerations
such as capital amount, marketing aspects and effect of government policy etc., which
are necessary in decision making.
2. It is assumed that sales, total cost and fixed cost can be represented as straight lines.
In actual practice, this may not be so.

3. It assumes that profit is a function of output. This is not always true. The firm may
increase the profit without increasing its output.
4. A major draw back of BEC is its inability to handle production and sale of multiple
products.
5. It is difficult to handle selling costs such as advertisement and sale promotion in BEC.
6. It ignores economics of scale in production.
7. Fixed costs do not remain constant in the long run.
8. Semi-variable costs are completely ignored.
9. It assumes production is equal to sale. It is not always true because generally there
may be opening stock.
10. When production increases variable cost per unit may not remain constant but may
reduce on account of bulk buying etc.
11. The assumption of static nature of business and economic activities is a well-known
defect of BEC.
1. Margin of safety: Margin of safety is the excess of sales over the break even sales. It can
be expressed in absolute sales amount or in percentage. It indicates the extent to which
the sales can be reduced without resulting in loss. A large margin of safety indicates the
soundness of the business. The formula for the margin of safety is:
Present sales Break even sales

or

Profit
P. V. ratio

Margin of safety can be improved by taking the following steps.

1.
2.
3.
4.

Increasing production
Increasing selling price
Reducing the fixed or the variable costs or both
Substituting unprofitable product with profitable one.

2. Angle of incidence: This is the angle between sales line and total cost line at the Breakeven point. It indicates the profit earning capacity of the concern. Large angle of
incidence indicates a high rate of profit; a small angle indicates a low rate of earnings. To
improve this angle, contribution should be increased either by raising the selling price
and/or by reducing variable cost. It also indicates as to what extent the output and sales
price can be changed to attain a desired amount of profit.
3. Profit Volume Ratio is usually called P. V. ratio. It is one of the most useful ratios for
studying the profitability of business. The ratio of contribution to sales is the P/V ratio. It
may be expressed in percentage. Therefore, every organization tries to improve the P. V.
ratio of each product by reducing the variable cost per unit or by increasing the selling
price per unit. The concept of P. V. ratio helps in determining break even-point, a desired
amount of profit etc.

The formula is,

Contribution
X 100
Sales

4. Break Even- Point: If we divide the term into three words, then it does not require
further explanation.
Break-divide
Even-equal
Point-place or position
Break Even Point refers to the point where total cost is equal to total revenue. It is a
point of no profit, no loss. This is also a minimum point of no profit, no loss. This is
also a minimum point of production where total costs are recovered. If sales go up
beyond the Break Even Point, organization makes a profit. If they come down, a loss
is incurred.

Fixed Expenses

1. Break Even point (Units) = Contribution per unit

2. Break Even point (In Rupees) =

Fixed expenses
X sales
Contribution

Depreciation
It is the process of allocating the cost of an asset over its life rather than all at once with
regard to tax deductions and is used by both large and small businesses. The Internal Revenue
Code describes the depreciation deduction as a reasonable allowance for the exhaustion,
wear, tear and obsolescence of business assets. There are several methods of depreciation but
only two that are widely recognized by the IRS.
Straight-Line
The straight-line method is most commonly used method for calculating depreciation because
it is the simplest. It can be used for any depreciable property except for those that are required
to use accelerated depreciation methods by the IRS. Under the straight-line depreciation
method, the basis of the asset deducted evenly over the assets useful life. Each year, the same
amount of depreciation is claimed on a businesss tax return. Under Generally Accepted
Accounting Principles (GAAP), the straight-line method is used for internal books. In

general, the formula for straight-line depreciation equals the asset's depreciable basis--the
original costs to purchase it--divided by its estimated longevity.
Accelerated
The Accelerated Cost Recovery System (ACRS) is a method for recovering the cost of
personal and real property that has a shorter useful life such, as a computer or automobile.
The Internal Revenue Service developed it under the Economic Recovery Tax Act of 1981,
and modified it in 1986 (MACRS). The ACRS and MACRS rules were developed to
encourage businesses to engage in capital investment more frequently. Different types of
property accelerate at different rates according to IRS rules.
Declining Balance
As less common form of deprecation is declining-balance depreciation. This method offers a
higher rate of depreciation during the earlier years of an assets life and is only useful for
assets with a useful life longer than three years. Using the declining balance does not
completely depreciate the asset; however, so the IRS lets you switch to the straight-line
depreciation method once during the assets life.
Considerations
Except for the declining-balance method, the IRS requires that you use the same depreciation
method as that used in the first year for the same item until its depreciation period has ended.
In addition, all items of the same class depreciated in the same tax year must use the same
method. Whatever rules or tables were in effect in the first year of depreciation must be used
throughout the depreciation period. It is important, therefore, to keep accurate records
regarding all asset depreciation items used as tax deductions.