Course Name: Accounting & Financial

Management
Module 5: Cost Accounting

1. Introduction.

Cost accounting is a form of managerial accounting that aims to capture a

company's total cost of production by assessing the variable costs of each step
of production as well as fixed costs, such as a lease expense.

Cost accounting is not GAAP-compliant, and can only be used for internal
purposes.

Cost accounting is used by a company's internal management team to identify

all variable and fixed costs associated with the production process. It will first
measure and record these costs individually, then compare input costs to output
results to aid in measuring financial performance and making future business
decisions. There are many types of costs involved in cost accounting, which are
defined below.

Cost accounting is helpful because it can identify where a company is spending

its money, how much it earns, and where money is being lost. Cost accounting
aims to report, analyse, and lead to the improvement of internal cost controls
and efficiency. Even though companies cannot use cost-accounting figures in
their financial statements or for tax purposes, they are crucial for internal
controls.

Cost-accounting systems, and the techniques that are used with them, can have
a high start-up cost to develop and implement. Training accounting staff and
managers on esoteric and often complex systems takes time and effort, and
mistakes may be made early on. Higher-skilled accountants and auditors are
likely to charge more for their services when evaluating a cost-accounting
system than a standardized one like GAAP.

Cost accounting is an informal set of flexible tools that a company's managers

can use to estimate how well the business is running. Cost accounting looks to
assess the different costs of a business and how they impact
operations, costs, efficiency, and profits. Individually assessing a company's
cost structure allows management to improve the way it runs its business and
therefore improve the value of the firm. These are meant to be internal metrics
and figures only. Since they are not GAAP-compliant, cost accounting cannot
be used for a company's audited financial statements released to the public.

2. Types of Costs

Cost accounting is an accounting process that measures all of the costs

associated with production, including both fixed and variable costs. The
purpose of cost accounting is to assist management in decision-making
processes that optimize operations based on efficient cost management. The
costs included in cost accounting are as follows:

Direct Costs
Direct costs are related to producing a good or service. A direct
cost includes raw materials, labour, and expense or distribution costs associated
with producing a product. The cost can easily be traced to a product,
department, or project. For example, Ford Motor Company (F) manufactures
cars and trucks. A plant worker spends eight hours building a car. The direct
costs associated with the car are the wages paid to the worker and the cost of
the parts used to build the car.

Indirect Costs
Indirect costs, on the other hand, are expenses unrelated to producing a good or
service. An indirect cost cannot be easily traced to a product, department,
activity, or project. For example, with Ford, the direct costs associated with
each vehicle include tires and steel. However, the electricity used to power the
plant is considered an indirect cost because the electricity is used for all the
products made in the plant. No one product can be traced back to the electric
bill.

What Are The Different Types Of Costs In Cost Accounting?

Fixed Costs
Fixed costs do not vary with the number of goods or services a company
produces over the short term. For example, suppose a company leases a
machine for production for two years. The company has to pay $2,000 per
month to cover the cost of the lease, no matter how many products that
machine is used to make. The lease payment is considered a fixed cost as it
remains unchanged.
Variable Costs
Variable costs fluctuate as the level of production output changes, contrary to a
fixed cost. This type of cost varies depending on the number of products a
company produces. A variable cost increases as the production volume
increases, and it falls as the production volume decreases. For example, a toy
manufacturer must package its toys before shipping products out to stores. This
is considered a type of variable cost because, as the manufacturer produces
more toys, its packaging costs increase, however, if the toy manufacturer's
production level is decreasing, the variable cost associated with the packaging
decreases.

Operating Costs
Operating costs are expenses associated with day-to-day business activities but
are not traced back to one product. Operating costs can be variable or fixed.
Examples of operating costs, which are more commonly called operating
expenses, include rent and utilities for a manufacturing plant. Operating costs
are day-to-day expenses, but are classified separately from indirect costs – i.e.,
costs tied to actual production. Investors can calculate a company's operating
expense ratio, which shows how efficient a company is in using its costs
to generate sales.

Opportunity Costs
Opportunity cost is the benefits of an alternative given up when one decision is
made over another. This cost is, therefore, most relevant for two mutually
exclusive events. In investing, it's the difference in return between a chosen
investment and one that is passed up. For companies, opportunity costs do
not show up in the financial statements but are useful in planning by
management.

For example, a company decides to buy a new piece of manufacturing

equipment rather than lease it. The opportunity cost would be the difference
between the cost of the cash outlay for the equipment and the improved
productivity vs. how much money could have been saved in interest expense
had the money been used to pay down debt.

Sunk Costs
Sunk costs are historical costs that have already been incurred and will not
make any difference in the current decisions by management. Sunk costs are
those costs that a company has committed to and are unavoidable
or unrecoverable costs. Sunk costs are excluded from future business decisions.

Controllable Costs
Controllable costs are expenses managers have control over and have the power
to increase or decrease. Controllable costs are considered so when the decision
of taking on the cost is made by one individual. Common
examples of controllable costs are office supplies, advertising
expenses, employee bonuses, and charitable donations. Controllable costs are
categorized as short-term costs as they can be adjusted quickly.

Cost accounting looks to assess the different costs of a business and how they
impact operations, costs, efficiency, and profits. Individually assessing a
company's cost structure allows management to improve the way it runs its
business and therefore improve
the value of the firm.

3. Cost centre

A cost centre is a department or function within an organization that does not

directly add to profit but still costs the organization money to operate. Cost
centres only contribute to a company's profitability indirectly, unlike a profit
centre, which contributes to profitability directly through its actions. Managers
of cost centres, such as human resources and accounting departments are
responsible for keeping their costs in line or below budget.

A cost centre is a function within an organization that does not directly add to
profit but still costs money to operate, such as the accounting, HR, or IT
departments. The main use of a cost centre is to track actual expenses for
comparison to the budget.A cost centre indirectly contributes to a company’s
profit via operational excellence, customer service, and enhanced product
value.The manager for a cost centre is only responsible for keeping costs in line
with the budget and does not bear any responsibility regarding revenue or
investment decisions.Cost centres can not simply be eliminated; their role
within a company is vital, even if it does not generate any income for the
business.

How a Cost Centre Works

A cost centre indirectly contributes to a company’s profit through operational
efficiency, customer service, or increasing product value. Cost centres help
management utilize resources used. Although cost centres contribute to revenue
indirectly, it is impossible to discern the actual revenue generated. Any
associated benefits or revenue-producing activities of these
departments are disregarded for internal management purposes.

Cost centres are often assigned their own general ledger coding that
management and personnel can use to absorb and report costs. As budgets are
prepared, cost centres are intentionally forecast to operate as a loss; in fact,
budgeted revenue will be $0. Instead, management's goal is to minimize the
deficit of a cost centre while still providing general support to profit centres.

Purpose of a Cost Centre

The main function of a cost centre is to track expenses. A cost centre manager
is only responsible for keeping costs in line with the budget and does not bear
any responsibility regarding revenue or investment decisions. Cost centres
provide metrics more relevant to internal reporting. Internal management
utilizes cost centre data to improve operational efficiency and maximize profit.

External users of financial statements, including regulators, taxation authorities,

investors, and creditors, have little use for cost centre data. Therefore, external
financial statements are generally prepared with line items displayed as an
aggregate of all cost centres. For this reason, cost-centre accounting falls
under managerial accounting instead of financial or tax accounting.

Expense segmentation into cost centres allows for greater control and analysis
of total costs. Accounting for resources at a finer level such as a cost centre
allows for more accurate budgets, forecasts, and calculations based on future
changes.

Types of Cost Centres

Companies can opt to segment out cost centres however they choose, as the end
goal of a cost centre is to isolate information for better internal data collecting
and reporting. Here are several common types of cost centres along with
examples of each.

Operational Cost Centre

Operational cost centres group people, equipment, and activities that engage in
a singular commonly-themed activity. Most often, operational cost centres may
be seen as common company departments that group employees based on their
function within the company. The important part to note is an operational cost
centre is a back-office function that, while it may represent an entire
department, does not generate revenue.

Personal/People Cost Centre

Personal cost centres break out a collection of individuals. As
opposed to the IT department above, a personal cost centre
would exclude physical materials. This type of cost centre allows a company to
isolate only the cost of headcount without being distorted by equipment,
materials, or other goods.

Impersonal/Machinery Cost Centre

On the other hand, an impersonal/machinery cost centre isolates the costs of all
non-employee costs. A company may be interested in only viewing the upfront
cost, maintenance expenses, repair requirements, and other costs related to just
the heavy machinery for a process. This type of cost centre may coincide with
other types of cost centres, as companies may want to know the non-personnel
cost of a specific department, for example.

Locational Cost Centre

A more specific type of impersonal cost centre may define a geographical

location for a cost centre. A company may decide it wants to include or exclude
the cost of employees for a certain region. In addition, be mindful that a
locational cost centre must also exclude revenue even if revenue is generated in
the region. The sales of that region would simply be reported in a different
profit centre.

Product Cost Centre

Though it may be referred to as a research and development centre, a product

cost centre aggregates the costs associated with developing, constructing, and
bringing a product to market. It often excludes the operational costs needed to
facilitate the sale of the product (as these costs often want to be reported
against revenue.

Project Cost Centre

On a very similar note, a company often decides to segregate out costs for a
project or service-driven endeavour. This project may simply be a capital
investment that requires tracking of a single purpose over a long period of time.
This type of cost centre would most likely be overseen by a project
management team with a dedicated budget and timeline.

Service Cost Centre

A service cost centre groups individuals based on their function and may more
closely refine the costs within a department. For instance, a company may feel
an IT department is too large of a cost centre and may want to break out
 employees by more dedicated services. Companies may opt to
include or exclude the costs necessary for the service cost
centre to be successful.

4 .Material Cost

Material cost is the cost of materials used to manufacture a product or

provide a service. Excluded from the material cost is all indirect materials,
such as cleaning supplies used in the production process. Follow these steps
to determine the amount of material cost to assign to a unit of production
(such as a completed finished goods item):

1. Ascertain the standard quantity of the material used to manufacture one unit.
2. Add the standard amount of scrap associated with manufacturing one unit.
3. Determine the standard amount of scrap associated with setting up the
production run, and apportion it to the individual unit.
4. If any scrap is then sold, apportion the revenue back to the individual unit.

For many materials, the cost of scrap and the revenue from the resale of
scrap are so small that it is not worthwhile to apportion it to the material cost.
If the material cost has been established as a standard, then you can
subsequently calculate the material yield variance to see if actual materials
usage was as expected, or you can calculate the purchase price variance to
see if the purchase price of the material was as expected.
These variances are useful for investigating problems in the production and
purchasing areas of a business.

5 .Labour Cost.
Labour cost is a financial term used interchangeably with "cost of labour" on
financial reports. This value calculates the total cost of employee pay and
benefits. If you're in human resources (HR), finance, accounting or executive
leadership, you may need to understand labour cost and how it impacts you and
your company.

In this article, we’ll explore labour costs, including indirect and direct costs,
provide examples of how to calculate it and answer some frequently asked
questions about cost of labour in the U.S.

To fully understand the cost of labour, a company needs to know what the direct
and indirect labour costs are, as well as the fixed and variable costs.Factors
included in labour cost include employee wages, payroll taxes, sick days and
benefits.If cost of labour isn’t accurately calculated, it could lead to a product
being priced incorrectly and, consequently, have a negative effect on profits for
a company.

What is the cost of labour?

Labour cost is an important value that finance and accounting professionals

calculate to determine the direct and indirect price that a company pays for
labour.
The direct labour cost includes the cost of wages and benefits
for employees who are directly involved in producing the
product or service commodity. The indirect cost of labour refers to amounts
paid for employees that support the commodity but aren't directly involved in
making it.

Understanding the cost of labour helps companies price their products, and
without an understanding of direct and indirect costs, a company may find it
challenging to arrive at the right cost for its products. As a result, a deep
understanding of labour cost and how to use it is beneficial for the economy.

Cost of labour can be further broken down into fixed and variable costs:

 Fixed: Fixed costs are usually contracted costs but sometimes include
essential costs that are predictable.
 Variable: Variable costs will increase and decrease with variables like
production demand and economic conditions.

Direct vs. indirect costs of labour

Here's more on how direct labour costs and indirect labour costs differ:

Direct labour costs

Direct labour costs refer to costs that are derived directly from supply chain
employees involved in the production. This group could include assemblers,
manufacturers, heavy machinery users, fabricators, craftsmen and artisans,
delivery drivers and other logistical employees essential for getting goods into
consumers’ hands. Examples of direct labour costs include:

 The hourly salary of a quality assurance inspector is adjusted to include

health care facility and short term benefits.
 The annual salary of a welder who works on the production line of a steel
parts manufacturing company.
 The payment made to a logistics company responsible for delivering goods
across the country.

Indirect labour costs

Indirect labour refers to any employee whose role isn’t essential to the direct
production of a product. These employees' roles may include administration,
supervisory roles and finance, which are still important roles but they aren't
involved in the supply chain. Examples of indirect labour costs include:
 The salaries of the employees in the human resources
department
 The salary, benefits and bonuses of a chief financial officer of a Fortune 500
company that manufactures auto parts

Fixed vs. variable costs of labour

Here's a comparison of how fixed and variable labour costs are different:

Fixed labour costs

Fixed labour costs are costs that are unlikely to change for a known period. For
example, a fixed labour cost for a company would be the annual salary of an
essential production worker in a given year. While this employee could get a
pay increase, employers have a good idea of the term of the salary relative to
when increases are likely to occur.

Variable labour costs

Variable labour costs are costs that increase and decrease with production. One

good example of a common variable labour cost is the rate of an hourly

employee. Several industries rely on variable labour, especially around the
shopping holidays. These include manufacturing companies,
restaurants and retailers. To fill the production needs in peak
season, businesses will direct-hire hourly employees or work with agencies to
find temp workers.

Another example of a variable labour cost might be the cost associated with
contract workers who respond to things like equipment malfunctions and/or
emergency repairs that are critical for business functioning. These things occur
on a case-by-case basis which makes them more difficult to predict.
6 .Overhead Expenses.
Overhead expenses are other costs not related to labour, direct materials,
or production. They represent more static costs and pertain to general business
functions, such as paying accounting personnel and facility costs.

These costs are generally ongoing regardless of whether a business makes any
revenue. Unlike operating expenses, these costs are fixed, meaning they can be
the same amount over time.

In the scenario with the soda bottler above, the facility lease payments are still
owed even if no current production takes place within the facility. Therefore,
facility costs are overhead expenses. Likewise, the company still incurs other
business expenses, such as insurance payments and administrative and
management salaries.

They may also be semi-variable, so the amounts that need to be paid may
change slightly over time. Utilities are one example. The cost of power can
change based on usage. If the soda company increases production, it will have
to pay more for electricity.

Overhead expenses also include marketing and other expenses incurred to sell
the product. For the soda bottler, this includes commercial ads, signage in retail
aisles, and promotional costs. These costs still remain if production is shut
down for a short period of time.

These expenses can be categorized based on where they fit into the business.
They can include:

 Administrative overhead
 General business overhead
 Research overhead
 Transportation overhead
 Manufacturing overhead
 Step costs
7 .Preparation of Cost Sheet.

A cost sheet is a statement prepared at periodical intervals of time,

which accumulates all the elements of the costs associated with
a product or production job. It is used to compile the margin earned
on a product or job and forms the basis for the setting of prices on
similar products in the future. We shall study the Cost Sheet Format
in detail.
What is a Cost Sheet?

A Cost sheet is a memorandum statement that provides the estimated detailed

costs in respect of a cost centre or a cost unit in a summarized manner. In a Cost
Sheet, the elements of cost are arranged under different heads following a logical
order. It depicts the detailed cost of the total output for a certain given period.

Cost Sheet Format

A Cost Sheet depicts the following facts:

1. Total cost and cost per unit for a product.

2. The various elements of cost such as prime cost, factory cost, production cost,
cost of goods sold, total cost, etc.
3. Percentage of every expenditure to the total cost.
4. Compare the cost of any two periods and ascertain the inefficiencies if any.
5. Information to management for cost control
6. Calculate and summarize the total cost of the product.

Importance and Objectives of Cost Sheet

1. For calculating the total cost break-up

A cost sheet shows the break-up of the total cost into different elements, i.e.
material, labour, overheads, etc. It also depicts the total cost and cost per unit of
the units produced.
2. For determining the selling price
A cost sheet helps in determining the selling price of a product or of a service. The
cost sheet ascertains cost at each stage of the product and also the total cost of the
product, where a margin of profit is added and thus the selling price is ascertained.

3. It facilitates comparison
It helps in comparing the costs of the product over a period of time. This helps the
organisation to investigate the reasons for increasing costs and also control them
on the basis of them.

4. Facilitating managerial decision making

Preparation of cost sheet helps managers at various levels in their decision-making
process such as

1. to produce or buy a component,

2. what price of goods to quote in the tender,
3. whether to retain or replace an existing machine,
4. how to reduce costs and maximize profit.
5. identify and make decisions whether they need to continue with the product
or not.
5. Preparation of budgets
Organizations can prepare a budget with the help of a cost sheet. We can prepare
the budget by using the current or previous year’s data.

Elements of Cost

Prime Cost: It comprises direct material, direct wages, and direct expenses.
Alternatively, the Prime cost is the cost of material consumed, productive wages,
and direct expenses.

Factory Cost: Factory cost or works cost or manufacturing cost or production

cost includes in addition to the prime cost the cost of indirect material, indirect
labour, and indirect expenses. It also includes the amount or units of WIP or
incomplete units at the end of the period.
 Cost of Production: When Office and administration cost at the
end of the period are added to the Factory cost, we arrive at the
cost of production or cost of goods sold. Here, we make an adjustment for opening
and Closing finished goods.

Total Cost: Total cost or alternatively cost of sales is the cost of production plus
selling and distribution overheads.

Based on our existing cost sheet, we can make estimates of our costs for the next
financial year. It helps to prepare and make the necessary arrangement of funds
for costs of the next financial year

Items excluded from Costs while preparing Cost Sheet

The following items of expenses, losses or incomes are excluded from the cost
sheet:

 Related to capital assets

 appropriation of profits
 amortization of fictitious or intangible assets
 abnormal gains and losses or items of a purely financial nature
Proforma of a Cost Sheet