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### Costing

1. 1. ORIENTAL Accounting Cost & Management COST: MEANING AND ITS ELEMENTS The term „cost. means the amount of expenses [actual or notional] incurred on or attributable to specified thing or activity. As per Institute of cost and work accounts (ICWA) India, Cost is „measurement in monetary terms of the amount of resources used for the purpose of production of goods or rendering services. Elements of cost Cost of production/manufacturing consists of various expenses incurred on production/manufacturing of goods or services. These are the elements of cost, which can be divided into three groups: Material, Labour and Expenses. COST SHEET: MEANING AND ITS IMPORTANCE Cost sheet is a statement, which shows various components of total cost of a product. It classifies and analyses the components of cost of a product. Previous periods data is given in the cost sheet for comparative study. It is a statement, which shows per unit cost in addition to Total Cost. Selling price is ascertained with the help of cost sheet. The details of total cost presented in the form of a statement are termed as Cost sheet. Cost sheet is prepared on the basis of: 1. Historical Cost 2. Estimated Cost Historical Cost Historical Cost sheet is prepared on the basis of actual cost incurred. A statement of cost prepared after incurring the actual cost is called Historical Cost Sheet. Estimated Cost Estimated cost sheet is prepared on the basis of estimated cost. The statement prepared before the commencement of production is called estimated cost sheet. Such cost sheet is useful in quoting the tender price of a job or a contract. Importance of Cost Sheet The importance of cost sheet is as follows: Cost ascertainment The main objective of the cost sheet is to ascertain the cost of a product. Cost sheet helps in ascertainment of cost for the purpose of determining cost after they are incurred. It also helps to ascertain the actual cost or estimated cost of a Job. BY Dinesh Makani For Private Circulation Only Page 1
2. 2. ORIENTAL Accounting Cost & Management Fixation of selling price To fix the selling price of a product or service, it is essential to prepare the cost sheet. It helps in fixing selling price of a product or service by providing detailed information of the cost. Help in cost control For controlling the cost of a product it is necessary for every manufacturing unit to prepare a cost sheet. Estimated cost sheet helps in the control of material cost, labour cost and overheads cost at every point of production. Facilitates managerial decisions It helps in taking important decisions by the management such as: whether to produce or buy a component, what prices of goods are to be quoted in the tender, whether to retain or replace an existing machine etc. COMPONENTS OF TOTAL COST The Components of cost are shown in the classified and analytical form in the cost sheet. Components of total cost are as follows: Prime Cost It consists of direct material, direct wages and direct expenses. In other words “Prime cost represents the aggregate of cost of material consumed, productive wages, and direct expenses”. It is also known as basic, first, flat or direct cost of a product. Prime Cost = Direct material + Direct Wages + Direct expenses Direct material means cost of raw material used or consumed in production. It is not necessary that all the material purchased in a particular period is used in production. There is some stock of raw material in balance at opening and closing of the period. Hence, it is necessary that the cost of opening and closing stock of material is adjusted in the material purchased. Opening stock of material is added and closing stock of raw material is deducted in the material purchased and we get material consumed or used in production of a product. It is calculated as: Material Consumed = Material purchased + Opening stock of material -Closing stock of material. Factory Cost In addition to prime cost it includes works or factory overheads. Factory overheads consist of cost of indirect material, indirect wages, and indirect expenses incurred in the factory. Factory cost is also known as works cost, production or manufacturing cost. Factory Cost = Prime cost + Factory overheads BY Dinesh Makani For Private Circulation Only Page 2
3. 3. ORIENTAL Accounting Cost & Management TOTAL COST AND COST SHEET If office and administrative overheads are added to factory or works cost, total cost of production is arrived at. Hence the total cost of production is calculated as: Total Cost of production = Factory Cost + office and administration overheads Cost of goods sold It is not necessary, that all the goods produced in a period are sold in the same period. There is stock of finished goods in the opening and at the end of the period. The cost of opening stock of finished goods is added in the total cost of production in the current period and cost of closing stock of finished goods is deducted. The cost of goods sold is calculated as: Cost of goods sold = Total cost of production + Opening stock of Finished goods – Closing stock of finished goods Total Cost i.e., Cost of Sales If selling and distribution overheads are added to the total cost of production, total cost is arrived at. This cost is also termed as cost of Sales. Hence the total cost is calculated as: Total Cost = Cost of Goods sold + Selling and distribution overheads Sales If the profit margin is added to the total cost, sales are arrived at. Excess of sales over total cost is termed as profit. When total cost exceeds sales, it is termed as Loss. Sales = Total Cost + Profit Sometimes profit is calculated on the basis of given information in percentage of cost or sales. In such a situation, the amount is assumed 100 in which the percentage is calculated. Then the Profit is calculated in the following ways: Case 1 If Cost is Rs.10,000 and profit on cost 10%. Assume the cost is Rs.100 and profit on cost is Rs.10. Hence Profit on cost of Rs.10,000 is 10,000 × 10/100 = Rs.1,000 Thus the sales value is Rs 11000 (10,000 + 1000) Case 2 If Cost is Rs.10,800 and profit on sales price is 10%. Assume sales price is Rs.100. cost price is Rs.90 [i.e. Rs.100 – Rs.10]. When profit on cost of Rs.90 is Rs.10. Hence profit on cost of Rs.10,800 is 10,800 × 10/90 = Rs.1,200 10,800 + 1200 = 12,000 sales value Case 3 BY Dinesh Makani For Private Circulation Only Page 3
4. 4. ORIENTAL Accounting Cost & Management If sales price is Rs.12,100 and profit on cost is 10%. Assume Cost price is Rs.100. Sales price is Rs.110 [i.e.100 + 10]. If sales price is Rs.110, profit is Rs.10. Profit on sales price of Rs.12,100 is 12,100 × 10/110 = Rs.1,100 profit There is no prescribed format of a Cost sheet. It may change from industry to industry. A specimen format of a Cost Sheet is given as under: Particulars A. Total (Rs.) Materials Consumed: Purchases Add: Opening Stock of Raw material Expenses on Purchases Less: Closing Stock of Raw Material Direct Material consumed B. Direct Labour (Wages) C. Direct Expenses D. Prime Cost (A + B + C) E. Factory/Works Overheads Add: Opening Stock of Work-in-Progress Less: Closing Stock of Work-in-Progress F. Works/Factory Cost (D + E) G. Office and administration overheads H. Total Cost of Production (F + G) Add: Opening Stock of finished Goods Cost of Goods available for sale Less: Closing Stock of finished Goods I. Cost of production of goods Sold or cost of good sold J. Selling and Distribution Overheads K. Total Cost (I + J) = Cost of Sales L. Profit M. Sales (K + L) BY Dinesh Makani For Private Circulation Only Page 4
5. 5. ORIENTAL Accounting Cost & Management Components of Total Cost Prime Cost = Direct material + Direct Wages + Direct expenses works/ factory cost; Factory Cost = Prime cost + Factory overheads Cost of production/office cost = Factory Cost + office and administration overheads Cost of production of goods sold = Cost of Production + Opening stock of Finished. Goods – closing stock of finished goods Total Cost = Cost of Production of goods sold + Selling and distribution overheads Sales = Total Cost + Profit CONTRACT COSTING Contract costing is A form of specific order costing; attribution of costs to individual contracts. A contract cost is Aggregated costs of a single contract; usually applies to major long term contracts rather than short term jobs. Features of long term contracts - By contract costing situations, we tend to mean long term and large contracts: such as civil engineering contracts for building houses, roads, bridges and so on. We could also include contracts for building ships, and for providing goods and services under a long term contractual agreement. - With contract costing, every contract and each development will be accounted for separately; and does, in many respects, contain the features of a job costing situation. - Work is frequently site based. Features of a Contract - The end product - The period of the contract - The specification - The location of the work - The price - Completion by a stipulated date - The performance of the product Collection of Costs BY Dinesh Makani For Private Circulation Only Page 5
6. 6. ORIENTAL Accounting Cost & Management Desirable to open up one or more internal job accounts for the collection of costs. If the contract not obtained, preliminary costs be written off as abortive contract costs in P&L In some cases a series of job accounts for the contract will be necessary: -To collect the cost of different aspects -To identify different stages in the contract Special features - Materials delivered direct to site. - Direct expenses - Stores transactions. - Use of plant on site Two possible accounting methods: 1. Where a plant is purchased for a particular contract & has little further value to the business at the end of the contract 2. Where a plant is bought for or used on a contract, but on completion of the contract it has further useful life to the business Alternatively the plant may be capitalized with Maintenance and running costs charged to the contract.” PROCESS COSTING PROCESS COSTING IMPORTANCE: In process costing, particular attention is given to (a) cost relating to the process, i.e., both direct and indirect cost, (b) period for which cost for the process is collected, © complete units in the process at the end of the period and (e) determining unit cost of the process for the period. USE OF PROCESS COSTING: Process coasting is useful for industries with following characteristics: (a) Continuous and mass production (b) Loss of identity of production against a particular order. (C) Homogeneous products (d) Production involves different process and output of one process forms input of another process. (e) Other uses: bottling companies, canning plants, packing, breweries and industries involved in processing milk products. Process Costing under different inventory costing methods. BY Dinesh Makani For Private Circulation Only Page 6
7. 7. ORIENTAL Accounting Cost & Management The effect of using FIFO method, LIFO method and average method will be differentiates on cost per unit of the process. FIFO METHOD: It is also referred to as first in first –out method of inventory costing. Under FIFO method it is presumed that units are completed in the order of introduction to the process. Units at the beginning are completed first. Then, newly introduced units are completed. Only after this, work is done on closing inventory. According to this method, it is assumed that cost incurred is used – (a) First to complete the units already in process, (b) Then to complete the newly introduced units, © For the work done to bring closing inventory to given stage of completion. If units completed are more than units representing opening inventory, it is presumed under FIFO method that all unfinished units in opening inventory have been completed. When FIFO method of inventory costing is followed, units completed during the period are divided in two categories for the purpose of statement of equivalent production: (a) Work done for completing opening work – in – process, (b) Newly introduced units completed during the process, LIFO METHOD: It is also referred to as “Last-in-First-out” method of inventory costing. It is presumed under LIFO method that cost incurred is used: (a) First to complete newly introduced units. (b) Then to complete units already in process. If there is closing work in process, it is supposed in LIFO method that units which represent opening inventory, remain in closing work – in – process at the end of the period, because units representing opening inventory are attended to in the last. If units under closing inventory are more than units under opening inventory, it will be presumed that all units, which represented opening work in process, remain in closing work – in – process at the end of period. Under FIFO method work completed is divided into two categories i.e. (i) units lying under opening work in process but completed during the period and, (ii) newly introduced units completed during the period. When LIFO method is followed closing inventory is divided into two categories i.e., (i) Units, which represent opening work in process, but are lying under closing work in process at the end of the period. (ii) Newly introduced units lyibg in closing stock. Difference between Job Order Costing & Process BY Dinesh Makani For Private Circulation Only Page 7
8. 8. ORIENTAL Accounting Cost & Management JOB ORDER COSTING / CONTRACT COSTING PROCESS COSTING 1 It is used in industries where production is carried on according to specific job order. Process Costing is used in continuous and mass production industries producing like units of standard specification. 2 Cost is collected for each individual job worked. Cost is collected according to process and departments 3 Items of prime cost can be traced with job order. Items of prime cost cannot be traced with a particular order due to continuous production. 4 Job cost is computed, when the job is completed Process cost is computed at the end of the cost period 5 There is no transfer of work from one job to another job, till it is necessary to transfer surplus work or excess production. Costs of one process are transferred to cost of next process, until goods are completely manufactured. 6 The cost of each unit in production is separately identified The total cost for production during the period is specified over units produced, as the separate identity of units is lost due to continuous production. This process cost per unit represents average cost per unit for the period. 7 The basis of cost collection is job order or batch. Cost is collected by period i.e., on time basis. 8 There may or may not be work-in-progress at the end of accounting period. There is always some work in progress at the beginning as well as at the end of the period Production record Units (i) When, material is introduced at the beginning of the process (ii) When material is continuously introduced throughout the process (iii) When material is introduced at 30% stage of processing. (iv) When material is introduced at the end of process BY Dinesh Makani For Private Circulation Only Page 8
9. 9. ORIENTAL Accounting Cost & Management MARGINAL COSTING Marginal costing is formally defined as: The accounting system in which variable costs are charged to cost units and the fixed costs of the period are written-off in full against the aggregate contribution. Its special value is in decision-making.. (Terminology.) The term „contribution. mentioned in the formal definition is the term given to the difference between Sales and Marginal cost. Thus MARGINAL COST = VARIABLE COST DIRECT LABOUR + DIRECT MATERIAL +DIRECT EXPENSE+ VARIABLE OVERHEADS Marginal cost means the cost of the marginal or last unit produced. It is also defined as the cost of one more or one less unit produced besides existing level of production. In this connection, a unit may mean a single commodity, a dozen, a gross or any other measure of goods. The marginal cost varies directly with the volume of production and marginal cost per unit remains the same. It consists of prime cost, i.e. cost of direct materials, direct labor and all variable overheads. It does not contain any element of fixed cost, which is kept separate under marginal cost technique. Contribution may be defined as the profit before the recovery of fixed costs. Thus, contribution goes toward the recovery of fixed cost and profit, and is equal to fixed cost plus profit (C = F + P). In case a firm neither makes profit nor suffers loss, contribution will be just equal to fixed cost (C = F). This is known as break-even point. The concept of contribution is very useful in marginal costing. It has a fixed relation with sales. The proportion of contribution to sales is known as P/V ratio, which remains the same under given conditions of production and sales. The principles of marginal costing The principles of marginal costing are as follows. a. For any given period of time, fixed costs will be the same, for any volume of sales and production (provided that the level of activity is within the „relevant range.). Therefore, by selling an extra item of product or service the following will happen. . Revenue will increase by the sales value of the item sold. . Costs will increase by the variable cost per unit. . Profit will increase by the amount of contribution earned from the extra item. b. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item. c. Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs. d. When a unit of product is made, the extra costs incurred in its BY Dinesh Makani For Private Circulation Only Page 9
10. 10. ORIENTAL Accounting Cost & Management manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased. Features of Marginal Costing The main features of marginal costing are as follows: 1. Cost Classification The marginal costing technique makes a sharp distinction between variable costs and fixed costs. It is the variable cost on the basis of which production and sales policies are designed by a firm following the marginal costing technique. 2. Stock/Inventory Valuation Under marginal costing, inventory/stock for profit measurement is valued at marginal cost. It is in sharp contrast to the total unit cost under absorption costing method. Marginal Contribution Marginal costing technique makes use of marginal contribution for marking various decisions. Marginal contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departments. Advantages and Disadvantages of Marginal Costing Technique BY Dinesh Makani For Private Circulation Only Page 10
11. 11. ORIENTAL Accounting Cost & Management Advantages 1. Marginal costing is simple to understand. BY Dinesh Makani For Private Circulation Only Page 11