Cost concepts

1. Basic Cost Concepts
By
Virtual CFO Team
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2. INDEX
S No Particulars
1 Introduction
2 Advantages of Cost Accounting
3 Financial Accounting vs Cost Accounting
4 Project Feasibility Study
5 Classificationof Costs
6 Concept of Contribution
7 Concept of Break Even Point
8 Product Pricing
9 Product Pricing Strategies
10 Return on Investment
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3. Introduction
Cost
• The amount of expenditure incurred on or attributable to a
specific thing or activity
Costing
• The technique and process of ascertaining the cost
Cost Accounting
• The Process of Accounting for Cost which begins with
recording and ends with reporting
Cost Accountancy
• The application of costing, cost accounting principles,
methods and techniques.
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4. Advantages
of Cost
Accounting
Cost
Determin
ation
Selling
Price
Determin
ation
Product
Profitability
Analysis
Decision
Making/
Budgeting
Cost Control
Cost
Reduction
Statutory
Compliance
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5. Financial Accounting vs Cost Accounting
Financial Accounting Cost Accounting
Provides information about
financial performance
Provided information about
ascertainment of cost
Interprets transactions in terms of
Money
Interprets costs in terms of material,
labour and overhead
Records historical data
Makes use both historical/ pre-
determined cost
Users are stakeholders
Information is used by internal
management
Shows profit/ Loss for the year
Provides details of cost and profit of
each product, process, job etc
Usually prepared on yearly basis Reports prepared as and when required
A set format is used No set of Formats
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6. Financial
Feasibility
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7. Financial feasibility
• Study of detailed financial analysis
based on certain assumptions,
workings and calculations such as
– Projection for price of the product,
Cost of various resources, capacity
utilization
– Finance Mix with regard to cost of
funds and repayment schedules
– Calculation of parameters such as
Interest coverage ratio, Net Present
value, IRR.
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8. Classification of Cost
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9. By Nature or Element
Material
• Cost of materials used for the manufacture of a product or
order
• Eg: Cloth for making a dress
Labour
• Expenditure borne by employers in order to employ workers.
• Eg: Remuneration, bonuses, ex gratia, training, perquisites etc
Overhead
• Expenses other than Material and Labour
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10. By Controllability
Controllable Costs
• costs which can be influenced by the action of a
specified member of an undertaking.
• The specific member can control the cost
associated with the activity allocated to him
Uncontrollable Cost
• Costs which cannot be influenced by the action
of a specified member of an undertaking.
• Eg: Costs of the administration department
allocated to production division who cannot
control administrative costs.
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11. By Function
Production Cost
• Cost incurred for the sequence of operations which begins with supplying
materials, labour & Overhead and ends with primary packing of the product
Administrative Cost
• The cost of formulating the policy, directing the organization and controlling
the operations of an undertaking
Selling & Distribution Cost
• The cost seeking to create and stimulate demand (sometimes termed
‘marketing’) and of securing orders as well as the cost of distribution
Research & Development Cost
• The cost of researching for new or improved products, new applications of
materials, or improved methods.
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12. By Relation
Direct Cost
• Expenses which are directly
traceable to product
• Eg: Material, Direct Labour
Indirect Cost
• Expenses which are not traceable to
the product
• Eg: Administrative Cost
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13. By Normality
Normal Cost
• Costs Normally incurred at a given
level of output
Abnormal Cost
• Costs Not Normally incurred at a
given level of output
• Eg: Machine Break down, Fire
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14. Accounting for Normal & Abnormal Loss
Normal Loss
• Unavoidable Losses
• Considered in product Cost
• Eg: Evaporation of Chemical
Abnormal Loss
• Loss which occurs for abnormal reasons
• Not considered in product cost
• Eg: Spoilage of chemical
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15. By Variability
Variable Cost
Fixed Cost
Semi-Variable Cost
Step Cost
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16. Variable Cost
These costs tend to vary with the
volume of output. Any increase in
the volume of production results in
an increase in the variable cost and
vice versa.
Example: cost of material, cost of
labour etc.
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17. Fixed Cost
The cost which does not vary but
remains constant within a given
period of time and range of activity
in spite of the fluctuations in
production.
Example: rent, insurance of factory
buildings etc. remain the same for
different levels of production.
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18. Semi Variable Cost
These costs does not vary proportionately
but simultaneously cannot remain
stationery. It can also be called as semi-
fixed cost.
Eg:
1. A Chef may prepare pizzas per day.
However if this limit crosses, another chef
will be required irrespective of the
number of additions.
2. Telephone operators charge a
minimum fee per month along with
additional charges as per usage
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19. Step Costs
Fixed cost can be further classified as follows:
Committed fixed costs: unavoidable in the
short term.
Eg: Rent, Salaries etc,
Discretionary fixed costs :
Set at a fixed amount for specific time periods
by management. This is avoidable at the
discretion.
Eg: Research and development costs,
advertisement & market research expenses
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20. Scenario:
A Shirt manufacturer starts a business and incurs following Costs
Sl. No Particulars Amount
Initial Investment
1 Cost of the Machine Rs. 25,00,000
2 Expected Life of Machine 4 years
Intervening Costs:
1 Material Cost Rs. 200 per shirt
2 Labour Cost Rs. 200 per shirt
3 Rent Rs. 3,00,000 p.a
4 Admin & manager Cost Rs. 4,00,000 p.a
5 Interest Cost Rs. 3,00,000 p.a
6 Depreciation Rs. 6,25,000 p.a
7 Other Overhead Rs. 1,75,000 p.a
8 Selling Cost per Shirt Rs. 1000
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21. Segregation of the costs based on their variability:
Sl. No Particulars Amount Type
1 Material Cost per Shirt Rs. 200 per Shirt Variable
2 Labour Rs. 200 per Shirt Variable
3 Rent Rs. 3,00,000 p.a Fixed
4 Admin & Managerial Cost Rs. 4,00,000 p.a Fixed
5 Interest Rs. 3,00,000 p.a Fixed
6 Depreciation Rs. 6,25,000 p.a Fixed
7 Other Overhead Rs. 1,75,000 p.a Fixed
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22. Contribution
• Excess of Sales revenue over variable cost
– Total Contribution = Total Sales revenue – Total Variable Cost
– Contribution per Unit = Sales price per unit – Variable cost per Unit
• Contribution for the illustrated scenario:
Particulars Amount (Rs.)
Selling Cost Per Shirt 1000
Less: Variable Cost
Material Cost 200
Labour 200
Total Variable Cost per shirt 400
Contribution for sale of one shirt 600
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23. Break Even Point
• It is the point at which there is neither a profit nor a loss to
the entity
• No Profit/ No Loss situation
• Volume of Operations at which total sales turnover is just
equal to total cost.
• Formula:
– Total Fixed Cost / Contribution per Unit
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24. Break Even Point
• For the illustrated scenario:
Particulars Amount (Rs.)
Total Fixed Cost:
Rent 3,00,000
Admin & Managerial Cost 4,00,000
Interest 3,00,000
Depreciation 6,25,000
Other Overheads 1,75,000
Total Fixed Cost 18,00,000
Contribution per Cake 600
Break Even Point (in no of shirts) 3000
Conclusion: After
selling the 3000th shirt
in the year, entity
reaches to no profit/ no
loss situation
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25. Break Even Point
• Demonstration:
Particulars Sales of 2500 shirts
Sales of 3000
shirts
Sales of 3500
shirts
Total Sales (Sale Qty * Rs. 1000) 25,00,000 30,00,000 35,00,000
Less: Variable Cost
Material Cost (Sales Qty * Rs. 200) 5,00,000 6,00,000 7,00,000
Labour Cost (Sales Qty * Rs. 200) 5,00,000 6,00,000 7,00,000
Total Variable Cost 10,00,000 12,00,000 14,00,000
Contribution 15,00,000 18,00,000 21,00,000
Total Fixed Cost 18,00,000 18,00,000 18,00,000
Profit/ (Loss) -3,00,000 Nil 3,00,000
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26. Pricing under Different Market Structures
Pure
Competition
No Pricing
policy of its own
for entity
Has to accept
Prevalent
Market price
Continue to sell
till variable cost
= Sales
Monopoly
Entities can
have Pricing
policy of its own
Can Influence
the price
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27. Methods of Pricing the Finished Goods
Pricing of
Finished
Goods
Variable
Cost
Pricing
Cost
plus
Pricing
Rate of
return
Pricing
Compe
titive
Pricing
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28. Variable Cost / Incremental Pricing
• This pricing model is followed after absorbing all fixed costs
• Only Variable costs are considered in pricing decisions
• Any sale price more than variable cost is accepted
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29. Scenario:
Let us take a scenario shirt manufacture presently selling 5000 shirts p.a.
at Rs. 1,000 per shirt and If he receives order for further 1000 shirts at Rs.
600 per shirt, whether he should accept?
Particulars
At present
level
With the new
order
Sales Turnover 50,00,000 50,00,000
Turnover for New order - 6,00,000
Total Sales Turnover 50,00,000 56,00,000
Less: Variable Cost
Material Cost 10,00,000 12,00,000
Labour 10,00,000 12,00,000
Total Variable Cost 20,00,000 24,00,000
Contribution 30,00,000 32,00,000
Less: Fixed Cost 18,00,000 18,00,000
Profit 12,00,000 14,00,000
Conclusion:
As the Profit of the
entity increases, the
order should be
accepted. After
absorbing all the
fixed costs, any offer
for sale price more
than variable cost
will be accepted
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30. • Cost + Desired Profit
Cost plus Pricing
• Investment + Desired return on investment
Rate of return Pricing
• Submitting bids/ tenders
Competitive Pricing
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31. Pricing Strategies
• Based on Customer
• Based on Product
• Based on Place
• Based on Time
• Skimming
• Penetrating
Geograph
ical
Pricing
Price
Discounts
Market
Entry
Price
Discrimin
ation
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32. Market Entry Strategies
Skimming
• Charging High Price at Introduction
• Eg: Mobile phones
Penetrating
• Charging Low Price at introduction
• Eg: Ola Cabs
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33. Price Discrimination Strategies
Based on Customer
• Same product at different rates to different customers
Based on product
• Slightly Different product charged st very high rate
• No Cost-price relationship
Based on Place
• Price charged based on place
• Eg: Movie Theatre
Based on Time
• Price charged based on time
• Eg: Off-season sales
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34. Return on Investment
Net Present Value
Pay Back Period
IRR
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35. Net Present Value
• Difference between Present Value of Cash inflows and the present
value of Cash outflows
• If the shirt manufacturer borrows initial investment of Rs. 25,00,000 at the interest rate of
15% p.a and estimates each year sales at 5000 shirts then NPV is calculated as follows:
Period Profit
Add:
Depreciation
Cash Inflows
Discounting
factor at 15% p.a
Present
Value
Year 1 12,00,000 6,25,000 18,25,000 0.87 15,86,957
Year 2 12,00,000 6,25,000 18,25,000 0.76 13,79,962
Year 3 12,00,000 6,25,000 18,25,000 0.66 11,99,967
Year 4 12,00,000 6,25,000 18,25,000 0.57 10,43,450
Total Cash Inflows 52,10,336
Initial Investment 25,00,000
Net Present Value 27,10,336
Conclusion: As the NPV of the Project is positive, project is accepted
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36. Internal Rate of Return (IRR)
• Rate at which Value of Cash inflows equal to the investment. This is the actual return given by
the project.
• In the case of shirt manufacturer, Present value of cash flows discounted at 60% equals the
initial investment. So, IRR of this project is 60%.
• Implications of IRR
Scenario Decision
If IRR > Cost of Capital Accept the Project
If IRR <= Cost of Capital Reject the Project
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37. Pay Back Period
• Period by which initial investment in a project gets recovered.
• In the present case of shirt manufacturer, the initial investment of Rs. 25 lakhs will be
recovered in 1 year 10 months. So Payback period is 1 year 10 months.
• Implications of Payback Period
Scenario Decision
If Payback Period >= Project
Duration
Reject the Project
If Payback Period < Project
Duration
Accept the Project
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38. Sales is Sanity
Profit is Vanity
Cost is Calamity
Cash is Rich
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39. Contact Us:
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