What is Cost concept and segregation?
Cost concept and segregation
Concept of cost
The term "cost" has a variety of interpretations in common use. In ordinary languages, it may mean price. The Oxford dictionary defines "cost" as the price for something. But in cost accounting, it is considered different from price.
In cost accounting cost is the amount of resources given up in exchange for some goods or services. The resources given up are generally in terms of money or if not in term of money they are always expressed in monetary units. It consists of all the expenses incurred in producing a commodity or executing a contract. It signifies an expenditure or monetary outlay to secure some benefit.
The term 'cost' itself has no significant meaning, therefore, it is always used with an adjective or phrase that covers the meaning interred, such as prime, direct, indirect, fixed variable, controllable,oppertinity, differential, marginal, replacement and the like. Such description implies a certain characteristic, which is important in computing, measuring and analyzing the cost.
According to The institute of cost and management Accountants (ICMA), London, "cost can be defined as the amount of expenditure (actual or notional) incurred on or attributable to a given thing."
According to Horngren, sundem and Stratton, "cost may be defined as the sacrifice or giving up resources for a particular purpose. Cost is frequently measured by monetary units that must be paid for goods and services."
From the above definitions, it is clear that cost is the expenditures or sacrifice made for goods or services.
Items relating to cost concepts
Some of the terms relating to the cost concepts are mentioned below:
Expenses
When the cost is recognized and recorded after the benefit has been obtained, it Is called expenses. To find out net income, it appears in the profit and loss account or income statement a given period as deduction. It is matched against the revenues to calculate the profit or loss of a certain period. It represents sacrifice or resources for an economic benefit.
Expenses are properly deducted from revenues. Therefore, expenses are also known as expired costs and are incurred and totally used up in generation of revenue. Examples of expired costs are cost of goods sold expense, selling and administrative expenses. Expenses need not necessarily have to be paid in cash immediately; even a promise to pay could be made for the benefits obtained. The cost that cannot be deducted from revenue in an expense not a cost.
Loss
If benefits are derived from an expired cost, it is called a profit. Its just reverse, if no benefit is received from the cost incurred or if there is no benefit accrued, the cost becomes a lost cost or loss. If allows refers to the amount of difference between the expenses and revenues i.e., when expenses exceed revenues for an accounting period. A loss is related to the net effect of an unfavorable transaction, event or situation not arising from a normal business activity. If it can be established that there is no matching economic benefit for cost, it is known as loss. If can also be said that, loss represent reduction in ownership equity other than from withdrawal of capital for which no compensating value is received e.g., destruction of property by fire.
Cost center
Cost center is a location, person or item of equipment for which cost may be ascertained and used for the purpose of cost control. ICMA defines cost center as "a production or service, function, activity or item of equipment whose costs may be attributed to cost units. A cost center is the smallest organization sub-unit for which separate cost allocation is attempted." from function point of view, a cot center may be relatively easy to establish because a cost center is any unit of the organization to which costs can be separately attributed. A cost center is an individual activity department, a machine or group of machines within a department or a work group is considered as cost center.
Profit center
A profit centre is any sub-unit of an organization to which both revenues and costs are assigned, so that the responsibility of a sub-unit may be measured. Profit centre is a segment of the business entity by which both revenues received and expenditures incurred are controlled, such revenues and expenditures being used to revalued segment performance. In profit center. Both input and output are capable of management in financial in financial terms and it provide more effective easement of the manager's performance since both and revenues are measured in monetary terms.
Cost unit
A cost unit Is a unit of product or unit of services tow which costs are ascertained by 'means of allocation, apartment and absorption. Chartered institute of management accountants (CIMA), London defines cost unit as "a quantitative unit of product or service in relation to which costs are ascertained." It is a unit of quantity of product, service or time or a combination of these in relation to which costs are expressed or ascertained. For example, specific job, contract, unit of product like fabrication job, road constrain contract, an automobile truck, a table, 1000 bricks etc.
A profit centre is any sub-unit of an organization to which both revenues and costs are assigned, so that the responsibility of a sub-unit may be measured. Profit centre is a segment of the business entity by which both revenues received and expenditures incurred are controlled, such revenues and expenditures being used to revalued segment performance. In profit center. Both input and output are capable of management in financial in financial terms and it provide more effective easement of the manager's performance since both and revenues are measured in monetary terms.
Cost unit
A cost unit Is a unit of product or unit of services tow which costs are ascertained by 'means of allocation, apartment and absorption. Chartered institute of management accountants (CIMA), London defines cost unit as "a quantitative unit of product or service in relation to which costs are ascertained." It is a unit of quantity of product, service or time or a combination of these in relation to which costs are expressed or ascertained. For example, specific job, contract, unit of product like fabrication job, road constrain contract, an automobile truck, a table, 1000 bricks etc.
Cost driver
A cost driver is any factor that influences costs. A change in the cost driver will lead to a change in the total cost of a related cost object. Examples of cost drivers are; number of advertisements, number of sales personal, number of products produced etc. any change made in any of the driver's causes a change in the total cost. It is for the management to see whether any change in any cost driver is to made or not keeping in view cost benefit analysis of the change in the cost driver.
Importance of cost
It has already been said that the term cost refers to the monetary value of an effort or a resource. It is the value of money that is used to create something's. It is an important element in data's business world, therefore, if has the following importance:
1. Preparation of business plan: a business plan provides the direction for the business and cost is an importance element for it. Without cost, a business plan incomplete.
2. Achievement of business goal: the main objective of every business concern is to maximize profit. In this regard, cost helps to achieve this objective, because minimizing the cost; a business can maximize its profit.
3. Helps in competition: by putting pressure on selling price, cost helps to capture the market of cost conscious customers.
4. Fixation of selling price: selling price is the sum of cost and desirable profit. Therefore, it helps to determine the selling price of the product.
5. Evaluation of performance: performance of the business is generally evaluated on the basis of profitability and without cost, profitability cannot be measure. Therefore, performance of the business of the business can be judged on the basis of cost too.
Costing methods
Over many years, various cost accounting methods have evolved to record the manufacturing costs to suit particular industries, and it is the need for the organization to establish a suitable cost accounting system for their business to facilitate the recording and collection of costs, allocation, apportionment and absorption into products and services, analysis and control or, costs etc. the costing method are broadly categorized into two.
1. Specific order costing
2. Continuous operation costing
Specific order costing
Specific order costing method are used by business organization, which involve making/ assembling/constructing jobs or products to individual customer's specific orders. CIMA defines specific order costing as "the basic costing method applicable where the work consists of separate contracts, job or batches, each of which is authorized by a special or contract." The specific order costing is further classified into (i) job costing, (ii) contract costing and (iii) batch costing.
Job costing
Where productions is not highly respective and, in addition, consist of distinct jobs or lots so that material and labour costs can be identified by order number, the system of job costing used. This method of costing is very common in commercial foundation and in plants making specialized industrial equipments. In all these cases an accounts is opened for each job and all appropriate expenditures is charged thereto.
Contract costing
Contract costing does not in principle different from job costing. A contract is a big job while a job is a small contract. The term is usually applied where at different sites large-scale contracts are carried out. In case of ship-building contractors etc., this system of costing is used. Job or contract costing is also termed as "terminal costing".
Batch costing
Where orders or jobs are arranged in different batches after taking into account the convenience of producing articles, batch costing is employed. Thus, in this method, the cost of a group of products is ascertained. The unit of costs is a batch of group of identical products, instead of single job or contract. The method is particularly suitable for general engineering factories, which product component in convenient economic batches and pharmaceutical industries.
Continues operation costing
When organizational involve in mass production of products not the specific requirement of the customers and sell their products from their sticks, then such organizations use continuous operating costing. ICMA defines continuous operation costing as "the basic costing method applicable hewer goods or services result from a series of continuous or representative operations or processes to which costs are charged before being averaged over the unit produced during the period.'
The important feature of continuous operation costing is that, the process involves in production of identical units of output and total costs are divided by number of units produced to give the average cost per unit. The continuous operation costing is calcified into:
• Process costing
• Operation costing
• Output costing, and
• Service costing.
Process costing
If a product passes through different stages, each distinct and well defined and it desired to know te cost of production at each stage, them it is called process costing. In other words, process costing is employed under which separate account is opened for each process. The system of costing is suitable for the attractive industries, e.g., chemical manufacture, paints, foods, explosives, soap making etc.
Operation costing
Operation costing is a further refinement of process costing. The system is employed in industries where mass or respective production is carried out or hewer articles or components have to be stocked in semi-finished stage, to facilitate the execution of special orders, or for convenience of issue or later operations. The procedure of costing in broadly the same as for process costing except that cost unit is an operation instead of a process. For example, the manufacturing of handles for bicycles involves a number of operations such as those of cutting steel sheets into proper strips, moldings, machining and finally polishing. The cost of each one of these operations may be found out separately.
Output costing
In this method cost per unit of output or production is ascertained and the amount of each element constituting such cost is determined. Where the products can be expressed in identical quantitative units and where manufacture is continuous, this type of costing is applied. Cost statements or cost sheets are prepared under which the various items of expenses are classified and thee total expenditure is divided by total quanlitity produced in order to arrive at per unit cost of production. The method is suitable in industries such as brick making, collieries, flourmills paper mills, and cement manufacturing etc. it is called units or single costing.
Service costing
The systems is employed where expense are incurred for provision of services such as those rendered by transport companies, electricity companies, hospitals etc. the total expenses regarding operation are divided by the units as may be appropriate and cost per unit or service is calculated.
Costing techniques
The costing techniques are categorized into adsorption costing, direct costing/marginal costing, standard costing and Activity based costing.
Absorption costing
The practice of changing all costs both variable and fixed to operations, products or processes is termed as absorption costing. The institute of Cost and works accountants of India defines absorption costing as "a method of costing by which all direct costs and applicable overheads are charged to products or cost center for finding out the total cost of of production. Absorbed cost included production cost as well a administrative another costs."
Marginal/ direct costing
The practice of charging all direct costs to operation, process or products, leaving all indirect costs to be written off against profit in the period in which they arise, is termed as direct costing.
It is a techniques of costing in which allocation of expenditures to production is restricted to those expenses, which arise as a result of production i.e. direct material, direct labor, direct expenses and variable overheads. Fixed overheads are excluded on the ground that in case where production various, the includision of fixed overhead may gives misleading results. This technique is useful in manufacturing industrities with varying levels of output.
Standard costing
Standard costing is a system which the cost of the product is ascertained in advance on the basis of certain pre-determined standards. Taking the above example, the cost of product can be calculated in advance if one is in a position to estimate in advance the materials, labor, and overhead costs that should be incurred over the product. All this requires an efficient system of cost accounting. However, this system will not be useful if a vigorous system of controlling cost and keeping it up to standard cost is not in force. Standard costing in becoming mere and popular now days.
Activity based costing
It is a recent techniques bestially used for apportionment of overhead costs in an organization having products that differ in volume and complexity of production. Under this technique, the overhead costs of the organization are indentified with each activity, which is acting as the cost driver i.e. the cause of incurrence of overheads cost. Such cost drivers may be purchase orders quality inspections, maintained request, material receipts, inventory movements, power consumed, machine hour etc. having identified the overhead costs with each cost center, cost per unit of cost driver can be ascertained. The overhead costs can now be assigned to jobs on the basis of the number of activities required for their completion.
Classification of costs
The way of groping the costs on the basis of some common characteristic and nature is called classification of cost. There are different costs for different purposed and no single cost concept is relevant in all situations. Therefore, costs can be classified on the following bases:
• On the basis of element of cost
• On the basis of functions
• On the basis of behavior
• On the basis of decision-making
• On the basis of controllability
On the basis of element of cost
On the basis of element, cost can be divided into material, labor and expenses. They have been mentioned in details in the following.
a. Materials: materials are needed to produce goods or provide services. Material can be classified into detail in the following.
• Direct material: means the materials which form part of finished output and can be indentified with the finished product easily. For example; wood, plywood, adhesive, wood polish, nails etc. in case of manufacturing furniture, cost of cotton in case of manufacturing cotton yarn, cost of yarn in case of manufacturing cloth, cost of iron in case of manufacturing machinery etc. the main future of direct materials is that these enter into and form part of the finished product.
• Indirect material cost: refers to the material costs, which cannot be allocated but can be apportioned to or absorbed by cost centers or cost units. There are the materials, which cannot be traced as part of the product, and there is distributed among the various cost center or cost units on some equitable basis.
b. Labour: labour is needed to convert the raw materials into finished products. it is also needed to supply the goods in the hand of ultimate consumer. It can further be divided into two types as given below:
• Direct labour: is the workforce, which is directly involved on production. It refers to labour cost, which can be identified with and allocated to cost units. It includes two remuneration paid for converting the raw material into finished products or for altering the conduction, composition or condition of the product manufactured by an undertaking. For example, wages paid for spinning yarm is case of spinning mills, wages paid for waving cloth in case of cloth mills, wages paid to a mason for construction of a building by a building contractor etc.
• Indirect labor cost: refers to the labour cost or wages, which cannot be allocated but can be apportioned to or absorption by cost centers or cost units. For example, salary paid to factory manager, salary paid to factory supervisor or foremen, salary paid to general manager or sales manager etc.
c. Other expenses: the expenses which are needed in course of production and distribution except material and labour fall into this category. They can be divided into types as mentioned below:
• Direct expenses: these costs are also called chargeable expenses. They are the expenses other than direct material and direct labour cost, and be indentified with and allocated to cost enters or cost units. Direct expenses are those which are incurred for each unit of manufacture specifically and identifiable with them. For example, royalties paid on the basis of output, hire changes of special plant or machinery, carriage and freight on direct material purchases, import duty and octopi paid on the purchases of imported direct materials, amount payable to such-contractor etc.
• Indirect expenses: refer to the expenses, which cannot be allocated but can be apportioned to or absorbed by cost centers or cost units. For example, rent rates taxes and insurance of factory building, factory lighting, repairs to factory building depreciation to plant and machinery, repairs to machinery, depreciation and insurance of office building, depreciation and insurance of showroom building etc. are known as indirect expenses.
Differences between direct and indirect cost
Direct costs are those which are directly involved in the press of manufacturing goods or providing services and become the part of output whereas indirect costs do not become the part of output. Direct costs are the part of prime costs and indirect costs are the part of overhead. Such differences between these costs are given below:
On the basis of functions
Based on the functions, the costs can be classified into production cost, administration cost, selling and distribution cost, and research and development cost.
a. Production cost: it included all direct materials, direct labour, direct expenses and manufacturing expenses. It refers to costs concerned with manufacturing activity, which starts with supply of material and ends with primary packing of the product.
b. Administration cost: it is incurred for carrying the administrative function of the organization i.e., cost of policy formulation and its implementation to attain the objective of the organization. T should not be related to research, development, production, and distribution or selling activiitity. It is also called office cost.
c. Selling and distributions cost: the selling cost refers to the cost of selling functions I.e., the cost of activities relating to create and stimulate demand for company's products and to secure orders. The distribution costs are incurred to make goods available to the customers. These costs incurred the cost of maintaining and creating demand of product, making the goods available in the hands of customer.
d. Research and development costs: the research cost is the cost of searching for new products, new manufacturing process, improvement of exiting products, processes or equipment and the development cost is the cost of putting research result on commercial basis.
On the basis of Behavior
On the basis of the behavior in relations to charges in the volume of activity, costs may be classified as, fixed costs, variable costs and semi-variable cost.
a. Fixed cost: the costs, whose total amount remains constant, up to an certain capacity is called fixed cost. The level of production changes, but total amount of fixed cost remains constant. Fixed cost is also called capacity cost, periodic cost, standing cost and burden cost. If the level of production increase then per unit cost decrease and vice-versa, but total amount of fixed cost remain constant. These costs remain fixed in total but their per units cost charges with changes in output or sales. The per unit fixed cost increase with decrease in output and vice versa. Rent depreciation and salary of permanent staff are the examples of fixed cost.
Features of fixed cost
i. The amount of fixed cost is never zero, even though the production is zero.
ii. The amount of fixed costs is constant up to a certain range.
iii. Per unit fixed cost changes in opposite direction of production activity.
iv. Fixed costs are either capacity costs or periodic costs or the committed costs.
v. Fixed cost cannot be controlled in a short-term period.
vi. Generally, fixed costs are unavoidable and uncontrollable costs.
b. Variable cost: the costs that change proportionately with the changes in output are known as variable costs. An increase in the volume means a proportionate increase in the total variable costs and decrease in the volume will lead to a proportionate decline in the total variable costs. There is a liner relationship between volume and variable costs. The per unit variable cost is always constant.
Feature of variable cost
i. Per unit variable cost remains constant.
ii. When the production is zero, then the total amount of variable cost is also zero, but per unit variable cost will never be zero.
iii. Total amount of variable cost charges according to changes in the level of production.
iv. Variable cost is a controllable cost.
c. Semi-variable cost: the costs which are neither perfectly variable nor absolutely fixed in relation to changes in volume are called semi-variable costs. Neither total amount nor per unit cost of semi-variable cost remains constant. If levels of production increase the total amount of semi-variable cost also increase and per unit cost decrease but not proportionately. These costs have the characteristics os both fixed and variable costs. Electricity telephone changes, water supply charges are the examples of semi-variable costs. They are called mixed costs, combined costs or semi-fixed costs.
Feature of semi-variable cost
i. Neither total amount nor per unit cost remains constant.
ii. Semi-variable cost can never be zero.
iii. When the level of production increase the total amount of semi-variable cost also increase but per semi-variable cost decreases and vice-versa.
On the basis of decision-making
For decision-making purpose, cost can be classified as follows:
a. Relevant and irrelevant cost: relevant costs are those costs which are afforested by the action and decision of management. If management changes the decision, these costs will also change. On the other, the costs which are not affected by the action and decision of the management are irrelevant costs. Irrelevant costs are ignored in decision-making. The examples of such costs are given in the following table.
b. Avoidable and unavoidable cost: avoidable costs are those costs that can be reduced or avoided by avoided a new alternative whereas unavoidable costs cannot be asterisked. Therefore, only avoidable cost irrelevant for decision-making purposes. For example, if a restaurant Terrie to take out certain item from the menu, the direct material and other expenses can be avoidable but the salary of the cook cannot be reduced. Therefore, the cost of direct material is avoidable cost whereas, the salary is unavoidable cost.
c. Opportunity cost: the sacrifice of benefit due to the selection of new alternative is called an opportunity cost.
d. Marginal cost: marginal cost is the additional cost to produce extra units of output.
e. Differential cost: a difference in cost between any two alternative is known as differential cost. It may be incremental or decremented. Differential costs are relevant for decision-making. Incremental costs are increase in cost due to change in decision whereas detrimental costs are reduction in cost.
On the basis of controllability
An effective cost control requires knowledge of cost controllability. Controllability may be defines in term of changes or alternatives of costs.
a. Controllable cost: the cost subject to control or substantial influence of a particular manner or individual is called controlled costs. The cost that can be changes or alternative by the action of a specific manager is treated as controllable costs.
b. Uncontrollable cost: cost that is not subject to influence by the action of manager is called uncontrollable costs. These costs remain unchanged.
Segregation of cost
Meaning and need of segregation of cost
The process of separating the semi variable costs into variable and fixed cost is known as segregation of semi variable cost. The reasons for the segregation of the semi variable cost are mentioned below.
• Segregation helps to calculate the selling price of the extra output. The cost does not increase with the extra output and the selling price is the total variable costs plus profit if any.
• It also helps to control the variable cost. The semi variable cost should be segregated to variable and fixed component since the fixed cost cannot be controlled.
• It aids the management in decision making. Since most of the managerial decisions are based on marginal costing, it is necessary to separate the semi variable costs into fixed and variable parts.
Method of segregating cost
Costs can be segregated in two ways:
1. High-low point method (two point method)
2. Least-square method
High-low point method (two pint method)
To separate fixed and variable costs, this method compares the highest and lowest activity level or volume and their costs. The variable cost rate is obtained by dividing the difference in costs by the difference in the high and low level of activity or volume. This method is also called two point methods since the segregation of mixed costs under it is based on two points of unit and costs. Here the units represent units of output, labour hours and machine hours. The fixed cost is calculated by subtracting the total variable cost from the total cost at any level of activity.
a. First step: two different levels of output along with their total costs are selected. It better to select the higher and lower range.
b. Second step: the difference in cost divided by the difference in output to calculate the variable cost per unit.
Variable cost per unit (b) = high cost –low cost/ high output or unit – low output or unit
c. Third step; after calculating the variable cost per unit, the following formula is used calculated the total fixed cost.
Fixed cost = total mixed cost – variable cost per unit x output units
d. Final step: after calculation the variable cost per unit and total fixed cost, the cost at any level of output can be calculated using the following cost equation.
Total cost = total fixed cost + total variable cost
Least-square method
Least square method is also known as simple statistical analysis. It is a sophisticated technique of segregating fixed and variable elements of a semi-variable cost. It established a mathematical relationship between costs and volume and costs being dependent upon volume. The least square principle determines a regression ebullition by minimizing the sum of the vertical distances between the actual values and the predicted values. Under this method, the mixed cost are separated into variable and fixed costs by following the below mentioned process.
a. First step: a table is prepared by denoting the independent variables such as output unit, working hours, service period by x and the total mixed cost by y.
b. Second step: the variable cost per unit is calculated using the following formula.
Variable cost per unit (B) = NEXY – EX. EY/ NEX2 – (EX) 2
c. Third step: after calculating variable cost per unit, the following formula is used to ascertain the fixed cost.
Fixed cost (a) = EY – bEX/ N
d. Final step: after calculating the variable cost per unit and fixed cost, the following equation is used to calculate the total cost at any level of output.
Least square Equation of Total cost (Y) on Output (X):Y = a+bX
Selection of suitable method
As mentioned earlier, there are two methods of segregating the mixed cost into variable and fixed. They are high and low cost method and least square method. The former is simple whereas the late seems a bit more complex.
Thee segregation of a particular cost motional in different levels of output should be made using high and low cost method. However, if the variable cost per and fixed cost tend to different in different level of output, the least square method should be used.
Estimation of cost
Cost estimation is the process of pre-determining the costs of a certain product, job or order. Such pre-determination may be required for several purposes such as budgeting, measurement of performance efficiencies, preparation of financial statements (valuation of stocks) make or buy decision fixation of the selling price of products etc. cost ascertainments is the process of determining costs on the basis of actual data. Hence, computation of historical costs is cost ascertainment while computation of future cost is cost
estimation. Cost estimation as well as cost ascertainment both are inter-related and are of immersed use to the management. In case of a concern, that has a sound costing system, the ascertained costs will greatly help the managements in the process of estimation of rational accurate costs, which are so necessary for a variety of purpose stated above.
When organizational involve in mass production of products not the specific requirement of the customers and sell their products from their sticks, then such organizations use continuous operating costing. ICMA defines continuous operation costing as "the basic costing method applicable hewer goods or services result from a series of continuous or representative operations or processes to which costs are charged before being averaged over the unit produced during the period.'
The important feature of continuous operation costing is that, the process involves in production of identical units of output and total costs are divided by number of units produced to give the average cost per unit. The continuous operation costing is calcified into:
• Process costing
• Operation costing
• Output costing, and
• Service costing.
Process costing
If a product passes through different stages, each distinct and well defined and it desired to know te cost of production at each stage, them it is called process costing. In other words, process costing is employed under which separate account is opened for each process. The system of costing is suitable for the attractive industries, e.g., chemical manufacture, paints, foods, explosives, soap making etc.
Operation costing
Operation costing is a further refinement of process costing. The system is employed in industries where mass or respective production is carried out or hewer articles or components have to be stocked in semi-finished stage, to facilitate the execution of special orders, or for convenience of issue or later operations. The procedure of costing in broadly the same as for process costing except that cost unit is an operation instead of a process. For example, the manufacturing of handles for bicycles involves a number of operations such as those of cutting steel sheets into proper strips, moldings, machining and finally polishing. The cost of each one of these operations may be found out separately.
Output costing
In this method cost per unit of output or production is ascertained and the amount of each element constituting such cost is determined. Where the products can be expressed in identical quantitative units and where manufacture is continuous, this type of costing is applied. Cost statements or cost sheets are prepared under which the various items of expenses are classified and thee total expenditure is divided by total quanlitity produced in order to arrive at per unit cost of production. The method is suitable in industries such as brick making, collieries, flourmills paper mills, and cement manufacturing etc. it is called units or single costing.
Service costing
The systems is employed where expense are incurred for provision of services such as those rendered by transport companies, electricity companies, hospitals etc. the total expenses regarding operation are divided by the units as may be appropriate and cost per unit or service is calculated.
Costing techniques
The costing techniques are categorized into adsorption costing, direct costing/marginal costing, standard costing and Activity based costing.
Absorption costing
The practice of changing all costs both variable and fixed to operations, products or processes is termed as absorption costing. The institute of Cost and works accountants of India defines absorption costing as "a method of costing by which all direct costs and applicable overheads are charged to products or cost center for finding out the total cost of of production. Absorbed cost included production cost as well a administrative another costs."
Marginal/ direct costing
The practice of charging all direct costs to operation, process or products, leaving all indirect costs to be written off against profit in the period in which they arise, is termed as direct costing.
It is a techniques of costing in which allocation of expenditures to production is restricted to those expenses, which arise as a result of production i.e. direct material, direct labor, direct expenses and variable overheads. Fixed overheads are excluded on the ground that in case where production various, the includision of fixed overhead may gives misleading results. This technique is useful in manufacturing industrities with varying levels of output.
Standard costing
Standard costing is a system which the cost of the product is ascertained in advance on the basis of certain pre-determined standards. Taking the above example, the cost of product can be calculated in advance if one is in a position to estimate in advance the materials, labor, and overhead costs that should be incurred over the product. All this requires an efficient system of cost accounting. However, this system will not be useful if a vigorous system of controlling cost and keeping it up to standard cost is not in force. Standard costing in becoming mere and popular now days.
Activity based costing
It is a recent techniques bestially used for apportionment of overhead costs in an organization having products that differ in volume and complexity of production. Under this technique, the overhead costs of the organization are indentified with each activity, which is acting as the cost driver i.e. the cause of incurrence of overheads cost. Such cost drivers may be purchase orders quality inspections, maintained request, material receipts, inventory movements, power consumed, machine hour etc. having identified the overhead costs with each cost center, cost per unit of cost driver can be ascertained. The overhead costs can now be assigned to jobs on the basis of the number of activities required for their completion.
Classification of costs
The way of groping the costs on the basis of some common characteristic and nature is called classification of cost. There are different costs for different purposed and no single cost concept is relevant in all situations. Therefore, costs can be classified on the following bases:
• On the basis of element of cost
• On the basis of functions
• On the basis of behavior
• On the basis of decision-making
• On the basis of controllability
On the basis of element of cost
On the basis of element, cost can be divided into material, labor and expenses. They have been mentioned in details in the following.
a. Materials: materials are needed to produce goods or provide services. Material can be classified into detail in the following.
• Direct material: means the materials which form part of finished output and can be indentified with the finished product easily. For example; wood, plywood, adhesive, wood polish, nails etc. in case of manufacturing furniture, cost of cotton in case of manufacturing cotton yarn, cost of yarn in case of manufacturing cloth, cost of iron in case of manufacturing machinery etc. the main future of direct materials is that these enter into and form part of the finished product.
• Indirect material cost: refers to the material costs, which cannot be allocated but can be apportioned to or absorbed by cost centers or cost units. There are the materials, which cannot be traced as part of the product, and there is distributed among the various cost center or cost units on some equitable basis.
b. Labour: labour is needed to convert the raw materials into finished products. it is also needed to supply the goods in the hand of ultimate consumer. It can further be divided into two types as given below:
• Direct labour: is the workforce, which is directly involved on production. It refers to labour cost, which can be identified with and allocated to cost units. It includes two remuneration paid for converting the raw material into finished products or for altering the conduction, composition or condition of the product manufactured by an undertaking. For example, wages paid for spinning yarm is case of spinning mills, wages paid for waving cloth in case of cloth mills, wages paid to a mason for construction of a building by a building contractor etc.
• Indirect labor cost: refers to the labour cost or wages, which cannot be allocated but can be apportioned to or absorption by cost centers or cost units. For example, salary paid to factory manager, salary paid to factory supervisor or foremen, salary paid to general manager or sales manager etc.
c. Other expenses: the expenses which are needed in course of production and distribution except material and labour fall into this category. They can be divided into types as mentioned below:
• Direct expenses: these costs are also called chargeable expenses. They are the expenses other than direct material and direct labour cost, and be indentified with and allocated to cost enters or cost units. Direct expenses are those which are incurred for each unit of manufacture specifically and identifiable with them. For example, royalties paid on the basis of output, hire changes of special plant or machinery, carriage and freight on direct material purchases, import duty and octopi paid on the purchases of imported direct materials, amount payable to such-contractor etc.
• Indirect expenses: refer to the expenses, which cannot be allocated but can be apportioned to or absorbed by cost centers or cost units. For example, rent rates taxes and insurance of factory building, factory lighting, repairs to factory building depreciation to plant and machinery, repairs to machinery, depreciation and insurance of office building, depreciation and insurance of showroom building etc. are known as indirect expenses.
Differences between direct and indirect cost
Direct costs are those which are directly involved in the press of manufacturing goods or providing services and become the part of output whereas indirect costs do not become the part of output. Direct costs are the part of prime costs and indirect costs are the part of overhead. Such differences between these costs are given below:
On the basis of functions
Based on the functions, the costs can be classified into production cost, administration cost, selling and distribution cost, and research and development cost.
a. Production cost: it included all direct materials, direct labour, direct expenses and manufacturing expenses. It refers to costs concerned with manufacturing activity, which starts with supply of material and ends with primary packing of the product.
b. Administration cost: it is incurred for carrying the administrative function of the organization i.e., cost of policy formulation and its implementation to attain the objective of the organization. T should not be related to research, development, production, and distribution or selling activiitity. It is also called office cost.
c. Selling and distributions cost: the selling cost refers to the cost of selling functions I.e., the cost of activities relating to create and stimulate demand for company's products and to secure orders. The distribution costs are incurred to make goods available to the customers. These costs incurred the cost of maintaining and creating demand of product, making the goods available in the hands of customer.
d. Research and development costs: the research cost is the cost of searching for new products, new manufacturing process, improvement of exiting products, processes or equipment and the development cost is the cost of putting research result on commercial basis.
On the basis of Behavior
On the basis of the behavior in relations to charges in the volume of activity, costs may be classified as, fixed costs, variable costs and semi-variable cost.
a. Fixed cost: the costs, whose total amount remains constant, up to an certain capacity is called fixed cost. The level of production changes, but total amount of fixed cost remains constant. Fixed cost is also called capacity cost, periodic cost, standing cost and burden cost. If the level of production increase then per unit cost decrease and vice-versa, but total amount of fixed cost remain constant. These costs remain fixed in total but their per units cost charges with changes in output or sales. The per unit fixed cost increase with decrease in output and vice versa. Rent depreciation and salary of permanent staff are the examples of fixed cost.
Features of fixed cost
i. The amount of fixed cost is never zero, even though the production is zero.
ii. The amount of fixed costs is constant up to a certain range.
iii. Per unit fixed cost changes in opposite direction of production activity.
iv. Fixed costs are either capacity costs or periodic costs or the committed costs.
v. Fixed cost cannot be controlled in a short-term period.
vi. Generally, fixed costs are unavoidable and uncontrollable costs.
b. Variable cost: the costs that change proportionately with the changes in output are known as variable costs. An increase in the volume means a proportionate increase in the total variable costs and decrease in the volume will lead to a proportionate decline in the total variable costs. There is a liner relationship between volume and variable costs. The per unit variable cost is always constant.
Feature of variable cost
i. Per unit variable cost remains constant.
ii. When the production is zero, then the total amount of variable cost is also zero, but per unit variable cost will never be zero.
iii. Total amount of variable cost charges according to changes in the level of production.
iv. Variable cost is a controllable cost.
Differences between variable and fixed cost
c. Semi-variable cost: the costs which are neither perfectly variable nor absolutely fixed in relation to changes in volume are called semi-variable costs. Neither total amount nor per unit cost of semi-variable cost remains constant. If levels of production increase the total amount of semi-variable cost also increase and per unit cost decrease but not proportionately. These costs have the characteristics os both fixed and variable costs. Electricity telephone changes, water supply charges are the examples of semi-variable costs. They are called mixed costs, combined costs or semi-fixed costs.
Feature of semi-variable cost
i. Neither total amount nor per unit cost remains constant.
ii. Semi-variable cost can never be zero.
iii. When the level of production increase the total amount of semi-variable cost also increase but per semi-variable cost decreases and vice-versa.
For decision-making purpose, cost can be classified as follows:
a. Relevant and irrelevant cost: relevant costs are those costs which are afforested by the action and decision of management. If management changes the decision, these costs will also change. On the other, the costs which are not affected by the action and decision of the management are irrelevant costs. Irrelevant costs are ignored in decision-making. The examples of such costs are given in the following table.
c. Opportunity cost: the sacrifice of benefit due to the selection of new alternative is called an opportunity cost.
d. Marginal cost: marginal cost is the additional cost to produce extra units of output.
e. Differential cost: a difference in cost between any two alternative is known as differential cost. It may be incremental or decremented. Differential costs are relevant for decision-making. Incremental costs are increase in cost due to change in decision whereas detrimental costs are reduction in cost.
On the basis of controllability
An effective cost control requires knowledge of cost controllability. Controllability may be defines in term of changes or alternatives of costs.
a. Controllable cost: the cost subject to control or substantial influence of a particular manner or individual is called controlled costs. The cost that can be changes or alternative by the action of a specific manager is treated as controllable costs.
b. Uncontrollable cost: cost that is not subject to influence by the action of manager is called uncontrollable costs. These costs remain unchanged.
Segregation of cost
Meaning and need of segregation of cost
The process of separating the semi variable costs into variable and fixed cost is known as segregation of semi variable cost. The reasons for the segregation of the semi variable cost are mentioned below.
• Segregation helps to calculate the selling price of the extra output. The cost does not increase with the extra output and the selling price is the total variable costs plus profit if any.
• It also helps to control the variable cost. The semi variable cost should be segregated to variable and fixed component since the fixed cost cannot be controlled.
• It aids the management in decision making. Since most of the managerial decisions are based on marginal costing, it is necessary to separate the semi variable costs into fixed and variable parts.
Method of segregating cost
Costs can be segregated in two ways:
1. High-low point method (two point method)
2. Least-square method
High-low point method (two pint method)
To separate fixed and variable costs, this method compares the highest and lowest activity level or volume and their costs. The variable cost rate is obtained by dividing the difference in costs by the difference in the high and low level of activity or volume. This method is also called two point methods since the segregation of mixed costs under it is based on two points of unit and costs. Here the units represent units of output, labour hours and machine hours. The fixed cost is calculated by subtracting the total variable cost from the total cost at any level of activity.
a. First step: two different levels of output along with their total costs are selected. It better to select the higher and lower range.
b. Second step: the difference in cost divided by the difference in output to calculate the variable cost per unit.
Variable cost per unit (b) = high cost –low cost/ high output or unit – low output or unit
c. Third step; after calculating the variable cost per unit, the following formula is used calculated the total fixed cost.
Fixed cost = total mixed cost – variable cost per unit x output units
d. Final step: after calculation the variable cost per unit and total fixed cost, the cost at any level of output can be calculated using the following cost equation.
Total cost = total fixed cost + total variable cost
Least-square method
Least square method is also known as simple statistical analysis. It is a sophisticated technique of segregating fixed and variable elements of a semi-variable cost. It established a mathematical relationship between costs and volume and costs being dependent upon volume. The least square principle determines a regression ebullition by minimizing the sum of the vertical distances between the actual values and the predicted values. Under this method, the mixed cost are separated into variable and fixed costs by following the below mentioned process.
a. First step: a table is prepared by denoting the independent variables such as output unit, working hours, service period by x and the total mixed cost by y.
Variable cost per unit (B) = NEXY – EX. EY/ NEX2 – (EX) 2
c. Third step: after calculating variable cost per unit, the following formula is used to ascertain the fixed cost.
Fixed cost (a) = EY – bEX/ N
d. Final step: after calculating the variable cost per unit and fixed cost, the following equation is used to calculate the total cost at any level of output.
Least square Equation of Total cost (Y) on Output (X):Y = a+bX
Selection of suitable method
As mentioned earlier, there are two methods of segregating the mixed cost into variable and fixed. They are high and low cost method and least square method. The former is simple whereas the late seems a bit more complex.
Thee segregation of a particular cost motional in different levels of output should be made using high and low cost method. However, if the variable cost per and fixed cost tend to different in different level of output, the least square method should be used.
Estimation of cost
Cost estimation is the process of pre-determining the costs of a certain product, job or order. Such pre-determination may be required for several purposes such as budgeting, measurement of performance efficiencies, preparation of financial statements (valuation of stocks) make or buy decision fixation of the selling price of products etc. cost ascertainments is the process of determining costs on the basis of actual data. Hence, computation of historical costs is cost ascertainment while computation of future cost is cost
estimation. Cost estimation as well as cost ascertainment both are inter-related and are of immersed use to the management. In case of a concern, that has a sound costing system, the ascertained costs will greatly help the managements in the process of estimation of rational accurate costs, which are so necessary for a variety of purpose stated above.
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