Classification of Costs

1] Classification by Nature

This is the analytical classification of costs. Let us divide as per their

natures. So basically there are three broad categories as per this
classification, namely Labor Cost, Materials Cost and Expenses.
These heads make it easier to classify the costs in a cost sheet. They
help ascertain the total cost and determine the cost of the work-in-
progress.

1. Material Costs: Material costs are the costs of any materials we use
in the production of goods. We divide these costs further. For
example, let’s divide material costs into raw material costs, spare
parts, costs of packaging material etc.
2. Labor Costs: Labor costs consists of the salary and wages paid to
permanent and temporary employees in the pursuit of the
manufacturing of the goods
3. Expenses: All other expenses associated with making and selling
the goods or services.
2] Classification by Functions

This is the functional classification of costs. So the classification

follows the pattern of basic managerial activities of the organization.

The grouping of costs is according to the broad divisions of functions

such as production, administration, selling etc.

 Production Costs: All costs concerned with actual manufacturing

or construction of the goods
 Commercial Costs: Total costs of the operation of an enterprise
other than the manufacturing costs. It includes the admin costs,
selling and distribution costs etc.
3] Classification by Traceability

This aspect one of the most important classification of costs, into

direct costs and indirect costs. This classification is based on the
degree of traceability to the final product of the firm.

 Direct Costs: So these are the costs which are easily identified with
a specific cost unit or cost centers. Some of the most basic
examples are the materials used in the manufacturing of a product
or the labor involved with the production process.
 Indirect Costs: These costs are incurred for many purposes, i.e.
between many cost centers or units. So we cannot easily identify
them to one particular cost center. Take for example the rent of the
building or the salary of the manager. We will not be able to
accurately determine how to ascertain such costs to a particular
cost unit.
4] Classification by Normality

This classification determines the costs as normal costs and abnormal

costs. The norms of normal costs are the costs that usually occur at a
given level of output, under the same set of conditions in which this
level of output happens.

 Normal Costs: This is a part of the cost of production and a part of

the costing profit and loss. These are the costs that the firm incurs
at the normal level of output in standard conditions.
 Abnormal Costs: These costs are not normally incurred at a given
level of output in conditions in which normal levels of output
occur. These costs are charged to the profit and loss account, they
are not a part of the cost of production.
Advantages

 Measuring and Improving Efficiency

 Identification of Unprofitable Activities
 Fixing Prices
 Price Reduction
 Control over Stock
 Evaluates the Reasons for Losses
 Aids Future Planning

Financial Accounting vs Cost Accounting

Let us now look at some key differences in Financial Accounting vs
Cost Accounting.

Sr No Financial Accounting Cost Accounting

Records and summarizes cost

Records financial data of the information and data. This includes
1 organization. So it records all information about labour, materials and
relevant monetary data various overheads of the manufacturing
process.

Financial accounting only Cost accounting uses both historical and

2 deals in historical costs (only pre-determined costs (standard costs,
actual costs and figures) estimates etc.)

3 The users of the information Information provided by cost accounting

 provided by financial
is only meant for people within the firm
accounting are both internal
like management, employees etc.
and external users

Financial accounting is
mandatory for all firms. Every Cost accounting is only done by
4 organization has to keep manufacturing firms. And in most cases, it
some record of its financial is not mandatory.
transactions

The emphasis here is on

recording the Other than recording data it also provides
5 transactions/data and a system of cost control of labour,
presenting it in the given material, overhead costs
format.

Financial accounts deal with

Costing will enable us to get the profit or
the business in its entirety.
6 loss for individual products, process, job
So it provides us with profit or
etc.
loss for the whole concern

In financial accounting, there

In Cost accounting, forecasting is
is no aspect of forecasting. It
7 possible using some of the budgeting
is simply a record of the
techniques
financial position of the firm

Financial accounting is strictly

a positive science. There is Cost accounting is both a positive and
8
rigidity in the process due to normative science.
legal requirements

Difference between Management Accounting and Financial

Accounting
Sr.
Management Accounting Financial Accounting
No.

For external reporting to various stakeholders and

1 Only used for internal purposes of the firm
mandatory by law in most cases

2 Is not under the regulation of any law or regulations Is governed by Standards, Laws, regulations, etc

The main purpose is to help internal management take Helps investors, creditors, etc. take investment
3
decisions decisions

4 Includes both financial and non-financial information Is only concerned with financial information

5 Not subject to any audits or investigation Financial records are audited as per the norms

Functions of Cost Accounting

To understand the entire cost structure of a firm, cost accounting is
crucial. It ascertains the costs of various products, processes etc.

So we can compare them to the sales and arrive at the true

profitability of the firm. This is one of the main objectives or
functions of cost accounting. To achieve this the actual functions of
cost accounting change daily. Let us take a look,

 ascertain the cost per unit of every product that the company
manufactures
 to identify any wastages whether in material, expense, time, tools
and spares etc. Also, suggest ways to minimize this wastage
 also, provide data that helps in the process of price fixing
 calculate with accuracy the profitability of each of the company’s
products. And figure out ways to maximize these profits
 cost accounting is also responsible for the control of raw material
and raw material ordering. So it must ensure that we are not
overordering which leads to capital being locked-up unnecessarily.
And underordering will lead to inefficiency in the manufacturing
process,
 also, perform the functions of cost control for materials, labor, and
other miscellaneous expenses
 present data to the management that allows them to interpret the
data and make business decisions
 help management with incentive plans that are based on efficiency
 also, help the management with the preparation of budgets and
setting up budgetary controls

Advantages of Cost Accounting

1] Measuring and Improving Efficiency

Cost accounting allows for data that enables the firm to measure
efficiency. This could be efficiencies with respect to cost, time,
expenses etc.

Standard costing is then used to compare actual numbers with the

industry or economy standards to indicate changes in efficiency.

Say for example the cost of producing one unit increased from
Rs.100/- to Rs. 110/-. Now was this due to an increase in prices or
due to inefficiency and wastages. Cost accounting will help you
measure this.

2] Identification of Unprofitable Activities

Just because a firm is making overall profits, it does not mean all
activities are profitable. Cost accounting will help us identify the
profitable and unprofitable activities of the firm.

So activities that cause the firm losses can be made profitable or

eliminated. This can happen due to the cost ascertainment done in
cost accounting.

3] Fixing Prices

This is one of the important advantages of cost accounting. Many

businesses price their products based on the cost of production of
these products.

To enable this, we first need to calculate the actual cost of production

of these products. Costing makes the distinction between fixed cost
and variable cost, which allows the firm to fix prices in different
economic scenarios. Prices that we fix without the help of cost
accounting can be too high or low, and both cause losses to the
business.

4] Price Reduction

Sometimes during tough economic conditions, like depression, the

prices have to be reduced. In some cases, these prices are reduced to
below the total cost of the product.

This is to help the company survive this tough period. Such decisions
the management has to take are guided by cost accounting.

5] Control over Stock

Another important advantage of cost accounting is that it helps with
restocking and control over materials. Cost accounting will help us
calculate the most ideal and economic re-order level and quantities.

This will ensure that the firm is never overstocked or understocked.

Also costing allows the management to keep a check over these raw
materials, WIP etc.

6] Evaluates the Reasons for Losses

Every firm has to deal with periods of profits and losses. But now
they must always evaluate or investigate the reasons for the losses
suffered.

This will help to tackle the problem or overcome the cause by some
other means necessary. So if you cannot eliminate the reason you can
at least minimize the losses.

Cost accounting plays a huge role in determining the cause of any

losses. Say, for example, your cost of production is low, and prices
are high but yet losses persist. This can be due to low output levels
due to inefficiency. Cost accounting helps us determine this.

7] Aids Future Planning

One of the biggest advantages of cost accounting is that it will help

the management with future plans they may have. For any production
or selling plans, it is important to have detailed data about the
machines, the labour capacity, output levels, levels of efficiency of
each process etc.

Say for example the management wishes to expand the production to

accommodate sales, cost accounting will help determine if the current
machines can handle these levels of production or not.
Following are the main principles of Cost Accounting:
1. Cause-Effect Relationship:
Cause-effect relationship should be established for each item of
cost. Each item of cost should be related to its cause as minutely as
possible and the effect of the same on the various departments
should be ascertained. A cost should be shared only by those units
which pass through the departments for which such cost has been
incurred.

2. Charge of Cost Only after its Incurrence:

Unit cost should include only those costs which have been actually
incurred. For example unit cost should not be charged with selling
cost while it is still in factory.

3. Past Costs Should not Form Part of Future Costs:

Past costs (which could not be recovered in past) should not be
recovered from future costs as it will not only affect the true results
of future period but will also distort other statements.

4. Exclusion of Abnormal Costs from Cost Accounts:

All costs incurred because of abnormal reasons (like theft,
negligence) should not be taken into consideration while computing
the unit cost. If done so, it will distort the cost figures and mislead
management resulting in wrong decisions.

5. Principles of Double Entry Should be Followed Preferably:

To lessen the chances of any mistake or error, cost ledgers and cost
control accounts, as far as possible, should be maintained on double
entry principles. This will ensure the correctness of cost sheets and
cost statements which are prepared for cost ascertainment and cost
control.
Methods of Costing:
. Job Costing:
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Under this method, costs are collected and accumulated for each
job, work order or project separately. Each job can be separately
identified; so it becomes essential to analyse the cost according to
each job. A job card is prepared for each job for cost accumulation.
This method is applicable to printers, machine tool manufacturers,
foundries and general engineering workshops.

2. Contract Costing:
When the job is big and spread over long periods of time, the
method of contract costing is used. A separate account is kept for
each individual contract. This method is used by builders, civil
engineering contractors, constructional and mechanical engineering
firms etc.

3. Batch Costing:
This is an extension of job costing. A batch may represent a number
of small orders passed through the factory in batch. Each hatch is
treated as a unit of cost and separately costed. The cost per unit is
determined by dividing the cost of the batch by the number of units
produced in a batch. This method is mainly applied in biscuits
manufacture, garments manufacture and spare parts and
components manufacture.

4. Process Costing:
This is suitable for industries where production is continuous,
manufacturing is carried on by distinct and well defined processes,
the finished products of one process becomes the raw material of
the subsequent process, different products with or without by-
products are produced simultaneously at the same process and
products produced during a particular process are exactly identical.

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As finished products are obtained at the end of each process, it will

be necessary to ascertain not only the cost of each process but also
cost per unit at each process. A separate account is opened for each
process to which all expenditure incurred thereon is charged.

The cost per unit is obtained by averaging the expenditure incurred

on the process during a certain period. Hence, this is known as
average costing. As the products are manufactured in a continuous
process, this is also known as continuous costing. Process costing is
generally followed in Textile Industries, Chemical Industries,
Tanneries, Paper Manufacture etc.

5. One Operation (Unit or Output) Costing:

This is suitable for industries where manufacture is continuous and
units are identical. This method is applied in industries like mines,
quarries, oil drilling, breweries, cement works, brick works etc. In
all these industries there is natural or standard unit of cost. For
example, a barrel of beer in breweries, a tonne of coal in collieries,
one thousand of bricks in brickworks etc.

The object of this method is to ascertain the cost per unit of output
and the cost of each item of such cost. Here cost accounts take the
form of cost sheets prepared for a definite period. The cost per unit
is determined by dividing the total expenditure incurred during a
given period by the number of units produced during that period.
6. Service (or Operating) Costing:
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This is suitable for industries which render services as distinct from

those which manufacture goods. This is applied in transport
undertakings, power supply companies, municipal services,
hospitals, hotels etc. This method is used to ascertain the cost of
services rendered.

There is usually a compound unit in such undertakings, e.g., tonne

kilometre (transport undertaking), kilowatt-hour (power supply)
and patient day (hospitals).

7. Farm Costing:
It helps in calculation of total cost and per unit cost of various
activities covered under farming. Farming activities cover
agriculture, horticulture, animal husbandry (i.e., rearing of live-
stocks), poultry farming, pisciculture (i.e., rearing of fish), dairy,
sericulture (i.e. silkworm breeding), nurseries for growing and
selling of seedlings and plants and rearing of fruits and flowers.

Farm costing helps to improve the farming practices to reduce cost

of production, to ascertain the profit on each line of farming activity
which ensures better control by management and to obtain loans
from banks and other financial institutions as they give loans on the
basis of proper cost accounting records.

8. (Multiple) Operation Costing:

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Multiple operation method of manufacture consists of a number of

distinct operations. It refers to conversion cost i.e., cost of
converting the raw materials into finished goods. This method takes
into consideration the rejections in each operation for calculating
input units and cost. The different operations in machine screw are
—stamps, knurl, thread and trim. The cost per unit is determined
with reference to final output.

9. Multiple Costing:
It represents the application of more than one method of costing in
respect of the same product. This is suitable for industries where a
number of component parts are separately produced and
subsequently assembled into a final product. In such industries
each component differs from the others as to price, material used
and process of manufacture undergone. So it will be necessary to
ascertain the cost of each component.

For this purpose, process costing may be applied. To ascertain the

cost of the final product batch costing may be applied. This method
is used in factories manufacturing cycles, automobiles, engines,
radios, typewriters, aeroplanes and other complex products. This
method has been dropped from the latest CIMA Terminology.

Types or Techniques of Costing:

Following are the main types or techniques of costing for
ascertaining costs:
1. Uniform Costing:
It is the use of same costing principles and/or practices by several
undertakings for common control or comparison of costs.
2. Marginal Costing:
It is the ascertainment of marginal cost by differentiating between
fixed and variable cost. It is used to ascertain the effect of changes
in volume or type of output on profit.

3. Standard Costing:
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A comparison is made of the actual cost with a pre-arranged

standard cost and the cost of any deviation (called variances) is
analysed by causes. This permits management to investigate the
reasons for these variances and to take suitable corrective action.

4. Historical Costing:
It is ascertainment of costs after they have been incurred. It aims at
ascertaining costs actually incurred on work done in the past. It has
a limited utility, though comparisons of costs over different periods
may yield good results.

5. Direct Costing:
It is the practice of charging all direct costs, variable and some fixed
costs relating to operations, processes or products leaving all other
costs to be written off against profits in which they arise.

6. Absorption Costing:
It is the practice of charging all costs, both variable and fixed to
operations, processes or products. This differs from marginal
costing where fixed costs are excluded.

Any of the methods of costing like unit or output costing, service

costing, process costing etc. can be used under any techniques of
costing.
cost

It refers to the amount of payment made to acquire any goods and services.

What are the uses of store ledger?

Stores Ledger refers to a document or statement that keeps the records of the
value and quantity of different stock items issued, received and their closing
balance.  It is an account.

bin card is used to mean a document that keeps a record of the items held in stores. 

BASIS FOR
BIN CARD STORES LEDGER
COMPARISON

Meaning Bin Card implies a Stores ledger alludes to a

quantity record of the subsidiary ledger, that
receipts, issue and keeps track of each and
balance of materials in every transaction relating to
stores. materials in the stores.

What is it? It is a recording It is an accounting record.

document.

Responsibility Storekeeper Cost accounting department

Location Kept inside the stock Kept outside the stock

room. room.

Details Contains quantitative Contains both quantitative

details only. and monetary details.

Interdepartmental Are not shown in bin Indicated in stores ledger.

transfer card.
 BASIS FOR
BIN CARD STORES LEDGER
COMPARISON

Entries Entries are posted Entries are posted after

when transaction takes transaction took place.
place.

Recording Transactions are Summarized transactions

recorded individually. are recorded.

VED Analysis is a popular inventory management strategy that classifies material

according to their criticality for the business into three categories of Vital,
Essential and Desirable. This analysis usually is used to classify items for a
production schedule.

What is Just-in-Time (JIT)? Just-in-time, or JIT, is an inventory

management method in which goods are received from suppliers
only as they are needed. The main objective of this method is to
reduce inventory holding costs and increase inventory turnover.

ABC analysis is an inventory management technique that

determines the value of inventory items based on their importance
to the business.