Basic Cost Concepts

UNIT 2 BASIC COST CONCEPTS

Structure
2.0 Objectives
2.1 Introduction
2.2 Need for Cost Data
2.3 Cost Concept
2.4 Classification of Costs
2.4.1 Functional Classification
2.4.2 On the Basis of Identifiability with Products
2.4.3 On the Basis of Variability
2.4.4 On the Basis of Product or Period
2.4.5 On the Basis of Controllable and Non-Controllable Costs
2.4.6 On the Basis of Relevance to Decision-Making
2.5 Concepts of Cost Unit and Cost Centre
2.5.1 Cost Unit
2.5.2 Cost Centre
2.6 Elements of Cost
2.6.1 Materials
2.6.2 Labour
2.6.3 Expenses
2.7 Total Cost Build-Up
2.8 Cost Sheet
2.9 Calculation of Recovery Rates
2.10 Statement of Quotation
2.11 Methods of Costing
2.11.1 Job Costing
2.11.2 Contract Costing
2.11.3 Batch Costing
2.11.4 Unit Costing
2.11.5 Bocess Costing
2.11.6 Operating Costing
2.11.7 Multiple Costing
2.11.8 Uniform Costing
2.12 Types of Costing
2.12.1 Marginal Costing
2.12.2 Absorption Costing
2.12.3 Historical Costing
2.12.4 Standard Costing
2.13 Let Us Sum Up
2.14 Key Words
2.15 Answers to Check Your Progress
2.16 Terminal Questions
2.17 Some Useful Books
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Fundamentals of
Accounting 2.0 OBJECTIVES
After studying this unit, you should be able to :
l describe the need for cost data;
l meaning and classification of costs;
l explain the concept of cost unit and cost centre;
l describe the elements of cost;
l prepare a Proforma of Cost Sheet and identify the components of total cost;
l prepare a statement of quotation and ascertain the price of a tender; and
l describe different methods of costing and identify the industries to which each
method is applicable.

2.1 INTRODUCTION
In this unit you will learn about certain basic cost concepts like cost, cost unit, cost
centre, classification of costs, elements of costs and components of total cost.
Apart from these aspects, the unit also covers preparation of cost sheet showing
details of various components of total cost. You will also study about the
preparation of statement of quotation. The unit also discusses various methods and
types of costing.

2.2 NEED FOR COST DATA

Enterprises may be either profit making or non-profit making organisations. If they
are profit making organisations, one of their primary objectives is to operate at a
profit. Non profit organisations are generally providers of service. Cost data is
required to know how much profit the enterprise is earned. To properly set their
prices at a level to ensure a profit for the entity as a whole, the enterprise must know
what their costs are. Similarly, decisions regarding adding new products or dropping
old products, etc., knowledge of cost data is essential to know how profit changes with
various alternatives. In case of non-profit institution, cost data helps to know what
level of funding is needed to provide the services. It also helps the management to
decide what kind of activities can engage in most efficiently. Thus the management
of an organisation requires cost data for the following purposes :
1) To ascertain profit or loss periodically,
2) To plan the operations and performance evaluation,
3) For cost control,
4) To price the products or services,
5) To value inventory and measure the expenses in external financial reports, and
6) In day to day operations of plans and policies,

2.3 COST CONCEPT

In principle, a cost is a sacrifice of resources. According to the terminology of British
Institute of Cost and Works Accountants, ‘‘Cost is the amount of expenditure (actual
or notional) incurred on or attributable to a given thing’’. In other words, cost
indicates, (i) an actual or estimated expenditure (ii) a direct or indirect expenditure,
and (iii) it relates to a job, process, product or service. Examples of such costs are :
Material, labour, factory overheads, administrative overheads, selling and distribution
3 6 overheads.
Cost is a very broad and flexible term. It does not give an exact meaning unless it is Basic Cost Concepts
used in some particular context. It varies with time, volume, firm, method or purpose.
The meaning of cost may change according to its interpretation and the manner in
which it is ascertained. It does not mean the same thing under all circumstances.
Therefore, cost must indicate its purpose and the conditions under which it is
computed.

Costs and Expenses

Cost information is necessary both for managerial accounting and financial
accounting. When costs are used inside the organisation to evaluate its performance
we say that costs are used for managerial accounting purposes. On the other hand
when costs are used by outsiders (interested parties) to evaluate the performance of
management and make investment decisions in the organisation, then costs are used
for financial accounting purpose.
It is also important to distinguish between cost as used in managerial accounting, from
expense, as used in financial accounting. A cost is a sacrifice of resource to achieve
specific objective which has been deferred or not yet utilized for the realisation of
revenues. The price paid for the acquisition of fixed assets, materials, etc. are the
examples of such deferred costs.
An expense is a cost that is charged against revenue in an accounting period
and hence expenses are deduced from revenue in that accounting period.
Examples are : Salaries, rent rates, etc. Generally Accepted Accounting
Principles and Regulations specify when costs are treated as expenses to be
charged to revenues.
In accounting for managerial decisions the focus is on costs, and not on expenses. For
external reporting, the term expense is used as defined by Generally Accepted
Accounting Principles. But in practice, the terms cost and expenses are sometimes
used synonymously.
Cost and Loss : There is difference between ‘cost’ and ‘loss’. You know that cost
signifies an expenditure incurred for recurring some benefit to the enterprise. If no
benefit is derived from a particular expenditure, it is treated as a loss. Cost of
material destroyed by fire, salary paid to a foreman during the period of strike etc.,
are the examples of loss to the business.

2.4 CLASSIFICATION OF COSTS

Costs may be classified into different categories depending upon the purpose.
The following are the various bases according to which costs have been classified :
1) According to functions to which they relate,
2) According to their identifiability with jobs, products, or services,
3) According to their variability with changes in output,
4) According to the association with product or period,
5) According to their controllability, and
6) According to their relevance to decision-making
Let us discuss all the above in detail.

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Fundamentals of 2.4.1 Functional Classification
Accounting
The most common classification of costs in a manufacturing establishment is on the
basis of functions to which they relate because costs have to be ascertained for each of
these functions. On the basis of functions, costs are classified into four categories.
They are :
i) Manufacturing Costs
ii) Administrative Costs
iii) Selling Costs
iv) Distribution Costs
Manufacturing Costs : Manufacturing costs are those costs related to factory
operations which are essential to the completion of the product. It includes direct
material costs, direct labour costs and manufacturing overheads. Direct materials are
the major components of the finished product and can be easily identified with the
product. Direct labour is the labour which is used in actually producing the product.
Manufacturing overheads consist of all other costs related to the manufacturing
process. These are also termed as ‘production costs’.
Administrative Costs: Administrative costs includes all those costs incurred on the
general administration and control of the firm. Examples of such costs are : salaries
of the office staff, rent of the office building, depreciation and repairs of the office
furniture etc. Infact any expenditure which is not related directly to production,
selling, distribution, research and development forms part of the administrative costs.
Selling Costs: Selling costs are those costs which are incurred in connection with the
sale of goods. Some examples of such costs are : Cost of warehousing, advertising,
salesmen salaries etc.
Distribution Costs: Distribution costs are those costs which are incurred on despatch
of finished products to customer including transportation. Examples of such costs are:
packing, carriage, insurance, freight outwards, etc.

2.4.2 On the Basis of Identifiability with Products

On this basis costs are divided into (i) Direct Costs, and (ii) Indirect Costs:
Direct Costs : Direct costs are those costs which are the major components of the
finished products and can be clearly identified with the product being produced. The
examples of direct costs are : raw materials, labour and other direct expenses which
are exclusively incurred for a particular job, product or process.
Indirect Costs : indirect costs are those costs which cannot be assigned to any
particular product, job or process. These costs are usually incurred for the business as
a whole and therefore, are to be allocated to various products manufactured in the
factory on some reasonable basis. Examples of indirect costs are : factory lighting,
rent of factory building, salaries of foreman, etc, Indirect costs are also called as
‘overheads’ or ‘on costs’. These overheads can be further subdivided into factory
overheads, administrative overheads, selling and distribution overheads.

2.4.3 On the Basis of Variability

Another classification is based on the cost behaviour. On this basis costs are
classified into (i) Fixed Costs, (ii) Variable Costs, and (iii) Semi-variable
(or semi-fixed) Costs, (iv) Step Costs.
Fixed Costs: These costs remain fixed irrespective of a change in the volume of
output. But fixed cost varies when it is expressed on per unit basis. In other words
fixed cost per unit decreases when the volume of production increases and vice versa.
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Rent and lease, salary of production manager, salaries of staff, etc., are the examples Basic Cost Concepts
of fixed cost. It should also be noted that fixed costs do not remain fixed always.
They remain fixed only upto a certain level of production activity. If there is a change
in the production capacity which require additional building and equipment, staff, etc.,
such cost will also change. Therefore, fixed costs are fixed within a relevant range of
production. For example, if we produce 1000 units or 10,000 units of a particular
product during a particular period, the rent of the factory building or the salary of the
production manager will remain the same.
Variable Costs: Variable costs are those costs which vary directly or almost
proportionately with the level of output. When volume of output increases, total
variable cost also increases and when volume of output decreases the variable cost
also decreases. But the variable cost per unit will remain unaffected. The examples
of variable costs are : direct material, direct wages, power, commission of salesmen
etc. Let us see the following example how the variable cost varies with the change in
the level of output.

Variable Cost Level of Output (Units)

3,000 4,000 5,000
Unit Costs: Rs. Rs. Rs.
Direct Material 3,000 4,000 5,000
(Rs. 1 per unit)
Direct Labour 6,000 8,000 10,000
(Rs. 2 per unit)
Direct Expenses 3,000 4,000 5,000
(Rs. 1 per unit)
Total Variable Cost 12,000 16,000 20,000
Cost per unit Rs. 4 Rs. 4 Rs. 4
(Total VC ÷ No. of Units)

In the above example the variable cost varies in direct proportion to the activity level
but the variable cost per unit is fixed.
The following are the characteristics of variable costs :
i) The variable cost varies direct proportion to the volume of output.
ii) The cost per unit will remain the same irrespective of level of activity.
iii) It is easy to accurate allocation and apportionment to different cost centres.
iv) Variable costs can be controlled by functional managers as they incur only when
production takes place.
Semi-variable Costs (or semi-fixed costs): These costs are partly fixed and partly
variable. These are the costs which do vary but not in direct proportion to output.
A part of semi variable costs comprising of fixed cost component , is not expected to
change in response to the changes in the level of activity. Thus, semi-variable
costs vary in the same direction but not direct proportion to the changes in the
volume of output. Telephone bills, power consumption, depreciation, repairs, etc.,
are the examples of semi-variable costs. In case of telephone bills, there is a
minimum rent and after specified number of calls, the charges are according to the
number of calls made. Similarly, power costs include a fixed portion of
minimum charge will be charged even if the power is not consumed and
variable charge is based on the consumption of power. Thus, telephone
and power charges increase with an increase in the usage level but not in the same
direction.
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Fundamentals of Step Costs: Fixed cost in general remain fixed over a range of activity and then jump
Accounting to a new level as activity changes. For example, a foreman can supervise a given
number of workers in a particular shift. The introduction of anther shift will require
additional foreman and certain costs will increase in lumps. Such costs are known as
‘step costs’ or ‘stair step costs’.
The graphical representation of fixed costs, variable costs semi-variable costs and
step costs is shown below:
Fixed Cost-Behaviour Variable Cost-Behaviour

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3 3

2 Fixed Cost Line 2

ƒs
Fixed Cost Line
1 1

0 0
100 200 300 400 100 200 300 400
Production (Units) Production (Units)

Semi-Variable Cost Behaviour Fixed Costs Rising in Steps

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Semi-variable cost line 3
3
ƒs

ƒs
2 2 Fixed cost rising line

1 1

0 0
100 200 300 400 100 200 300 400
Production (Units) Production (Units)

Identification of costs according to their behaviour into fixed and variable elements is
essential for profit planning, cost control, fixation of prices, preparation of budgets
and also in various managerial decisions like make or buy or drop out decisions,
selection of a product mix, level of activity decisions, etc.

2.4.4 On the Basis of Product or Period

Product costs are those costs which are easily attributable to products. These costs
are necessary for the production and will not be incurred if there is no production.
Product costs consist of direct material, direct labour and a reasonable share of
factory overhead. These costs are also called inventoriable costs because these are
included the cost of product as work-in-progress, finished goods or cost of sales.
Generally all manufacturing costs are treated as product costs.
Costs which are easily attributable to time interval are known as period costs. These
costs do not attach to products. These costs incurred for a time period and generally
non-manufacturing costs are treated as period costs. These costs are charged to profit
and loss account. The examples of period costs are rent of office building, salary of
company executives, etc.
Period costs affect profit as they are charged to profit and loss account after they are
incurred whereas product costs will affect profit only when they goods are realized.
Thus, classification of costs on the basis of product and period is significant from
4 0 profit determination point of view.
2.4.5 On the Basis of Controllable and Non-Controllable Costs Basic Cost Concepts

Controllable costs are those costs which can be controlled by a specified person or a
level of management. Variable costs are generally controllable by the lower level of
management like departmental heads. For example cost of raw materials can be
controlled by purchasing them in bulk quantities. Uncontrollable costs are those costs
which cannot be controlled or influenced by a specified person of an enterprise. For
example costs like factory rent, managerial salaries etc. It should be noted that the
costs which are not controllable in the short run likely to become controllable in the
long run at some level in the organisation. Similarly, when one moves to the higher
levels of management in the organisation more and more costs become controllable.
Sometimes classification of costs as controllable or non controllable will be a
discretionary matter of the management. The classification of costs on the basis of
controllability is important for the evaluation of performance of the executives and
assigning the responsibility in the organisation.

2.4.6 On the Basis of Relevance to Decision-Making

The following are some important cost concepts which help the management in
decision making process.
Differential Costs: The difference in total costs among the various alternatives is
termed as differential cost. In other words, differential cost is the result of change in
the total cost from an alternative course of action. If the change increases the cost it is
called incremental cost and the change decreases the cost it is called decrimental cost.
The difference in the total cost may be due to change in the methods of production,
change in sales volume, product mix, make or buy or drop out decisions, etc. While
assessing the profitability of a proposed change, the incremental costs should be
matched with the incremental revenues. Look at the following example :
A company is selling 1500 units @ Rs. 15 per unit. The variable cost per unit is
Rs. 7 and the total fixed costs is Rs. 6000. The company receives an export order for
the supply of 300 units @ Rs. 12 per unit. If this order is accepted, fixed cost will be
increased by Rs. 300.
Solution
The cost and sales before and after accepting the export order is worked out as follows:

Particulars Before the Export After the Export Incremental

Order Order
Cost Revenue Cost Revenue Cost Revenue
Rs. Rs. Rs. Rs. Rs. Rs.
Sales 22,500 26,100 3,600
Less Variable Costs 10,500 12,000
Fixed Costs 6,000 16,500 6,300 18,900 2,400

Profit 6,000 7,200 1,200

The proposed export order will result a profit of Rs. 1200. If the proposal is
implemented it results an incremental revenue of Rs. 3600 against the incremental cost
of Rs. 2400. Thus the differential concept is important for managerial decision making.
Sunk Costs: Sunk costs results from past expenditure. Sunk costs cannot be changed
now and management has no control over such costs. The examples of Sunk costs are :
past cost of inventory, past costs of long term assets etc. It should be noted that past
information is totally irrelevant but can be used to predict differential costs in future
course of actions. Further the management uses the past expenditure information in
performance evaluation. 4 1
Fundamentals of Imputed Costs : These costs are also called hypothetical costs or notional costs.
Accounting These costs are included in cost accounts only for the purpose of taking managerial
decisions. For example, interest on capital, rent of own building should be taken into
account while evaluating the relative profitability of the projects.
Opportunity Costs : Opportunity cost refers to the benefit foregone as a result of
accepting one course of action. The manager, while taking a decision should not only
take into account the costs and benefits of the proposed alternative but also the profit
scarified by making the decision. For example, if an owned building is proposed to be
utilized for housing a new project plant, the likely revenue which the building could
fetch, if it is let out, is the opportunity cost which should be taken into account while
evaluating the profitability of the project.

2.5 CONCEPTS OF COST UNIT AND COST CENTRE

2.5.1 Cost Unit

The main function of costing is to ascertain cost per unit of output. Each economic
activity has to be measured in identifiable units which may serve as the basis of
accounting. Such units for the purpose of costing may be as follows :
1) Unit of product, or a group of products (e.g., pair of shoes or one batch of shoes
say one dozen)
2) Unit of operating service (e.g., cost of running a bus per one kilometer)
3) Unit of time (e.g., cost of generating electricity per hour)
4) Unit of weight (e.g., cost per one tonne of steel)
5) Unit of measurement (e.g., cost per meter of cloth or one litre of petrol)
Thus a cost unit is ‘a unit of product, service or time in relation to which costs may be
ascertained or expressed’. In other words cost unit is unit of measurement of cost. It
will be normally the quantity of product for which price is quoted to the consumers.
The selection of cost unit must be appropriate, natural to the business, easily
understandable and acceptable to all concerned. Firstly, it should offer convenience in
cost ascertainment. Secondly, it should be easier to associate expenses with cost units.
Thirdly, it should be according to the nature and prevailing practice of the business.
Some examples of cost unit for different products and services are given below:
Product/Activity Cost Unit
Cement Per-tonne/per bag
Iron Per-tonne/quintal
Chemicals Per-tonne/kilogram/litre, etc
Power Per-kilowatt hour
Coal Per tonne/kilogram
Bricks Per thousand
Printing press Per thousand copies
Paper Per ream/per kilogram
Transport Per passenger per kilometer/per
kilogram per kilometer
Telephone Per call
Timber Per cubic foot/square foot
Pencils Per dozen or gross
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 Petrol Per litre Basic Cost Concepts
Television Per set
Gold Per gram
Hotel Per room per day
Nursing Homes Per bed per day
Cars Per car

2.5.2 Cost Centre

A cost centre is ‘location, person, or item of equipment (or group of these) for which
costs may be ascertained and used for the purpose of control’. Thus a cost centre
refers to a section of business to which costs can be charged. It may consist of either
or a combination of the following :
Location : Factory, Department, Office, Warehouse, Stores, Sales Depot, etc.
Person : Salesman, a machine operator, customer, etc.
Equipment : Machine, Car, Truck, etc.
Types of Cost Centres : Cost centres may be divided into the following four types :
1) Process Cost Centre (Based on sequence of operations)
2) Production Cost centre (for regular production in a factory)
3) Operation Cost Centre (where various operations are involved in the production
process)
4) Service Cost Centre (for activities supporting the main production)
Thus identification or selection of cost centres depends on the nature and types of
industry. The identification of cost centres helps us in :
i) ascertaining the centre-wise costs,
ii) comparing the centre-wise costs periodically,
iii) finding out the major trends of variance, and
iv) applying the techniques of control to check undue, undesirable or unexpected
movements in cost.
A cost centre segregates operations, democrats activities, and distributes expenses.
This also helps in fixing responsibilities for every cost centre.

Check Your Progress A

1. What is the concept of Cost ?
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2. Distinguish between direct and indirect costs.
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3. Give four examples of indirect expenses.
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Fundamentals of 4. Distinguish between cost and loss.
Accounting
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5. Give two examples of semi-variable costs.
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6. State whether each of the following statements is True or False
i) Variable cost remains fixed per unit but varies direct proportion to the
volume of output.
ii) Variable costs are controllable.
iii) Operating costing is used in transport industry.
iv) Semi-variable costs vary in the same direction to the volume of output but
not direct proportion to the changes in the volume of output.
v) Fixed costs are also known as period costs.
vi) Direct Material + Direct wages + Direct expenses = Works cost.
vii) Works cost + Office overheads = Cost of production.

2.6 ELEMENTS OF COST

In order to understand and interpret the term ‘cost’, it will be necessary to
understand about the elements of cost. The following are the three elements
of costs: (1) Materials, (2) Labour, (3) Expenses
These can be further sub-dividend into as direct or indirect as follows :
Direct Indirect
Material Material
Labour Labour
Expenses Expenses

2.6.1 Materials
The term ‘materials’ refers to those commodities which are used as raw materials,
components, or consumables for manufacturing a product. In other words, the
substance from which the product is made is known as ‘materials’. Materials can be
direct or indirect.
Direct Materials: All materials which become an integral part of the finished product
and which can be conveniently assigned to specific physical units is termed as ‘Direct
Materials’. Direct material generally becomes a part of the finished product. The
following are some examples of direct material :
i) All materials or components specifically purchased, produced or requisitioned
from stores (e.g., sugar can for sugar, cloth for ready-made garments, cotton for
cloth, tyres for car, etc.)
ii) Primary packing material (e.g., wrapping, cardboard, boxes etc.)
iii) Partly produced or purchased components
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Indirect Materials: All materials which are used for purposes ancillary to the Basic Cost Concepts
business and which cannot conveniently be assigned to specific physical units is
termed as ‘indirect materials’. These materials cannot be conveniently identified with
individual cost units. Their cost is insignificant in the finished product. Pins, screws,
nuts, bolts etc., are some examples. There are some other items which do not
physically become part of the finished product. Examples are : Consumable stores,
lubricating oil, Greece, printing and stationery etc., These items do not form part of
the finished product.

2.6.2 Labour
The workers employed for converting material into finished product or doing various
odd jobs in the business are known as ‘Labour’. Labour can be direct as well as
indirect.
Direct Labour: The workers who are directly involved, in the production of goods
are known as ‘direct labour’. They may be labourers producing manually or workers
operating machinery. Direct labour costs can be conveniently identified with a
particular product, job or process. For example, the wages paid to a machine
operator engaged in the manufacture of goods. The wages paid to such workers are
known as ‘manufacturing wages’.
Indirect labour : The workers employed for carrying out tasks incidental to
production of goods or those engaged for office work and selling and distribution
activities are known as indirect labourí. The wages paid to such workers are known
as ‘indirect wages’. Indirect labour is of general character in nature and cannot be
conveniently identified with a particular unit of output. The examples of indirect
labour costs are : wages of storekeepers, foremen, directors’ fees, salaries of
salesman, etc.

2.6.3 Expenses
All expenses other than material and labour are termed as ‘expenses’. Expenses may
be direct or indirect.
Direct Expenses : Expenses which can be identified with and allocated to cost
centres or units are called direct expenses. These are the expenses which are
specifically incurred in connection with a particular cost unit. Direct expenses are
also called as ‘chargeable expenses’. The examples of such expenses are : Carriage
inwards, production royalty, hire charges of special equipment, cost of special
drawings, designs and layouts, experimental costs, etc.
Indirect Expenses : These are expenses which cannot be directly or wholly allocated
to cost centres or cost units. In other words, all expenses other than indirect material
and labour which cannot be directly attribute to a particular product, job or service
are called indirect expenses. Examples of such expenses are : Rent and Rates,
lighting and heating, advertising, insurance, repairs, carriage, etc.
The above elements of cost may be shown in the form of a chart as shown below:

Elements of Cost
Cost
s s s
Materials Labour Expenses
s s s s s s
Direct Indirect Direct Indirect Direct Indirect

Overheads
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Fundamentals of All materials, Labour, expenses which cannot be identified as direct costs are termed
Accounting as ‘indirect costs’. The three elements of indirect costs viz., indirect materials, indirect
labour and indirect expenses are collectively known as ‘overheads’ or ‘on costs’.
Overheads are grouped into three categories:
1) Factory (or manufacturing) overheads,
2) Office (or administrative) overheads, and
3) Selling and distribution overheads.

1) Factory Overheads
All indirect manufacturing costs which cannot be identified with specific unit of
output are called factory overheads. It includes:
i) Indirect material such as lubricants, oil, consumable stores etc.,
ii) Indirect labour a such as gate-keepers’ salary, works manager’s salary etc., and
iii) Indirect expenses such as factory rent, depreciation on factory building and
equipment, factory insurance, factory lighting etc.,
iv) Factory overheads are also known as manufacturing overheads, indirect
production costs, factory on cost, overhead expenses etc.

2) Office Overheads
Indirect expenses incurred in connection with the general administration like
formulating policies, planning and controlling of a firm for attainment of its goal, are
included in these overheads. They include (i) indirect material used in office such as
printing and stationary material, brooms and dusters etc. (ii) Indirect labour such as
salaries payable to office manager, clerks, etc. and (iii) indirect expenses such as rent,
insurance, lighting of the office etc.,

3) Selling and Distribution Overheads

Selling and distribution overheads include all those costs which are incurred for
promoting and marketing the products. These include :
(i) Indirect material used such as packing material, printing and stationary
material etc, (ii) Indirect labour such as salaries of salesmen, sales manager, etc. and
(iii) Indirect expenses such as rent, insurance, advertising expenses etc.
The above classification of overheads can be shown with the help of the following
Figure:

Classification of Overheads

Overheads (Indirect Costs)

s s s
Factory Overheads Office Overheads Selling and Distribution Overheads
s s s s s s
s s s
Indirect Indirect Indirect Indirect Indirect Indirect Indirect Indirect Indirect
Materials Labour Expenses Materials Labour Expenses Materials Labour Expenses

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 Basic Cost Concepts
2.7 TOTAL COST BUILD-UP

Components of Total Cost

Total cost of a product is the combination of direct costs and indirect costs. Direct
Costs, as you know, consist of direct materials, direct labour and direct expenses and
it is also known as prime cost. Indirect Costs known as overheads consists of factory
overheads, office overheads and selling and distribution overheads. Thus, the two
main components of total cost are: 1) Prime cost, and (2) Overheads.
If we add various costs one by one, we get the framework of total cost build up as
follows :
1) Prime Cost: It consists of cost of direct material, direct labour and direct
expenses. It is also known as basic, first or flat cost. Thus,
Prime cost = Direct material + Direct Labour + Other direct expenses
2) Factory Cost : It includes Prime Cost and factory overheads which consists of
indirect material, indirect labour and indirect factory expenses. The factory cost
is also known as works cost, production or manufacturing costs. Thus,
Factory Cost = Prime Cost + Factory Overheads
3) Cost of Production: It comprises factory cost and office and administrative
overheads. It is also known as office cost. Thus,
Cost of Production = Factory Cost + Office and Administrative Overheads
4) Total Cost: It comprises cost of production and selling and distribution
overheads. It is also called as cost of sales.
Total Cost = Cost of Production + Selling and Distribution overheads
The above framework of total cost building-up is shown in the following Figure :
Total Cost Build Up
Materials
Labour Prime Cost
Direct Expenses +
Factory Factory Cost
Overheads s+ Cost of
Office Production Cost of
Overheads + Sales
Selling and
Distribution
Overheads

Thus, the components of total cost are :

Prime Cost, (2) Works Cost, (3) Cost of Production, and (4) Cost of Sales.

2.8 COST SHEET

The elements of cost can be presented in the form of a statement called ‘Cost Sheet’.
A cost sheet is a statement showing the various components of total cost of output for
a certain period which acts as a guide to pricing decisions and cost control. It has
been defined as ‘‘a document which provides for the assembly of the detailed cost of a
cost centre or cost unit’’. The cost sheet should be prepared properly and at frequent
intervals, i.e., weekly, monthly, quarterly, yearly etc. Cost sheet may be prepared
separately for each cost centre. Additional columns can also be provided for the
purpose of comparison of current data with the previous data. 4 7
Fundamentals of Cost Sheet, generally serves the following purposes :
Accounting
i) It provides total cost and cost per unit of production,
ii) It gives the details regarding various elements of total cost, i.e., material, labour,
overheads, etc.,
iii) It gives scope for a comparative study of cost of production of the current period
with that of the previous period.
iv) It helps the management in taking managerial decisions relating to pricing
decisions, quotation of tenders, cost control etc.
The information to be shown in the cost sheet will depend upon the nature and
requirement of the enterprise. Generally, following information may be incorporated
into a cost sheet :
1) Name of the product, cost centre or cost unit
2) Period to which the statement relates
3) Output of the period
4) Details of various components of total cost
5) Item-wise cost per unit
6) Changes in stock position
7) Cost of goods sold
8) Profit or loss position
The Proforma of Cost sheet is given below :

Proforma of Cost Sheet

COST SHEET OF..................................................
For the month ending..................................................
Output..................nits

Total Per Unit

Rs. Rs.
Raw Materials consumed :
Opening Stock of Raw of materials .....................
Add : Purchases of Raw Materials .....................
Less : Closing stock of raw materials ....................
Direct Labour
Direct Expenses
PRIME COST
Factory Overheads :
Rent
Depreciation on premises
Power and light
Indirect material
Indirect wages
Telephone Charges
Insurance etc.
WORKS COST

4 8
 Basic Cost Concepts
Office and Administrative Overheads:
Office salaries
Office rent
Office expenses, etc
COST OF PRODUCTION
(.................units)
Add Opening Stock of Finished goods
(.................units)
Less Closing Stock of Finished Goods
(.................units)
COST OF GOODS SOLD
(.................units)
Selling and Distribution Overheads :
Salaries and commission
Advertising
Packing expenses
Travelling expenses
Warehouse charges
Carriage outwards, etc.
COST OF SALES
(.................units)
PROFIT (LOSS)
SALES/SELLING PRICE

Look at the following illustration and see how a Cost Sheet is prepared with the
following information:
Illustration 1
From the following particulars of a manufacturing firm prepare a cost sheet showing
different components of total cost for the year ending 31st March, 2003.
Particulars Amount (Rs.)
Stock of material (April 1, 2002) 80,000
Purchase of Raw materials 12,00,000
Stock of finished goods on 1,00,000
1-4-2002 (10,000 units)
Direct wages 8,00,000
Direct chargeable expenses 8,000
Finished goods sold (1,80,000 units) 25,40,000
Factory rent rates and power 20,000
Indirect wages 5,000
Depreciation on Plant and Machinery 2,000
Carriage Outwards 20,000
Carriage Inwards 2,000
Office rent and taxes 1,500
Telephone charges 3,000
Travelling expenses 60,000
Advertising 10,000
Depreciation on office premises 1,500
Stock of materials on 31.3.2003 1,60,000
Stock of finished goods on 31.3.2003 (12,000 units) 1,20,000 4 9
Fundamentals of Solution
Accounting
Firstly, we have to find out the number of units produced during the year, before
preparing the cost sheet.

No. of Units
Closing Stock (31.3.2003) 12,000
Add: Number of Units sold 1,80,000
1,92,000
Less : Opening Stock (1.4.2002) 10,000
Number of units produced during the year 1,82,000

COST SHEET
for the year ending 31.3.2003
Output: 1,82,000 Units

Particulars Total Per Unit

Rs. Rs.
Raw Materials Consumed:
Opening Stock (1.4.2002) 80,000
Add: Purchase of Raw material 14,21,000
Add : Carriage inwards 2,000
__________
15,03,000
Less : Closing stock of raw material 1,60,000
(as on 31.3.2003) __________ 13,43,000
Direct wages 8,00,000
Other direct chargeable expenses 8,000
_________
Prime Cost 21,51,000
Works Overheads:
Indirect wages 5,000
Factory rent, rates and power 20,000
Depreciation on plant and machinery 2,000
______ 27,000
_________
Works Cost 21,78,000
Office and Administrative Overheads:
Office rent and taxes 1,500
Telephone charges 3,000
Depreciation on office premises 1,500
_______ 6,000
_________
Cost of Goods Sold 21,84,000 12.00
(1,82,000 units @ Rs.12 per unit)
Add : Opening stock of Finished goods
(10,000 units @ Rs.12 per unit) 1,20,000 12.00
––––––––
2,30,000
Less : Closing stock of Finished goods 1,44,000 12.00
(12,000 units @ Rs.12 per unit) ––––––––
5 0 21,60,000
 Basic Cost Concepts
Cost of Goods Sold
(180,000 units)
Selling and Distribution Overheads:
Travelling expenses 60,000
Carriage outwards 20,000 90,000 0.50
Advertising Cost of Sales 10,000 _______ _______
Profit 22,50,000 12.50
6,30,000 3.50

SALES 28,80,000 16.00

2.9 CALCULATION OF RECOVERY RATES

Sometimes, you are required to calculate overheads recovery rates based on the cost
sheet prepared by you. Such rates are usually in respect of factory overheads and
administration overheads. Factory overhead rate is usually calculated as a percentage
of direct wages as follows:
Factory Overheads
Factory Overhead Rate = —————————— × 100
Direct wages
Administration overhead rate is usually calculated as a percentage of works cost as follows:

Office Administration Overheads

Administration Overhead Rate = —————————————––––— × 100
Factory or Works Cost
Selling and distribution overheads rate may be computed either as a percentage of Works
cost or as a percentage of sales as follows :
Selling and Distribution Overheads
Selling and Distribution Overhead Rate = ————————————————— × 100
Works Cost or Sales
Let us see the following illustration how the recovery rates are calculated :
Illustration 2
The following is the cost data relating to a manufacturing company for the period ending
December 31, 2002 :
Rs.
Raw material purchased 1,20,000
Stock of raw material on 1-1-2002 25,000
Direct wages 1,00,000
Factory overheads 60,000
Carriage inwards 1,00,000
Selling and distribution overheads 72,800
Administration overheads 67,200
Stock of raw material on 31.12.2002 35,000
Sales during the year 6,12,000
Find out a) Cost of Production
b) Cost of Sales
c) The Net Profit for the year
d) The percentage of factory overheads on direct wages
e) The percentage of administration overheads on works cost
f) The percentage of selling and distribution overheads on works cost and
g) The percentage of profit to cost of sales.
5 1
Fundamentals of Solution
Accounting
Cost Sheet for the period ending December 31, 2002

Cost of Raw material consumed : Rs. Rs.

Stock of Raw Material (as on 1-1-2002) 25,000
Add : Raw material purchased 1,20,000
Add : Carriage inwards 1,00,000
––––––––
2,45,000
Less : Stock of Raw Material (as on 31-12-2002) 35,000
–––––––– 2,10,000
Direct Wages 1,00,000
––––––––
PRIME COST 3,10,000
Factory Overheads 60,000
––––––––
WORKS COST 3,70,000
Administration Overheads 67,200
––––––––
(a) COST OF PRODUCTION 4,37,200
Selling and Distribution Expenses 72,800
—————
(b) COST OF SALES 5,10,000
(c) PROFIT 1,02,000
—————
SALES 6,12,000
—————

(d) Percentage of Factory Overheads to Direct Wages

Factory Overheads
= ————————— × 100
Direct Wages
60,000
= ————— × 100
1,00,000

= 60%

(e) Percentage of Administration Overheads to Works Cost

Administration Overheads
= ————————————— × 100
Works Cost

67,200
= ————— × 100
3,70,000

= 18.16%

(f) Percentage of Selling and Distribution Expenses on Works Cost

Selling and Distribution Expenses

= ———————————————— × 100
Works Cost

5 2
 Basic Cost Concepts
72,800
= ———— × 100
3,70,000

= 19.68%
(g) Percentage of Profit to Cost of Sales

Profit
= ——————— × 100
Cost of Sales

1,02,000
= ————— × 100
5,10,000

= 20%

2.10 STATEMENT OF QUOTATION

A manufacturer, sometimes, may be asked to quote a price for supply a particular
article with certain specifications. The term ‘Quotation’ refers to quoting the
minimum price for obtaining a specific order. Such a price is quoted before the
commencement of actual production in anticipation of obtaining a particular order.
While quoting the price the manufacturer has to keep in view the likely impact of
inflationary trends on the input. Before submitting a tender or fixing price he must
have full information regarding cost of inputs like raw materials, wages, different
overheads and a reasonable amount of profit. On the basis of past records, he can
prepare a cost sheet incorporating inflationary trends in price levels of various
components of production. While quoting the price for such specific order, he has to
be cautious that the price is neither too high nor too low. In case the price is too high,
the tender will be rejected outright. On the other hand, if the price is too low, it will
result in either lower profit or loss. Therefore, it is important to estimate the cost as
accurately as possible.
Statement of quotation is prepared in the same manner as Cost Sheet as shown in
illustration 3

Illustration 3
A manufacturing company receives a quotation for the supply of 10,000 units of its
products. The costs are estimated as follows :
Raw material 80,000 kgs. @ Rs. 4 per kg.
Direct wages 10,000 hours @ Rs. 2 per hour
Variable overheads :
Factory @ Rs. 2.50 per labour hour
Selling and Distribution Rs. 30,000
Fixed Overheads :
Factory Rs. 10,000
Office and Administration Rs. 75,000
Selling and Distribution Rs. 20,000
The company adds 10% to its cost as its margin of profit. Prepare a Statement of
Quotation showing the price to be quoted.

5 3
Fundamentals of Solution
Accounting
Statement of Quotation showing the price to be quoted for 10,000 units

Total Per Unit

Rs. Rs.
Estimated cost of Direct Materials 3,20,000 32.00
(80,000 kgs X Rs. 4 per kg)
Estimated Cost of Direct Labour 20,000 2.00
(10,000 hours X Rs. 2 per hour)
Estimated Prime Cost 3,40,000 34.000
Add : Estimated Factory Overheads :
Variable (10,000 hours X Rs. 2.50) 25,000
Fixed 10,000 35,000 35.00
Estimated Factory Cost 3,75,000 37.50
Add:Estimated Office and Administrative 75,000 45.00
Overheads
Estimated Cost of Production 4,50,000 45.00
Add: Estimated Selling and Distribution Overheads
Variable Rs. 30,000
Fixed Rs. 20,000 50,000 5.00
Estimated Cost of Sales 5,00,000 50.00
Add: Deserved Profit @ 10% on cost price 50,000 5.00
Estimated Selling Price 5,50,000 55.00

Sometimes, cost records for a particular period are given and the estimated cost of
material and labour of a work order are provided for the purpose of ascertaining its
selling price to be quoted. In such a situation, you should prepare the cost sheet first
and ascertain the recovery rates for factory overheads as a percentage to direct wages,
for administrative overheads as a percentage of works costs, and for selling and
distribution overheads as percentage of cost of goods sold or as suggested in the given
question. These rates must be duly adjusted with the anticipated changes, if any,
before preparing the statement of quotation. Look at the following illustration and
how the statement of quotation for a work order is prepared with the help of a give
cost data.
Illustration 4
The following figures have been obtained from the cost records of a manufacturing
company for the year 2002 :
Cost of Materials 1,20,000
Wages for Direct labour 1,00,000
Factory overheads 60,000
Distribution expenses 28,000
Administration expenses 67,200
Selling expenses 44,800
Profit 84,000
A work order was executed in 2003 and the following expenses were incurred :
Cost of Materials 16,000
Wages for labour 10,000
Assuming that in 2003 the rate for factory overheads went up 20%, distribution
charges went down by 10% and selling and administration charges went up by 12 1 2 ,
5 4
at what price should the product be quoted so as to earn the same rate of profit on the Basic Cost Concepts
selling price as in 2002. Show the full workings.
Factory overheads are based on direct wages while administration, selling and
distribution expenses are based on factory cost.

Solution
Statement of Cost for the year 2002
Rs.
Cost of Direct Materials 1,20,000
Direct wages 1,00,000
PRIME COST 2,20,000
Factory Overheads 60,000
WORK COST 2,80,000
Administration Overheads 67,200
COST OF PRODUCTION 3,47,200
Selling Overheads 44,800
Distribution Overheads 28,000
COST OF SALES 4,20,000
Profit 84,000
SALES 5,04,000

Factory Overheads
Factory Overhead Rate = ————————— × 100
Direct Wages

60,000
= ———— × 100
1,00,000

= 60%

Administration Overheads
Administrative Overheads Rate = ——————————— × 100
Works Cost

67,200
= ———— × 100
2,80,000

= 24%

Selling Overheads
Selling Overheads Rate = ———————— × 100
Works Cost

44,800
= ————— × 100
2,80,000

= 16%
Distribution Overheads
Distribution Overhead Rate = —————————— × 100
Works Cost

28,000
= ————— × 100
2,80,000

= 10% 5 5
Fundamentals of
Accounting Profit
Rate of Profit = —————— × 100
Cost of Sales

84,000
= ———— × 100
4,20,000

= 20% cost of sales

Statement of Quotation showing the price to be quoted for a work order

Rs.
Cost of Direct Materials 16,000
Direct wages 10,000
PRIME COST 26,000
Factory Overheads : 60% of wages 6,000
Add 20% increase 1,200 7,200
WORK COST 33,200
Administration Overheads: 24% of works cost 7968
1 996 8,964
Add : 12 increase
2
COST OF PRODUCTION 42,164
Selling Overheads : 16% of works cost 5312
1
Add : 12 increase 664 5,976
2
Distribution Overheads : 15% of works cost 3320
Less : 10% decrease 332 2,988
COST OF SALES 51,128.00
Profit (20% of Cost of Sales) 10,225.50
SALES 61,353.50

Check Your Progress B

1) What is a cost Sheet ?
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................

2) Name the basic methods of costing

..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
3) Name different types of costing.
..........................................................................................................................
..........................................................................................................................

5 6
..........................................................................................................................
4) What do you mean by quotation? Why is it necessary ? Basic Cost Concepts

..........................................................................................................................
..........................................................................................................................
..........................................................................................................................
5) State whether each of the following statement is True or False
i) Selling and distribution overheads are recovered on the basis of
percentage to cost of production.
ii) Office and administrative overheads are recovered usually on the basis of
percentage to factory cost.
iii) Factory overheads rate is usually calculated as a percentage of direct
wages.
iv) Cost of sales = Factory cost + Selling and Distribution overheads.
v) Selling price = Cost of sales + Profit.

2.11 METHODS OF COSTING

Business enterprises are not alike. They are different from another in some way or
other. The basic principles and procedures of costing remains the same in all
industries but the method of analysis and presentation of cost of their products and
services vary from industry to industry. Therefore, the choice of a particular method
of costing depends upon the nature and types of the product or service provided by a
business unit. The various methods of costing can be summarized as follows :

2.11.1 Job Costing

Under this method, costs are ascertained for each job or work order separately. The
job may consist of a single unit or it may consist of identical or similar products under
a single work order. This method applies where work is undertaken against
customers’ requirements. Job costing is suitable to industries like printing, repairs,
foundries, interior decorators, building construction etc. Non profit organisations like
rehabilitation or street repair programmes also use job costing to ascertain cost of
individual projects. It can also be used in industries where different product lines are
manufactured. For example, a furniture manufacturer may produce a batch of similar
chairs, a batch of tables and so on. Each batch can be treated as a job for accounting
purposes. Job costing also found in service organisations like engineering,
consultancy and accounting firms. Job costing procedure is the same both in
manufacturing and service organisations, except that service units use no direct
material.
The purpose of job costing is to ascertain the cost of production of each job for fixing
selling prices, bidding, controlling costs and evaluating performance. It also provides
information for negotiating price increase with the customers.

2.11.2 Contract Costing

This method is used in case of big jobs and therefore, the principles of job costing are
applied to contract costing The contract work usually involves heavy expenditure,
spreads over a long period and is usually undertaken at different sites. Hence, each
contract is treated as a separate unit for the purpose of cost ascertainment and control.
Contract costing is also termed as terminal costing as the cost can be terminated at
some point and related to a particular job. Contract costing is employed in business
undertakings engaged in construction of buildings, roads, bridges, ship building and
other civil and mechanical engineering works. 5 7
Fundamentals of 2.11.3 Batch Costing
Accounting
This method of costing is used in industries where the production is carried on in
batches. Each batch consist of identical products which maintains its identity
throughout one or more stages of production. Each batch cost is used to determine the
unit of cost of products. On completion of the batch the cost per unit can be
calculated by dividing the ‘total batch cost’ by the number of units produced. This
method of costing is suitable to industries where production consists of repetitive
production in nature and specified number of products are produced in one batch. It
is generally used in industries like engineering component industry, pharmaceuticals,
footwear, bakery, readymade garments, toy manufacturing, bicycle parts etc.

2.11.4 Unit Costing

Unit Costing is a method of cost accounting where costs are determined per unit of a
single product. This method is also called single or output costing. This method is
suitable to industries where production is continuous and uniform and engaging in the
production of a single product in two or three varieties. The cost per unit is found by
dividing the total cost by the total number of units produced. Where the product is
produced in different grades, costs are ascertained grad wise. It is suitable for
industries like collieries, quarries, brick works, flour mills, paper mills, cement, textile
mills, diaries etc.

2.11.5 Process Costing

Where a product passes through different processes and each process is distinct and
well defined the method employed for ascertaining the cost at each stage of production
is called process costing. Process costing is used in those industries where the
production is continuous and the final product is the result of sequence of operations
or processes. The finished product of one process will become the raw material of the
next process and the output of the last process will be the finished stock. The cost per
unit at each process will be calculated by dividing the total cost by the number of units
produced at each stage and the cost per unit of the final product is the average cost of
all the processes. During the course of processing of raw material, loss of some raw
material is unavoidable or it may give rise to the production of several products called
joint products or by products. Process costing is used in case of chemicals, paints,
textiles, bakeries, oil refining, food products, etc. Standardization of processes helps
the management to submit quotations in time without any delay. As actual and
budgeted costs are available in each process it facilitates managerial control by
evaluating the performance at each process level.

2.11.6 Operating Costing

Operating Costing is also called as ‘service costing’ because this method is used in
those undertakings which provide services and are not engaging in manufacturing
tangible products. It is used for ascertaining the cost of operating a service such as
railways, roadways, airways, hotels, nursing homes, power supply, water supply etc.
In these undertakings the cost unit is a service unit which is as follows:
Undertaking Cost Unit
Canteen per cup of tea
Cinema per seat
Electricity per kilo watt
Hospital per bed
School/College per student
Transport per passenger kilometer/per tonne kilometer
5 8
A large amount of capital is invested in fixed assets and comparatively less Basic Cost Concepts
working capital is required in these industries. Operating costing is different from
operation costing. Operating costing is used to determine the cost of providing a
service whereas operation costing is used to find out cost of each operation
in those of industries which produce goods consisting of a number of
operations.

2.11.7 Multiple Costing

It is an application of more than one method of costing in respect of the same
product. This method is suitable in industries where a number of components are
manufactured separately and then assembled into a finished product. In cases of
motor car, type writer, television, refrigerators, etc., costs are to be ascertained for
each component as well as for finished product. This involves use of different
methods of costing for different components and so it is known as ‘multiple’ or
‘composite costingí.

2.11.8 Uniform Costing

The practice of using a common method of costing by a number of firms in the same
industry is known as ‘uniform costing’. Thus it is not a separate method of costing. It
simply refers to a common system using agreed concepts, principles and standard
accounting practices. This helps in making inter-firm comparisons and fixation of
prices.
It should be noted that there are two basic methods of costing. They are : (i) Job
costing, and (ii) Process costing. The other methods discussed above are simply
variants of these two methods.

2.12 TYPES OF COSTING

2.12.1 Marginal Costing

It is also known as Variable Costing. It may be defined which methods of costing
rebers to the process and practice of ascertaining costs of products and serrices, the
types of costing rebers to the techniqu of analysing and presenting costs for the
purpose of control and managerial decisions. The hypes of costing (also known as
techniques of costing) generally used are as follows:
as ‘‘the ascertainment of marginal costs and of the effect on profit of changes in
volume or type of output by differentiating between fixed costs and variable costs.’’ It
is a technique of costing which emphasizes the distinction between product costs and
period costs. Only variable costs (direct material, direct labour, other direct expenses
and variable overheads) are allocated to products without taking into account fixed
costs. Fixed costs are treated as period costs and are charged to costing profit and
loss account of the period in which they are incurred. The profitability of the product
is based on the amount of contribution made by each product. Contribution is the
difference between selling price and marginal cost of sales. The price of a product
will be determined on the basis of marginal cost plus contribution. The difference
between the total contribution and total fixed cost represents the profit (Profit =
Contribution – Fixed cost).
The technique of marginal costing is a valuable tool to management in making
managerial decisions like fixation of selling price, selection of suitable product mix,
selection of alternative methods of production, make or buy decisions, and also for
cost control.
5 9
Fundamentals of 2.12.2 Absorption Costing
Accounting
Absorption costing is a principle whereby fixed as well as variable costs are allotted
to cost units. It is a technique of charging all costs, both fixed and variable costs, to
production of a product. Absorption costing does not require a break-down of costs
into fixed and variable costs. As such fixed costs are treated as product costs under
absorption costing. The reports prepared under absorption costing can be used for
external use.

2.12.3 Historical Costing

It refers to a system of cost accounting under which costs are ascertained only after
they have been incurred. In other words, accounting is done in terms of actual costs
and not in terms of predetermined and standard costs. In the initial stages of
development of cost accounting, historical costing is the only system available for
ascertaining costs. This system is not useful for cost control and measuring the
performance efficiency of the concern. Moreover, it is not useful in price quotations
and production planning.

2.12.4 Standard Costing

It refers to the system of cost accounting under which costs are determined in advance
on certain predetermined standards. These are known as standards which indicate the
level of costs that should be attained under a given set of operating conditions. The
standard costs are compared periodically with the actual costs and underlying causes
for variances are analysed so that corrective action may be taken in time wherever
necessary. The Standard Costing is helpful to the management for cost control,
production planning, formulation of policies, measuring efficiencies, eliminating
inefficiencies, etc.

2.13 LET US SUM UP

Cost data is required by an organisation for the purpose of ascertaining profit or loss
periodically, to plan its future operations as well as to evaluate its performance and
cost control. It also requires to price its products or services, to value its inventory and
day to day operations of plans and policies. Costs indicates (i) an actual or estimated
expenditure (ii) a direct or indirect expenditure and (iii) it relates to a job, process,
product or services. Cost is a flexible concept. It varies with time, volume, firm,
method or purpose. There is difference between ‘cost’ and ‘loss’. Cost signifies an
expenditure incurred for recurring some benefit and if no benefit is desired from a
particular expenditure, it is treated as loss.
Cost can be classified in various ways. On the basis of functions to which they relate,
costs are classified into manufacturing costs, administrative costs, selling and
distribution costs. On the basis of Identifiability with products costs can be classified
into direct costs and indirect costs. On the basis variability costs can be classified into
fixed costs, variable costs and semi variable costs. Costs can also be classified on the
basis of product or period. Product costs are those costs which are easily attributable
to products where as costs which are easily attribute to time interval are known as
period costs. Costs can also be classified on the basis of controllable and non-
controllable costs.
A cost unit is a unit of product, service or time in relation to which costs may be
ascertained or expressed. A cost centre is a location, person or item of equipment (or
group of these) for which costs may be ascertained and used for the purpose of
control. There are three elements of costs : (i) Materials (ii) Labour and (iii)
6 0
Expenses. These costs can be further sub-dividend into as direct or indirect costs. Basic Cost Concepts
Indirect costs are : indirect material, indirect labour, and indirect expenses. Indirect
costs are known as ‘overheads’. Overheads can be classified into factory overheads,
office overheads, selling and distribution overheads.
The main components of total cost are prime cost, works cost, cost of production and
cost of sales. The elements of cost can be presented in the form of a statement called
‘cost sheet’ A cost sheet is a statement showing the various components of total cost
of output for a certain period which acts as a guide to pricing decisions and cost
control. Overhead recovery rates are based on the cost sheet. Sometimes, a statement
of quotations is required to be prepared in order to find out the price to be quoted to
the prospective buyer for obtaining a specific order. Such a price is quoted before the
commencement of actual production after taking into consideration the inflationary
trends in the price levels of various components of production.
There are various methods of costing. These are: (i) Job costing (ii) Contract costing
(iii) Batch costing (iv) Unit costing (v) Process costing (vi) Operating costing (vii)
Multiple costing (viii) Uniform costing. The types of costing refers to the techniques
of analysing and presenting costs for the purpose of control and managerial decisions.
The types of costing generally used are: (i) Marginal costing (ii) Absorption costing
(iii) Historical costing, and (iv) Standard costing.

2.14 KEY WORDS

Allocation: Distribution of expenditure among various cost centres.
Costing: The technique and process of ascertaining costs.
Cost Sheet: A statement showing different elements of cost relating to a particular
product or a job for a particular period.
Cost Centre: A location, person, equipment or department for which costs may be
ascertained and used for purpose of control.
Direct Expenses: Expenses or decrease in the same proportion on the increase or
decrease in the output.
Cost of Sales: Total cost of a product including selling and distribution expenses.
Prime Cost: Cost of direct expenses including direct materials and wages.
Semi-variable costs: Expenses which change with changes in output, but not in the
same proportion.
Works cost: Prime cost plus factory overheads.
Chargeable expenses: Other direct expenses.
By-product: A product of relatively small value produced incidentally from
processing the raw material for the main product.
Joint Product: Two or more products resulting from processing a particular raw
material.
Process Costing: A method of ascertaining the cost of a product at each stage or
process of manufacturing.
Contract Costing: A special form of job costing applicable to big projects which
involves huge cost to complete and is usually site-based.
Job Costing: Specific order costing involving accumulation of costs relating to a
single cost unit - the job - when each order is of comparatively short duration.
6 1
Fundamentals of
Accounting 2.15 ANSWERS TO CHECK YOUR PROGRESS
A) 6 i) True (ii) False iii) True (iv) True (v) True (vi) False (vii)True
B) 4 i) False (ii) True iii) True iv) False v) True

2.16 TERMINAL QUESTIONS

1) Distinguish among variable, fixed and semi-variable costs. Why is this distinc-
tion important?
2) ‘‘fixed Costs are really variable. The more you produced the less they become’’.
Comment the statement.
3) Describe briefly the different methods of costing and state the particular indus-
tries to which they can be applied.
4) Distinguish between the following :
i) Product cost and period cost
ii) Controllable and uncontrollable cost
iii) Variable and fixed costs
iv) Direct and indirect costs
5) Costs may be classified according to their nature and characteristics’ Explain.
6) Cooling Ltd manufactured and sold 1,000 refrigerators in the year ending 31st
March, 2002. The summarized Trading and Profit & Loss Account is set out
below :
Rs. Rs.
To Cost of Sales 8,00,000 By Sales 40,00,000
To Direct Wages 12,00,000
To Other Manufacturing Cost 5,00,000
To Gross Profit c/d 15,00,000
40,00,000 40,00,000
To Management and Staff Salaries 6,00,000 By Gross Profit b/d 15,00,000
To Rent, Rates and Insurance 1,00,000
To Selling Expenses 3,00,000
To General Expenses 2,00,000
To Net Profit 3,00,000
15,00,000 15,00,000

For the year ending 31st March, 2003, it is estimated that

a) Output and sales will be 1,200 refrigerators.
b) Prices of Material will go up by 20% on the level of previous year.
c) Wages will rise by 5%
d) Manufacturing costs will rise in proportion to the combined cost of Material and
wages.
e) Selling cost per unit will remain unaffected
f) Other expenses will also remain constant
You are required to submit a statement to the Board of Directors showing the price at
which the refrigerators should be marketed so as to show profit of 10% on selling
price.
6 2 (Answer : Estimated selling price Rs. 51,00,000 Profit Rs. 5,10,000)
7) The following particulars have been made available from the Cost Ledger of a Basic Cost Concepts
Company :
Rs.
Stock of Raw materials on 31.12.2000 25,600
Stock of finished Goods on 31.12.2000 56,000
Purchase of Raw materials 5,84,000
Direct wages 3,97,000
Sales 11,84,000
Stock of Raw Materials on 31.12.2001 27,200
Stock of Finished goods on 31.12.2001 60,000
Works Overheads 88,072
Office and general Charges 71,048
The company is required to submit a tender for a large machine. The Cost
Department estimates that the materials will cost Rs. 40,000 and wages to fabricate
the machine Rs. 24,000. The tender is to be made at a net profit of 20% on selling
price.
Prepare a statement showing a) Cost of materials used, b) total cost, c) percentage of
factory overheads to direct wages, and d) percentage of office overheads to works
cost.
Also prepare a statement of quotation showing the price at which the tender of the
machine can be submitted.
(Answer : Cost of materials used Rs. 5,82,400; Total Cost Rs. 11,38,520;
Percentage of Factory overheads to Direct Wages 22%; Percentage of Office
Overheads to Works Cost 6.65%; Price to be quoted in tender : Rs. 92,360)

Note : These questions will help you to understand the unit better.
Try to write answers for them. But do not submit your
answers to the University. These are for your practice only.

2.17 SOME USEFUL BOOKS

Arora, M. N. 2000, A Text Book of Cost Accountancy. Vikas Publishing House Pvt.
Ltd., New Delhi (Chapter 1-2).
Bhar, B. K. 1990. Cost Accounting : Methods and Problems. Academic Publishers,
Calcutta (Chapter 1-2)
Maheswari, S. N. and Mittal, S. N. 1990. Cost Accounting : Theory and Problems.
Shree Mahavir Book Dept, Delhi (Chapter I)
Nigam B. M. L. and Sharma G. L. 1990. Theory and Techniques of Cost Accounting.
Himalaya Publishing House, Bombay (Chapter 1-3)
Owler. L. W. J. and J. L. Brown 1984. Wheldon’s Cost Accounting. ELBS, London
(Chapter 1-2)

6 3