Cost Accounting

Definition Chartered Institute Of Management Accountants ( CIMA London ) “ Costing is the technique and process of ascertaining cost”

Cost Accounting Cost accounting measures and reports information relating to the cost of acquiring and utilizing resources Cost accounting provides information for management and financial accounting Cost management describes the approaches and activities of managers in short-run and long-run planning and control decisions These decisions increase value of customers and lower costs of products and services Cost management is an integral part of a company’s strategy

Cost Accounting It provides information for both management accounting and financial accounting. It measures and reports from financial and non financial data.

Financial Accounting Financial accounting measures and records business transactions and provides financial statements that are based on generally accepted accounting principles (GAAP) Managers are responsible for the financial statements issued to investors, government regulators, and other parties outside the organization Financial accounting focuses on external parties Financial accounting reports on what happened in the past

Costs and Cost Objects Cost a resource sacrificed or foregone to achieve a specific objective Cost Object any product, machine, service or process for which cost information is accumulated cost objects can vary in size from an entire company, to a division or program within the company, or down to a single product or service

Direct and Indirect Costs Direct Cost a cost which is related to a particular cost objective and can be traced to it in an economically feasible way Indirect Cost a cost which is related a particular cost objective but cannot be traced to it in an economically feasible way indirect costs are allocated to cost objectives Direct Cost Indirect Cost Cost Object Trace Allocate

Cost Drivers and Cost Management Cost driver (cost generator or cost determinant) a factor which causes the amount of cost incurred to change production costs are driven by the number of products produced, labour costs, number of setups required, and the number of change orders Cost Reduction Programs focus on two things: Doing only value-added activities Efficiently manage the use of cost drivers in those value-added activities

Variable and Fixed Costs Variable Cost a cost which is constant per unit but changes in total in proportion to changes in the output materials (parts), fuel costs for a trucking company Rs Volume Rs Volume Fixed Cost a cost which does not change in total as volume changes but changes on a per-unit basis as the cost driver increases and decreases amortization, insurance

Total Costs and Unit Costs Unit Cost (or Average Cost) Total cost / some number of units Average cost = Total manufacturing costs / Number of units produced = Rs980,000 / 10,000 = Rs98 per unit Unit or average costs must be interpreted with caution As volume increases, the unit or average cost falls as the fixed costs are spread over a larger number of units

Types of Inventory Direct material inventory (stock awaiting use in the manufacturing process) Work-in process inventory (partially completed goods on the shop floor) Finished goods inventory (goods completed but not yet sold)

Period and Product Costs Period Costs are expensed on the income statement as they are incurred also called operating costs (excluding cost of goods sold) examples: selling, general and administrative costs Product Costs are inventoried on the balance sheet and expensed only when the product or service is sold also called inventoriable costs Examples: materials and labour (manufacturing)

Costing System Terminology Cost Object anything for which a separate measurement of costs is desired Cost Pool a grouping of individual cost items Cost Allocation Base a factor that is the common denominator for systematically linking an indirect cost or group of indirect costs to a cost object

Alternative Classifications of Costs Business function R&D Design Production Marketing Distribution Customer service Assignment to a cost object Direct costs Indirect costs Behaviour pattern Variable costs Fixed costs Aggregate or average Total costs Unit costs Assets or expenses Inventoriable costs Period costs

Costs in a Manufacturing Company Inventoriable (Product) Costs Direct Material Purchases Work in Process Inventory Cost of Goods Sold Revenue Gross Margin Marketing and Administrative Costs Operating Income Period Costs Income Statement Balance Sheet Materials Inventory Direct Labour Indirect Manufacturing Costs Finished Goods Inventory

Costing Systems Job-Costing System Costs are assigned to a distinct unit or batch Resources are expended to bring a distinct product or service to market for a specific customer advertising campaign, audit, aircraft assembly Process-Costing System Costs are assigned to a mass of similar units Resources are used to mass-produce a product or service and not for any specific customer Postal delivery, oil refining

Job Costing Approach 1. Identify the cost object(s) 2. Identify the direct costs for the cost object(s) 3. Select cost-allocation bases to use in allocating the indirect costs to the cost object(s) 4. Identify the indirect costs associated with each cost-allocation base 5. Compute the rate per unit of each cost-allocation base to allocate indirect costs to the cost object(s) 6. Compute the indirect costs allocated to the cost object(s) 7. Determine the cost of the cost object(s) by adding the direct and indirect costs

Job Costing Overview Indirect Cost Pool Manufacturing Overhead Rs1,215,000 Rs45 per direct Manufacturing Labour Hours Cost Object: Direct + Indirect Costs Direct Material Direct Labour Cost Allocation Base 27,000 Direct Manufacturing Labour-Hours

Job Costing System in Manufacturing Cost of Goods Sold Finished Goods Inventory Work-In-Process Inventory Materials Inventory Buy Materials Use Materials Incur Labour Costs Incur Overhead Costs Complete Production Sell Goods

Cost Sheet It is a statement designed to show the output of a particular accounting period along with breakup of cost. It is a memorandum statement It does not form part of double entry cost accounting records. It discloses the total cost and cost per unit. It helps To fix Selling Price. To submit quotation price. To Control cost.

COST SHEET Direct Materials Direct Labour Prime Cost Add: Works Overheads Works Cost Add: Administration overheads Cost of Production Add: Selling & Distribution Overheads Total Cost or Cost of Sales Cost Per unit Total Cost

Elements of Cost Direct Material :- Identify in the product Easily measure & directly charge to the product e.g. Timber in furniture making Categories raw material Specifically purchased for specific job or process Parts or components purchased. e.g. tyres for cycles Primary Packing material to protect finished product for easy handling inside the factory.

Direct Labour :- Labour engaged in converting raw material into finished goods Altering the construction Actual Production Composition of Product i.e labour which can be attributed to a particular job,product or process Exception :- Where the cost is not significant like wages of trainees- their labour though directly spent on product is not treated as direct Labour Test:- Easily Identify Feasible to Identify

Overheads :- It may be defined as the aggregate of the cost of indirect materials, indirect labour and such other expenses including services as can’t conveniently be charged direct to specific cost unit. Categories:- Manufacturing Overheads Administration of machines Selling & distribution of machines

Why is Standard Costing Used? A standard is a preestablished benchmark for desirable performance. A standard cost system is one in which a company sets cost standards and then uses them to evaluate actual performance. A variance is the difference between actual performance and the standard.

Favorable versus Unfavorable An unfavorable variance occurs when actual performance falls below the standard. A standard is a preestablished benchmark for desirable performance.

. Standard cost is the Predetermined cost based on a technical estimate for material, labor and overhead for a selected period of time and for a specified set of working conditions. Standard costing is the preparation of standard cost and applying them to measure the variations from actual costs and analyzing the causes of variations with a view to maintain maximum efficiency in production

Quantity and Price Standards What can cause a cost to increase? Quantity used Price paid

Ideal versus Practical Standards A standard that allows for the normal inefficiencies of production is called a practical standard. A standard that allows for no inefficiencies of any kind is an ideal standard.

The Standard Costing Process Gather information and set standards. Compare actual performance to standard and prepare performance reports. Determine which variances to investigate. Investigate the cause of variances. Take corrective action. Determine if corrective action is needed.

Problems With Standard Costing Employees may try to set low standards to make them easier to achieve. Using historical data to set standards may build in past inefficiencies. Managers might focus on the “ numbers” to the exclusion of other important factors.

Problems With Standard Costing Focus on unfavorable variances may result in ignoring the favorable variances. Managers may lose sight of the big picture.

Comparison of Cost Systems Cost Classification Actual Cost System Normal Cost System Standard Cost System Direct Material Direct Labor Manufacturing Overhead Actual Actual Actual Actual Actual Estimated Estimated Estimated Estimated

Analysis of Variance may be done in respect of each element of cost and sales: 1.Direct Material Variance 2.Direct Labor Variance 3.Overhead Variance 4.Sales Variance Analysis of Variance

Material Variances Material Cost Variance: (Standard Price x Standard Rate) - ( Actual quantity x Actual Rate )

Direct Materials Variances There are two variances calculated for material cost variance. The material quantity variance (also called the usage variance) is a measure of the amount of materials used. The material price variance is a measure of the cost to buy the various materials that were purchased.

Material Variances Material price variance: Material quantity variance: ( Standard material price – Actual material price) × Actual material quantity ( Standard material quantity – Actual material quantity) × Standard unit price

Direct Materials Variances Again Material Qt variances can be divided into two varainces The material mix variance . The material Yield variance

Material Mix Variances Standard Cost of Standard Mix – Standard Cost of Actual Mix Std. Unit cost (SQ – AQ) Actual weight do not differ

Material Mix Variances Actual weight differ Total wt. Of actual mix X Std. Cost - Std. Cost Total wt. Of standard of Std. Mix of actual mix mix

Material Variances Material yield variance: Standard Rate (Actual Yield – Standard Yield ) {If std. & actual mix are same} Standard Rate = Std. Cost of Std. Mix Net Std. Output (Gross output – Standard loss)

Material yield Variances {Standard Rate (Actual Yield – Revised Standard Yield ) If std. & actual mix are not same} Standard Rate = Std. Cost of Revised Std. Mix Net Std. Output (Gross output – Standard loss)

Labor Variances The labor cost variance is the difference between actual cost of hour worked and the standard cost allowed. The labor rate variance is the difference between the actual direct labor cost incurred and the standard cost for the actual hours worked.

Labor variance: St. Cost of labor – Actual cost of labor Rate variance =Actual Time Taken (Standard Rate – Actual Rate) Labor Cost Variance Labor Rate Variance

Standard Rate (Standard time for actual Output - Actual time Paid for) Total Labor Efficiency Variance

Labor Variances Total Labor efficiency variance are of two types Labor Efficiency Variance Labor Idle Time variance

Labor Variances Labor Efficiency Variance Labor Efficiency Variance = Standard rate(Standard time for actual output - Actual time worked)

Labor Variances Labor Idle Time variance = Abnormal Idle Time x Standard Rate Labor Idle Time variance

St. Cost of St Composition (Actual time taken)– Standard cost of actual Composition ( Actual time worked) Labor Mix Variance Labor Variances

Standard Rate (Actual Yield –Revised Standard Yield) Labor Yield Variance Labor Variances

Overhead cost variance can be defined as the difference between the Standard cost allowed for the actual output achieved and the actual overhead cost incurred. Overhead Variance:

Overhead :- According to terminology of cost Accountancy (ICWA London) Overhead is defined as “ The aggregate of indirect material cost, indirect wages (indirect Labor Cost) and indirect expenses.”

Overhead Costs Overhead costs are significant for most organizations Variable Overhead Recall that variable overhead is allocated to products and services using a budgeted variable overhead rate Fixed Overhead Recall that fixed overhead is allocated to products and services using a budgeted fixed overhead rate

Overhead Cost Variances Variable Overhead Fixed Overhead How the Cost is Planned and Controlled How Costs are Allocated to Products Rs Volume Rs Volume Rs Volume Rs Volume

Overhead cost Variance:- Overhead Cost Variance Variable overhead variance Fixed overhead variance Expenditure Efficiency Expenditure Volume variance variance variance variance Capacity Calendar Efficiency variance variance variance

Overhead Cost Variance :- Overhead Cost Variance ( Actual output x Standard overhead Rate per unit ) – Actual overhead cost

Overhead Cost Variances Overhead Cost variances can be divided into two varainces Variable Overhead variance . 2. Fixed Overhead variance

Variable Overhead Variance Variable Overhead variance (Actual output x Standard variable overhead rate) – (Actual variable overheads)

Variable Overhead Variances Variable Overhead variances can be divided into two variances Variable Overhead Expenditure variance . 2. Variable Overhead Efficiency variance

(A) Variable overhead (spending) expenditure variance = (Actual hours worked x standard variable overhead rate) – Actual variable overheads (B) Variable overhead efficiency variance = Standard variable overhead rate(standard Hours for Actual output – Actual Hours)

Fixed overhead variance Fixed overhead variance (Actual output x standard fixed overhead rate) – Actual fixed overheads Fixed overhead variance can be categorized into:- Expenditure variance = Budgeted Fixed overheads – Actual fixed overheads Volume variance = actual output x Standard rate – Budgeted fixed overheads

Capacity variance = standard rate( Revised Budgeted units – Budgeted units) Calendar variance = (Decrease or increase in number of units produced due to the difference of budgeted and actual days x standard rate per unit) e) Efficiency Variance = Standard Rate (Actual Production – Standard Production)

Using Standard Cost Variances A performance report should be prepared on a periodic basis for the managers who are responsible for the standard cost variances. The management by exception concept would then be used by the managers to focus their attention on the most significant cost variances.

Marginal Costing :- Chartered Institute of Management Accountant , England- “ Marginal costing is the ascertainment of marginal cost and of the effect on profit of changes in volume or type of output by differentiating between fixed cost and variable costs”.

Features of Marginal Costing: Cost is classified into : Fixed Cost Variable Cost Variable cost is only charged to production Fixed cost is recovered from contribution Valuation of stock of WIP and F.G. is done on the basis of marginal cost. Selling price is based on marginal cost and contribution It is technique used to ascertain the marginal cost & to know the impact of V.C. on volume of output Profit is calculated by deducting marginal cost and fixed cost from sales C-V-P analysis is one of integral part of marginal costing

Costs Fixed (Indirect/Overheads) – are not influenced by the quantity produced but can change in the long run e.g., insurance costs, administration, rent, some types of labour costs (salaries), some types of energy costs, equipment and machinery, buildings, advertising and promotion costs. Variable (Direct) – vary directly with the quantity produced, e.g., raw material costs, some direct labour costs, some direct energy costs. Semi-fixed – Where costs not directly attributable to either of the above, for example some types of energy and labour costs.

Costs Total Costs (TC ) = Fixed Costs (FC)+ Variable Costs (VC) Average Costs = TC/Output (Q) AC (unit costs) show the amount it costs to produce one unit of output on average Marginal Costs (MC) – the cost of producing one extra or one fewer units of production MC = TC n – TC n-1

Revenue Total Revenue – also known as turnover, sales revenue or ‘sales’ = Price x Quantity Sold TR = P x Q Price – may be a variety of different prices for different products in the portfolio Quantity – Units sold

Profit Profit = TR – TC Normal Profit – the minimum amount required to keep a business in a particular line of production Abnormal/Supernormal Profit – the amount over and above the amount needed to keep a business in its current line of production

Marginal Cost Equation Sales = Variable Cost + Fixed Cost + Profit/Loss Sales - Variable Cost = Fixed Cost + Profit/Loss Sales - Variable Cost = Contribution Therefore, Contribution = S.P. – V.C. or Contribution = Fixed Cost + Profit

Cost-Volume-Profit (CVP) Analysis

Cost volume Profit Analysis Cost volume Profit Analysis is a logical extension of marginal costing C.V.P. analysis examines the relationship of cost & profit to the volume of business to maximize profits Indicates direct relationship between volume & profit Indicates Indirect relationship between volume & cost per unit (Inverse)

Cost-Volume-Profit Assumptions and Terminology 1. Changes in the level of revenues and costs arise only because of changes in the number of product (or service) units produced and sold. 2. Total costs can be divided into a fixed component and a component that is variable with respect to the level of output.

Cost-Volume-Profit Assumptions and Terminology 3. When graphed, the behavior of total revenues and total costs is linear (straight-line) in relation to output units within the relevant range (and time period). 4. The unit selling price, unit variable costs, and fixed costs are known and constant.

Abbreviations SP = Selling price VCU = Variable cost per unit CMU = Contribution margin per unit CM% = Contribution margin percentage FC = Fixed costs

Abbreviations Q = Quantity of output units sold (and manufactured) OI = Operating income TOI = Target operating income TNI = Target net income

Breakeven Point Sales Variable expenses Fixed expenses – = Total revenues = Total costs

Break Even Point of No Profit and No Loss Occurs where Total Costs = Total Revenue Fixed Costs Break-Even Point = --------------- Contribution

Break even point ( Rs ) =Fixed Cost / P/V ratio Break Even point (Units) = Fixed Cost (Total) ----------------------------- (S.P per unit – M.C per unit) or( Contribution per Unit) Cost-Volume-Profit Assumptions and Terminology P/V Ratio =  Profit /  Sales P/V Ratio = Contribution / Sales

Value of sales to earn desired amount of profit:- (Fixed Cost + Desired Profit) ------------------------------------------ P/ V ratio Cost-Volume-Profit Assumptions and Terminology

Variable Cost = Sales – (sales x P/V ratio) Profit= (sales x P/V ratio) – Fixed Cost Fixed Cost= (sales x P/v ratio) – Profit Margin of safety = (Rs) = Profit/ P/V ratio or = Actual sales – Break Even Sales (Units) = Profit / Contribution per unit Cost-Volume-Profit Assumptions and Terminology

Essentials of Cost-Volume-Profit (CVP) Analysis Example Assume that the Furniture Shop can purchase Chairs for Rs32 from a local factory; other variable costs amount to Rs10 per unit. The local factory allows the Furniture Shop to return all unsold Chairs and receive a full Rs32 refund per pair of Chairs within one year. The average selling price per pair of Chairs is Rs70 and total fixed costs amount to Rs84,000.

Essentials of Cost-Volume-Profit (CVP) Analysis Example How much revenue will the business receive if 2,500 units are sold? 2,500 × Rs70 = Rs175,000 How much variable costs will the business incur? 2,500 × Rs42 = Rs105,000 Rs175,000 – 105,000 – 84,000 = (Rs14,000)

Essentials of Cost-Volume-Profit (CVP) Analysis Example What is the contribution margin per unit? Rs 70 – Rs 42 = Rs 28 contribution margin per unit What is the total contribution margin when 2,500 pairs of Chairs are sold? 2,500 × Rs 28 = Rs70,000

Essentials of Cost-Volume-Profit (CVP) Analysis Example Contribution margin percentage (contribution margin ratio) is the contribution margin per unit divided by the selling price. What is the contribution margin percentage? Rs28 ÷ Rs70 = 40%

Essentials of Cost-Volume-Profit (CVP) Analysis Example If the business sells 3,000 pairs of Chairs, revenues will be Rs 210,000 and contribution margin would equal 40% × Rs 210,000 = Rs 84,000.

Equation Method Rs70Q – Rs42Q – Rs84,000 = 0 Rs28Q = Rs 84,000 Q = Rs84,000 ÷ Rs28 = 3,000 units Let Q = number of units to be sold to break even (Selling price × Quantity sold) – (Variable unit cost × Quantity sold) – Fixed costs = Operating income

Contribution Margin Method Rs84,000 ÷ Rs28 = 3,000 units Rs84,000 ÷ 40% = Rs210,000

Graph Method Revenue Total costs Breakeven Fixed costs

Target Operating Income (Fixed costs + Target operating income) divided either by Contribution margin percentage or Contribution margin per unit

Target Operating Income Assume that management wants to have an operating income of Rs 14,000. How many pairs of Chairs must be sold? (Rs84,000 + Rs14,000) ÷ Rs 28 = 3,500 What sales are needed to achieve this income? (Rs84,000 + Rs14,000) ÷ 40% = Rs245,000

Target Net Income and Income Taxes Example Proof: Revenues: 4,822 × Rs70 Rs337,540 Variable costs: 4,822 × Rs42 202,524 Contribution margin Rs135,016 Fixed costs 84,000 Operating income 51,016 Income taxes: Rs51,016 × 30% 15,305 Net income Rs 35,711

Alternative Fixed/Variable Cost Structures Example What is the new contribution margin? Decrease the price they charge from Rs32 to Rs25 and charge an annual administrative fee of Rs30,000. Suppose that the factory the Chairs Shop is using to obtain the merchandise offers the following:

Alternative Fixed/Variable Cost Structures Example Rs70 – (Rs25 + Rs10) = Rs35 Contribution margin increases from Rs28 to Rs35. What is the contribution margin percentage? Rs35 ÷ Rs70 = 50% What are the new fixed costs? Rs84,000 + Rs30,000 = Rs114,000

Alternative Fixed/Variable Cost Structures Example Management questions what sales volume would yield an identical operating income regardless of the arrangement. 28x – 84,000 = 35x – 114,000 114,000 – 84,000 = 35x – 28x 7x = 30,000 x = 4,286 pairs of Chairs

Alternative Fixed/Variable Cost Structures Example Cost with existing arrangement = Cost with new arrangement .60x + 84,000 = .50x + 114,000 .10x = Rs30,000  x = Rs300,000 (Rs300,000 × .40) – Rs 84,000 = Rs36,000 (Rs300,000 × .50) – Rs114,000 = Rs36,000

. Financial accounting income statement emphasizes gross margin. Contribution income statement emphasizes contribution margin.

Application Of Marginal Costing Cost Control Profit planning Evaluation of performance Decision Making Fixation of selling Price Key or limiting factors Make or Buy Decision

Selection of suitable product mix Effect of change in price Maintained a desired level of Profit Alternative methods of Production Diversification of Products Closing down of activities Alternative course of action Level of activity planning Application Of Marginal Costing

Typical Relevant Costing Decisions One-Time-Only Special Order (Pricing) Make or Buy Decisions (Outsourcing) Opportunity Costs Product Mix Decisions under Capacity Constraints Add or Drop a Product Line or Customer Equipment Replacement Decisions

One-Time-Only Special Order Without With Order Order Difference Volume 30,000 35,000 5,000 Relevant revenues Rs600,000 Rs655,000 Rs55,000 Relevant costs: Variable manufacturing (225,000) (262,500) (37,500) Incremental income Rs17,500

Outsourcing and Make/Buy Decisions Make Buy Difference Relevant costs: Outside cost of parts Rs160,000 Rs160,000 Direct materials Rs80,000 (80,000) Direct labour 10,000 (10,000) Variable overhead 40,000 (40,000) Fixed purchasing, receiving and setup overhead 20,000 (20,000) Incremental difference In favour of making Rs10,000

Outsourcing and Opportunity Costs Make Buy Relevant cost to make Rs150,000 Relevant cost to buy Rs 160,000 Opportunity cost: Profit forgone because Capacity cannot be used to make another product 25,000 Total relevant costs Rs175,000 Rs160,000 Opportunity cost considers the profits lost by not following the next best alternative course of action

Product Mix Decisions Under Constraint Snowmobile Boat Engine Engine Contribution margin per unit Rs240 Rs375 Machine hours required per unit 2 5 Contribution margin per machine hour Rs120 Rs75 If machine hours are constrained, maximize income by first producing as many snowmobile engines as can be sold and then shift production to boat engines

Customer Profitability Analysis Keep Drop Account Account Difference Relevant revenue Rs1,200,000 Rs800,000 Rs(400,000) Relevant costs: Cost of goods sold 920,000 590,000 330,000 Material-handling labour 92,000 59,000 33,000 Marketing support 30,000 20,000 10,000 Order/delivery 32,000 20,000 12,000 Decline in operating income if drop account Rs(15,000)

Cost Accounting

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