Unit – III: Cost Accounting – Elements of Cost – Preparation of Cost Sheet – Absorption Vs.

Marginal Costing –Cost – Volume – Profit Analysis – Cost Behaviour – Fixed Cost and Variable
Cost – Breakeven Analysis – Standard Costng – Variance Analysis.

Cost : The amount of expenditure incurred on a specified thing or activity is called ‘Cost’.

Cost Accounting: Ascertainment of cost through the accounting policies and practices is called
‘Cost Accounting”

COST – ANALYSIS

Elements of Cost:

In cost there are three elements (1) Material (2) Labor (3) Other Expenses (Overheads)

Elements of Cost

Materials Labor Other Expenses

Direct Indirect Direct Indirect Direct Indirect

Overheads

Production or Works OH Administration Overheads Selling & Distribution O.H.

By grouping the above elements of cost, the following divisions of cost are obtained.

(1) Prime Cost = Direct Materials + Direct Labor

(2) Works or Factory Cost = Prime Cost + Works or Factory Overheads.
(3) Cost of Production = Works Cost + Administration Overheads
(4)Total Cost of Sales = Cost of Production + Selling and Distribution O.H.

Material: Material is a substance from which a product is made. Material can be direct or
indirect.

(i)Direct Materials : Direct materials are those materials can be identified in the product and
can be conveniently measured and directly charged to the product. Thus, these materials
directly enter the production and form a part of the finished product. For example, timber in
furniture making, cloth in dress making and bricks in building a house. The following are
normally classified as direct materials:

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 (i) All raw materials like jute in the manufacture of gunny bags, pig iron in foundry,
etc.,

(ii) Materials specifically purchased for a specific job, process or order like glue for
book binding, starch powder for dressing yarn.

(iii) Parts or components purchased or produced like batteries for transistor-radios and
tyres for cycles.

(iv) Primary packing materials like cartons, wrappings, cardboard boxes, etc., used to
protect finished product from climatic conditions or for easy handling inside the
factory.
(ii)Indirect Materials: Consumables, like cotton waste, lubricants, brooms, cleaning materials,
materials for repairs and maintenance of fixed asserts, high speed diesel used in power
generators, etc.,

2. Labor: Labor converts the materials into finished product. It can also be direct and indirect.

(i)Direct Labor: Labor who are engaged directly in the production of goods or services.

(ii)Indirect Labor: The persons who are not engaged directly in the production of goods or
services Eg: Storekeeper, Watchman, Supervisor, Production Manager, etc.,

3.Expenses/Overheads: All costs other than the cost of materials and labour are called expenses.
Expenses can be classified as direct expenses and indirect expenses.

(i)Direct Expenses: All expenses other than direct materials and direct labour incurred
specifically for a particular product, job, department, etc., are called direct expenses. These are
directly charged to the product. Examples of such expenses are royalty, excise duty, hire charges
of a specific plant and equipment , cost of any experimental work carried out specially for a
particular job, traveling expenses incurred in connection with a particular contract or job, etc.,

(ii)Indirect Expenses: Expenses other than indirect materials and indirect labour may be
termed as ‘Indirect Expenses’. These expenses are not directly related to a particular
product or job or order.
Overheads: All Indirect Costs Indirect Material, Indirect Labor and Indirect expenses are termed
as ‘overheads’. Overheads can be classified under the following three categories:

(a) Manufacturing (or works or production or factory) overheads.

(b) Administrative (or office, or general) overheads
(c) Selling and Distribution Overheads.

Manufacturing Overheads: Rent and rates of factory building, salary of production manager,
supervisors, foreman, storekeeper, etc., repairs of factory building, plant and machinery,
furniture etc., depreciation of assets used in factory, power, etc.,

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Office and Administrative Overheads: Such expenses are indirect expenses including indirect
materials and labour which operation to management and administration of business. Such
expenses are incurred in formulating policies, planning and controlling the functions, general
expenses.

The examples of office and administrative overheads are – rent and taxes of office building, staff
salaries, postage and stationary, directors fees, bank charges, etc.,

Selling Distribution Overheads: Selling overheads include all indirect costs including indirect
materials, labour and expenses incurred for promoting sales and retaining customers of the
business. For example, advertising expenses, salaries and commission to salesmen, market
research expense, bad debts, etc.,

Distribution Overheads: Distribution overheads include all expenditure incurred from the time
the product is completed until it reaches its destination. All expense incurred in executing orders
are distribution expenses. Examples of such overheads are – warehouse expenses, delivery van
expenses, cost of packing, dispatch cost.

PREPARATION OF COST SHEET

Specimen of Cost Sheet
Direct Materials - xxxx
Director Labor - xxxx
---------
Prime Cost - xxxx
Add: Works Overheads - xxxx
---------
Works Cost - xxxx
Add: Administration Overheads - xxxx
---------
Cost of Production - xxxx
Add: Selling and Distribution OH - xxxx
---------
Total Cost - xxxx
---------
Illustration: (1)Ascertain the prime cost, works cost, cost of production, total cost and profit
from the under-mentioned figures:

Direct Materials-Rs.5,000
Direct Labor-Rs.3,500
Factory Expenses-Rs.1,500
Administration Expenses – Rs.800
Selling Expenses Rs.700 and Sales Rs.15,000.

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 Cost Sheet
Direct Materials - 5,000
Director Labor - 3,500
---------
Prime Cost - 8,500
Add: Works Overheads - 1,500
---------
Works Cost - 10,000
Add: Administration Overheads - 800
---------
Cost of Production - 10,800
Add: Selling and Distribution OH - 700
---------
Total Cost - 11,500
---------
Profit : Sales – Total Cost (15,000 – Rs.11,500) = Rs.3,500

Illustration-2: Following are the particulars for the production of 2,000 sewing machines of
Nath Engineering Co. Ltd., for the year 2006:

Cost of Materials Rs.1,60,000, Wages Rs.2,40,000, Manufacturing Expenses Rs.1,00,000,

Salaries Rs.1,20,000, Rent, Rates and Insurance Rs.20,000, Selling Expenses Rs.60,000,
General Expense Rs.40,000 and Sales Rs.8,00,000.

Solution:
STATEMENT OF COST AND PROFIT FOR THE MANUFACTURE OF 2,000 SEWING MACHINES

Total Cost Cost Per

Machine
Rs. Rs.
Materials 1,60,000 80.00
Direct Wages 2,40,000 120.00
Prime Cost 4,00,000 200.00
Manufacturing 1,00,000 50.00
Expenses
Factory / Works Cost 5,00,000 250.00
Salaries 1,20,000
Rent, Rates & 20,000
Insurance
General Expenses 40,000 1,80,000 90.00
Cost of Production 6,80,000 340.00
Selling Expenses 60,000 30.00
Cost of Sales 7,40,000 370.00
Profit 60,000 30.00
Selling Price 8,00,000 400.00

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 ABSORPTION VS. MARGINAL COSTING

Absorption Costing Marginal Costing

1 All the direct and indirect costs are considered Only variable costs are considered for
for ascertaining the cost computing marginal cost.

2 Fixed and Variable Costs are considered for Fixed costs are absorbed from contribution
ascertaining the cost.
3 Profit is calculated by subtracting the total Profit is calculated by subtracting the fixed
cost from the total revenue. cost from contribution.

(Contribution is the difference between sales

4 Absorption costing is not useful for many
managerial decisions such as export pricing,
make or buy decisions, etc.,
5 Costs are classified on functional basis.
6 Absorption costing fails to establish
relationship of Cost, Volume and Profit.
revenue and variable cost)
The technique of marginal costing is very
useful in taking managerial decisions.
Costs are classified according to the behavior
of costs i.e., fixed costs and variable costs.
Cost, Volume and Profit analysis is an
integral part of marginal cost.

COST-VOLUME-PROFIT ANALYSIS

Planning the activities consistent with the objectives of the enterprise is a managerial function.
Profit on an undertaking depends upon a large number of factors. But the most important of
these factors are the cost of manufacture, volume of sales and selling prices of the products.
The analytical technique used to study the behaviour of profit in response to the changes in
volume, costs and prices is called Cost-Volume-Profit (CVP) analysis. In other words cost,
volume and profit analysis analyze the three variables viz. Cost, Volume and Profit. It explores
the relationship existing amongst costs, revenue, activity levels and the resulting profit. CVP
analysis stresses the relationship among the factors affecting profits.

CVP analysis studies the inter-relationship of three basic factors of business operations:

(a) Cost of Production

(b) Volume of Production/Sales and
(c) Profit

These three factors are inter-connected in such a way that they act and react on one another
because of cause and effect relationship amongst them. The cost of a product determines its
selling price and the selling price determines the level of profit. The selling price also affects the
volume of sales which directly affects the volume of production and volume of production in turn
influences cost. In brief, variations in volume of production results in changes in cost and profit.

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 Total cost = total fixed cost + total variable cost

Important of Cost – Volume – Profit Analysis:

The study of CVP analysis is very significant for the management. It assists the management in
profit planning, cost control and decision making. Management apply the CVP analysis to get
the answers to the following questions.

01.What should be the sales level to earn a desired profit ?

02.How much sales should be made to avoid losses ?
03.What will be the effect of change in prices on cost and profits ?
04.How will change in cost effect profit ?
05.Which product or product mix is more profitable ?
06.How the change in selling price affect the profit position of the company ?
07.Should we make or purchase some product or component ?
08.What will be the cost of production for varying levels of production ?
09.What will be the amount of profit at various levels of production.
10.What will be the impact of plant expansion on cost volume-profit-relationship ?
11.What sales volume is required to meet the proposed expenditure.

Cost-volume-profit analysis is a useful tool in the hands of management. It helps the

management in determining the most profitable price for the products. It assists the
management in the optimization of profits, and maximum utilization of resources.

Uses of CVP Analysis:

The following are the uses of Cost-Volume-Profit analysis.

01.Cost volume profit analysis helps the management in seeking the most profitable
combination of costs and volume.
02.This analysis assists the management in profit planning, cost control and decision
making.
03.CVP analysis helps the management in preparing flexible budget.
04.It helps the management in determining the prices of products at various situations.
05.It helps the management in performance evolution of business concern which is
necessary for cost control.

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 06.This analysis assists the management in formulating price policies.
07.It helps the management in taking various management decisions.
Assumptions behind Cost-Volume-Profit Analysis:

The cost volume profit analysis is subject to the following assumptions:

01.All costs can be segregate into fixed and variable elements.
02.Variable costs vary in proportion to output and fixed costs remain constant.
03.Costs and revenues are influenced only by volume.
04.There will be no change in the price level.
05.Productivity per worker remains mostly unchanged.

Assumptions of Break-Even Analysis:

The break-even analysis is based on the following assumptions.

01.All elements of cost i.e., production, administration, selling and distribution can be
segregated into fixed and variable.
02.Costs and revenues are influenced only by volume.
03.Selling price per unit remains unchanged or constant at all levels of output.
04.Variable cost per unit is constant whereas total variable costs varies in proportion to
production.
05.Total fixed cost remains constant.
06.There will be no change in operating efficiency.
07.Productivity per worker remains mostly unchanged.
08.There will be no change in operating efficiency.
09.There will be no change in the general price level.
10.The state of technology, methods of production and efficiency remain unchanged.
11.The analysis relates to one product only or constant product mix.
12.Costs and Revenues are linear over the range of activity under consideration.

Importance of BEP:

Break-even-analysis helps the managers in a number of ways. Some noteworthy uses of this
analysis are as follows:

01.Calculation of profit for different sales volumes.

02.Calculation of sales volume to produce desired profit.

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03.Calculation of selling price per unit for a particular break-even-point.
04.Calculation of the sales volume required to meet proposed expenditures.
05.Determination of sales required to offset price reduction.
06.Measurement of effect of changes in profit factors.
07.Choosing the most profitable alternative. S
08.Determining the optimum sales mix.
09.Deciding on changes in capacity.
10.It helps the management accountant in preparing flexible budgets.
11.It helps the management accountant in formulating price policy.
12.It assists the management accountant in performance evaluation for the purpose of
management control.

Application of BEP for various business problems:

Contribution and Marginal Cost Equation:

Contribution = Sales – Variable Cost (C=S–V)

= Fixed Cost + Profit (C=F+P)

= Fixed Cost – Loss (C= F–L)

Margin of safety
Margin of safety in percentage = x 100 (or)
sales

Actual Sales  Sales at BEP

= x 100
sales

Margin of safety calculated in percentage is also known as Margin of Safety Ratio.

Margin of Safety can also be calculated by the following formulae:

Profit
Margin of Safety (in Rupees) =
P/VRaio

Profit
Margin of Safety (in Units) =
Contribution

Contributi on C
Profit Volume Ratio (P/V Ratio) = ( or)
Sales S

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 Fixed Cost  Profit FP
= ( or)
Sales S

Sales - Variable Cost S-V

= ( or)
Sales S

Changes in profit or contribution

=
Change in sales

P.No.1

From the following information calculate (i)Break-even point (units), (ii)Required sales to earn
a profit margin of Rs.36,000.

Fixed Cost - Rs.1,80,000

Variable Cost per Unit- Rs.2
Selling Price per unit - Rs.20.

Solution:

(a)Break-even point:

Fixed Cost
Break-even point (in units value) = Selling Pr ice perunit  var iable cost per unit

1,80,000
= = 10,000 units
20  2

(b)Sales required to earn a profit of Rs.36,000

Fixed Cost  Desired Profit

=
Contribution Per Unit

P.No.2: A limited company’s total fixed cost is Rs.2,10,000 for a year. Variable Cost per Unit
Rs.7. Selling Price per unit Rs.5.

Fixed Cost
Break-even point (in units value) = Variable cost perunit  Selling Price perunit

2,10,000
=
75

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 = 1,05,000

Fixed Cost
Break-even point (in sales value) = Contributi on per unit x Selling Price per unit

2,10,000
= x5
75

= 1,05,000 x 5

= 2,25,000

Contribution
P/V Ratio = x 100
Sales

2
= x 100
5

= 40%

P.No.3

You are given the following data for the coming year of a factory.

Budgeted output (units) - 80,000

Fixed expenses - Rs.4,00,000
Variable expense per unit - Rs.10
Selling price per unit - Rs.20

Draw a break even chart showing the break-even point, if the selling price is reduced to Rs.18
per unit. What will be the new break-even point.

Solution:

Fixed Cost
Break-even point (in units) = Contribution per unit

Contribution = Selling price per unit – Variable cost per unit

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 4,00,000
=
20 - 10
 Break-even point (in units) = 40,000 units

If the sale price is reduced to Rs.18

4,00,000
Break-even point (in units) =
18 - 10
 Break-even point (in units) = 50,000 units

Break-even point (in rupees) = 50,000 units x Rs.18 = Rs.9,00,000

Break-even point (in rupees) = 40,000 units x Rs.20 = Rs.8,00,000

***

COST BEHAVIOUR

The primary responsibility of business management is to plan business operations with certain
definite objectives. Management accomplishes its basic objective by organizing the business
activities and controlling the operations. Without appropriate and detailed accounting data,
management would not be able to control operations, nor be able to make the large number of

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decisions inherent in successful business operations. One of the important phases of managerial
control through accounting data and reports revolves around costs and their compilation.

Cost classifications and Concepts

1. Costs classified according to the function of business activity.

a. Manufacturing costs
b. Distribution or marketing costs
c. Administrative costs

2. Costs classified according to the nature of manufacturing operations

a. Job order costs
b. Process or Departmental costs
c. Assembly Costs

3. Costs classification according to time.

a. Historical costs
b. Daily, weekly, or monthly costs.

4. Costs classification according to type of business activity.

a. Banks
b. Municipalities
c. Retail or Department Stores.
d. Insurance Companies

Advantages of Cost Accounting

Pricing
Cost Control and Cost Reduction
Decision Making.
Helps in formulation of policies.

Fixed Costs:

The fixed costs are associated with inputs that do not fluctuate in response to changes in the
activity or output of the firm, within relevant range. They may also be called non-variable costs.
They are normally fixed for a relevant range of volume but fluctuate beyond that range.
Moreover, fixed costs are to be analyzed in relation to a given period of time.

Example: Rent, Salaries, Insurance, Property Tax

Variable Costs

The variable costs are costs that are assumed to fluctuate in direct proportion to production
activity/sales activity/some other measure of volume. The level of variable costs at any volume
can be estimated easily if the relationship between costs and volume is shown.

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Example: Raw Material Cost, Piece Rate Labour, etc.,

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