What is Cost?
Table of Contents
Cost can be defined as value expended for procuring some resources. In general terms, we can say that the amount we have spent to acquire a particular product is its cost. For instance, Mr. A visits a book store to purchase books and the shopkeeper charges extra money for the bag. Mr. A pays the amount and returns home. So the cost of books will include all the cost incurred to buy that book i.e. cost of books will be equal to the amount paid for books and the bag.
For a manufacturer, the amount spent to produce goods is cost. Similarly, for a trader, the amount spent from procuring goods from manufacturers to selling them to buyers is the cost. And for a buyer, the price paid for the product is its cost which is generally the MRP of that product.
In the case of businesses, one has to incur expenses to run it and earn money. A few examples of costs that are generally associated with every business type are raw materials, labor, administration costs, electricity, marketing expenditure, etc.
The cost doesn’t include the profit element.
What is Costing?
Costing refers to identifying costs at various different stages of production. There are various kinds of costing techniques for determining the process to be adopted for calculating the cost of various products and services. The objective of costing is to identify the cost per unit, batch and process, contract, and so on. It provides data to management which eventually helps in taking a number of decisions.
Cost Accounting
Cost accounting is basically applying general accounting principles to calculate the costs of various products and services. It is the method of determining cost by collecting, recording, classifying and allocating expenses to the products or services. Cost accounting is done for internal decision-making only. And it is a great tool in the hands of management.
What is the Need to Find Cost?
The main purpose of finding cost is to arrive at the profits. The only way to know about the earnings is to deduct the cost from the sales value. Or we can say, to determine the selling price of a product we need to find the cost. Also one should find the cost in order to become cost-efficient. One of the reasons is to prepare a budget for the upcoming period.
Elements of Cost
There are generally four elements of cost
Material Cost
Raw materials are the tangible substance which are processed and converted into finished goods for the purpose to sell or to consume. These are also known as stores. Materials hold a major portion of total cost i.e. almost 50% to 80%.
Employee/Labor Cost
Nowadays, a large number of organizations are shifting from labor-intensive to capital-intensive technologies yet the role of labor will never go out of the frame. Therefore, it is important to study how labor costs are computed.
Direct Expenses
These can be defined as expenses related to the production of goods. These expenses are directly linked with units produced. It includes all other direct expenses except direct material and direct labor.
Overheads
This type of cost cannot be associated with any particular type of product. It is a type of indirect expense. These can be apportioned on different basis depending upon the type of overhead. For example, telephone bills are apportioned on the basis of the numbers of extensions in a department.
Cost Sheet
| Particulars | Cost per unit ($) | Total cost ($) |
| Direct Material | ||
| Direct Labor | ||
| Direct Expenses | ||
| Add: Opening Stock of Raw Material | ||
| Less: Closing Stock of Raw Material | ||
| Prime cost | ||
| Add: Factory Overhead | ||
| Add: Opening Stock of WIP | ||
| Less: Closing Stock of WIP | ||
| Factory Cost | ||
| Add: Administration Overhead | ||
| Add: Opening Stock of Finished Goods | ||
| Less: Closing Stock of Finished Goods | ||
| Cost of Production | ||
| Add: Selling & Distribution Overhead | ||
| Cost of Goods Sold | ||
| Profits/Loss | ||
| Sales |
Classification of Costs
Cost can be classified on the basis of its application as well as its relation to output
Fixed and Variable Cost
Variable cost is one that remains constant per unit while fixed cost keeps increasing or decreasing with the decrease or increase in production capacity respectively. For example, for each unit of the finished product, 2 units of raw material will be required. Hence, the cost of raw material will be fixed per unit and therefore, it is a variable cost. However, the cost of electricity cannot be determined on the basis of per unit and hence, it is an example of fixed cost.
Direct and Indirect Cost
The cost that can be directly attributed to the product is direct cost whereas the cost which cannot be attributed directly to a product are indirect cost. The wages paid to labor are directly associated with the product. Therefore, it is an example of direct cost. However, the salary paid to the supervisor cannot be associated with a particular product so it is an indirect cost to the organization.
Prime Cost and Conversion Cost
Prime cost includes all the direct costs attributable to the production of a product however, conversion cost includes all direct manufacturing cost except the direct material cost.
Product Cost and Period Cost
Product cost can be defined as a cost that can be associated with outputs and used in valuing inventories and period cost are expenses charged to the period in which it has incurred. Hence, the cost included in opening and closing stock cannot be included in period costs.
Sunk Cost
These are the cost which are spent on a project and cannot be recovered, whether or not that project is accepted. Sunk costs are historical in nature. Expenses made on research and development is an example of sunk costs.
Opportunity Cost
Profit foregone by opting any one opportunity out of available opportunities becomes the cost of that one opportunity opted.
Types of Costing Techniques
Different industries follow different methods of costing on the basis of their products, process, orders, etc. Some of them are listed below.
Job Costing
This technique is used when the organization doesn’t produce any standard product and deals in customization on the basis of orders received from customers. Every order received from different customers is defined as a job. Every customer have their different taste and orders are executed on the basis of their specifications only. The purpose of this technique is to find the cost of each job. This type of costing is used in automobile garages, engineering industries, etc.
Process Costing
When an organization is engaged in the production of goods that have to pass through different processes, it goes for the method of process costing to ascertain the cost. Here, the finished goods of one process are the raw materials for the next process. The cost of each process is analyzed by opening a separate account for each. Examples of industries where this type of costing is used are textile industries, chemical industries, etc.
Batch Costing
It can be defined as an extended version of job costing. A batch can be defined as a group of similar identical products. Here limited varieties are demanded by customers. For example, a food-producing industry will use batch costing as it has to produce goods in batches of different quantities.
Contract Costing
This kind of costing technique is used in the case of contracts related to the construction of buildings, ships. Bridges and so on. For each contract, a separate account is prepared to compute the cost of those contracts.
Unit Costing
Manufacturers use unit costing when they have to produce goods in mass capacity to compute the cost of every single unit. It is also known as single or output costing. Cost per unit is derived by dividing the total cost of production from the number of units manufactured. This type of costing is used in the case of mines, oil drilling units, cement works, etc.
Operating Costing
This technique is used in the case of service industries such as hotels, hospitals, transport industry, etc. to calculate the cost per unit defined by them. For example, in the case of hospitals, the unit is defined as per bed. Similarly, in the case of the transport industry, the unit is defined as per passenger kilometer or per ton kilometer.
Cost Accounting Techniques
Cost accounting techniques that are generally adopted by organizations are listed below.
Marginal Costing
Marginal cost is a total of prime cost and all other variable overheads. Marginal costing states the variation in per-unit price due to an increase or decrease in the level of output. In this method variable cost and fixed cost are shown differently as well as the semi-variable cost is also accurately divided into variable and fixed cost. Here, inventories are valued at variable cost only.
Advantages
- It helps in taking a number of managerial decisions such as make or buy, accept or reject orders, subcontracting, to invest in the foreign market or not, shutdown or continue, etc.
- It helps in forecasting market conditions and formulating strategies to overcome such situations.
- Helps in selecting the optimum product mix from available options.
- There is no difficulty in the apportionment of overheads as compared to absorption costing.
- The presentation of data under marginal costing is useful for different levels of management.
Tools of Marginal Costing
- Contribution
It is the amount recovered towards the fixed cost and profit. It is computed by deducting the variable cost from sales.
- Profit Volume Ratio
It defines the relationship between the sales and the contribution. Formula for finding P/V ratio is (contribution/sales)*100.
Standard Costing
In this technique, a comparison is made between pre-determined standard cost and the actual cost incurred. The pre-determined costs are calculated on the basis of management`s standard of efficient operations and necessary relevant expenditure.
Process of Standard Costing
- Setting of standards.
- Determination of actual cost.
- Comparison of actual cost with standard cost.
- Finding out reasons for variances.
- Taking corrective action for disposal of unfavorable variances.
Budgetary Control
A budget can be defined as a statement of income and expenses prepared prior to the period to which those incomes and expenses belong. It is prepared for a definite period and in accordance with the policies of the organization.
Essential Elements of Budget
- The period for which the budget is prepared should be defined clearly.
- It should be flexible for revision.
- It should be prepared for the future based on expected events.
- Objectives and degree of responsibility should be clearly stated and communicated to the management or person responsible for them.
- Terms of receiving money and making payments should be kept in mind while preparing a budget.
- Budgetary performance should be linked to the reward system effectively.
Final Words
Cost accounting is a very great tool in the hands of management that allows them to set better profit margins, helps in making comparisons, reduces wastage, estimates for the future, taking managerial decisions and a lot more. Cost accounting has increased the consciousness of businessmen towards costing and how to manage resources available in an efficient manner. And it has led to rapid industrial development and rising competition in manufacturers.
It provides various methods and techniques for calculating costs and analyzing them. This has made industrialists to become cost-efficient by taking a step towards quality control. Knowledge of costing is a must in today’s world to overcome competition and earn profits.