Cost Accounting Basics in Q & A format

Commerce for IAS – Cost Accounting Basics in Q & A format

Question. What is Cost Accounting?

Answer. Cost Accounting is a branch of accounting and has been developed due to limitations of financial accounting.

The costing terminology of C.I.M.A ., London defines costing as the “the techniques and processes of ascertaining costs”. These techniques consist of principles and rules which govern the procedure of ascertaining cost of products or services. The techniques to be followed for the analysis of expenses and the processes by which such an analysis should be related to different products or services differ from industry to industry. These techniques are also dynamic and they change with time.

The main object of traditional cost accounts is the analysis of financial records, so as to subdivide expenditure and to allocate it carefully to selected cost centers, and hence to build up a total cost for the departments, processes or jobs or contracts of the undertaking. The extent to which the analysis of expenditure should be carried will depend upon the nature of business and degree of accuracy desired.

The other important objective of costing are cost control and cost reduction.

Cost Accounting may be regarded as “a specialized branch of accounting which involves classification, accumulation, assignment and control of costs.” The costing terminology of C.I.M.A, London defines cost accounting as “the process of accounting for costs from the point at which expenditure is incurred or committed to the establishment of its ultimate relationship with cost centers and cost units. In its widest usage, it embraces the preparation of statistical data, the application of cost control methods and the ascertainment of profitability of activities carried out or planned.”

Question. What are Objectives of Cost Accounting?

Answer. Cost accounting aims at systematic recording of expenses and analysis of the same so as to ascertain the cost of each product manufactured or service rendered by an organization. Information regarding cost of each product or service would enable the management to know where to economize on costs, how to fix prices, how to maximize profits and so on.

Thus, the main objectives of cost accounting are the following.

1. To analyse and classify all expenditure with reference to the cost of products and operations.

2. To arrive at the cost of production of every unit, job, operation, process, department or service and to develop cost standard.

3. To indicate to the management any inefficiencies and the extent of various forms of waste, whether of materials, time, expenses or in the use of machinery, equipment and tools. Analysis of the causes of unsatisfactory results may indicate remedial measures.

4. To provide data for periodical profit and loss accounts and balance sheets at such intervals, e.g. weekly, monthly or quarterly as may be desired by the management during the financial year, not only for the whole business but also by departments or individual products. Also, to explain in detail the exact reasons for profit or loss revealed in total in the profit and loss accounts.

5. To reveal sources of economies in production having regard to methods, types of equipment, design, output and layout. Daily, Weekly, Monthly or Quarterly information may be necessary to ensure prompt constructive action.

6. To provide actual figures of costs for comparison with estimates and to serve as a guide for future estimates or quotations and to assist the management in their price fixing policy.

7. To show, where Standard Costs are prepared, what the cost of production ought to be and with which the actual costs which are eventually recorded may be compared.

8. To present comparative cost data for different periods and various volume of output and to provide guidance in the development of business. This is also helpful in budgetary control.

9. To record the relative production results of each unit of plant and machinery in use as a basis for examining its efficiency. A comparison with the performance of other types of machines may suggest the necessity for replacement.

10. To provide a perpetual inventory of stores and other materials so that interim Profit and Loss Account and Balance Sheet can be prepared without stock taking and checks on stores and adjustments are made at frequent intervals.

Also to provide the basis for production planning and for avoiding unnecessary wastages or losses of materials and stores.

Last but not the least, to provide information to enable management to make short term decisions of various types, such as quotation of price to special customers or during a slump, make or buy decision, assigning priorities to various products, etc.

Question. Differentiate between Cost Accounting & Financial Accounting.

Answer. The following table broadly covers the most important differences between financial accounting and cost accounting.

Point of DifferencesFinancial AccountingCost Accounting
MeaningRecoding of transactions is part of financial accounting. We make financial statements through these transactions. With the help of financial statements, we analyze the profitability and financial position of a company.Cost accounting is used to calculate cost of the product and also helpful in controlling cost. In cost accounting, we study about variable costs, fixed costs, semi-fixed costs, overheads and capital cost.
PurposePurpose of the financial statement is to show correct financial position of the organization.To calculate cost of each unit of product on the basis of which we can take accurate decisions.
RecordingEstimation in recording of financial transactions is not used. It is based on actual transactions only.In cost accounting, we book actual transactions and compare it with the estimation. Hence costing is based on the estimation of cost as well as on the recording of actual transactions.
ControllingCorrectness of transaction is important without taking care of cost control.Cost accounting done with the purpose of control over cost with the help of costing tools like standard costing and budgetary control.
PeriodPeriod of reporting of financial accounting is at the end of financial year.Reporting under cost accounting is done as per the requirement of management or as-and-when-required basis.
ReportingIn financial accounting, costs are recorded broadly.In cost accounting, minute reporting of cost is done per-unit wise.
Fixation of Selling PriceFixation of selling price is not an objective of financial accounting.Cost accounting provides sufficient information, which is helpful in determining selling price.
Relative EfficiencyRelative efficiency of workers, plant, and machinery cannot be determined under it.Valuable information about efficiency is provided by cost accountant.
Valuation of InventoryValuation basis is ‘cost or market price whichever is less’Cost accounting always considers the cost price of inventories.
ProcessJournal entries, ledger accounts, trial balance, and financial statementsCost of sale of product(s), addition of margin and determination of selling price of the product.

Question. What is difference between Cost Unit & Cost Centre.

Cost units- The Chartered Institute of Management Accountants, London, defines a unit of cost as “a unit of quantity of product, service or time in relation to which costs may be ascertained or expressed”. The forms of measurement used as cost units are usually the units of physical measurements like number, weight, area, length, value, time etc.

Cost centre – According to Chartered Institute of Management Accountants, London, cost centre means “a location, person or item of equipment (or group of these) for which costs may be ascertained and used for the purpose of cost control”.

Cost centre is the smallest organizational sub- unit for which separate cost collection is attempted. Thus cost centre refers to one of the convenient unit into which the whole factory organization has been appropriately divided for costing purposes.

Each such unit consists of a department or a sub-department or item of equipment or , machinery or a person or a group of persons. For example, although an assembly department may be supervised by one foreman, it may contain several assembly lines. Some times each assembly line is regarded as a separate cost centre with its own assistant foreman.

Question. What is difference between Cost Centre & Profit Centre.

Profit centre – A profit centre is that segment of activity of a business which is responsible for both revenue and expenses and discloses the profit of a particular segment of activity. Profit centres are created to delegate responsibility to individuals and measure their performance.

Difference between Profit centre and Cost centre

The various points of difference between Profit centre and cost centre are as follows:

Cost centre is the smallest unit of activity or area of responsibility for which costs are collected whereas a profit centre is that segment of activity of a business which is responsible for both revenue and expenses.

(i) Cost centres are created for accounting conveniences of costs and their control whereas as a profit centre is created because of decentralization of operations i.e., to delegate responsibility to individuals who have greater knowledge of local conditions etc.

(ii) Cost centers are not autonomous whereas profit centres are autonomous.

(iii) A cost centre does not have target cost but efforts are made to minimize costs, but each profit centre has a profit target and enjoys authority to adopt such policies as are necessary to achieve its targets.

(iv) There may be a number of cost centres in a profit centre in a profit centre as production or service cost centres or personal or impersonal but a profit centre may be a subsidiary company within a group or division in a company.

Question. Proper classification of costs is very important for identifying the costs with the cost centers or cost units. Write a short note on Cost Classification.

Answer. Cost classification Costs can be classified or grouped according to their common characteristics. Proper classification of costs is very important for identifying the costs with the cost centers or cost units. The same costs are classified according to different ways of costing depending upon the purpose to be achieved and requirements of a particular concern. The important ways of classification are:

1. By Nature or Elements. According to this classification the costs are classified into three categories i.e., Materials, Labour and Expenses. Materials can further be sub-classified as raw materials components, spare parts, consumable stores, packing materials etc. This helps in finding the total cost of production and the percentage of materials (labour or other expenses) constituted in the total cost. It also helps in valuation of work-in-progress.

2. By Functions: This classification is on the basis of costs incurred in various functions of an organization ie. Production, administration, selling and distribution. According to this classification, costs are divided into Manufacturing and Production Costs and Commercial costs. Manufacturing and Production Costs are costs involved in manufacture, construction and fabrication of products. Commercial Costs are (a) administration costs (b) selling and distribution costs.

3. By Degree of Traceability to the Product : According to this, costs are divided indirect costs and indirect costs. Direct Costs are those costs which are incurred for a particular product and can be identified with a particular cost centre or cost unit. Eg:- Materials, Labour. Indirect Costs are those costs which are incurred for the benefit of a number of cost centre or cost units and cannot be conveniently identified with a particular cost centre or cost unit. Eg:- Rent of Building, electricity charges, salary of staff etc.

4. By Changes in Activity or Volume: According to this costs are classified according to their behavior in relation to changes in the level of activity or volume of production. They are fixed, variable and semi-variable.

Fixed Costs are those costs which remain fixed in total amount with increase or decrease in the volume of the output or productive activity for a given period of time. Fixed Costs per unit decreases as production increases and vice versa. Eg:- rent, insurance of factory building, factory manager’s salary etc.

Variable Costs are those costs which vary in direct proportion to the volume of output. These costs fluctuate in total but remain constant per unit as production activity changes. Eg:- direct material costs, direct labour costs, power, repairs etc.

Semi-variable Costs are those which are partly fixed and partly variable. For example; Depreciation, for two shifts working the total depreciation may be only 50% more than that for single shift working. They may change with comparatively small changes in output but not in the same proportion.

5. Association with the Product: Cost can be classified as product costs and period costs. Product costs are those which are traceable to the product and included in inventory cost, thus product cost is full factory cost. Period costs are incurred on the basis of time such as rent, salaries etc. thus it includes all selling and administration costs. These costs are incurred for a period and are treated as expenses.

6. By Controllability: The CIMA defines controllable cost as “a cost which can be influenced by the action of a specified member of an undertaking” and a non-controllable cost as “a cost which cannot be influenced by the action of a specified member of an undertaking”.

7. By Normality: There are normal costs and abnormal costs. Normal costs are the costs which are normally incurred at a given level of output under normal conditions. Abnormal costs are costs incurred under abnormal conditions which are not normally incurred in the normal course of production.Eg:- damaged goods due to machine break down, extra expenses due to disruption of electricity, inefficiency of workers etc.

8. By Relationship with Accounting Period: There are capital and revenue expenses depending on the length of the period for which it is incurred. The cost which is incurred in purchasing an asset either to earn income or increasing the earning capacity of the business is called capital cost, for example, the cost of a machine in a factory. Such cost is incurred at one point of time but the benefits accruing from it are spread over a number of accounting years. The cost which is incurred for maintaining an asset or running a business is revenue expenditure. Eg:- cost of materials, salary and wages paid, depreciation, repairs and maintenance, selling and distribution.

9. By Time: Costs can be classified as 1) Historical cost and 2) Predetermined Costs. The costs which are ascertained and recorded after it has been incurred is called historical costs. They are based on recorded facts hence they can be verified and are always supported by evidences. Predetermined costs are also known as estimated costs as they are computed in advance of production taking into consideration the previous periods’ costs and the factors affecting such costs. Predetermined costs when calculated scientifically become standard costs. Standard costs are used to prepare budgets and then the actual cost incurred is later-on compared with such predetermined cost and the variance is studied for future correction.

Question. The management of an organization needs necessary data to analyze and classify costs for proper control and for taking decisions for future course of action. Hence the total cost is analyzed by elements of costs. What are various elements of cost?

Answer. The elements of costs are three and they are materials, labour and other expenses. These can be further analyzed as follows.

1. Direct Materials are those materials which can be identified in the product and can be conveniently measured and directly charged to the product. For example, bricks in houses, wood in furniture etc. Hence all raw materials, materials purchased specifically for a job or process like glue for book making, parts or components purchased or produced like batteries for radios and tyres for cycles, and primary packing materials are direct materials.

2. Indirect Materials are those materials which cannot be classified as direct materials. Examples are consumables like cotton waste, lubricants, brooms, rags, cleaning materials, materials for repairs and maintenance of fixed assets, high speed diesel used in power generators etc.

3. Direct Labour is all labour expended in altering the construction, composition, confirmation or condition of the product. Thus direct wages means the wages of labour which can be conveniently identified or attributed wholly to a particular job, product or process or expended in converting raw materials into finished goods. Thus payment made to groups of labourers engaged in actual production, or carrying out of an operation or process, or supervision, maintenance, tools setting, transportation of materials, inspection, analysis etc is direct labour.

4. Direct Expenses are expenses directly identified to a particular cost centre. Hence expenses incurred for a particular product, job, department etc are direct expenses. Example royalty, excise duty, hire charges of a specific plant and equipment, cost of any experimental work carried out especially for a particular job, travelling expenses incurred in connection with a particular contract or job etc.

5. Overheads may be defined as the aggregate of the cost of indirect materials, indirect labour and such other expenses including services as cannot conveniently be charged direct ot specific cost units. Overheads may be sub-divided into (i) Manufacturing Overheads; (ii) Administration Overheads; (iii) Selling Overheads; (iv) Distribution Overheads; (v) Research and Development Overheads.


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