Cost Concepts and Classification In Cost Accounting
Cost Accounting like other management sciences has
principles or concepts that guide the preparation of cost statement or
information such rules trough not statutory in nature are generally accepted
and applied in the preparation of cost information.
i. All
costs should be charged to the functions, section or product that caused them.
For example, the salary of production engineering should be charged to
production department and not to marketing department.
ii. No
cost should be charged until it is incurred. For example, distribution costs
should not be charged products that are still in the store. It is only proper
to charge such costs to the products when they have been transported to various
warehouses or customers.
iii. Costs
or losses incurred in the past should not be charged to current or future
operations. The exception to this rule is accepted where there is evidence that
the present or future operation benefit from the past cost. For example, if the
cost of adverting in the past was capitalized, a part of the cost may be
charged to current or future marketing cost.
iv. Any
cost that is classified as abnormal cost should be excluded from the cost
information and is transferred to financial accounting for appropriate
treatment. The classification of a cost into normal or abnormal cost depends on
the frequency of its occurrences. This means that what is classified as
abnormal cost in one organization may be seen as a normal cost in others. For
example, if a shoe factory has four distribution vans, the probability that one
of them will be involved in a serious accident that Will result in total
write-off of the vehicles in a year is low. If such accidents do occur, it can
be classified as abnormal loss. But in a transport organization with about five
hundred or more passenger buses, the probability of such accident is high.
Therefore, when such accident do occur, the cost of such accident vehicles are
classified as normal cost.
Element of Cost
We have earlier defined costs as the value of economic
resources used in the production of goods or services. What are these economic
resources used in the production of goods and services? They are basically
three namely: (a) materials (b) labour and (c) expenses. In cost accounting we
refer to these three resources as the “elements of cost”. Everything produced
by man is a combination of material, labour and expenses. Cost varies with
industries. In manufacturing industries, materials may constitute over 60% of
cost product, while in coal mining, labour may constitute over 70% of cost of
production. The cost accountant logically groups or classifies the three
elements of cost to enable him accumulate cost data for the preparation of cost
statements.
Cost Classification
The logical grouping of cost data to enable the cost
accountant draw-up a cost can be classified in any of the following four ways
to arrive at the total cost of a product.
(a) According
to the relationship to production: Those elements of cost that are directly
related to the production process are classified as direct cost and those that
are not directly related to production are classified as indirect costs. For
example in a shoe factory, the labour of a shoe-maker is classified as a direct
labour cost while the services rendered by the accountant is classified as
indirect labour.
DC + Ind Cost = TC
(b) According
to the reaction to change in volume of activities. If the element of cost
changes with the volume of activity or output, it is classified as a variable
cost; but if the element of cost is relatively unchanged with change in volume
of activities, it is classified as fixed cost. For example, in a shoe factory,
the labour of shoe maker is classified as variable cost while that of supervisor
and foremen are classified as fixed cost.
VC + FC = TC
(c) According
to the function of the department that causes the cost: In every organization,
there are certain distinct functions that are noticeable in the organizational
chart such as production, administration, marketing, maintenance etc.
Any cost incurred in the organizational is classified
according to the functional unit that caused the cost. For example a cost is
classified as production cost if it is used in administration marketing cost,
if it is used in carrying out marketing functions etc. for instance, in a shoe
factory, the salary paid to the shoemaker is charged to production while that
of the accountant is charged to the administration cost.
PC
+ AC + MC + ------ + etc. = TC
(d) According
to their nature: All the element of cost may be classified according to their
nature. For example materials can be classified as raw materials and
components, labour can be classified as skilled or unskilled and expenses can
be classified as rate, rent etc.
CRM + C + SL + USL + R + R etc = TC.
(e) The
cost accountant is at library to select any of the above methods of cost
classification that suits his peculiar work situation.
This is the collective name for all the direct cost
elements; i.e.
Direct Materials + Direct Labour +Direct Expenses +Prime
Cost
DM DL DE PC
Overhead Cost
This is the collective name for all the indirect cost
elements i.e. indirect materials + Indirect labour + Indirect expenses =
Overhead cost.
Cost Terminologies
Some important cost terminologies are explained below.
Cost Object
A cost object is any item, process or activity for which a
separate measurement of cost is required. Examples include the cost of
manufacturing a component or product, the cost of operating a department, the
cost of dealing with an enquiring at a call centre, the cost of an operation at
a hospital or indeed the cost of ruining the whole hospital. When an individual
unit cost is required it is normal to refer to it as cost units.
Cost Unit
This is a unit of quantity of a product or service in
relation to which costs may be ascertained or expressed. Some examples are:
(a) Units
of Product: Contract, tons of cement, litres of liquid, books pairs of shoes,
caps, tables etc.
(b) Units
of Service: Kilowatt-hours, cinema seats, passenger-kilometer, hospital
operations, consulting hours etc.
In relation to each of the products or services mentioned
above costs (of material, labour and expenses can be ascertained or expressed).
The cost accountant should be able to avail management with information about
the total cost of a product or service per unit.
Cost Centre
This refers to a location, a person or an item of equipment
in relocation to which costs may be ascertained and used for the purpose of
cost control.
A location may mean a department, store-yard, sales area, or
factory. A person may be a sales manager, production manager, personnel
manager, finance manager or work engineer, production manager, personnel
manager, finance manger or work engineer. An item of equipment may be machine,
delivery vehicles, car, truck and lathe.
As the purpose of cost centre is to aid effective cost
control within an organization, all the cost incurred will have to be charged
to the relevant cost centre. It is then that cost control could be exercised.
For example in an academic department of university all these costs incurred
must be charged to that department as a cost centre, such as repairs and
maintenance of vehicles, start-times, entertainment telephone, postage etc. a
car as a cost centre is to be charged with depreciation, petrol, tires,
maintenance licenses insurance, etc.
In relation to each of the cost centre’s mentioned above,
allocation of resources can be made at the beginning of an accounting period
for cost to be incurred and report is to be submitted at the end of the
accounting period as to how the money is spent comparison can be made between
their amount, allocated and the amount spent. Comparison can be made between
the amount allocated and the amount spent, bearing in mind the purpose(s) to be
achieved. Appropriate action is taken on the variance that is bound to arise.
Cost Control
This refers to the ability of management to monitor and
supervise expenditures (re-current and capital) in order, to ensure that things
are going according to plan and that actual results (cost incurred) are
obtained for comparison against planned results (cost to be incurred) so that
appropriate corrective action(s) can be taken on the variance that is bound to
arise before it is too late.
Before any cost control can be affected, standards or
targets of performance must be set against which actual costs can be measured
and compared. This would reveal inefficiencies so that appropriate actions
could be taken to guard against such occurrence in the future.
Cost Allocation
This can be defined as to assigning a whole item of cost, or
of revenue, to a single cost unit, centre, account or time period. The part of
this definition is whole item. Where a cost, without division or splitting, can
be clearly identified with a cost centre or cost unit then it can be allocated
to particular cost units or groups of particular cost units, but cost
allocation can, of course apply equally to indirect costs.
Cost Apportionment
Frequently it is not possible to identify a discrete item of
cost with a cost centre and it is necessary to split a cost over several cost
centres on some agreed basis. A classic example is that of rates which are
levied upon the premises as a whole, but which for internal cost ascertainment
purposes need to be shared or apportioned between the cost centres. The basis
normally used for rates being the floor area occupied by the various cost
centres. The formal definition of cost apportionment is to spread revenues or
costs over two or more cost units, centres, accounts or time periods. This may
also be referred to as indirect allocation.
The basis upon which the apportionment is made varies from
cost to cost. The basis chosen should produce, as for as possible, a fair and
equitable share of the common cost for each of the receiving cost centres. The
choice of an appropriate basis is a matter of judgment to suit the particular
circumstances of the organization and wherever possible there should be a
cost/cause relationship.
Conventional bases used are as follows:
Basis costs
which may be apportioned on this basis.
Floor
Area Rates,
Rent, Heating, Cleaning, Lighting, Building, Depreciation
Volume or Space
occupied Heating,
Lighting, Building, Depreciation,
Number of Employees in
Each Cost
Centre Canteen,
Welfare, Personnel, General Administration Industrial Relations, safety
Book (or Replacement)
value Insurance, Depreciation
Of plant, Equipment Premises
Etc.
Stores
Requisitions Store-Keeping
Weight of
Materials Store-Keeping,
Materials Handling
The process of apportionment is an essential part of
building of overheads, because many indirect costs apply to numerous cost centers
rather than just one.
Note
Although cost apportionment is a normal part of the cost
ascertainment process it must be realized that it is convention only and cost
so apportioned are not verifiable.
Overhead Absorption
Directs costs, by definition are readily indefinable
traceable to cost objects or cost units, but overheads, which are often
considerable, cannot be related directly, but nevertheless form part of the
total cost of a particular product or service. Accordingly overheads must be
shared out in some equitable fashion among all of the cost units produced or
services offered conventionally, the process by which this is done is known as
overhead absorption rate, based on factors such as direct machine or labour hours
is calculated and the overheads shared out over the cost objects concerned
according to the number of machine or labour hours involved.
Period Cost
This is a cost, such as rent and insurance, arising from
being in business during a period of time as opposed to a cost identified with
producing a product. A good cost is a cost that is charged to profit and loss
account in the year of occurrence of the cost as no part of it is included in
the closing stock. All the non-manufacturing costs are written off against
profit and loss account in the same year that are incurred and hence regarded
as period costs.
Product Cost
This is a cost, such as that of manufacture that does not
have to be written off to profit and loss account in the same years that they
are incurred. The proportion of the years manufacturing costs to be written off
depends upon the number of units produced and sold during the year. Any unit
produced but not sold is carried forward as closing stock until it is sold in
another period.
The closing stock contains the proportionate share of the
years manufacturing cost assuming we are using FIFO pricing method such cost
that can be assigned to either the units sold or the units left in closing
stock are known as product cost. As an illustration, let us consider the case
of a manufacturing company which produces 1,000 units of a product during a
period at a total manufacturing cost of N5000, so that manufacturing cost
per unit is N5.00. Let us assume that 800units are sold in the year. In
this case total product cost is N5000 out of which N1000 is included
in the closing stock (200xN5) while the remaining N4000 is incurred on
non-manufacturing cost, the whole N4000 is written off against profit and loss
account as an expense for the period. No past of the N4000 is therefore
included in the cost of the units of closing stock as there is no vacancy for
any period least in the closing stock.
Direct Cost
Costs may be classified in numerous ways, but a fundamental
and important method of classification is into direct and indirect costs.
Direct costs (composing direct material costs, direct wages cost and direct
expenses) are those costs which can be directly identified with a job, batch,
product or services typical examples are:
Direct
materials: The
raw materials used in a product bought in parts and assemblies, incorporated
into the finished product.
Direct wages or direct labour
cost: The remuneration paid to
production workers for work directly related to production, the salaries
directly attributable to a saleable service (audit clerk’s salaries for
example).
Direct
expenses Expenses
incurred specifically for a particular product, job, batch or service,
royalties paid per unit for a copyright design, plant or tool hire charges for
a particular job or batch.
It follows therefore that direct costs do not have to be
spread between various categories because the whole cost can be attributed
directly to a production unit or saleable service.
The total of direct costs is known as prime cost i.e. direct
material + direct labour + direct expenses = prime cost.
Invariably when direct costs are mentioned, the costing of
production costs units is involved. Technically this need not be so, but unless
the context of the question clearly points to some other conclusion, any
reference to direct costs should be taken to refer to production costs units.
Indirect Costs
All material labour and expense costs, which cannot be
identified as direct costs are termed indirect costs the three element of
indirect costs; indirect materials indirect labour and indirect expenses are
collectively known as overheads.
Typical examples of indirect costs in the production area
are the following:
Indirect
Materials: Lubricating
oil, stationery, consumable materials, maintenance materials spare parts for
machinery, etc.
Indirect
Labour: Factory
supervision, maintenance wages, store men’s wages etc.
Indirect
Expenses Rent
and rates for the factory units insurance, etc.
Indirect materials + indirect labour + indirect expenses =
overheads note:
It should be noted that in practice overheads are usually
separated in categories such as production overheads, Administration Overheads,
selling overheads. The above are examples of production overheads.
It must be emphasized that the choice of cost object determines
what can be classified as a direct or indirect cost for example in a
manufacturing firm the cost object may be to find the cost of running the
inspection department, in which case the salaries of the inspectors Auditing in
direct cost. However, if the costs object was to find a unit component cost
then the inspector salaries would be an indirect cost because they cannot be
directly identified with an individual component. The more costs that can be
classified as direct the more accurate will be the cost
assignment.
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