BASIC COST CONCEPTS

COST: MEANING AND ITS ELEMENTS

The term ‘cost’ means the amount of expenses [actual or notional] incurred on or attributable
to specified thing or activity.
As per Institute of cost and work accounts (ICWA) India, Cost is ‘measurement in monetary
terms of the amount of resources used for the purpose of production of goods or rendering
services.
To get the results we make efforts. Efforts constitute cost of getting the results. It can be
expressed in terms of money; it means the amount of expenses incurred on or attributable to
some specific thing or activity. The term cost is used in this very form. In reference to
production/manufacturing of goods and services cost refers to sum total of the value of
resources used like raw material and labour and expenses incurred in producing or
manufacturing of given quantity.

Elements of cost
Cost of production/manufacturing consists of various expenses incurred on
production/manufacturing of goods or services. These are the elements of cost which can be
divided into three groups: Material, Labour and Expenses.

1. Material
All material which becomes an integral part of finished product and which can be conveniently
assigned to specific physical unit is termed as “Direct Material”. It is also described as raw
material, process material, prime material, production material, stores material, etc. The
substance from which the product is made is known as material. It may be in a raw or
manufactured state. Material is classified into two categories:
_ Direct Material
_ Indirect Material

_ Direct material
Direct Material is that material which can be easily identified and related with specific product,
job, and process. Timber is a raw material for making furniture, cloth for making garments,
sugarcane for making sugar, and Gold/ silver for making jewellery, Implants and devices,
Medical-grade plastics such as polyvinyl chloride (PVC) used to produce blood bags, IV
tubing, and urine bags. Catheters Medical supplies Diagnostic kits Protective equipment etc are
some examples of direct material.

_ Indirect material
Indirect Material is that material which cannot be easily and conveniently identified and related
with a particular product, job, process, and activity. Consumable stores, oil and waste, printing
and stationery etc, are some examples of indirect material. Indirect materials are used in the
factory, the office, or the selling and distribution department e.g. cleaning supplies, office
supplies, and personal protective equipment (PPE) like disposable gloves and masks as these
are essential for operations but are not part of the patient's direct treatment.
2. Labour
Labour is the main factor of production. For conversion of raw material into finished goods,
human resource is needed, and such human resource is termed as labour. Labour cost is the
main element of cost in a product or service. Labour can be classified into two categories:
_ Direct Labour, and
_ Indirect labour

_ Direct labour
Labour which takes active and direct part in the production of a commodity. Direct labour is
that labour which can be easily identified and related with specific product, job, process, and
activity. Direct labour cost is easily traceable to specific products. Direct labour costs are
specially and conveniently traceable to specific products. Direct labour varies directly with the
volume of output. Direct labour is also known as process labour, productive labour, operating
labour, direct wages, manufacturing wages, etc. Cost of wages paid to carpenter for making
furniture, cost of a tailor in producing readymade garments, cost of washer in dry cleaning unit
and doctors, nurses, and medical technicians are some examples of direct labour.

_ Indirect labour
Indirect labour is that labour which cannot be easily identified and related with specific product,
job, process, and activity. It includes all labour not directly engaged in converting raw material
into finished product. It may or may not vary directly with the volume of output. Labour
employed for the purpose of carrying out tasks incidental to goods or services provided is
indirect labour. Indirect labour is used in the factory, the office, or the selling and distribution
department. Wages of store-keepers, time-keepers, salary of works manager, salary of
salesmen, Hospital administration, billing and medical records, finance and accounting staff,
Hr Personnel etc, are all examples of indirect labour cost.

3. Expenses
All cost incurred in the production of finished goods other than material
cost and labour cost are termed as expenses. Expenses are classified into
two categories:
Direct expenses, and
Indirect expenses (An item of overheads)

• Direct expenses
These are expenses which are directly, easily, and wholly allocated to specific cost center or
cost units. All direct cost other than direct material and direct labour are termed as direct
expenses. Direct expenses are also termed as chargeable expenses. Some examples of the direct
expenses are hire of special machinery, cost of special designs, moulds or patterns, feed paid
to architects, surveyors and other consultants, inward carriage and freight charges on special
material, Cost of patents and royalties.
• Indirect expenses
These expenses cannot be directly, easily, and wholly allocated to specific cost center or cost
units. All indirect costs other than indirect material and indirect labour are termed as indirect
expenses. Thus,
Indirect Expenses = Indirect cost – Indirect material – Indirect labour

Indirect expenses are treated as part of overheads. Rent, rates and taxes of building, repair,
insurance and depreciation on fixed assets, etc, are some examples of indirect expenses.

OVERHEADS: MEANING
Overheads are the indirect expenses of running a business that are not directly tied to producing
a specific product or service. These are ongoing costs required for day-to-day operations and
include expenses like rent, utilities, salaries for administrative staff, insurance, and marketing.
While not directly generating profit, they are essential for a company to carry out its profit-
making activities.
The term overhead has a wider meaning than the term indirect expenses. Overheads include the
cost of indirect material, indirect labour and indirect expenses. This is the aggregate sum of
indirect material, indirect labour and indirect expenses.
Overhead = Indirect material + Indirect labour + Indirect expenses

Overheads are classified into following three categories:

• Factory/works/ production overheads
• Office and administrative overheads
• Selling and distribution overheads
_
Factory/works overheads
All indirect costs incurred in the factory for production of goods is termed as factory/works
overheads. Such costs are concerned with the running of the factory or plant. These include
indirect material, indirect labour and indirect expenses incurred in the factory. Some examples
are as follows:

Indirect materials:
(i) Grease, oil, lubricants, cotton waste etc.
(ii) Small tools, brushes for sweeping, sundry supplies etc.
(iii) Cost of threads, gum, nails, etc.
(iv) Consumable stores
(v) Factory printing and stationery

Indirect wages
(i) Salary of factory manager, foremen, supervisors, clerks etc.
(ii) Salary of storekeeper
(iii) Salary and fee of factory directors and technical directors
(iv) Contribution to ESI, PF., Leave pay etc. of factory employee.

Indirect expenses

I. Rent of factory buildings and land

II. Insurance of factory building, plant, and machinery
III. Municipal taxes of factory building
IV. Depreciation of factory building, plant and machinery, and their repairs and
maintenance charges
V. Power and fuel used in factory
VI. Factory telephone expenses.
_ Office and administrative overheads
These expenses are related to the management and administration of the business. They are
incurred for the direction and control of an undertaking. These represent the aggregate of the
cost of indirect material, indirect labour, and indirect expenses incurred by the office and
administration department of an organisation. Some examples are as follows:

Office printing and stationery, Cost of brushes, dusters etc. for cleaning office building and
equipments, Postage and stamps. Salary of office manager, clerks, and other employees, Salary
of administrative directors, Salaries of legal adviser, Salaries of cost accountants and financial
accountants, Salary of computer operator. Rent, insurance, rates and taxes of office building,
Office lighting, heating and cleaning, Depreciation and repair of office building, furniture, and
Equipment etc., Legal charges, Bank charges, Trade subscriptions, Telephone charges, Audit
fee etc.

_ Selling and distribution overheads

Selling and distribution overheads are incurred for the marketing of a commodity, for securing
order for the articles, dispatching goods sold or for making efforts to find and retain customers.
These expenses represent the aggregate of indirect material, indirect labour, and indirect
expenses incurred by the selling and distribution department of the organisation.

These overheads have two aspects (i) procuring orders (ii) executing the order. Based upon this
concept the selling and distributions are studied separately.
I. Selling overheads
Indirect costs incurred in relation to the procurement of sale orders are termed as selling
overheads. Some of the examples of selling overheads are as follows:
Indirect material
(i) Catalogues, price list (ii) Printing and stationery
(iii) Postage and stamps (iv) cost of sample
Indirect wages
(i) Salaries of sales managers, clerks and other employees
(ii) Salaries and commission of salesmen and technical representatives
(iii) Fees of sales directors
Indirect expenses
(i) Advertising
(ii) Bad debts
(iii) Rent and insurance of showroom
(iv) Legal charges incurred for recovery of debts
(v) Travelling and entertainment expenses
(vi) Expenses of sending samples
(vii) Market research expenses.

II. Distribution overheads

Indirect costs incurred in relation to the execution of the sales order is termed as distribution
overheads. Some of the examples of distribution overheads are as follows:
Indirect material
(i) Cost of packing material
(ii) oil, grease, spare parts etc. for maintaining delivery vans
Indirect wages
(i) Salaries of godown employees
(ii) Wages of drivers of delivery vans
(i) (iii) Wages of packers and dispatch staff.
Indirect expenses
(i) Packing expenses
(ii) Godown rent, insurance, depreciation, and repair etc.
(iii) Freight carriage outwards and other transport charges.
(iv) Running expenses of delivery vans, repair, and depreciation.
(i) (v) Insurance in transit etc.

CLASSIFICATION OF COST

Costs are classified into following categories:

1. Cost behavior basis
(a) Fixed Cost
(b) Variable cost
(c) Semi-variable cost
2. Cost inventory basis
(a) Product cost and
(b) Period cost

Cost Relation to Cost Centre basis

(a) Direct and
(b) Indirect costs

1. Cost behavior basis

(a) Fixed Cost
A cost that remains constant within a given period of time and range of activity in spite of
fluctuations in production. Per unit fixed cost varies with the change in the volume of
production. If the production increases, fixed cost per unit decreases and as there is decrease in
production, the fixed cost per unit increases.

Rent and insurance of building, depreciation on plant and machinery, salary of employees etc.,
are some examples of fixed costs. Thus, the fixed cost per unit decreases as the total number of
output units increase.

(b) Variable cost

Variable costs are those cost which vary directly in proportion to change in volume of
production/output. The cost which increases or decreases in the same proportion in which the
units produced is termed as variable cost. Direct material, direct labour, direct expenses,
variable overheads are some examples of variable cost.

Variable costs, per unit same but total goes on fluctuating depending
upon volume of production/level of activity.
Thus, the variable cost per unit same and does not change if the total number of output units
increases.

(c) Semi-variable cost

A cost contains both fixed and variable component and which is thus partly affected by
fluctuations in the level of activity. Semi-variable costs is that cost of which some part remains
fixed at the given level of production and other part varies with the change in the volume of
production but not in the same proportion of change in production. For example, expenses may
not change if output is upto 50% capacity but may increase by 5% for every 20% increase in
output over 50% but up to 70%. For example, Telephone expenses of which rent portion is
fixed and call charges are variable, utility bills (electricity, water) which have a fixed base
charge plus a variable charge based on consumption, and laboratory costs where there is a fixed
cost for equipment and its maintenance, plus a variable cost for test strips per test, maintenance
of medical equipment, some staff compensation (base salary + overtime) etc.

Segregation of semi-variable cost

Semi-variable costs are segregated into fixed and variable cost by using the following formula
Semi-variable cost = Fixed cost + variable cost
Variable cost per unit = change in cost/change in output

COST SHEET: MEANING AND ITS IMPORTANCE

Cost sheet is a statement, which shows various components of total cost of a product. It
classifies and analyses the components of cost of a product. Previous periods data is given in
the cost sheet for comparative study. It is a statement which shows per unit cost in addition to
Total Cost. Selling price is ascertained with the help of cost sheet. The details of total cost
presented in the form of a statement is termed as Cost sheet. Cost sheet is prepared on the basis
of :
1. Historical Cost 2. Estimated Cost

Historical Cost
Historical Cost sheet is prepared on the basis of actual cost incurred. A statement of cost
prepared after incurring the actual cost is called Historical Cost Sheet.

Estimated Cost
Estimated cost sheet is prepared on the basis of estimated cost. The statement prepared before
the commencement of production is called estimated cost sheet. Such cost sheet is useful in
quoting the tender price of a job or a contract.

Importance of Cost Sheet

The importance of cost sheet is as follows:
_ Cost ascertainment
The main objective of the cost sheet is to ascertain the cost of a product. Cost, sheet helps in
ascertainment of cost for the purpose of determining cost after they are incurred. It also helps
to ascertain the actual cost or estimated cost of a Job.
_ Fixation of selling price
To fix the selling price of a product or service, it is essential to prepare the cost sheet. It helps
in fixing selling price of a product or service by providing detailed information of the cost.
_ Help in cost control
For controlling the cost of a product it is necessary for every manufacturing unit to prepare a
cost sheet. Estimated cost sheet helps in the control of material cost, labour cost and overheads
cost at every point of production.
_ Facilitates managerial decisions
It helps in taking important decisions by the management such as: whether to produce or buy a
component, what prices of goods are to be quoted in the tender, whether to retain or replace an
existing machine etc.

COMPONENTS OF TOTAL COST

The Components of cost are shown in the classified and analytical form in the cost sheet.
Components of total cost are as follows:

_ Prime Cost
It consists of direct material, direct wages and direct expenses. In other words, “Prime cost
represents the aggregate of cost of material consumed, productive wages, and direct expenses”.
It is also known as basic, first, flat or direct cost of a product.

Prime Cost = Direct material + Direct Wages + Direct expenses

Direct material means cost of raw material used or consumed in production.

It is not necessary that all the material purchased in a particular period is used in production.
There is some stock of raw material in balance at opening and closing of the period. Hence, it
is necessary that the cost of opening and closing stock of material is adjusted in the material
purchased. Opening stock of material is added and closing stock of raw material is deducted in
the material purchased and we get material consumed or used in production of a product. It is
calculated as:

Material Consumed = Material purchased + Opening stock of material

– Closing stock of material.

Factory Cost
In addition to prime cost it includes works or factory overheads. Factory overheads consist of
cost of indirect material, indirect wages, and indirect expenses incurred in the factory. Factory
cost is also known as works cost, production or manufacturing cost.

Factory Cost = Prime cost + Factory overheads

Adjustment for stock of work-in-progress

In the process of production, some units remain to be completed at the end of a period. These
incomplete units are known as work-in-progress. Normally, the cost of incomplete units
includes direct material, direct Labour, direct expenses, and average factory overheads. Hence,
at the time of computing factory cost, it is necessary to make adjustment of opening and closing
stock of work in progress to arrive at the net Factory cost/works cost.

Preparation of cost sheet

The various components of cost explained above are presented in the form of a statement. Such
a statement of cost consists of prime cost, works cost, cost of production of goods, cost of goods
sold, total cost and sales and is termed as cost sheet.
There is no prescribed format of a Cost sheet. It may change from industry to industry. A
specimen format of a Cost Sheet is given as under:
Illustration:
From the following information, prepare a cost sheet for period ended on 31st March 2006.
Solution: