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Cost Accounting.Pdf 170 Accounting and Financial Management for I.T. Professionals Chapter–6 Cost Accounting LEARNING OBJECTIVES In this chapter we will study: Fundamentals of Cost Cost Accounting l Objective of Cost Accounting l Cost-Volume-Profit (CVP) Analysis/Break-even Analysis l Advantages and Limitations of CVP Analysis Absorption Costing and Marginal Costing Inventory Management l Inventory/Types of inventory l Inventory Management l Need of Inventory Management l Objective of Inventory Management l Approach of Inventory Management l Techniques/Models used for Inventory Control q EOQ Model q A-B-C Analysis Cost Accounting 171 6.1 FUNDAMENTALS OF COST Meaning of Cost Cost means sacrificing resources to receive benefits. Benefits may be anything tangible or intangible. On the other hand, an expired cost is expense. Depreciation (amortization of asset), maintenance charges, telephone bill etc. are examples of expenses. Basic Elements of Cost There are three basic elements of cost of product/services viz. material cost, labour cost and overhead cost. Overhead cost includes expenses other than material and labour. It might happen that as compared to one basic element other elements are negligible/insignificant. Classification of Cost Classification of cost is done on the basis of purpose of management. Following are some important classification: l Direct cost and indirect cost Direct costs are those costs which affects Cost of Goods Sold (COGS) e.g. material cost, labour cost, manufacturing expenses are direct costs. Here the purpose of management is to know the gross profit, net profit etc. l Controllable and uncontrollable cost Controllable costs are those costs, which remain under jurisdiction of concerned manager. Here the purpose of management is to set accountability. e.g. consumption of material is controllable cost for production manager whereas it is uncontrollable cost for purchase manager who is responsible for purchasing of material and hence material prices. l Shut down cost and sunk cost Shut down costs are those costs, which incur at the time of shut down of the production e.g. rent, minimum taxes, salaries or permanent labour. Shut down cost are important for continue or shut down decision. Sunk costs on the other hand are historical or past costs. These costs cannot be altered by later decisions and hence are irrelevant for decision-making. l Conversion cost Conversion cost is the cost incurred in converting Raw Material (R/M) into Finished Goods (FG). l Explicit cost and implicit cost All those costs, which incur exclusively like material cost, labour cost and overhead costs are explicit costs. Whereas all the implied costs like opportunity cost, depreciation, loss on sale are implicit costs. l Out of pocket costs, traceable costs and untraceable costs All the explicit costs are out of pocket costs whereas implicit costs are not out of pocket costs. Traceable costs are those, which can be traced. Whereas those, which cannot be traceable, e.g. scam, suspense account etc. are untraceable costs. l Fixed cost, semi variable cost and variable cost q Fixed costs are those costs, which remain unchanged with change in level of activity up to the capacity level e.g. interest cost, fixed salary, depreciation etc. are fixed costs. q Semi variable costs are those costs part of which changes with change in level of activity e.g. telephone bill is semi variable cost as after free calls every additional call increases bill amount. q Variable costs are those costs which changes with change in level of activity e.g. material cost, labour cost etc. are variable costs. 172 Accounting and Financial Management for I.T. Professionals Fixed Fixed cost line cost 0 Level of activity Variable cost Variable cost line 0 Level of activity Remark: Total fixed cost remains fixed whereas fixed cost per unit changes with change in level of activity. Similarly, total variable cost changes whereas variable cost per unit remains fixed with change in level of activity. 6.2 COST ACCOUNTING Cost accounting is the process of maintaining cost records and controlling cost. Cost accounting process includes: 1. Cost determination/costing 2. Cost analysis 3. Cost control Cost Determination/Costing l Costing is a technique used to determine cost of product/services at different levels of ongoing operation. l Costing is done through process of accumulation. l Preparation of cost sheet is a method of costing. l Cost sheet helps in knowing unit cost at different levels (known as cost centres) of ongoing operation. l Costing helps in cost control because costing estimates cost incurred at departments/sub-departments level and cost can be controlled only at the point of incurrence i.e. at department/sub-department levels popularly known as cost centers. Cost Accounting 173 Cost analysis l Cost analysis means analyzing cost. l The most popular technique used for cost analysis is Cost-Volume-Profit analysis (CVP analysis). l CVP analysis refers to study of behaviour of profit with respect to cost and volume. l CVP analysis is also referred as Break-Even Analysis (BE-Analysis) l CVP analysis helps in profit planning and therefore recognized as important tool of management accounting. Cost control l Cost control means comparison of actual cost with predetermined cost (known as standard cost) and if there is deviation, taking corrective action. l The most popular technique for cost control is standard costing. l Standard costing leads to variance analysis. l Variance exists when there is deviation between actual cost and standard cost. Variance may be favourable (when Actual Cost is less than Standard Cost) or Unfavourable/Adverse (when Actual Cost is more than Standard Cost). 6.2.1 Objective of Cost Accounting The objective of cost accounting is to maintain cost records and to control cost in order to accomplish ultimate goal of an organization i.e. wealth maximization. 6.2.2 Cost-Volume-Profit (CVP) Analysis l CVP analysis is study of behaviour of profit with respect to cost and volume i.e. level of activity. l CVP analysis is also referred as Break-Even Analysis (BE-Analysis). l Thus under CVP analysis we try to find out Break-Even Point (BEP). l BEP is that level of activity at which there is no profit no loss. l For the purpose of CVP analysis cost is divided into two parts—Fixed cost and Variable cost. l Fixed cost is that cost which remains unchanged with change in level of activity e.g. depreciation, interest cost, fixed salary, monthly rent etc. l Variable costs are those cost which changes with change in level of activity e.g. raw material cost, productive labour, manufacturing expenses etc. Thus at BEP, Profit/Loss = 0 Revenue – Cost = 0 Revenue = Fixed cost + Variable cost ...(i) Let at BEP, ‘n’ units is the level of activity. Let S.P. is the selling price per unit and V.C. is the variable cost per unit. Then, According to equation (i), n × S.P. = Fixed cost + n × V.C. n ( S.P. – V.C.) = Fixed cost Fixed cost n = BEP (Units) = (S.P.–V.C.) 174 Accounting and Financial Management for I.T. Professionals Fixed cost (FC) BEP (units) = Contribution Margin per unit (CM) Fixed Cost (FC) Again, BEP (Sales or Rs.) = BEP (units) × S.P. =S× .P. Contribution Margin per unit (CM) Fixed Cost (FC) Or, BEP (Sales or Rs.) = (CM) per unit/SP per unit) Fixed Cost (FC) Or, BEP (Sales or Rs.) = P/V ratio Where P/V ratio is also referred as Profit-Volume ratio and P/V ratio = (CM per unit/SP per unit) CM per unit × n P/V ratio = SP per unit × n Total Contribution P/V ratio = Total Sales Revenue (Total Sales Revenue – Total Variable Cost) P/V ratio = Total Sales Revenue (S–V) P/V ratio = S V P/V ratio =1– S Thus, P/V ratio = f (V, S) P/V ratio is function of variable cost and selling price. It is independent of fixed cost. l P/V ratio is very important ratio for multi-product organization. l Multi-product organizations choose that product for maximum operation whose P/V ratio is maximum because this will lower the BEP as, BEP α 1/PV ratio Relationship between Actual units/Target units and Actual profit/Desired profit Acutal profit or Desired profit Actual units or Target units = BEP (units) + Contribution Margin per unit (CM) Or, (Fixed cost + Acutal profit or Desired profit) Actual units or Target units = Contribution Margin per unit (CM) Cost Accounting 175 Relationship between Actual Sales/Target Sales and Actual profit/Desired profit Actual profit or Desired profit Actual sales or Target sales = BEP (sales) + P/V ratio Or, (Fixed cost + Actual profit or Desired profit) Actual sales or Target sales = P/V ratio Margin of safety It measures the extent up to which the level of operation may go down for no profit, no loss. Thus, Margin of safety in Rs. = Actual sales – BEP (sales) Or, Margin of safety in units = Actual units – BEP (units) Actual profit or Desired profit Or, Margin of safety in units = Contribution Margin per unit (CM) Break-Even (BE) Chart Y axis Sales revenue line Profit region Total cost line Sales Sales revenue = Total cost revenue Sales revenue > Total cost & cost Loss region Fixed cost line Sales revenue < Total cost 0 P1 P= BEP P2 X axis Level of activity l BE chart depicts graphical presentation of BEP (Break-even point). l As shown in above chart, at P = BEP there is no profit no loss i.e., Sales revenue = Total cost. l Beyond BEP i.e., at P2 there is profit region, means sales revenue > total cost. l Before BEP i.e., at P1 there is loss region, means sales revenue < total cost.
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