1. Nature of Accounting

8/8/2019 1. Nature of Accounting

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NATURE OF ACCOUNTING AND

COST CLASSIFICATION

BY

SC MALHOTRA

ASSOCIATE PROFESSORSHRI RAM COLLEGE OF COMMERCE

DELHI - 110007


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Branches of accounting for business

Accounting may be defined as a system ofcollecting, summarizing, analyzing and reportinginformation about a business enterprise in

monetary terms.

Accounting for business may broadly becategorized into three parts as

Financial Accounting

Cost Accounting

Management Accounting


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FINANCIALACCOUNTING

Financial accounting is mainly concerned with recording businesstransactions in the books of accounts for the purpose of communicatingeconomic information about the enterprise to the users of suchinformation.

In financial accounting, business transactions are recorded in a mannerwhich is helpful in preparing financial statements for the purpose of

reporting to the management, shareholders, tax authorities, creditors, etc.

COSTACCOUNTING

It is that branch of accounting information system, which records,measures and reports information about costs.

It is the process of accounting for costs. It aims at providing cost data,statements and reports for the purpose of managerial decision making.

It embraces the accounting procedures relating to recording of all incomeand expenditure and the preparation of periodical statements and reportswith the object of ascertaining, controlling and reducing costs.


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Distinction between

1. Users

2. Source of authority

3. Nature of information

4. Terms of expression

5. Time frame

6. Report criterion

Cost accounting and

management accounting

1. Scope

2. Functions

3. Organization structure

4. Source of information

5. Planning

Financial accounting and

management accounting

Management accounting is the blending together of financial accounting, cost accounting

And financial management so as to serve as a good guide to management in planning,

coordinating, executing, controlling and motivating.


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Nature and functions of cost

accountingAs Cost accounting is the process of accounting for costs,it embraces the accounting procedures relating torecording of all income and expenditure and the

preparation of periodical statements and reports with theobject of ascertaining, controlling and reducing costs.

Cost ascertainment. The main purpose of accounting

initially was to ascertain cost of products, operations,processes, jobs, etc. Cost ascertainment is concernedwith computation of actual cost incurred. It refers tomethods and processes employed in ascertainingcosts.


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Nature and functions of accountingcotd.

Cost control. A cost accountant is now concerned withfurnishing such information that enables the management tocontrol the costs of operating the business. As a matter offact, this function has become the prime function of the costaccountant these days. Cost control is exercised by a variety oftechniques such as those of standard costing, budgetarycontrol, quality control etc.

Cost reduction. This is a new dimension to the function of acost accountant. In the era of liberalization and competitiononly those will survive who can deliver quality goods and

services at the least cost. This needs constant research anddevelopment in the areas of product design, productionprocedures etc. for reducing costs.


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Meaning of some important terms

Cost It may be defined as the amount of expenditure (actual or notional)incurred on or attributable to a given object. Cost represents theresources that have been or must be sacrificed to attain a particularobjective. Sacrifice may be direct or indirect but must be able to bemeasured in terms of money.

Cost unit It is a quantitative unit of output (product or service) in relationto which costs are ascertained by means of allocation, apportionment andabsorption. For example, tonnes in cement/coal/sugar industry,, metre intextile industry, crate (of 24 or 12 bottles) in soft drink industry, kilogramof yarn spun in spinning industry, kilowatt-hour (Kwh.) in electricityindustry, room per day in hotel industry, passenger kilometer or tonnekilometer in transport industry, are some of the examples of cost unit.

In the case of service organisations a composite cost unit is used such astonne-kilometre, kilowatt-hour, patient-day etc., to be more meaningful.


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Meaning of some important terms.cotd.

Cost object A cost object is something for which we want tocompute a cost. It can be a product (motor car), service(airline flight from Delhi to Dubai), project (construction ofa building), activity (holding games), program (malaria

eradication), etc. Thus cost object may be anything forwhich a separate measurement of costs is desired.

Cost centre It is a location, person or item of equipment (orgroup of these) for which costs may be ascertained and

used for the purpose of control. Thus a cost centre refers toa section of the business to which costs can be charged.The purpose of creation of cost centre is basically (i) therecovery of costs and (ii) cost control.


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Elements Of Cost

Material cost The substance from which the product ismade is known as material. The cost of this material is

material cost. It may be in a raw or manufactured state. Itcan be direct as well as indirect. Examples of direct materialcost are: cotton in cloth, cloth in garments, leather inleather products, jute in gunny bags, iron in iron products,

timber in furniture, paper in books, clay in bricks, etc. Labour cost For conversion of materials into finished

goods, human effort is needed. Such human effort is calledlabour. Thus the cost of remuneration (wages, salaries,commissions, bonuses, etc.) of the employees is called

labour cost. Labour cost can be direct as well as indirect. Expenses All costs other than material and labour are

termed as expenses. They may be direct or indirect.


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ELEMENTSOF COST

MATERIALCOSTS

DIRECT

INDIRECT

LABOURCOSTS

DIRECT

INDIRECT

OTHERCOSTS

DIRECT

INDIRECT

ELEMENTSOFCOST


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ELEMENTS OF COST

MATERIAL

COST

LABOURCOST

OTHERCOSTS

DIRECT INDIRECT DIRECT INDIRECT DIRECT INDIRECT

OVERHEADS


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Overheads

Overheads include the cost of indirectmaterial, indirect labour and indirectexpenses.

These overheads may be classified under thefollowing three categories:

Manufacturing (works, factory or production)expenses

Office and administrative expenses

Selling and distribution expenses


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ELEMENTS OFCOST

DIRECT MATERIALCOST

DIRECT LABOURCOST

DIRECT EXPENSES OVERHEADS

MANUFACTURING

OFFICE ANDADMINISTRATIVE

SELLING ANDDISTRIBUTING


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Elements ofCost

COST

DIRECTCOST

MATERIALCOST

LABOURCOST

OTHEREXPENSES

INDIRECTCOST

MATERIALCOST

LABOURCOST

OTHEREXPENSES

Factory OverheadsPrime Cost Overheads Cost

Office & Admin Overheads

Selling & Distribution

Overheads


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Components of total cost

Direct material cost (Cost of direct material consumed):

Opening stock of direct material xxx

AddDirect material purchased xxx

Less Closing stock of direct material (xxx) xxx

Direct labour cost xxx

Direct expenses xxx

PRIME COST xxx

Works or factory overheads xxx

GROSS WORKS OR FACTORY COST xxx

Add Opening work-in-progress xxxLess Closing work-in-progress (xxx)

WORKS OR FACTORY COST xxx

cotd.


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Components of total cost .cotd.

WORKS OR FACTORY COST xxx

Office and administrative overheads xxx

OFFICE COST OR TOTAL COST OF PRODUCTION xxx

Add Opening stock of finished goods xxxLess Closing stock of finished goods (xxx)

COST OF GOODS SOLD xxx

Selling and distribution overheads xxx

COST OF SALES xxx

Profit xxx

SALES xxx


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COSTCLASSIFICATION PURPOSEWISE

(1)COSTCONCEPTSRELATINGTOSTOCK VALUATIONANDINCOMEMEASUREMENT

Direct and indirect costs

Product costs and period costs Expired and unexpired costs

Joint product costs and separable costs


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Cost classification purpose wise .cotd.

2) COSTCONCEPTSRELATINGTOPROFIT,PLANNINGANDCONTROL

Fixed, variable and semi-variable/mixed costs

Fixed costs - *Committed fixed costs *Discretionary fixed costs

Variable costs Semi-variable costs (Mixed costs)

Methods of mixed cost segregation - *Graphic method *Two

point method *Analytical approach * Method of

least squares

Controllable and non-controllable costs


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(3) COSTCONCEPTSFORDECISION-MAKING

Relevant and irrelevant costs

Incremental cost/differential cost Out of pocket costs and sunk costs

Opportunity costs and imputed costs

Avoidable costs and unavoidable costs


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Cost classification purpose wise ..contd.

Direct and indirect costs

Direct costs are those costs which can be convenientlyand wholly identified with a cost unit or a cost centre,i.e., product, process, job, contract, department, etc.

These are costs of resources that are acquired for orused by a single cost object. The cost of wood infurniture making, the cost of cloth in textile factory, thecost of computer chip in computer assembly unit areexamples of direct cost.

Since these costs are incurred exclusively for aparticular cost object, they are conveniently identifiedwith the cost object for which they are purchased.


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Cost classification purpose wise .contd.Indirect costs

Indirect costs are those costs which cannot be conveniently andwholly identified with a cost unit or cost centre. These are the costsof resources that are acquired for or used by more than one costobject. Since these costs are common to certain number of costunits or cost centres, they need to be distributed among those costunits (or cost centres) on some reasonable basis. Their distributioninvolves exercise of judgment.

Salaries of timekeepers, storekeepers, foreman, etc. engaged inproduction and expenses incurred for running the administrationare examples of indirect costs.

Sometimes, certain costs which can be identified with a cost unitmay be treated as indirect costs due to convenience and small sizeof such costs. For example, in a garment factory threads, buttons,stiffeners, buckles, etc. may be treated as indirect materials.

Thus classification of cost as direct or indirect is situational. A costmay be direct in one situation and indirect in another situation.


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Product costs and period costs

Cost which becomes part of the cost of the product rather thanexpenses of the period in which they are incurred are called asproduct costs. They are included in inventory values. In financialstatements such costs are treated as assets until the goods, towhich they are assigned, are sold. Product costs become expense atthe time of sale. These costs may be fixed as well as variable, e.g.,

cost of raw-materials and direct wages, depreciation on plant andmachinery etc.

Costs which are not associated with production are called periodcosts. They are treated as an expense of the period in which theyare incurred. They may also be fixed as well as variable. Such costsinclude general administrative costs, salesmen salaries andcommission, depreciation on office facilities. They are chargedagainst the revenue of the relevant period.


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Expired and unexpired cost

An expired cost is one which cannot contribute to the production

of future revenues. In contrast, an unexpired cost is one which

has the capacity of contributing to the production of revenuein the future.

Inventory constitutes a good example of unexpired cost, as it can

be sold in subsequent years and will influence future

revenues.


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Joint product costs and separable costs

Joint product costs are the costs of a single process, or series ofprocesses that simultaneously produce two or more productsof significant sales value. In this case, it is not possible toprecisely determine the cost of each joint product because

these costs cannot be identified with individual products.

The share of individual joint products in common costs can onlybe approximately estimated. For example, in a petroleumrefinery industry, petrol, diesel oil, kerosene oil, naptha, tar,

etc. are produced jointly in the refinery process.

Separable cost, in contrast, refers to any cost that can beattributed exclusively and wholly to a particular product,process, division or department.


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Cost concepts relating to profit, planning and control

Fixed, Variable and Semi-variable costs

Fixed costs are fixed, their totals do not change with

change in the output over a wide range of activity in agiven period. For example, rent and insurance ofbuilding, municipal taxes, salaries of permanent staff,etc. remain fixed irrespective of actual output. Sincetotal of fixed costs remains constant, fixed costs per

unit of output decreases with the increase in outputand it increases with decrease in output.


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Cost classification purpose wise cotd.

Variable costs are those costs which vary in direct proportion tochange in output. These costs increase or decrease in the sameproportion in which output increases or decreases. In other words,there is perfect positive correlation between variable cost andoutput. It holds true when variable cost per unit is constant.

As a matter of fact, this concept of fixed cost and variable cost holdsgood in short-run and hence it is more a theoretical concept.Further, variable costs remain constant per unit of output and fixedcosts remain constant in total or per unit of time.

Semi-variable costs are also called as semi-fixed or mixed costs.

These costs fall between the two extreme of fixed costs andvariable costs. They are neither perfectly variable nor absolutelyfixed in relation to changes in level of activity. They vary with thechange in output but not in the same proportion in which outputvaries.


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Cost classification purpose wise ..cotd.

Both fixed and variable costs are relevant for decisionmaking purposes. However, there relative importancediffers at proposal stage and at operations stage.

At proposal stage, all costs are important whether they arefixed or variable. A project will not be accepted, if it doesnot hope to recover both fixed and variable costs at theanticipated level of activity. At this stage, fixed costs arerather more important because they are, usually,irrevocable and involve relatively large sums of money.

On the other hand, at operations stage, decisions aremainly guided by variable costs as fixed costs becomeirrelevant for a number of decisions.


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Controllable and Uncontrollable Costs

An item of cost is controllable if the amount of cost incurred (or

assigned to) a responsibility centre is significantly influenced

by the actions of the manager of the responsibility centre.Otherwise, it is uncontrollable.


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(3) COSTCONCEPTSFORDECISION-MAKING

Relevant and irrelevant costs

Incremental cost/differential cost

Out of pocket costs and sunk costs

Opportunity costs and imputed costs


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1. Nature of Accounting

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