UNIT 1

1. Introduction
Accounting is a very old science which aims at keeping records of various transactions. The
accounting is considered to be essential for keeping records of all receipts and payments as well
as that of the income and expenditures. Accounting can be broadly divided into three categories.
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Financial Accounting aims at finding out profit or losses of an accounting year as well as the
assets and liabilities position, by recording various transactions in a systematic manner.
Cost Accounting helps the business to ascertain the cost of production/services offered by the
organization and also provides valuable information for taking various decisions and also for cost
control and cost reduction.
Management Accounting: It is the presentation of accounting information in such a way so as
to assist the management in creation of policy and day to day operation of a company.
Management Accounting utilises the principles and practices of financial accounting and cost
accounting in addition to other modern management techniques for the purpose of policy
formulation, planning, control & decision making by the management.
1.1

Cost Accounting

In the modern days of cut throat competition, any business organization has to pay attention
towards their cost of production. Computation of cost on scientific basis and thereafter cost
control and cost reduction has become of paramount importance. Cost accounting is, thus,
concerned with recording, classifying and summarizing costs for determination of costs of
products or services, and planning, controlling and reducing such costs and furnishing of
information to management for decision making.
Wilmot has summarized the nature of cost accounting as the analyzing, recording,
standardizing, forecasting, comparing, reporting and recommending.

1.1.1 Cost: - Cost can be defined as the expenditure incurred on a given thing. It can also be
described as the resources that have been sacrificed or must be sacrificed to attain a particular
objective. In other words, cost is the amount of resources used for something which must be
measured in terms of money. For example Cost of preparing one cup of tea is the amount
incurred on the elements like material, labor and other expenses.
1.1.2 Costing: - Costing may be defined as the technique and process of ascertaining costs.
According to Wheldon, Costing is classifying, recording, allocation and appropriation of
expenses for the determination of cost of products or services and for the presentation of suitably
arranged data for the purpose of control and guidance of management.
1.1.3 Cost Accountancy: - Cost Accountancy is defined as, the application of costing and cost
accounting principles, methods and techniques to the science and art and practice of cost control
and the ascertainment of profitability as well as presentation of information for the purpose of
managerial decision making.
1.1.4 Objectives of Cost Accounting: - Objectives of Cost Accounting can be
summarized as under:
1. To Know the Cost: To ascertain the cost of production on per unit basis, for example,
cost
per kg, cost per meter, cost per liter, cost per ton etc.
2. To determine Selling Price: Cost accounting helps in the determination of selling price.
Cost accounting enables to determine the cost of production on a scientific basis and it helps to
fix the selling price.
3. To Control the Cost: Cost accounting helps in cost control and cost reduction.
4. Ascertainment of division wise, activity wise and unit wise profitability becomes possible
through cost accounting.
5. To Control the wastage: Cost accounting also helps in locating wastages, inefficiencies
and other loopholes in the production processes/services offered.
6. To Guide the Business Policy: Cost accounting helps in presentation of relevant data to the
management which helps in decision making. Decision making is one of the important
functions of Management and it requires presentation of relevant data. Cost accounting
enables presentation of relevant data in a systematic manner so that decision making becomes
possible.
7. To Estimate Future Cost: Cost accounting also helps in estimation of costs for the future.
1.1.5 Costing Systems or Techniques of Costing:1) Historical or Absorption Costing: Under this method cost is ascertained on the basis of
actual expenses incurred after the production is complete. To ascertain the price of a
tender or quotation, actual cost figures of previous year are used as a basis. For example,
costs incurred in the month of April, 2007 may be ascertained and collected in the month
of May.
2) Standard Costing: The standard cost of a commodity or a service is estimated before
actual production. After the production standard cost is compared with actual cost of
production and the amount and causes of variance are known. On the basis of actual costs
necessary adjustments are made in standard cost and future standard costs are fixed.
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3) Marginal Costing: In this technique only such expenses are included in cost which are
directly related to production that is which are variable to quantity of production. No part
of fixed expenses is included in this cost. If the production of the factory is increased in
future within the production capacity, the additional cost of production is called marginal
cost.
4) Absorption Costing: - In this type of costing system, costs are absorbed in the product
units irrespective of their nature. In other words, all fixed and variable costs are absorbed
in the products. It is based on the principle that costs should be charged or absorbed to
whatever is being costed, whether it is a cost unit, cost center.
5) Budget Costing: This technique is also known as budgetary control. Budgetary control is
a technique applied to the control of total expenditure on materials, wages & overheads
by comparing actual performance with planned performance. In addition to its use in
planning, the budget is also used for control & co-ordination of business operations.
6) Uniform Costing: It is the use of same costing principles & /or practices by different
companies & firms for common control or comparison of costs. The system, thus,
facilitates inter- firm comparisons, establishment of realistic pricing policies, etc.

1.1.6 Methods of Costing:-

Costing can be defined as the technique and process of ascertaining costs.

The principles in every method of costing are same but the methods of
analyzing and presenting the costs differ with the nature of business.
1. Job Costing: The system of job costing is used where production is not
highly repetitive & is done against orders. Each job is treated as a
distinct unit, and related costs are recorded separately. This type of
costing is suitable to printers, machine tool manufacturers, job
foundries, furniture manufacturers etc.
2. Batch Costing: This method is employed where the cost of a group of
product (i.e. a batch) is ascertained. In this case a group of identical
products is treated as a job. Batch costing is generally followed in
general engineering factories, biscuit factories, bakeries &
pharmaceutical factories.
3. Contract Costing: A contract is a big job and, hence, takes a longer
time to complete. For each individual contract, account is kept to
record related expenses in a separate manner. In case of ship-building,
bridges, building contractors etc., this system of costing is used.
4. Single Costing: This method is also known as output costing or unit
costing. This method is used in such industries where only one item is
produced in large quantities during the whole year EXAMPLES cement,
flour, sugar and coal. Under this method cost per ton, per thousand
bricks etc. is computed.
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5. Operating Costing: In industries where no commodity is produced

but public utility service is provided. EXAMPLES railways, bus transport,
and electric supply.
6. Process Costing: In the industries where the production is completed
through many processes or where the production may be sold after
completion of one or a few or all processes, this method of costing is
used. EXAMPLES chemical, textile, and oil industries.
7. Departmental Costing: When in a factory more than one item is
manufactured, it is necessary to ascertain the cost of each item
separately. For this purpose total expenses are divided between
various departments on some fair basis and cost per unit of each
department is ascertained. EXAMPLES almirahs, boxes, bed, and
tables.

1.1.7 Components or Elements of Cost:The elements of costs are classified as materials, labor and expenses. These three elements of
cost would be grouped in to direct and indirect categories:

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Following are the three broad elements of cost:

a) Materials
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b) Labour
c) Expenses
Materials: The term materials may be defined as the substances from which products are
manufactured. These materials may be in a raw or a manufactured state. Materials may be
direct or indirect. These are the physical items used in manufacturing.
Direct and Indirect Material :- Direct material is the material which is identifiable with
the product. For example, in a cup of tea, quantity of milk consumed can be identified,
so this will be direct material for this products. Indirect material cannot be identified with the
product, for example lubricants, fuel, oil, cotton wastes etc cannot be identified with a given unit
of product and hence these are the examples of indirect materials.
Labour:
Direct and Indirect Labor: - Direct Labour represents wages payable / paid to those
employees who directly engaged in the production (i.e. conversion of raw materials into
final product). For example, In a furniture mart, the carpenters engaged in conversion of
raw wood with sofa set, tables, doors, benches are said to be the direct workers and
wages paid to him will be considered as direct wages.
On the other hand, Indirect labor is the labor which is not directly engaged in the
production operations. They are, however, help in the production operations. The wages
paid to workers like sweepers, gardeners, maintenance workers etc. are indirect wages as
they cannot be identified with the given unit of production.
Expenses:

Direct and Indirect Expenses :- Direct expenses refers to expenses that are specifically
incurred and charged for specific or particular job, process, service, cost center or cost
unit. These expenses are also called as chargeable expenses. Examples of these expenses
are cost of drawing, design and layout, royalties payable on use of patents, copyrights etc,
consultation fees paid to architects, surveyors etc. Indirect expenses on the other hand
cannot be allocated to specific product, job, process, service or cost center or cost unit.
Several examples of indirect expenses can be given like insurance, electricity, rent,
salaries, advertising etc. They may relate to the factory, the office and administration and
selling and distribution divisions. These are now popularly known as overheads.

1.1.8 Classification of Costs: An important step in computation and analysis of cost is the classification of costs into different
types. Classification of costs can be made according to the following basis.

On the
basis of
Decision
Making

On the
basis of
Attributabi
lity to the

On the
basis of
Time

On the
basis of
Nature/

On the
basis of
Function

Classificati
on of
Costs
On the
basis of
Element

On the
basis of
Normalit

On the
basis of
Controlla

On the
basis of
Relation
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a. On the basis of Time period:

1. Historical Costs: Costs relating to the past period, which has already been incurred.
2. Current Costs: Costs relating to the present period.
3. Pre-determined Costs: Costs relating to the future period; Cost, which is computed in
advance, on the basis of specification of all factors affecting it.
b. On the basis of Behaviour / Nature / Variability:
1. Variable Costs: These are costs which tend to vary or change in relation to volume of
production or level of activity. These costs increase as production increases and viceversa e.g. cost of raw material, direct wages etc. However, variable costs per unit are
generally constant for every unit of the additional output.
2. Fixed Costs: The cost which remains fixed irrespective of the change in the level of
activity / output. These costs are not affected by volume of production e.g. Factory Rent,
Insurance etc. If production increases fixed costs per unit decreases and vice-versa.
Sometimes, these are also known as Capacity Costs or Period Cost.
3. Semi-variable Costs: These are those costs which are party fixed and partly variable.
These are fixed up to a particular volume of production and become variable thereafter
for the next level of production. Hence, they are also called Step Costs. Some examples
are Repairs and Maintenance, Electricity, Telephone etc.
c. On the basis of Elements:
1. Materials Cost of tangible, physical input used in relation to output/production, for
example, cost of materials, consumable stores, maintenance items etc.
2. Labour Cost incurred in relation to human resources of the enterprise, for example,
wages to workers, Salary to Office Staff, Training Expenses etc.
3. Expenses Cost of operating and running the enterprise, other than materials and labour,
it is the residual category of cost. For example, Factory Rent, Office Maintenance,
Salesmen Salary etc.

d. On the basis of Relationship:

1. Direct Costs: Costs which are directly related to / identified with / attributable to a Cost
Centre or a Cost unit. Example: Cost of basic raw material used in the finished product,
wages paid to site labour in a contract etc.
2. Indirect Costs: Costs that are not directly identified with a cost centre or a cost unit.
Such costs are apportioned over different cost centers using appropriate basis. Examples:
Factory Rent incurred over various departments; Salary of supervisor.
e. On the basis of Controllability
1. Controllable Costs Costs, which can be influenced and controlled by managerial action.
2. Uncontrollable Costs These are the costs that cannot be influenced and controlled by a
specific member of the organization. The line of difference between controllable and noncontrollable costs is thin.
f. On the basis of Normality:
1. Normal Cost: Cost, which can be reasonably expected to be incurred under normal,
routine and regular operating conditions.
2. Abnormal Cost: Costs over and above normal costs; Costs which is not incurred under
normal operating conditions e.g. fines and penalties.
g. On the basis of Functions or operations:
1. Production Cost: All the costs incurred for the production of goods are known as
Production costs. Thus it is equal to the total of Direct Materials, Direct Labour, Direct
Expenses and Production /factory Overheads.
2. Administration Cost: Costs incurred for administration are known as administrative
costs. Examples of these costs are office salaries, printing and stationery, office
telephone expenses, office rent, office insurance etc.
3. Selling & Distribution Cost: All costs incurred for procuring an order are called as
selling costs while all costs incurred for execution of order are distribution costs. Market
research expenses, advertising, sales staff salary, sales promotion expenses are some of
the examples of selling costs. Transportation expenses incurred on sales, warehouse rent
etc are examples of distribution costs.
4. Research & Development Cost: The cost of researching for new or improved products,
new applications of materials or improved methods is known as Research Cost & The
cost incurred in the implementation of the decision to produce a new or improved
product, or to employ a new or improved method is called Development Cost.
h. On the basis of Attributability to the product:

1. Period Cost: These are the costs, which are not assigned to the products but are charged
as expenses on the basis of the time period in which they are incurred. Nonmanufacturing costs e.g. Selling and Distribution Costs are generally recognized as
period costs. These costs are not included in inventory valuation.
2. Product Cost: These are the costs, which are assigned to the product and are included
in inventory valuation. Under absorption costing, total manufacturing costs are regarded
as product costs while under marginal costing, only variable manufacturing costs are
considered.
i. On the basis of Decision Making
A. Relevant Costs: The costs, which are relevant and useful for decision-making
purposes.
1. Marginal Cost Marginal cost is the total variable cost i.e. prime cost plus variable
overheads. It is assumed that variable cost varies directly with production whereas fixed
cost remains fixed irrespective of volume of production. Marginal cost is a relevant cost
for decision taking, as this cost will be incurred in future for additional units of
production.
2. Differential Cost It is the change in costs due to change in the level of activity or
pattern or method of production. Where the change results in increase in cost it is called
incremental cost, whereas if costs are reduced due to increase of output, the difference
is called decremental costs. The differential costs are relevant costs.
3. Opportunity Cost This cost refers to the value of sacrifice made or benefit of
opportunity foregone in accepting an alternative course of action.
For example:
(1) a firm financing its expansion plans by withdrawing money from its bank deposits. In
such a case the loss of interest on the bank deposit is the opportunity cost for carrying
out the expansion plan.
.
4. Replacement Cost It is the cost at which there could be purchase of an asset or
material identical to that which is being replaced or devalued. It is the cost of
replacement at current market price and is relevant for decision-making.
B. Irrelevant Costs: The costs, which are not relevant or useful for decision-making.
1. Sunk Cost It is the cost, which has already been incurred or sunk in the past.
2. Committed Cost A cost, which has been committed by the management, is not
relevant for decision making.
3. Explicit and Implicit Costs:
Explicit Costs These are also known as out of pocket costs. They refer to costs
involving immediate payment of cash. Salaries, wages, postage & telegram, printing &
stationery, interest on loan etc. are some examples of explicit costs involving immediate
cash payment.
Implicit Costs These costs do not involve any immediate cash payment. They are not
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recorded in the books of account. They are also known as economic costs.
4. Shut down costs:
Those costs, which continue to be, incurred even when a plant is temporarily shutdown,
e.g. rent, rates, depreciation, etc. These costs cannot be eliminated with the closure of the
plant. In other words, all fixed costs which cannot be avoided during the temporary
closure of a plant will be known as shut down costs.

1.2 COST SHEET

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. It is a statement which shows per unit cost in
addition to Total Cost.
Cost Sheet is a statement of cost showing the total cost of production and profit or loss from a
particular product or service. A Cost Sheet shows the cost in a systematic manner and element
wise. A typical format of the Cost Sheet is given below.

Cost Sheet for the period.........................................

Production ............................... units
Particulars

Amount
(Rs.)

A. Direct Materials or
Opening Stock of Raw Materials
+ Purchases
+ Carriage inwards
- Closing Stock of Raw Materials
B. Direct Wages
C. Direct Expenses
i.

Prime Cost ( A + B + C )

D. Factory Overheads- Indirect materials

Loose Tools
Indirect wages
Rent and Rates ( Factory)
Lighting and heating ( F )
Power and fuel
Repairs and Maintenance
Drawing office expenses
Research and experiment
Depreciation Plant ( F )
Insurance ( F )
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Amount
(Rs.)

Work Managers salary

Add : Opening stock of Work in Progress
Less : Closing Stock of Work in Progress
ii.

Factory Cost/Works Cost ( i + D )

E. Office and Administrative Overheads :

Rent and Rates office
Salaries office
Insurance of office building and equipments
Telephone and postage
Printing and Stationery
Depreciation of furniture and office equipments
Legal expenses
Audit fees
Bank Charges
iii.

Cost of Production ( ii + E )

Add: Opening stock of Finished Goods

Less : Closing Stock of Finished Goods
iv.

Cost of Goods Sold

F. Selling and Distribution Overheads :

Showroom rent and rates
Salesmens salaries and commission
Traveling expenses
Printing and Stationery Sales Department
Advertising
Bad debts
Postage
Debt collection expenses
Carriage outwards
Depreciation of delivery van
Debt collection expenses
Samples and free gifts
v.
vi.
vii.

Cost of Sales ( iv + F )
Profi t/Loss
Sales (v + vi)

1.2.1 Importance of Cost sheet The importance of cost sheet is as follows:

i.
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.
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ii.

iii.

iv.

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.

Illustration 8
From the following information, prepare a cost sheet for period ended on 31st March 2006.
Rs.
Opening stock of raw material
12,500
Purchases of raw material
1, 36,000
Closing stock of raw material
8,500
Direct wages
54,000
Direct expenses
12,000
Factory overheads 100% of direct wages
Office and administrative overheads 20% of works cost
Selling and distribution overheads
26,000
Cost of opening stock of finished goods
12,000
Cost of Closing stock of finished goods
15,000
Profit on cost 20%
Solution:
Cost sheet
Details
Direct Material : Material consumed
Add: Opening stock of raw material
Add: Purchases
Less: Closing stock of raw material
Direct wages
Direct expenses
Prime cost
Factory overheads: 100% of direct wages
(i.e. 100 54000/ 100)
Works cost
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Amount (Rs.)
12500
136000
148500
8500

Amount (Rs.)

1,40,000
54,000
12,000
2,06,000
54,000
2,60,000

Office and administrative overheads

20% of works cost, (2,60,000 20/100)
Total cost of production
Add : opening stock of finished goods

52,000
3,12 000

Less : Closing stock of finished goods

Cost of goods sold
Selling and distribution overheads
Total Cost = cost of sales
Profit (20% On Cost i.e. 3,35,00 20/100)
Sales

12,000
3,24,000
15,000
3,09,000
26,000
3,35,000
67,000
4,02,000

1.3MANAGEMENT ACCOUNTING
1.3.1 Introduction:-

Management Accounting is an accounting system which will help the Management to improve
its efficiency. The main thrust of Management Accounting is towards determining policy and
formulating plans to achieve desired objectives of management. It helps the Management in
planning, controlling and analyzing the performance of the organization in order to follow the
path of continuous improvement. Management Accounting utilizes the principle and practices of
financial accounting and cost accounting in addition to other modern management techniques for
effective operation of a company.
1.3.2 Features of Management Accounting
Information is collected , analyzed & communicated in Management Accounting. The features of
Management Accounting are given below:
1. The Management Accounting data are derived from both, the financial accounting and cost
accounting.
2. The main thrust in management accounting is towards determining policy and formulating
plans to achieve desired objectives of management.
3. Management Accounting makes corporate planning and strategy effective and meaningful.
4. It is concerned with short and long range planning and uses highly sophisticated techniques
like sensitivity analysis, probability techniques, decision tree, ratio analysis etc for planning,
control and evaluation.
5. It is futuristic in approach and predictive in nature.
6. Management accounting nature is selective type. It selects and picks only the relevant data
from the financial records.
7. Management Accounting systems generate various reports which are extremely useful from
the Management point of view.
8. Management Accounting has no specific set of principles & rules.
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1.3.3 Difference between Cost Accounting & Management

Accounting
Points of Difference
1. Object

2. Scope
3. Nature
4. Origin

5. Accounting
principles & forms
6. Description
7. Parties

Cost Accounting
Its main object is to control
& minimize the costs.

It has narrow scope.

It is related with present &
past events.
It is very old. It had
originated in the beginning
of 20th century.
Cost accounting has certain
principles & rules
It is only related with
monetary events.
Cost accounting is useful
for internal & outside
parties.

Management Accounting
Its main objective is to
provide information to the
top management for the
execution of their work.
It has wide scope.
It is concerned with future
events.
Management accounting is
only three decade old.
Management accounting
has uncertain principles &
rules.
It is related with monetary
& non-monetary events.
Management Accounting is
only useful for internal
parties.

1.4RECONCILIATION OF COST & FINANCIAL ACCOUNTS

1.4.1 Introduction
A reconciliation statement is prepared in cost accounts for reconciling the profits
shown by the cost accounts and financial accounts. Obviously this is required when
the profits shown by both the methods differ. Profit shown by the cost accounts and
financial accounts differ when accounts are kept on non-integrated system, which
means that cost accounts and financial accounts are prepared separately and
independently of each other. In such a case, profit disclosed by one accounting system
will differ from the profit shown by the other and need for reconciliation will arise.
1.4.2 Reasons for Difference in Profit
The profit shown by financial accounts and cost accounts differ on account of the
following reasons.
1. Items of Financial Nature not recorded in Cost Accounts: The following items are not
recorded in cost accounts as they are of purely financial nature and consequently the
profits differ as these items are recorded in the financial accounts.
_ Interest received on bank deposits.
_ Dividend, interest received on investments.
_ Rent received
_ Losses on sale of assets
_ Bad debts written off, recovered
_ Transfer fees received
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_ Interest on proprietors capital

_ Fines and penalties payable
_ Compensation payable.
2. Items Charged to Profit and Loss Account but not Recorded in Cost Accounts: The
following items are found in the cost accounts but not recorded in the financial accounts.
_ Corporate taxes
_ Appropriations out of profi ts, such as transfer of profi ts to reserves
_ Certain payments like dividend
_ Additional provisions of depreciation
_ Certain amounts written off such as goodwill, patents, preliminary expenses,
underwriting commission etc.
3. Items Peculiar in Cost Accounts: The items described below are peculiar in cost
accounts while their treatment in financial accounts is different. Hence there is a
difference between the profits shown by both the systems
a) Overheads: In cost accounts, overheads are finally absorbed in the products by
computing the predetermined rate of absorption. In such cases, there may be under/over
absorption of overheads.
This means that the overheads actually incurred will not tally with the overheads charged
to the product. In financial accounts overheads are always taken at actual basis. In such
cases the profits shown by both the systems will differ.
b) Valuation of Closing Stock and Work-in-Progress: The principle of valuation of closing
stock in financial statements is cost price or market price whichever is less. However, in
cost accounts, valuation of closing stock may be made on the basis of marginal costing
where only the variable costs are taken into consideration while valuing the closing stock.
Thus the closing stock valuation may differ. Due to this difference in valuation, profits
shown by cost accounts and financial accounts differ.
c) Abnormal Losses and Gains: In cost accounts, abnormal losses and gains are computed
and transferred to the Costing Profit and Loss A/c. No such computation is made in the
financial accounts. This results in difference between the profits shown by cost accounts
and financial accounts.

1.4.3 Methodology for Preparing Reconciliation Statement

Beginning to this statement may be made from either the profits as per the financial
accounts or cost accounts. The items, which are responsible for the difference between the two
are either added or deducted from the profits taken in the beginning. After addition or deduction,
the profit as shown by the other method is arrived at. Thus if the beginning is made from profits
as shown by cost accounts, we will arrive at the profits as shown by the financial accounts and
vice versa. The following steps are to be taken for preparing this statement.
1. The starting point may be either profit shown by cost accounts or financial accounts.
2. If the profit as taken in the beginning is reduced due to the various causes given, these
items should be added in the profits.
3. If the profit as taken in the beginning is increased due to the various causes given, these
items should be deducted from the profits.
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4. After completion of these additions and deductions, we will arrive at the profit as shown
by the other system, i.e. if profits as per cost accounts are taken in the beginning, we will
arrive at the profit as shown by financial accounts and vice versa.

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