DEPARMENT OF APPLIED SCIENCES AND BUSINESS STUDIES

COSTING AND ESTIMATION FEBRUARY 2016

DEFINITION OF COSTING
Costing also known as cost accounting can be defined as the determination of an actual cost of a component after
adding different expenses incurred in various departments. It may also be defined as a system which systematically
records all the expenditures to determine the cost of manufactured products.

Costing is the process of calculating how much you have spent to produce a product or offer a service before you
can price that product or service at a profit. It is concerned with the ascertainment and control of costs so as to
provide detailed information for control, planning and decision making.
IMPROTANCE OF COSTING
Knowing your costs enable you to:
Set your prices in such a way that you make a profit;
Identify which items are most costly in the running of your business and if it is possible to reduce certain costs;
Avoid over-pricing yourself out of competition i.e. charging prices which are well above the average market
prices; and
Avoid underpricing yourself to bankruptcy i.e. charging prices which are well below the unit cost of
production.
To be of use, costing information must be appropriate, relevant, timely, well presented and sufficiently accurate
for the purposes intended.
USES OF COSTING INFORMATION
Control- the costing system is the key financial control system and monitors the results of all activities and all
other control systems.
Decision Making- as decision making is concerned with making a choice between alternatives, correctly
presented costing information can be of great value to management in decision making.
Planning- management is not only concerned with analysis and recording of past costs and activities, but also
with future costs so that appropriate plans and decisions can be made in good time through budgeting.
Estimating and Pricing- as pricing decisions are complex and many interacting factors need to be considered,
costing information based on past costs and expected future costs needs to be considered in pricing decisions.
METHODS OF COSTING
(a) Process costing.
(b) Job costing.
(c) Batch costing.

(a) Process costing

This method is employed when a standard product is being made which involves a number of distinct processes
performed in a definite sequence. In oil refining, chemical manufacture, paper making, flour milling, and cement
manufacturing etc., this method is used. This method indicates the cost of a product at different stages as it passes
through various processes.
(b) Job costing or order costing
Job costing is concerned with finding the cost of each individual job or contract. Examples are to be found in
general (job order) engineering industries, ship building, building contracts, etc.
(c) Batch costing
Batch costing is a form of job costing. Instead of costing each component separately, each batch of components
are taken together and treated as a job. Thus, for example, if 100 units of a component, say a reflector are to be
manufactured, then the costing would be as far a single job. The unit price would be ascertained by dividing the
cost by 100.

COSTS
Cost may be defined as The amount of expenditure (actual or notional) incurred on, or attributable to, a
specified thing or activity. (Lucey, 2009)
At the simplest level, cost includes two components i.e. quantity used and price. Thus:
Cost= Quantity used x Price

TYPES OF COST
Costs are mainly classified as:
Direct costs; and
Indirect costs.
DIRECT COSTS
These are costs which can be directly identified with a job, batch, product or service. These costs become part of
the product or service. Direct costs comprise direct material costs, direct wages or direct labour costs and direct
expenses.
Direct Materials- are the raw materials used in a product, bought in parts and assemblies incorporated into
the finished product.
Direct Wages or Direct Labour Cost- is the remuneration (salary, bonus) paid to production workers for work
directly related to production.
Direct expenses- are expenses incurred specifically for a particular product, job, batch or service, plant or tool
hire charges for a particular job or batch. Others include brand and loyalty expenses.
The total of direct costs is known as Prime Cost. Thus:
Prime Cost = Direct materials + Direct labour + Direct expenses
INDIRECT COSTS
These are all material, labour and expense costs which cannot be identified as direct costs. Indirect costs comprise
indirect materials, indirect labour and indirect expenses.
Indirect Materials- include lubricating oil, consumable materials, maintenance materials, spare parts for
machinery, etc.
Indirect Labour- includes factory supervision, maintenance wages, storemans wages, etc.
Indirect Expenses- include rent and rates for factory/plant and land, plant insurance, depreciation of
equipment and machinery, etc.
Indirect costs are also known as Overheads. Thus:

Overheads = Indirect materials+ Indirect Labour + Indirect Expenses

Therefore, the framework of cost build-up is as follows:

Total Manufacturing Cost = Prime Cost + Overheads
COSTS-TERMINOLOGY
Sunk cost- a cost that has already been incurred and thus cannot be recovered. A sunk cost differs from other,
future costs that a business may face, such as stock costs or Research & Development expenses, because it has
already happened. Sunk costs are independent of any event that may occur in the future.
Variable cost- a cost which varies with a measure or level of activity/production.
Fixed cost- a cost incurred for an accounting period and which within certain output or turnover limits tend to
be unaffected by fluctuations in the levels of activity i.e. output or turnover. An example is rent of factory or
plant.
Semi-variable cost- a cost containing both fixed and variable components and which is thus partly affected by
a change in the level of activity.
Step cost- a cost which remains constant for a range of activity, then when activity increases still further, the
cost has to be increased by a significant amount. When stated on a graph, step costs appear to be incurred in
a stair step pattern, with no change over a certain volume range, then a sudden increase, then no change over
the next (and higher) volume range, then another sudden increase, and so on. The same pattern applies in
reverse when the volume of activity declines.
Standard cost- is a planned unit cost of products, components, or services produced in a period and can be
determined on a number of bases.
COST ESTIMATION
Cost estimation may be defined as the process of forecasting the expenses that must be incurred to manufacture a
product. These expenses take into consideration all expenditures involved in design and manufacturing with all
the related service facilities such as pattern making, tool making as well as portion of the general administrative
and selling costs.

Cost estimates are the joint product of the engineer and the cost accountant.

REASONS FOR DOING ESTIMATES

Cost estimates are developed for a variety of different reasons. The most important reasons are shown below.

Should the product be produced? When a company designs a new product, a detailed estimate of cost is
developed to assist management in making an intelligent decision about producing the product.
Estimates as temporary work standards. Many companies that produce product in high volume, such as
automotive companies, will use estimates on the shop floor as temporary work standards. Temporary
work standards are replaced with time studied work standards as rapidly as possible.
Estimate is also required to control the expenditure during the execution of work. Estimate decides
whether the proposed plan matches the funds available or not.

Procedure of estimating or method of estimating

Estimating involves the following operations
1. Preparing detailed Estimate.
2. Calculating the rate of each unit of work
3. Preparing abstract of estimate

STANDARD COSTING

Cost control is one of the important objectives of cost accounting. This cannot be achieved without some standard
against which actual can be compared. Standard costs are highly detailed scientifically determined costs of
material labour and overhead chargeable to the product or service. Standard cost is also defined as a pre-
determined cost which is calculated from managements standards of efficient operation and the relevant
necessary expenditure.

Standard Costing is defined as the preparation and use of standard costs, their comparison with actual costs and
the analysis of variance to their causes and points of incidence.

Standard cost expresses what costs should be under attainable good performance.

Advantages of Standard Costing:

1. Standard costs are more convenient than actual costs for budget preparations .They are very much useful in
management planning.
2. Establishment of standards co-ordinates all functions-Manufacturing-R & D, Marketing and Accounting
towards achieving a common goal.
3. Helps in cost control and cost reduction
4. It is an economical means of costing and record keeping
5. Helps in formulating price and production policies.
6. It helps for variance analysis and fixation of standardization of incentives

Types of Standards
a) Ideal (perfect) standards (costs) are the standards which can be attained under the most favorable conditions
possible.
b) Normal Standards-The average standards, which can be attained during a future period of time preferably one
business cycle and standards are set on normal capacity basis.
c) Basic Standards It is a standard which is established for use for infinite period of time without alternation.
d) Material Standards (Usage)
I. Material quantity standards-specify what kind, what quantity of material should be used to make a
product desirable.
II. Material price standard-Pre-established measure in monetary terms of the price of the material
e) Labour Standards
I. Labour Usage (efficiency) standards
II. Labour Cost ( or rate)Standards (price of labour)
f) Overhead cost standard

Limitations of Standard Costing

1. It is difficult to select the type of standards which can help in cost control;
2. Standards are predetermined and costs should be carefully predetermined.
 PRICING
DEFINITION OF PRICING
This is the process of determining how much your products or services will be sold for after carefully calculating
the cost of producing them.

It is important to note that prices chosen for an enterprises various products and services should give it some
profit to ensure its sustainability and growth.
PRICE
A price is an amount (figure) arrived at after adding a profit margin to the unit production cost.
It is the value of a commodity (product) or service measured in terms of the standard monetary unit. The price of
anything is its value measured in money.

FACTORS AFFECTING PRICING

Therefore, when developing a pricing strategy, a number of factors that need considering:
i) The cost or break-even price
Costs set the floor price that a company can charge. The enterprise will set a price that covers all its costs of
production, administration and distribution of the product.
ii) Competitors prices
An enterprise must consider competitors prices and if possible the competitors reaction to the enterprises
own pricing moves.

iii) Premium can you charge above the competition

Where the customer perceives your product as superior to competitors, you may charge higher than the
competitors by adding a premium to the price.
iv) Affordability of Target Customers afford
Customers will buy only the products they can afford. In pricing its products, an enterprise must ensure the
prices set are affordable to the target market.
v) Demand for the Product
If demand is increasing, the enterprise may maintain or increase its prices. If demand in declining, the
enterprise may consider reducing its prices.

IMPORTANCE OF PRICING
Pricing is important as it ensures that:
1. The prices you charge are able to give your enterprise a profit;
2. The prices you charge are not pushing you out of competition;
3. The prices you charge reflect the value and quality of your products/services.