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Introduction to Cost Accounting

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Namaste.Welcome to the new course that is a course on Cost and Management Accounting. In this course this a short course just for 10 hours we are going to discuss certain important conceptual aspects as to what cost accounting is? In very very brief we will discuss about the types of cost, the methods of cost accounting and then we will go to management accounting part of it or the techniques of cost accounting part.

So, techniques include marginal costing or breakeven point analysis or cost volume profit analysis, then standard costing, budgetary control. So, we will be also taking into consideration various cases of CVP analysis or of standard costing or budgetary control. As far as the methods or the introductory part is concerned, we will only go through the conceptual part, I hope the course will be very much useful those who in short in just 10 hours want to just get a glimpse of cost and management accounting the course will be very much useful.

Myself Varadraj Bapat, I am a faculty in Accounting and Finance in School of Management IIT, Mumbai. I am a rank holder chartered accountant and cost accountant then I have done M.Com, DISA and have done PhD in finance from IIT Bombay. My major teaching interests include financial cost accounting and also Indian economic and financial model. My research interest is also accounting, financial inclusion, corporate finance. I am also into various extracurricular, but very important activities like yoga, spirituality or Sanskrit, Bharathiya Sanskrithi, ABVP and so on.

Let us move to cost accounting now with this discussion. So, in the beginning, we see this particular PPT we talk about, what is cost accounting? what is the distinction between cost and other streams of accounting, then what is cost and classification of costs.There are three majors streams; financial, cost and management accounting; some of you might be knowing about financial accounting.There are three important steps in financial accounting, first is a recording of financial transactions.So, every financial transaction as and when happens is recorded in the financial accounting system.Then it is summarized in ledger and report is prepared which is in the form of financial statements, the target users for the financial accounting system is external users.So, it is meant for shareholders, it is meant for employees, it is meant for government; internal users also use it but, the major target is an external user.Now, in relation or in comparison with this let us see what is cost accounting?In cost accounting again the first step is a similar recording of cost, in financial accounting also it was a recording of financial transactions, here it is a recording of the cost you may feel it is duplication, but it is not.So, because in cost accounting cost are recorded with a lot more details.For example, if the salary bill for an organization is 5 crore, in financial accounting total amount 5 crores will be include recorded.But in cost accounting for each type of employees how much is paid, what were the activities done by them on a daily or hourly basis, for what that salary is paid like those details are recorded that is why this is a more detail recording of the cost that is involved.Next is an analysis of costs so, each of the costs is now broken down.So, suppose we were talking about salary cost, they would be broken down as to what is factory related salary cost, how much are admin related, how much is selling related, how much is a over time, how much is paid as incentives?What was the nature of work being done for that by that employee, how much is a direct cost in the salary, how much is the indirect cost in the salary?Like that detailed analysis is made, comparisons are made sometimes projections are made in financial accounting these are only the actuals you are not allowed to make projections.But, in cost accounting we make estimates and those estimates are also used to make budgets or to make future projections.Based on all this analysis the cost statements are prepared as for the needs of users and here the users are internal users.So, manager, decision-makers within the organization right from a supervisor level to mid management to CEO and even to board of directors, this is the confidential data.So, it is normally shared with external users except for a few statements ok.So, this is in brief what is cost accounting.Now, this is the definition of cost accounting.It involves recording, estimating, controlling and reporting of costs.So, you would observe estimating is also involved and controlling is also involved.So, cost accounting does not just stop at recording, it tries to keep those costs in check, tries to control the cost.Now, this process begins with the recording and also the basis on which they are calculated and ultimately we prepare the cost estimates.Now, the objectives of cost accounting system are the ascertainment of cost, so, to know the cost, but it is not the total only; to the know the cost for the product, for a process, category wise, plant wise, function-wise.So, it is detailed ascertainment of cost, now this detailed assessment is ascertainment is used for cost control.So, certain standards are set or budgets are laid down, their actuals are compared with the norms or the standards and efforts are made to see that actual cost does not exceed what is permitted or what is budgeted.So, cost control exercises are done, cost reduction is also done.So, that we have the permanent benefit of lesser cost then a variety of information is generated help in decision making that could be for pricing decisions.So, if we know correct information about the cost we will be able to price our product or service properly.Customers might ask for some extra things, we have to give delivery, we may have to incur certain risk like giving guarantee; all those aspects are calculated and built into the cost.So, that proper pricing can be done, it is also useful for other decisions like profit planning because entity should know how much units it should produce or up to what level it should extend its service.Then budgeting is done so, that a systematic allocation of resources can be done; like that variety of management decisions are catered and they would be taken much in a much better way if accurate and timely cost data is available.So, these are the objectives of the cost accounting system.Now, the advantages, since we know detail cost record it helps us in identifying losses and efficiencies.So, unprofitable activities can be weeded out, then certain cost reduction techniques can be used or value analysis can be done.So, that wasteful cost can be eliminated altogether and more value can be provided from whatever resources which we are using.And the third part which you already discussed that better information helps in much improved decision making.It could be profit planning, it could make or buy decision or instead of we making we can go for outsourcing that product or going for the outsourcing of a particular service.All these types of decisions are made in a much better way because of the cost accounting system.Now, management accounting this is a kind of umbrella concept where both financial and cost data are taken together and it is mainly targeted to internal users.As the name suggests it is called management accounting because it is mainly for internal users.So, here in this figure, we are seeing a comparison of management versus financial accounting.In management accounting variety of decision making is done for better control and fora good decision making, in financial accounting financial statements are prepared and target are external stakeholders ok.In this particular course, we are going to focus on cost and management accounting.Now, the definition of cost; now, in business or even in other activities other than business the cost is usually a monitory valuation of any of these things; maybe of effort or of material, resources, time, the risk involved and opportunities forgone for production or delivery of any goods or service.So, for any activity we are doing normally we have to sacrifice some resources either to we have to give up opportunities are we have to spend on material or we have to give our time or we have to give our resources. All this will be included in the cost we will try to give a monitory valuation to it and go on adding it for calculations of cost.Normally, this is how business functions some production may be done, then we go for supply chain or distribution and the product is supposed to reach the customer.Now, the costs are incurred all these stages and accordingly the cost is also classified related to production, related to marketing and distribution, related consumer service or related to administration for looking after all these activities and there can be other costs like research and development cost and so on.This is one more definition of cost, it can be defined as the amount of resources given up in exchange of any goods or services.So, suppose we want to buy material, we will have to pay the supplier that is called as a material cost.When we pay salaries or overtime or incur on perquisites of the employees it will be included as a labour cost or as salary cost or human resource cost.Then we buy various services like electricity or like insurance on which costs are incurred, these are included as an example of cost.There is also another type of cost known as capitalized cost.Now, this is a cost incurred on fixed assets like the purchase of machinery or like installation of machinery. Now, this cost is going to give us long term benefits; these are not cost just for that period, if machinery as a life of 5 years we will get the benefit for 5 years.So, we will charge depreciation on that asset for 5 years period and that depreciation is included on day to day cost.So, the whole of capitalized cost is not considered as the cost of that period, but a proper proportion of that in the form of depreciation or amortization is included in the cost.Now, a very important part that is cost classification. Now, these will tell us different chapters in cost accounting because these is a detailed analysis on the lines of the classification we can go for more detail study of a cost for a particular item or for a particular product ok. So, first, we of classifying is by elements, first in a sense that is one of the most traditional ways, then by function or by direct indirect, by controllability, variability, relevance and so on right.Now, let us go for the first classification that is cost classification by elements.Do you know what are the important elements of cost?There are three important elements; the first one is material, labour and expenses.Now, the material cost; this is the cost incurred on any tangible substance or a thing. The best example could be the purchase of raw material, it can also be the purchase of any of the components, suppose you are purchasing any other tangible item that will be included in the material cost. Next is employee cost; this is the cost on all human resources will include salary, wages, bonuses, perquisites, retirement benefits any other incentives or ESOP’s. All this is included in the labour cost or employee cost. Third, are services so, when we purchase any outside service the cost incurred on the same like electricity, like insurance, like rent that is all included in the expense, this is also a residuary head.So, what is not included material and labour will be included in the expense. Now, this is the most traditional way of classifying as material, labour and expense. But, to know more details or to try to control the cost further type of classifications were also involved and that lead to classification by function. So, as per the important business functions, the cost also is classified. So, what are the important business functions?Just think over it, I think most of you are getting it can be produced, it can be selling and distribution, it can be administration and so on.According to that the costs are also classified. So, we have got production cost, admin cost, selling cost; there can be other functions like R and D, those according to than the cost will be classified.Now, what is the advantage of this classification?Because now it is as per the function so, it helps us in better control of the cost.So, whatever is material labour or overheads consume for production we can hold production manager responsible for it.We can set a target for the same according to the level of output, we can make admin manager responsible for admin cost and go on adding the cost related to office or related to administration.This is our functional cost, help us in better control that does not mean element-wise costs are not important.This is overlapping, that is one way of classifying this is another way we are going to learn further different ways.The third important function is selling and distribution.So, we the classification helps us in whether we should outsource a function, whether we should go for better control, whether we should give more focus, is it our strength, weakness we come to know from cost classification by function.Now, the next important classification is cost classification by direct and indirect.So, the direct cost is those cost which can I easily identified.So, the different cost can be divided as per cost centres or as per products.If we can identify a cost to a cost centre we can consider it as a direct cost, for example, cost of fruits in fruit pulp production.So, if you are making fruit pulps we know that raw material in the form of fruit will be purchased.We also know that for which product, let us see if your making mango juice the mangoes which are purchased can be charged to mango juice production unit.If we are making some juice of some other product, let us say guavas we can go for identifying that purchase to that particular unit then those costs that is the purchase of raw material will become a direct cost. Because it can be easily traced or identify as against this there are certain there is one example given over here.That if you are into the business of hardware of computers, suppose you are assembling PC you know that hard disc goes into the making of PC.So, the cost of hard disk you can easily identify with the particular PC which is getting assembled.So, you call it a direct cost as against this there are several cost which is common in nature.They may not be for a specific product then they those are called as an indirect cost, let us say we are in we are a small unit making hardware.So, we make we assemble PC’s, we assemble certain other things, we also do some small service or repair work.Now, the number of engineers or technical personnel either work for servicing maintenance or they also work for assembling of PCs or certain items.Now, we exactly do not know the salary paid to a particular person and its linkage to any one particular product or a service job because different work is being done simultaneously in our office or in the workshop.So, salary cost cannot be as easily identified as we are able to know the cost of a hard disk, are you getting? So, the cost of hard disk for a particular PC is a direct cost whereas, the salary cost become a better example of indirect cost.Can you think of any other example of indirect cost?For example, rent if we are paying rent for our shop or our factory can we identify it to for any one product?That will not be possible, because rent is for the whole system in that we are making several products, we are also doing certain service-related jobs.So, rent remains an indirect cost, earlier we took an example of fruit pulp manufacture.So, we know that the raw material that is fruits purchased are for the making of a particular type of pulp, it is a direct cost.Can you think of any indirect cost?For example, if we are if you have a maintenance team or even one person for maintenance of these machines, the same person whenever there is any problem services or maintains different machines.So, it will not be possible for us to know exactly with accuracy salary of the person to be charged to which unit of pulp manufacture.So, it is an example of indirect cost, are you getting me?So, here is an example given maintenance support group or security.So, outside the factory there is a security, that security is for let us say there are10 units inside the factory.Security is common for all the 10 units, we will not know exactly the salary of security to be charged to which unit that is why it is considered as an indirect cost.Same way storage cost in godowns or in showrooms this also become an indirect cost.There is another name for an indirect cost which is more popular and you might have heard it that is overheads.Now, the overhead cost being common in nature cannot be charged directly or cannot be charged cannot be attributed directly to a direct cost.So, many times a rate per hour is calculated.We take the total for that type of overhead divided by a number of hours.Suppose here is an example of maintenance if we have a maintenance and support group we calculate their total cost divided by a number of hours for which they have work which will give us rate per hour.Now, whenever maintenance person is called and suppose works for 5 hours and rate per hour is 2000 then 5 into 2000 we will be able to charge 10000 for the unit which has used maintenance facility, getting it?So, overheads are charged using rate per hour, sometimes composite or departmental rates are calculated.There are also some techniques like an activity-based costing which are little advanced techniques for charging of overheads.Later on, we will go into it, but right now let us understand that this particular classification direct versus indirect is very much useful for better control of cost.It helps us in the ascertainment of cost for a particular product or for a particular cost centre, it also helps us in better control.Because we will know that for this product this is a direct cost and we will be able to give more attention or make a budget or a standard for more and more suitable control of that particular cost.So, here will stop at whatever classification we have discussed and we are going to continue this and discuss some more types of classifications in the next session. Namaste Thank you.