COSTING

INTRODUCTION: After passing your senior secondary examination, if you set up a small
manufacturing unit, say manufacturing of packing boxes, a problem will arise what price of each
box you should quote to the buyer. Many factors are considered while fixing the price of a
product/item such as competitors’ price etc. One of the basic factors is the cost of its production.
Cost is essential not only to fix price but also to ascertain the margin of profit. Knowledge of the
cost determination is also necessary to keep a check on the cost of product/control on wastages,
etc. The accounting used to study the various aspects of cost is known as cost accounting

The dictionary meaning of cost is “a loss or sacrifice”, or “an amount paid or required in payment
for a purchase or for the production or upkeep of something, often measured in terms of effort or
time expended”.

C I M A Terminology defines cost as ‘resources sacrificed or forgone to achieve a specific

objective’. Cost is generally measured in monetary terms

For example, the cost of preparing one pizza which in itself include various other
costs like cost of flour, other ingredients, labor, electricity and other overheads. Just
the same way, cost of production of any product or service can be determined.

Cost’ is a term whereas ‘Costing’ is a process for determining the cost. It may be
called a technique for ascertaining the cost of production of any product or service in
the business organization.

Definitions : “A costing is an estimate of all the costs involved in a project or a

business venture.”

“An estimate of the cost of a product, process, etc, for the purposes

of pricing, budgeting, control, etc”

ELEMENTS OF COSTING:

There are three elements of cost:

- Material Cost: This is the cost of material or the commodity used by the organisation for its
production purpose. Material is the substance, from which a product is made. Thus, it may be
in a raw or a manufactured state. It can be direct or indirect.
- Direct Material Cost forms an integral part of the finished product and is identified with the
individual cost centre. It is also described as process material, stores material, production
material, etc. Example: Raw materials purchased or purchased primary packing material, etc.
- Indirect Material Cost is used for ancillary purposes of the business and cannot be
conveniently identified with the individual cost centre. Example: Consumable stores, oil and
waste, printing and stationery material etc.
- Labour Cost: This is the cost, incurred in the form of remuneration paid to the employees or
labours of the organization. The workforce required to convert material into finished product is
called labour. It can be direct or indirect.
- Direct Labour Cost is the cost incurred on those employees who directly take part in the
manufacturing process and easily identified with the individual cost centre.Examples: Wages
paid to the goldsmith for making gold ornament is an example of direct labour.
- Indirect Labour Cost is the cost incurred on those employees who do not directly take part in
the manufacturing process and cannot identified with the individual cost centre. Example:
salary of foreman, salesmen, director’s salary, etc.
- Expenses: are the costs of services provided to the organization. It can be direct or indirect.
- Direct Expenses are the expenses which can be directly identified with the individual cost
centres. Example: hire charges of machinery, cost of defective work for a particular job or
contract etc.
- Indirect Expenses are the expenses which cannot be directly identified with the individual
cost centres. Example: rent, lighting, telephone expenses, etc.

Types of cost

(A) Actual Cost

Actual cost is defined as the cost or expenditure which a firm incurs for producing or
acquiring a good or service.  The actual costs or expenditures are recorded in the books of
accounts of a business unit.  Actual costs are also called as "Outlay Costs" or "Absolute
Costs" or "Acquisition Costs".
Examples: Cost of raw materials, Wage Bill etc.
(B) Opportunity Cost
Opportunity cost is concerned with the cost of forgone opportunities/alternatives.  In other
words, it is the return from the second best use of the firms resources which the firms
forgoes in order to avail of the return from the best use of the resources.  It can also be
said as the comparison between the policy that was chosen and the policy that was
rejected.  The concept of opportunity cost focuses on the net revenue that could be
generated in the next best use of a scare input.  Opportunity cost is also called as
"Alternative Cost".
If a firm owns a land, there is no cost of using the land (ie., the rent) in the firms account. 
But the firm has an opportunity cost of using the land, which is equal to the rent forgone
by not letting the land out on rent.
(C) Sunk Cost
Sunk costs are those do not alter by varying the nature or level of business activity.  Sunk
costs are generally not taken into consideration in decision - making as they do not vary
with the changes in the future.  Sunk costs are a part of the outlay/actual costs.  Sunk
costs are also called as "Non-Avoidable costs" or "Inescapable costs".
Examples: All the past costs are considered as sunk costs. The best example is
amortization of past expenses, like depreciation.
(D) Incremental Cost
Incremental costs are addition to costs resulting from a change in the nature of level of
business activity.  As the costs can be avoided by not bringing any variation in the activity
in the activity, they are also called as "Avoidable Costs" or "Escapable Costs". More ever
incremental costs resulting from a contemplated change is the Future, they are also called
as "Differential Costs"
Example: Change in distribution channels adding or deleting a product in the product line.
(E) Explicit Cost
Explicit costs are those expenses/expenditures that are actually paid by the firm.  These
costs are recorded in the books of accounts.  Explicit costs are important for calculating
the profit and loss accounts and guide in economic decision-making.  Explicit costs are
also called as "Paid out costs"
Example: Interest payment on borrowed funds, rent payment, wages, utility expenses etc.
(F) Implicit Cost
Implicit costs are a part of opportunity cost. They are the theoretical costs ie., they are not
recognised by the accounting system and are not recorded in the books of accounts but
are very important in certain decisions.  They are also called as the earnings of those
employed resources which belong to the owner himself.  Implicit costs are also called as
"Imputed costs".
Examples: Rent on idle land, depreciation on dully depreciated property still in use,
interest on equity capital etc.

(G) Book Cost
Book costs are those business costs which don't involve any cash payments but a
provision is made in the books of accounts in order to include them in the profit and loss
account and take tax advantages, like provision for depreciation and for unpaid amount of
the interest on the owners capital.

(H) Out Of Pocket Costs

Out of pocket costs are those costs are expenses which are current payments to the
outsiders of the firm.  All the explicit costs fall into the category of out of pocket costs.
Examples: Rent Played, wages, salaries, interest etc

(I) Accounting Costs

Accounting costs are the actual or outlay costs that point out the amount of
expenditure that has already been incurred on a particular process or on production as
such accounting costs facilitate for managing the taxation need and profitability of the
firm.
Examples: All Sunk costs are accounting costs

(J) Economic Costs

Economic costs are related to future.  They play a vital role in business decisions as
the costs considered in decision - making are usually future costs.  They have the
nature similar to that of incremental, imputed explicit and opportunity costs.

(K) Direct Cost

Direct costs are those which have direct relationship with a unit of operation like
manufacturing a product, organizing a process or an activity etc.  In other words, direct
costs are those which are directly and definitely identifiable.  The nature of the direct
costs are related with a particular product/process, they vary with variations in them. 
Therefore all direct costs are variable in nature. It is also called as "Traceable Costs"
Examples: In operating railway services, the costs of wagons, coaches and engines
are direct costs.

(L) Indirect Costs

Indirect costs are those which cannot be easily and definitely identifiable in relation to
a plant, a product, a process or a department.  Like the direct costs indirect costs, do
not vary ie., they may or may not be variable in nature.  However, the nature of indirect
costs depend upon the costing under consideration.  Indirect costs are both the fixed
and the variable type as they may or may not vary as a result of the proposed changes
in the production process etc. Indirect costs are also called as Non-traceable costs.
Example: The cost of factory building, the track of a railway system etc., are fixed
indirect costs and the costs of machinery, labour etc.
Overheads
Introduction
An organization in its day-to-day operation of business requires raw materials to produce its products.
A group of labour is employed to transfer those input into output. A manufacturing organization
insures material cost, labour cost and other direct chargeable expenses which are directly proportional
to the volume of output of output and referred, as prime cost. Instead of those costs, an organization
needs to expend some other costs or expenses which are non-directly related with the production
processes but supportive in nature are known as overhead. Hence, overhead represents those cost
which cannot be directly traced out to specific product or department. Instead, these cost are allocated
into different department and finally to the output of organization for costing of the product. So, the
direct part of the cost of the total cost is known as prime cost and indirect portion is knows as
overhead.
Meaning and definition of overhead
“Resource consumed or lost in completing a process that does not contribute directly to the end-
product. Also called burden cost”.
Overhead refers to the ongoing operating expenses necessary to running a business, but are not
attributed to a specific business activity.  Also referred to as "indirect costs. EXAMPLE: Generally,
overhead expenses include expenses that do not directly generate revenues, such as labor and
materials, but are needed to maintain the business operations.  Overhead expenses include expenses
such as accounting, advertising, depreciation, insurance, interest, legal, rent, repairs, office
supplies, taxes, information and communications, utilities, research and development, customer
relations and service, and travel.

Classification of overhead
Cost classifications is the process of grouping cost according to the common characteristic and
establish a series of special group according to which costs are classified. Those beings so, overhead
can be studies by classifying as follows:
a. Overhead on the basis of elements
b. Overhead on the basis of function
c. Overhead on the basis of behavior
d. Overhead on the basis of control

Overhead may be classified into three different categories, on the basis of element. These are 
1.Indirect material: those materials, which plays supplementary role in production and cannot be
allocated to a particular unit of product nor form a part of finished product. These materials may be
not be visible in finished product. So all those materials used to assist production, process,
administrating, and selling and distributions are indirect materials. For example, lubricating oil, cotton
waste, parts used for repair and maintenance.
2.Indirect labor: for production and sales different types of payment have to be made to labor, which
cannot be allocated to a particular unit of product. Such type of cost is knows as indirect labor. For
example, wages for repair and maintenance, fringe and benefit, pay leave salary to storekeeper,
Foreman etc.

3.Indirect expenses: except indirect material and indirect labor, there are some other
expenses, which do not come under these headings re indirect expenses. Only indirect
materials and indirect labor are not sufficient to produce and sell the product. For
example rent, lighting and heating, training expenses, insurance etc.
Overhead on the basis of function
Total function of an organization can be divided into manufacturing and non-
manufacturing work. Manufacturing function of an organization is concerned with
transferring (raw material) input to output (finish goods). Likewise, non-manufacturing
function of an organization is concerned with office, administrative, distribution and
selling of manufacture goods.
On the basis of work/job/function, overhead can be classified as
1.Production/ manufacturing/ factory overhead/ work overhead: the total indirect cost
incurred for manufacturing department i.e. within factory are manufacturing overhead.
It is also production overhead, factory overhead and work overhead. The manufacturing
overhead starts with receiving materials to producing final product. The manufacturing
overhead includes.
•Factory rent or depreciation of factory building.
•Lighting and heating, fuel.
•Insurance of factory building and equipment
•Stationary and printing and equipment.
•Depreciation of plant and equipment,
•Salaries and wages of factory staffs,
•Fringe and benefit of factory workers.
•Repair and maintenance of factory building and equipment
2.Office and administrative overhead  without
policy formulation production process does not take place. To prepare policy office is
needed. In office, different types of expenses were incurred for policy formulation and
matriculation and management. It includes all such expenses which are incurred in
office for proper management and administration i.e. planning, controlling, directing etc.
some other example of office and administrative overhead are as:
•Office rent or depreciation of office building
•Office lighting, heating and cleaning
•Insurance & depreciation of office building and office equipment,
•Repair and maintenance of office building and  office equipment
•Salaries of office staffs, office manager, director,
• Postage & telephone,
•Legal expenses,
• Financial expenses
•Financial expenses
•Bank charges
•Printing and stationary
• Audit fee
•Repair and maintenance office building etc.
3.Selling and distributing overhead: selling is the function, which generate revenues and
distribution by means delivery of product to customer. All the indirect expenses incurred
for distribution and sales of product come under this heading. Salesman salaries and
commission, advertisement are the examples of selling and distribution overhead. It
includes:
•C analogues expenses
•Samples, display material expenses
•Salary and commission of sales persons
•Advertisement expenses
•Cash discount
•Packaging charges etc.
Overhead on the basis of control
controlling overhead is one of the major factions of management. All overhead cannot
be controlled by management. Cost control helps to reduce cost and increase profit by
best utilization of resources. From the controlling point of view, overhead can be derided
into two. They are as follows:
1.Controllable overhead: controllable overhead are those which can be controlled by the
efficient management. Those overhead which incurs in a particulars cost center or
decrease due to managerial decision are known as controllable overheads. Indirect labor
indirect material, telephone expenses and lighting and power expenses are the example
of controllable overhead.
2.Non-controllable overhead: those overhead which are beyond the management or
which do not change due to managerial decision are known as non-controllable
overhead. All types of fixed overhead rent, salaries, depreciation etc. are the best
example.

Overhead on the basis of behavior

On the basis of behaviours/ nature of overhead, it can be classified into three parts
1.Variable overhead: that portion of overhead which increase or decrease
proportionately with the increase or decrease in output is known as variable overhead.
The variable overhead cost per unit remains unchanged though the production unit
changes. For example, indirect material, direct labour etc.
2.Fixedoverhead: thoseoverheadwhich remains constant up to a certain level of
production is called fixed overhead. In total, it does not changes, though production unit
increase or decrease. Butfixed overhead per unit decrease when production unit
increase and fixed overhead per unit increase, when production unit decrease. For
example, rent, salaries depreciation etc.
3.Semi-variable overhead/mixed overhead: those indirect expenses, which neither
remain constant nor change proportionately as per change in production unit is called
semi variable overhead. Semi-variable overhead is the aggregate of variable overhead
and fixed overhead for example: electricity, water supply, telephone expenses,
supervision cost, repair and maintained cost.

Overhead allocation and apportionment

Allocation of overhead
Meaning
Allocation of overhead means assigning overhead to cost center. Only those cost and be
allowable, which is directly identified or related to any specific cost canter. It is the
process of charging overhead to a particular department or cost canter.For example,
repair and maintenance of equipment is allocated to factory department.
In general, there are two departments involves in manufacturing concern, production
department and service department. Allocation of overhead cost means thus allotment
whole amount of overhead cost not in proportion to cost center.

Apportionment of overhead
Some overhead cannot be identified with specific department, to distribute such
overhead to different department, different basis are used. To apportion the overhead
suitable basis are used, which is based on benefit or service received or capacity to bear
cost etc.

Importance
Overhead and allocation of overhead are important to all concern organization from the
following reasons.
•Overhead is significant part of total cost of product so it needs very careful allocation.
•It helps to make proper judgment for measurement of department efficiency.
•It helps to provide cost information for planning, controlling and managerial decision
making.
•It provides basis for product costing.
•It helps to make accurate pricing for competitive market.
•It provides basis for effective use of available resources.
•It can be used to control wastage and defective.

Apportionment of overhead
some overhead cannot be identified with specific department, to distribute such
overhead to different department, different basis are used. To apportion the overhead
suitable basis are used, which is based on benefit or serviced or capacity to bear cost
etc.

Absorption of overhead
The term absorption refers to changing of overhead to products or jobs. It is the process
of determining of overhead, which is incurred to a particular. Ascertaining the total
overhead of a particular job or output by using different overhead rate is known as
overhead absorption rate.