1. Cost Concepts Cost Accounting By Horngren, Foster, Datar

2. Value and Cost Concepts The output of an organization, goods or services, has a value, which accounts for the income of the organization directly or indirectly. To produce the goods or services, various types of costs are involved. The object of maximizing the profit can be achieved by minimizing the costs and maximizing the value of goods and services or income. The understanding of basic concepts related to value and costs will be helpful for engineers

3. involved in various stages of operation, which influence both the value and cost of output. Costing The costing of products is an important function of an organization. It involves the determination of the costs of all the factors, which contribute onwards the total cost of a product. An organization must know exactly how much a product costs to the organization so that the profit at a certain value of sale price can be estimated for various levels of activity.

4. Cost Factors The factors constituting the product cost can be classified as variable cost factors and fixed cost factors. The variable cost factors include the material cost, labor cost and variable overheads. The fixed cost factors considered as fixed overheads include all costs, which do not change with the level of the activity. Costs of administration, insurance, and rents, etc are all included in the fixed overhead cost.

5. Cost Cost is defined as resource sacrificed or forgone to achieve a specific objective. Most people consider cost as monetary amounts, such as Dollars, Pounds, and Rupees etc. Cost Object Cost Object is anything for which a separate measurement of cost is desired. (How much a certain thing?)

6. Cost Value It is the sum of all costs incurred in providing a product or service. The costs of material, labor and overheads are all added together to calculate the cost value of a product or service. In the case of purchased items, the cost value is the sum of amount paid to the supplier plus the cost of ordering and transport etc. For example, a bearing is purchased for Rs. 150 and Rs 50 is spent to affect the purchase. The cost value of the bearing in this case will be Rs. 200.

8. Esteem Value It is that part of the price, which a customer offers to possess it, in excess of use value. A product with lower demand and large supply will have low esteem and a product with high demand and low supply will have a high esteem value. Exchange Value is the sum of Use Value and Esteem Value.

9. Book Value It is the worth of an equipment or asset as shown on the accounting record of a company. Usually the book value is equal to the original value of the equipment minus the amount charged as depreciation. The book value is of interest for the purpose of balance sheets. The market value or actual worth of the equipment or asset may be quite different from the book value.

10. Salvage Value It is the residual value or price of the equipment or asset that can be obtained after it has been used. Salvage value may be positive or negative. A negative value implies the cost of removal of the equipment or structure when its use value is zero. Net Present Value It is the present value of all cash flows associated with an investment. It may be expressed as the difference between the present value of the future returns and the capital cost.

11. An analysis of net present value of various investment alternatives helps in decision making for maximum returns. Value Added The value added may be defined as that part of income, which is available to the organization after paying for the materials and utilities. Value Added=Income – Cost of materials & utilities All other expenses like rent, insurance, capital

12. costs, depreciation, design cost, administration costs and taxes are paid from the value added leaving the rest of value added as profit. Sunk Cost The sunk cost is the cost, which has occurred in the past and is common to all feasible alternatives to be considered for future. Suppose an equipment costs Rs. 1.5(M) and Rs. 100,000 are paid as down payment. An alternative equipment with the same functional characteristics is available for Rs. 1.2(M).

13. For the purpose of decision the cost of 1 st equipment is considered as Rs. 1.4(M) (1,500,000 – 100,000 as Sunk Cost = 1,400,000) and that of the 2 nd will be considered as Rs. 1.2(M). In this case, the sunk cost is Rs. 100,000 and it has occurred in the past. Opportunity Cost It is the cost of the best forgone or rejected opportunity for the use of a resource. The

14. opportunity cost is often implied or hidden. An investor invests in an enterprise a capital sum of Rs. 1(M). The best available deposit scheme of banks offer him a profit of 12 %. By investing the capital in the enterprise, he forgoes a profit of Rs. 120,000, which is the opportunity cost of capital invested. Fixed Cost A fixed cost is a cost that does not change in total despite changes in a cost driver. The fixed

15. cost includes all those costs which are not affected by the level of activity over a feasible range of operations for the available plant capacity. It includes costs like cost of administration, lease and rent costs, and insurance etc. Variable Cost A variable cost is a cost that changes in total in proportion to changes in a cost driver. Cost of material, and direct labor usually constitute the variable cost.

16. Incremental Cost It is the addl cost that will result when the output of a system increases by one or a limited number of units. An alternate term used for incremental cost is "Marginal Cost”. The incremental cost is actually the change in variable cost associated with limited change in the output level.

17. Cost Accumulation & Cost assignment A costing system typically accounts for costs in two basic stages: Stage-1. It accumulates costs by some natural classification, such as material, labor, fuel, advertising, and shipping etc. Stage-2. It assigns these costs to cost object. Cost Accumulation Cost Accumulation is the collection of cost data in some organized way through an accounting system.

18. Cost Assignment Cost assignment is a general term that encompasses both tracing accumulated costs to a cost object and allocating accumulated costs to a cost object. Costs that are traced to a cost object are direct costs and costs that are allocated to a cost object are indirect cost. Direct Cost Direct costs of a cost object are costs that are related to the particular cost object and that

19. can be traced to it in a cost effective way. Direct material and labor are included in the direct cost. Indirect Cost Indirect costs of an cost object are the costs that are related to the particular cost object but cannot be traced to it in a cost effective way. Indirect costs are allocated to the cost object using a allocation method. (Some costs cannot be attributed to a single product or service and are shared by several types of products. These costs may be termed as indirect costs)

20. Take a cricket bat as a cost object. The cost of the piece of wood used to make that bat is a direct cost, whereas the cost of lighting in the factory where the bat was made is an indirect cost of the bat. Cost Tracing Cost tracing is the assigning of direct cost to the chosen cost object. Cost Allocation Cost Allocation is the assigning of indirect cost to the chosen cost object.

21. Cost Assignment encompasses both cost tracing and cost allocation. One particular cost may be both direct & indirect.The direct/indirect classification depends upon the choice of the cost object. For example salary of an assembly department supervisor may be a direct cost of the assembly department at Toyota Motors but an indirect cost of a product such as Toyota Hilux.

22. Cost Driver( also called as cost generator or cost determinator) A cost driver is any factor that affects total cost. That is a change in the level of the cost driver will cause a change in the level of the total cost of a related cost object. Unit Cost A unit cost (also called as average cost) is computed by dividing some total cost by some number of units.

23. Capitalized Cost are first recorded as an asset (capitalized) when they are incurred. These costs are presumed to provide future benefits to the company. Non-Capitalized Cost are recorded as expenses of the accounting period when they are incurred Operating Cost are all costs associated with generating revenue, other than the cost of goods sold.

24. Prime Costs Prime Costs are all direct manufacturing costs. This is the sum of direct material cost and direct manufacturing labor cost. Conversion Costs Conversion Costs are all manufacturing costs other than direct material costs. This is the sum of direct manufacturing labor costs and indirect manufacturing costs.

25. Suppose that $. 980,000 of manufacturing cost was incurred to produce 10,000 units of a finished good, then the unit cost would be $ 98 If 8000 units are sold and 2000 units remain in ending inventory, the unit cost concept helps in assigning total cost for the income statement and balance sheet.

26. Cost of goods in the i/statement$ 784,000 (8000 units x $ 98) Ending inventory of finished goods 196,000 (2000 units x & 98) Total manufacturing costs 980,000 (10,000 units x $ 98)

27. Manufacturing Cost Three terms in widespread use are direct material costs, direct manufacturing labor costs, and indirect manufacturing costs. Direct Material Cost Direct material costsare the acquisition costs of all materials that eventually become part of the cost object (say units finished or in process), and that can be traced to the cost object in an economically feasible way.

28. Direct Manufacturing Labor Cost Direct manufacturing costsinclude the compensation of all manufacturing labor that is specifically identified with the cost object (say units finished or in process) and that can be traced to the cost object in an economically feasible way. Indirect Manufacturing Cost Indirect manufacturing costs are all manufacturing costs considered to be part of the

29. cost object (say units finished or in process) but that cannot be individually traced to the cost object in an economically feasible way.

30. Labor Cost The labor cost of a job is a function of time taken by the labor in hours and hourly rate of wages. Records in the form of job cards (or time sheets) may be used to obtain the data of labor time. A separate job card is filled for each job and each stage. Ratio of total labor hours to the total production on weekly or monthly basis may be used to determine labor time per unit of production.

31. JOB CARD Job No.192Job Desc: SolderingDepartment: M-1 Operator No. 135Operator Name: Shakir Ali DateStart TimeFinish TimeTime Taken NormalOvertime 04-08-200510:3012:302:00 04-08-20051:306:003:301:00 09-08-20058:0012:304:30 09-08-20051:306:303:301:30 12-08-20052:305:302:300:30 12-08-2005 Total Time163

32. Material Cost The quantity of material used for each part is estimated from the production routing sheet. This quantity multiplied with unit cost of material cost gives the cost of material for each part. The materials purchased at different times may have price variations. Several methods are used for the cost of material. 1.Weighted Average Cost In this method of material costing the cost

33. values of two different lots are added and the total is divided by the total quantity of the material to get weighted average cost per unit of the material. For example a lot of 200 units was purchased at a unit cost of Rs. 20. Fifty units of this lot are available in the store when a new lot of 200 units is purchased at a unit cost of Rs. 25. The weighted average cost per unit will be (50 x 20 + 200 x 25)/250 = Rs. 24 2. Last in First out (LIFO) Under LIFO the units sold (used) are

34. assumed to be those most recently purchased. The remaining inventory is assumed to consist of earliest purchases. In this method the actual cost of material used on the basis of last in first out is taken for the purpose of costing. For example if a job requires 150 units out of 250 in the stock as in the preceding case, the cost will be (150 x 25/150) = Rs. 25 The next job which requires 80 units will have a material cost equal to (50 x 25 +30 x 20) / 80 = Rs. 23.13

35. First in First out (FIFO) FIFO involves the assumption that goods sold (used) are the first units that were purchased. For example if a job requires 150 units out of 250 in the stock as in the preceding case, the cost will be (50 x 20 + 100 x 25)/150 = Rs. 23.33 The next job which requires 80 units will have a material cost equal to (80 x 25)/80 = Rs. 25

36. Standard Costing In this method a value of material cost based on past data is set as standard. Variance in actual cost of material is added to the standard cost to determine the actual cost. Replacement Costing A material lot is purchased at a unit cost of Rs. 25 per unit. At the time of use the cost of material is Rs. 28 per unit. In this method the cost charged will be Rs. 28 per unit.

37. Overhead Costs The overhead costs can be divided into variable overheads and fixed overheads. The variable overhead includes all such costs which change with the level of activity. In an electroplating operation the metal electrode is a direct material but the chemicals are indirect material. The cost of fuel, lubricant and power for running the plant are included in the variable overhead. The cost of indirect labor is also included in the variable

38. overhead. Other costs such as building rent, administration, depreciation and capital costs may be included in the overhead costs as fixed overheads. A simple way of accounting for the cost is that all overheads may be charged to the job in the proportion of labor time such as in absorption costing.

39. ProductQty Produced Per Year Material Cost Per Unit Labor Hours Per Unit A800100015 B1000120012 C150080010 Absorption Costing Proportionate absorption of overhead costs by different products. The basis is the labor cost. The following example will elaborate the method. A company makes three types of products A, B, and C. Following information is provided for costing.

40. The average labor rate is Rs. 30 per hour and the total expenditure of the company is Rs.10,220,000. Determine the cost per unit of each product. Also determine the sale price per unit for 10% profit. Solution: Firstly we calculate total direct labor cost and total direct cost (prime cost).

41. Product Qty Produced Per Year Material Cost Per Unit Labor Hours Per Unit Total Material Cost Direct Labor Cost Direct Cost A800100015800,000360,0001,160,000 B10001200121,200,000360,0001,560,000 C1500800101,200,000450,0001,650,000 Total3,200,0001,170,0004,370,000 ProductTotal Direct Material CostDirect Labor CostDirect Cost A800 x 100080000015 x 30 x 8003600001160000 B1000 x 12001200000 12 X 30 x 1000 3600001560000 C1500 x 800120000010 x 30 x 15004500001650000 3200000 11700004370000

42. Total Expenditure:Rs.10,220,000 (given) Total Direct Cost:Rs. 4,370,000 Total Overheads:Rs. 5,850,000 Overhead Recovery Factor= = 5 Unit Cost of Product A = mat cost + direct labor cost + overheads = 1000 + (15 x 30) +(15 x 30) x 5

43. = Rs. 3700 Unit Cost of Product B =1200+(12 x 30)+(12 x 30) x 5 =Rs. 3360 Unit Cost of Product C =800+(10 x 30)+(10 x 30) x5 =Rs.2600 Now we calculate sale price of the product A, B, and C, at 10 % profit

44. Sale Price at 10 % profit Product A =3700+ 3700 x 10/100 =Rs.4070 per unit Product B =3360+ 3360 x 10/100 =Rs.3696 per unit Product C =2600+ 2600 x 10/100 =Rs.2860 per unit

45. Marginal Costing: In practice, it may not be possible to sell the products at calculated prices. The competitors and market conditions influence the selling price. Under such conditions, suppose the product A sells for Rs. 3600, B for Rs.3500, and C for Rs. 3000. From the absorption costing calculations, it is obvious that each unit of A sold will cause a loss of Rs. 100 (Rs. 3700 – 3600) Should we stop the production of Product A ?

46. The marginal costing has the answer to this question. The management has to calculate the marginal costing. Marginal costing accounts for the variable overheads in product costing to determine the marginal cost. We have to divide the overheads into fixed and variable overheads.

47. In the previous example, suppose the total overheads of Rs. 5,850,000 includes Rs. 1,755,000 as variable cost and the remaining Rs. 4,095,000 as fixed overhead charges. The recovery rate for variable overhead shall be; =1.5 Marginal Cost per unit of

48. Product A 1000 + 450 + (450 x 1.5) = 2,125 Product B1200 + 360 + (360 x 1.5) = 2,100 Product C 800 + 300 + (300 x 1.5)= 1,550 Difference between the selling price and the marginal cost is contribution Contribution per unit Total Contribution A 3600 – 2125 = 1475 1475 x 800 = 1,180,000 B 3500 – 2100 = 1400 1400 x1000= 1,400,000 C 3000 – 1550 = 1450 1450 x1500= 2,175,000

49. Total contribution of products A, B and C is Rs. 4,755,000. Fixed O/H Cost=Rs. 4,095,000 Profit=Contribution – Fixed O/H =4,755,000 – 4,095,000 =660,000 It may be noted that product A has a total cost of Rs. 3700/unit and marginal cost of Rs. 2125 /unit. At 10% profit, the sale price should be Rs. 4070/unit. But at an actual selling price of Rs.3600, apparently there is a loss of Rs 100

50. per unit. The marginal costing shows that each unit of product A earns a contribution of Rs.1475 to contribute towards the fixed cost. Although the product A is sold at Rs 100 loss/ unit but if it is dropped from production, the contribution of B and C, amounting to (Rs. 1180000 +Rs. 2175000) Rs. 3,575,000 will fall short of fixed expenses by (Rs. 4095000-Rs. 3575000) Rs.520,000. Total contribution=3575000

51. Fixed O/Heads=4095000 Profit= Contribution – Fixed O/Heads = 3575000 – 4095000 = (520000) So the company will suffer a loss of Rs 520,000 instead of a profit of Rs.660,000. The marginal costing is therefore more valuable in product costing & price decisions.

52. BREAK-EVEN ANALYSIS A break-even point may be defined as the level of activity at which the income equals the costs and there is no profit or loss. At break-even point; Income = Total Cost Income=Fixed Cost+Variable Cost or

53. where =Break-even Quantity =Sale Price per Unit =Variable Cost per Unit =Fixed Cost(total fixed cost)

54. Breakeven Analysis Profit Loss Total Cost Fixed Cost AB F D E

55. In a break-even chart the activity level of output is plotted along x-axis, while the y-axis represents the monetary values of costs and income. The fixed cost is a straight line parallel to x-axis, because it is not affected by the activity level. The total cost is shown by the straight line AD. The income line is OF passing through the origin and intersecting the total cost line at point E.is the break- even quantity and value of y coordinate of E represents the income at break-even point.

56. The activity level above will generate income greater than total cost resulting into profit. The higher the level of activity above the breakeven quantity, the greater is the profit (safety against loss). A measure of this safety is “Margin of safety.” Margin of Safety = (Income at Planned level – Income at breakeven pt. ) Income at planned level

57. A knowledge of the percentage of capacity utilization at breakeven point is useful as reference to set the goal of activity level for specific profit targets. where

58. Economic Evaluation and Capital Productivity On the criteria of economic benefit and utility the engineering projects may be classified as commercial and public utility projects. The commercial projects have to be economically feasible and compete with alternate investment plans for payback period and internal rate of return. A break-even analysis provides the necessary information for investment decisions and also for the levels of activity for safe and

59. profitable operations. The benefit cost ratio is a significant criteria for the evaluation of various alternatives for public utility projects such as roads, rails, hospitals and schools etc. In the cost benefit ratio comparison of various alternatives, the auxiliary benefits also affect the decisions. For example if the cost of a highway and rail track between two cities for given traffic density is equal, the option of rail traffic may be preferred as it is fuel efficient mode and will cause less pollution.

60. The decision of the level of activity and the costing information is used for the preparation of budgets providing allocation of funds for various expense heads. The financial planning and control is an important managerial tool for the control of all the operations. The awareness of the engineers with the economic aspect of decisions is necessary for the optimum return on investment and for the maximum benefit of capital expenditure in public utility projects.