COST ACCOUNTING – AN INTRODUCTION

Student’s Tip –
Students should prepare this chapter thoroughly from two view points one because this
chapter forms the basis of your in class quiz and two unless you understand the concepts
discussed here you will not be able to grasp the following concepts easily.

Definition of Cost Accounting:

Based on the terminology published by the Institute of Cost and Management Accountants
of England, Cost Accounting is defined as
“The process of accounting for costs.”

This process begins with the recording of costs and ends with the preparation of periodical
statements and reports for the purpose of ascending and controlling costs
Only heading
Why Cost Accounting?
Following are the main objectives of Cost Accounting

1. Ascertainment of Cost:
It can be done in two ways, namely
Post Costing - where the ascertainment of cost is done based on actual information as
recorded in financial books.
Continuous Costing - where the process of ascertainment is of a continuous nature i.e.
where cost information is available as and when a particular activity is completed, so that
the entire cost of a particular job is available the moment it is completed.

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 2. Determination of Selling Price:
Though there are various other considerations for fixing the selling price of a product (like
the market conditions, social factors etc.), cost of the product is probably by far the most
important factor.

3. Ascertainment of Profit :
The purpose of any business activity is to earn a profit and profit can be computed by
matching the revenue and cost of that particular product.

4. Cost Control and Cost Reduction:

Cost Control and Cost Reduction are two different concepts.
Cost Control aims at maintaining the costs in accordance with established standards.
Cost Reduction on the other hand aims at real and permanent reduction in the unit cost of
goods manufactured or services rendered without decreasing the quality of the product.

5. Assisting Management in Decision-making :

Decision-making is a process of choosing between two or more alternatives based on
outcome of the various alternatives. A Cost Benefit Analysis also needs to be done. All this
can be achieved through a good Cost Accounting system.

Advantages of Cost Accounting:

1. Helps optimum utilization of men, materials and machines.

2. Identifies areas requiring corrective action
3. Identifies unprofitable activities and inefficient areas
4. Helps price fixation
5. Facilitates cost control and cost reduction
6. Helps management in formulation of policies
7. Helps management in making strategic financial decisions. For e.g.: the technique
of marginal costing helps the management in taking various short term decisions

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COST ACCOUNTING, FINANCIAL ACCOUNTING AND MANAGEMENT
ACCOUNTING Main points only

Financial Accounting and Cost Accounting:

Both Financial Accounting and Cost Accounting are Management information

Systems. However they are both very different in their objectives, purpose and
application.

Financial Accounting is concerned with the
preparation of financial statements such as
Balance Sheet, Income statement etc
Financial Accounting reports are viewed
externally by public and posted on the
internet.
Financial Accounting reports such as
Balance Sheet, Income statement etc are
prepared once at the end of the financial year
Financial Accounting reports such as
Balance Sheet, Income statement etc follow
prescribed international formats
Financial Accounting reports such as
Balance Sheet, Income statement etc have
many users internal and external to the
organisation
Cost Accounting system generates reports as
per needs and requirements of the
management.
Cost Accounting reports are confidential in
nature and generally only viewed by
management.
Cost Accounting reports are prepared as and
when necessary
The format of Cost Accounting reports is
often decided by the Cost Accountant
Management is the main user of Cost
Accounting reports.

Financial Accounting i helps to assess the overall profits/losses and financial position of an
organisation, its strength and weakness. It facilitates effective control over the assets of the
organisation. However, there are serious limitations of financial accountancy from the point
of view of the management. It is on account of these limitations that "Costs Accounting" has
been developed for the purpose of management control and internal reporting. Financial

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Accounting mainly focuses on what happened in the past while Cost Accounting focuses on
why it happened?

Main points only

COST ACCOUNTING vs. MANAGEMENT ACCOUNTING

The scope of management accounting is broader than that of cost accounting. In Cost
Accounting, the main emphasis is on costs and its collection and analysis, for various
problems issues of the management.
The main role of management accounting is determining policy and formulating plans to
achieve the desired objectives of the management. Cost Accounting aids the management
accounting through provision of timely, accurate and efficient data.
Following are the point of difference between the two:
1. A cost accounting system can exist on its own while a management accounting
system cannot be implemented without a proper cost system.
2. Cost accounting is procedural in nature and is concerned with ascertaining,
apportionment, allocation, distribution, and accounting aspects of cost. On the
other hand, management accounting is non procedural.
3. Cost accounting is concerned with the past and is historical in approach while
management accounting deals with the future and is futuristic in approach.
4. Management accounting uses data derived from financial as well as cost accounting.
5. Management accounting takes a wider view of data in comparison to cost
accounting. The management accountant has a clear understanding of the items and
types of costs required in various problem solving situations.

COST CONCEPTS

Cost - Cost represents the amount of expenditure incurred on a given thing. It represents the
resources that have been or must be given up to attain a particular objective.
Why to study cost?establishing the selling price, planning production, management control,
decision making

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Cost unit - A cost unit is a unit of quantity of product or service in relation to which costs
may be expressed.

Cost units are usually units of physical measurement like number, weight, time, area, length,
volume etc. Cars – number, Hospital – day, Chemical Liter - gallon, Sugar- Tonne etc
Activity: suggest appropriate cost units for the following businesses:
1. Vehicle manufacturer: vehicle
2. Carrier bag manufacturer: batch of say 1000 bags because taking 1 bag would be too
small to measure.
3. Transport company: 1 tonne km
4. Plumber: each job
Cost centers: A unit of activity within the factory to which costs may be practically
and equitably assigned.

Techniques of Costing

• Historical Costing
• Uniform Costing
• Standard Costing
• Direct Costing
• Marginal Costing
• Absorption Costing

Methods of Costing

• Job Costing
• Batch Costing
• Contract Costing
• Process Costing
• Operating Costing

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 • Unit Costing
• Multiple Costing

COST CLASSIFICATION

Classification of cost means the grouping of costs according to their common characteristics.

The important ways of classification of costs are:

1. By element: materials, labour, expenses

2. By function: production, selling, distribution, administration, R&D, development,
3. By nature: direct and indirect
4. By behavior: fixed, variable, semi-variable
5. By controllability: controllable, uncontrollable
6. By normality: normal, abnormal
7. By time: Sunk and estimated.
8. By relation : product and period

By Nature:

• Direct cost - Direct cost is that cost which can be identified with a cost unit. For e.g.

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 • Indirect cost - Cost which cannot be identified with a cost unit is called indirect
costs. For e.g. wages paid to indirect labour.

1. By Behavior:

• Fixed cost - Fixed cost is that cost which remains constant at all levels of
production. For e.g. rent, insurance.

• Variable cost - The cost which varies with the level of production is called variable
cost i.e., it increases on increase in production volume and it decreases on decrease
in production volume and when there is no production these costs cease to occur. For
e.g. materials, labour.

• Semi-variable cost - This cost is partly fixed and partly variable in relation to the
output. For e.g. telephone bill, electricity bill.

2. By Element:

Material Costs:

• Direct Materials - Materials which are present in the finished product or can be
identified in the finished product are called direct materials. For eg.
Milk in ice-cream or wood in furniture.

• Indirect Materials - Indirect materials are those materials which do not normally
form part of the finished products or which cannot be directly traced to the finished
product. For e.g. stores, oil, grease, cotton wool etc.

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Labour Cost:

• Direct Labour - Labour which can be attributed wholly to a particular product,

process or job is called direct labour. It is the labour utilised in converting raw
materials into finished products. For e.g. Labour employed in the crushing
department of an oil mill.
• Indirect Labour - Labour which cannot be identified with a particular product is
called indirect labour. For e.g. Maintenance workers.

Expenses:

• Direct Expenses - Expenses incurred (except direct materials and direct labour)
specifically for a product known as direct expenses. For e.g. Hiring charges for a
machine specifically hired for a particular process, excise duty for material etc.
• Indirect Expenses - Expenses incurred other than direct expenses are called indirect
expenses. For e.g. electricity, general repairs.

4. By Function:

• Manufacturing cost - It is the cost of the entire process of production. In other

words it is nothing but the cost of manufacture which is incurred up to the stage of
primary packing of the product. It includes indirect materials, indirect labour, heat
and light, depreciation, insurance on manufacturing facilities, repair and maintenance
of production equipment.

• Administrative cost - It is the indirect cost pertaining to the administrative function .

It includes executive compensation, general accounting, public relations etc

• Selling cost - Selling cost represents the indirect cost which is incurred for

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 creating and increasing demand for our product. . It includes advertising, shipping,
sales travel, sales commissions, sales salaries, cost of warehouse,

• Distribution cost - It is the cost of the sequence of operations which begins with
sales. It includes drivers salary, delivery van depreciation etc.

• Research and Development cost- Research and Development cost is the cost of
researching for new and introducing them in the market.

5. By Controllability:

Note : It may be noted that controllable and uncontrollable cost concepts are related to the
authority of a person in the organisation

Controllable cost - The cost, which can be influenced by the action of a specified person in
an organisation, is known as controllable cost. Variable costs cannot be cut or at least its
very difficult to decrease these whereas fixed costs such as R & D costs, advertising,
salaries of the top executives and so on can controlled

Uncontrollable cost – The cost which cannot be controlled by the action of the person
heading the responsibility centre is called uncontrollable cost. For e.g. all the allocated costs
and the fixed costs.

6. By Normality:

Normal cost - It is the cost which is normally incurred at a given level of output, under the
conditions in which that level of output is normally attained.

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Abnormal cost – It is the cost which is not normally incurred at a given level of output in the
conditions in which that level of output is normally attained.

7. By Time when Computed :

Sunk cost - Historical cost which is incurred in the past is known as sunk cost. This cost is
not relevant in decision making in the current period. For e.g. In the case of a decision
relating to the replacement of a machine, the written down value of the existing machine is a
sunk cost and hence irrelevant to decision making

Estimated cost - It is an approximate assessment of what the costs are likely to be in the
future. It is based on past data adjusted to anticipated future changes.

8. By relation

Product Cost - It is the cost which is assigned to the product. For financial accounting
purposes, product costs include all the costs that are involved in acquiring or making
product. These costs consist of direct materials, direct labour, and manufacturing overheads.

Period Cost - It is the cost which is not assigned to the product but is charged as an expense
against the revenue of the period in which it is incurred. All the non manufacturing costs like
administrative, selling and distribution expenses are treated as period costs. Sales
commission and office rent are good examples of period cost Or Selling and Administrative
expenses.

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QUESTION 1: COST CLASSIFICATION DIRECT AND INDIRECT COSTS

Clasiify each of the following as being usually fixed, variable, semi-variable:

Cost Fixed Variable Semi-Variable

1. Direct Labour X
2. Depreciation on machinery X
3. Factory rental X
4. Supplies and other indirect X
materials
5. Advertising X
6. Maintenance of machinery X
7. Factory manager’s salary X
8. Royalty payments X

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 QUESTION 2: IDENTIFYING COSTS FIXED & VARIABLE AND TYPE OF
OVERHEAD

Below are listed a number of costs items typically found in organizations. Required:

Cost Item Variable/ Fixed Selling Administrative Product Period

Shipping costs on goods sold
Magazine subscriptions for staff
Factory lunchroom exps
Thread in a garment factory
Packaging costs
Executive life insurance
Ink used in textbook production
Yarn used in sweater production
Salary of office receptionist

Classify each cost item as either fixed or variable cost. Then place an "X" under each
heading that helps to describe the type of cost given to state whether it would be a selling, an
administrative cost, or a manufacturing (direct, indirect) cost.

QUESTION 3: CLASSIFICATION OF COSTS AS FIXED OR VARIABLE

Below are a number of costs that are incurred in a variety of organizations.

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 Cost Behavior
Variable Fixed
1. X-ray film used in the radiology lab
2. The cost of advertising a Madonna rock concert
3. Rent of McDonald’s restaurant building
4. The electricity bills of running a machinery
6. Commission paid to salesperson
7. Fire insurance of a Coca-Cola bottling plant
8. Costs of material used to make Nike shoes
9. Costs of shipping Panasonic televisions to retail stores
10. Cost of leasing a machine

Required:
Classify each cost as being variable or fixed with respect to the number of units of product
or services sold by the organization. Place an X under the correct column.

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QUESTION 4
For each of the following, indicate whether the cost would typically be variable or fixed.

Variable Fixed
Direct materials
Direct labor
Rent on building
Supervisor salaries
Sales commissions based on units sold

QUESTION 5
For each of the following, indicate whether the cost would typically be considered direct or
indirect cost for the cost object given.

Direct Indirect
Direct labour costs for the manufacturing
division.
Factory supervisor’s salary
Sales supervisor’s salary
Manufacturing overheads
Sales overheads

For each of the following, indicate whether the cost would be product period, which type of
overhead it is

QUESTION 6

Classify the following costs into Product/ period cost and over head category.

Product/ period Overhead

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1. Telephone bill
2. Security guards salary
3. Wages of operators
4. Research and development costs
5. Drivers wages
6. Accountants salary
7. Auditors fees
8. Lubricants
9. Licenses
10. Storekeepers salary
11. Painting of stores
12. Interest on loan
13. Advertising
14. Depreciation of machinery
15. Raw material cost
16. Printer ink cost
17. Spare parts
18. Cleaning detergent
19. Showroom rent
20. Packing charges

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 COST SHEET

Every Business wants to earn maximum profits. For this Purpose, we has two options

[1] Increase in Selling Price

[2] Decrease the Cost

Rise in selling Price is not always possible due to competition in the market. Hence efforts
are made to reduce the cost.

Cost Sheet:-
Cost Sheet is a statement in which all expenses are grouped under suitable heads for there
analysis, Control, and Reduction.

The aim is to earn maximum profit

COST OF GOODS MANUFACTURED AND SOLD STATEMENT OF ____________

FOR THE YEAR ENDING_______________

Particulars Rials Rials

Opening stock of raw materials 1300
Add purchase of raw materials
Less closing stock of raw materials
Add carriage on purchases
Less discount on purchases
Raw Materials consumed
Add Direct labour / Production Wages / Factory wages
Add direct expenses
Prime cost
Add: Factory overheads
Indirect material
Indirect labour

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Indirect expenses such as Factory Rent and Taxes Power
Electricity, Repairs, Maintenance etc
Total factory cost
Add work - in process opening stock
Less work – in process closing stock
Cost of goods manufactured
Add opening stock of finished goods
Less closing stock of finished goods
Cost of goods sold

INCOME STATEMENT OF ______________ FOR THE YEAR ENDING___________

Sales
Less cost of goods sold (from SOCOGS)
Gross profit
Less operating expenses
A. Administrative overheads such as office rent, insurance,
salaries etc
B. Selling and distribution overheads / marketing overheads
such as Advertisement , Salesman Salary , Cash Discount ,
Bad Debts , Showroom Exp
Net profit

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Practical Exercises

QUESTION 1

From the following data you are required to prepare a cost sheet and calculate Prime cost,
Cost of Production, Total cost and Profit.

Carriage inwards 500

Indirect material 600
Repair of machinery 700
Wages direct 1900
Salaries 800
Rent - office building 900
Rent - factory building 1000
Insurance of machinery 1100
Insurance of office furniture 1200
Raw material purchased 9000
Stock of raw material as on 1st Jan 2009 1300
Stock of raw material as on 31st Jan 2009 400
Direct expenses 1400
Advertisement 1500
Sales 30000
Units produced 10000

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QUESTION 2

From the following data you are required to prepare a cost sheet and calculate Prime
cost, Cost of Production, Total cost and Profit.

Material used 50000

Direct labour 20000
Direct expenses 10000
Factory overheads 15000
Administrative overheads 25000
Marketing overheads 5000
Sales 150000
Units sold 10000

QUESTION 3

From the following particulars pertaining to AL Surur LLC prepare Cost of goods
manufactured and Income statement sheet showing the following

1. Prime cost
2. Total factory cost
3. Cost of goods manufactured
4. Cost of goods sold
5. Net Profit

Rials
st
Stock of raw materials, 1 January 2009 15,600
Stock of raw materials on 31st December 2009 14,000
Purchase of raw materials 120,000
Productive wages 72,000

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 Direct expenses 2,700
Unproductive wages / indirect labour 36,000
Factory rent and taxes 6,000
Factory lighting 4,000
Factory insurance 2,000
Office insurance 1,600
Rent of warehouse 3,000
Depreciation of plant 22,000
Director’s fees (factory) 3,000
Director’s fees (office) 4,000
Stationery 500
Sales 400,000
Rent and taxes 6,500
Depreciation of office building 7,500
Advertisement 2,500
Bad debts 1,000
Work in process 1-1-2009 10,000
Work in process 31-12-09 14,000
Opening stock of finished goods 8,000
Closing stock of finished goods 6,000

Calculate cost per tonne if 1000 tonnes were produced.

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QUESTION 4

Prepare cost of goods manufactured statement and Income statement of Brian

Company for the year ending 31st December 2009.

Rials
Accounts receivable 7600
Administrative expenses 10500
Cash 100
Depreciation on factory equipment 3000
Direct labour 4000
Opening stock of raw material 1-1-2009 2500
Closing stock of raw materials 31-12-2009 5000
Factory miscellaneous expenses 350
Factory insurance 500
Indirect labour 390
Indirect material used 250
Marketing expenses control 6000
Purchase of raw material 8000
Sales 50000
Work in process opening 5060
Work in process closing 2800
Opening stock of finished goods 5000
Closing stock of finished goods 2000

Calculate cost per tonne if 5000 tonnes were produced.

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QUESTION 5
From the following information relating to XYZ Company, for the year ending 31st
December 2009 prepare Cost of goods manufactured Statement and Income statement.

Rials
st
Opening stock of raw material 1 January 200 10,000
Closing stock of raw material 31st December 2009 8,000
Purchase of raw material 65,000
Direct expenses 5,000
Carriage inward 1,000
Wages unproductive 5,750
Factory rent 5,450
Office rent and taxes 6,000
Office staff salaries 12,000
Insurance of plant and machinery 2,000
Sales department salaries 5,400
Sundry office and administration expenses 4,500
Direct wages 66,000
Opening stock of work in process 1st January 2009 18,000
Closing stock of work in process 31st January 2009 16000
Advertisement 4,000
Opening stock of finished goods 1st January 2009 20,000
Closing stock of finished goods 31st January 2009 15,000
Sales 300,000

Calculate cost per unit if 10000 units were produced.

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QUESTION 6

From the following data of Sana Engineering Co. prepare Cost of goods manufactured
and Income statement for the year ending 31st December 2009.

Rials
Opening stock of Work in process – 1st January 2009 12,000
Closing stock of work in process as on 31st December 2009 15,000
Purchase of raw material 77,000
Carriage on purchase of raw material 1,500
Direct wages 56,600
Wages unproductive 6,500
Factory rent and insurance 5,450
Office rent 6,000
Office staff salaries 12,000
Insurance of machinery 2,000
Sales department salaries 5,400
Office and administration expenses 4,500
Direct expenses 4,500
Opening stock of raw material as on 1st January 2009 18,000
Closing stock of raw material on 31st December 2009 16,000
Bad debts 4,000
Opening stock of finished goods 1st January 2009 20,000
Closing stock of finished goods 31st January 2009 15,000
Sales for the year 300,000

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QUESTION 7
The following particulars relating to the year 2009 have been taken from the books of a
chemical factory manufacturing and making a chemical mixture.
Stock on 1 January 2009 Rials
Raw materials 1000
Finished mixture 1000
Factory stores 3000
Purchases
Raw materials 80000
Factory stores 15000
Sales
Finished mixture 900000
Factory wages 100000
Power 4000
Depreciation on machinery 8000
Salaries
Factory 20000
Office 5000
Selling 4000
Expenses
Direct 1500
Office 8200
Selling 8000
Stock on 31 December 2009
Raw materials 1250
Finished mixture 1500
Factory stores 3550

Prepare a statement giving the maximum possible information about cost and its break
up for the year and the profit generated by the end of the year 2009.
QUESTION 8

From the following information of Muscat Flour mills prepare Cost of goods
manufactured and Income statement for the year ending 31st December 2009.

Rials
Sales 200,000
Opening stock of raw materials on 1st January 2009 25,000
Closing stock of raw materials on 31st December 2009 17,000

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Direct labour 21,000
Factory rent 10,500
Indirect labour 4,600
Office rent 10,400
Administration expenses 1,200
Purchase of raw material 45,000
Opening stock of work in process on 1st January 2009 28,000
Closing stock of work in process 31st December 2009 20,000
Insurance of machinery 2,000
Sales staff salaries 6,000
Advertisement 4,000
Opening stock of finished goods 1st January 2009 24,800
Closing stock of finished goods 31st December 2009 20,500
Office staff salaries 3,500

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QUESTION 9

From the following information of Majan Pharmacy, prepare Cost of goods

manufactured and Income statement for the year ending 31st December 2009.

Rials
Sales 260,000
Opening stock of raw materials on 1st January 2009 15,000
Closing stock of raw materials on 31st December 2009 17,000
Direct wages 21,000
Office rent 10,500
Indirect labour 4,650
Factory rent 10,400
General expenses 1,200
Purchase of raw material 45,000
Opening stock of work in process on 1st January 2009 28,000
Closing stock of work in process 31st December 2009 20,000
Insurance of plant and machinery 2,000
Sales staff salaries 6,000
Promotion expenses 4,000
Opening stock of finished goods 1st January 2009 24,800
Closing stock of finished goods 31st December 2009 20,500
Office staff salaries 3,500
Carriage outwards 1,000

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QUESTION 10

The following particulars relating to the year 2009 have been taken from the books of a
chemical factory manufacturing and making a chemical mixture.

Stock on 1 January 2009 Rials

Raw materials 4000
Finished mixture 2000
Factory stores 3500
Purchases
Raw materials 150000
Factory stores 22000
Factory wages 125000
Power 18000
Depreciation on machinery 10000
Salaries
Factory 50000
Office 30000
Selling 15000
Expenses
Direct 10000
Office 12000
Selling 17000
Stock on 31 December 2009
Raw materials 1250
Finished mixture 1500
Factory stores 5000

Prepare Cost of goods manufactured and Income statement

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QUESTION 11

The following particulars relating to ABC company for the year 2009.

Purchases Rials
Raw materials 150000
Factory stores 22000
Factory wages 200000
Power 30000
Depreciation on machinery 18000
Expenses
Direct 17000
Office 12000
Selling 20000
Stock on 31 December 2009
Raw materials 5000
Finished mixture 2500
Factory stores 4000
Stock on 1 January 2009
Raw materials 1000
Finished mixture 500
Factory stores 6000
Salaries
Factory 50000
Office 21000
Selling 30000

Prepare a statement of cost of goods sold and the relevant Income Statement giving the
maximum possible information.

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QUESTION 12

The following figures have been extracted from the Trial Balance of Al Hassan Co on
31st December, 2009. Prepare statement of Cost of Goods Sold and Income Statement
for the year 2009.

Rials
Inventories:
Finished stock 150000
120000
Raw materials
Work – in- process 100000
Office furniture 30000
Plant and machinery 50000
Factory building 50000
Sales 700000
Sales return 20000
Material purchased 100000
Freight inwards 4000
Purchase returns 10000
Direct labour 7000
Indirect labour 7000
Factory supervision 9000
Factory repairs 80000
Electricity 20000
Factory rates and taxes 4500
Sundry factory expenses 6500
Sales commission 2000
Sales travel 18000
Sales promotion 10000
Distribution expenses 50000
Office salaries 15000

Further details were given as follows:

1. Closing inventories were as follows

Finished stock - 100000
Raw materials - 150000

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 Work – in- process – 50000
2. Depreciation to be provided at 5% on office furniture, 10% on plant and 5% on
buildings.
3. Electricity to be distributed in the ratio of 1:1 between factory and office.

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QUESTION 13

The following figures have been extracted from the Trial Balance of Al Mazoon Co on
31st December, 2009. Prepare statement of Cost of Goods Sold and Income Statement
for the year 2009.

Rials
Inventories:
Finished stock 90000
240000
Raw materials
Work – in- process 300000

Office furniture 60000

Plant and machinery 200000
Factory building 80000
Sales 900000
Sales return 50000
Material purchased 200000
Freight inwards 3000
Purchase returns 6000
Direct labour 5500
Indirect labour 7000
Factory supervision 9000
Factory repairs 80000
Electricity 20000
Factory rates and taxes 4500
Sundry factory expenses 3500
Sales commission 2500
Sales travel 10000
Sales promotion 25000
Distribution expenses 30000
Office salaries 25000

Further details were given as follows:

1. Closing inventories were as follows

• Finished stock - 215000

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Raw materials - 280000
• Work – in- process – 290000

2. Depreciation to be provided at 5% on office furniture, 10% on plant and 5% on

buildings.

3. Electricity to be distributed in the ratio of 1:1 between factory and office.

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