Unit 2: Cost, marginal and standard costing

Costing is the technique and process of ascertaining costs. Cost accounting is the process of accounting for costs from the point at which expenditure is incurred to the establishment of its ultimate relationship with cost centres and cost units (CIMA).

Objectives

• Ascertainment of cost per unit, job, process or department.
• Cost control and cost reduction.
• Fixing selling prices and preparing tenders.
• Providing information for managerial decisions (make or buy, shut down, accept an order).
• Identifying wastage, losses and inefficiencies.
• Valuation of inventory (WIP and finished goods).

Nature and scope

• A branch of accounting, both a science (systematic body of knowledge) and an art (applied with skill), and a profession (ICMAI — Institute of Cost Accountants of India).
• Scope: cost ascertainment, cost accounting (recording), cost control, cost reports, cost audit (Section 148, Companies Act, 2013).

• Elements of cost: direct material, direct labour, direct expenses (together prime cost) and overheads (indirect material, labour and expenses).
• Cost unit: a unit of product or service in relation to which costs are ascertained — per tonne (steel), per kWh (electricity), per passenger-km (transport), per bed-day (hospital), per 1,000 bricks.
• Cost centre: a location, person or item of equipment for which costs are ascertained — production cost centres (machining shop) and service cost centres (stores, maintenance); personal and impersonal.
• Profit centre: a segment responsible for both revenue and costs.

A cost sheet is a statement showing the various components of total cost of a product for a period, with cost per unit.

Items excluded from cost accounts

Purely financial items — interest received, dividends, profit or loss on sale of fixed assets, income tax, donations, goodwill written off, preliminary expenses written off, transfer to reserves.

Marginal costing is the ascertainment of marginal costs and the effect on profit of changes in volume or type of output by differentiating between fixed and variable costs (CIMA). Only variable costs are charged to products; fixed costs are written off against contribution.

• Break-even chart shows total cost, total sales and the BEP; the angle of incidence between sales and total cost lines indicates profitability.
• Decisions using marginal costing: make or buy, accept a special order, key (limiting) factor, shut down, product mix, pricing in recession.

Applications of marginal costing

• Make or buy: buy if the purchase price is below the marginal cost of making (and capacity has other uses).
• Accept a special order below normal price if it covers marginal cost and there is spare capacity.
• Key factor: rank products by contribution per unit of the limiting factor (e.g., per machine hour).
• Shut down or continue: continue in the short run if contribution covers avoidable fixed costs.
• Product mix and pricing in recession.

Standard costing sets predetermined costs for each element, compares actual costs with standards, and analyses variances to control performance.

• Favourable (F) when actual cost is below standard; adverse (A) when above.
• Advantages: cost control, management by exception, pricing, performance evaluation; limitations: setting standards is difficult, standards become outdated, may demotivate.

• Budget: a quantitative statement, for a defined period, of the policies, plans, objectives and goals established by management (CIMA).
• Budgetary control: establishment of budgets relating to responsibilities of executives and continuous comparison of actual with budgeted results to secure objectives or revise them.

• Key (principal budget) factor: the factor that limits activity — usually sales; can be materials, labour or plant capacity.
• Advantages: planning, coordination, control, motivation, cost consciousness. Limitations: based on estimates, rigidity, time and cost, may cause conflict.

Cash budget

Estimates cash receipts and payments to show expected cash surplus or deficit each month.

• Uses: plan borrowing and investment of surplus, ensure liquidity, time capital expenditure.

Flexible budget

A budget designed to change with the level of activity attained — fixed costs remain constant, variable costs change in proportion, semi-variable costs are split.

• Zero-base budgeting: every activity justified from zero each period through ranked decision packages.
• Participative (bottom-up) budgeting: managers who will implement the budget help prepare it — improves commitment and information; risk of budgetary slack.
• Performance budgeting: links expenditure to outputs and outcomes (Outcome Budget in India).