Unit 1: Cost accounting fundamentals
Management and Cost Accounting notes · PTU syllabus (MCOP202-18)
On this page
- Unit summary
- Meaning, objectives and scope of cost accounting
- Classification of costs
- Installation of a costing system
- Materials control and inventory management
- Methods of pricing material issues
- Labour cost classification
- Overheads: collection, apportionment and absorption
- The cost sheet
- Job and contract costing
- Contract costing
- Process costing
- Key terms
- Quick revision
- Important questions
Unit summary
Cost accounting tells managers what things cost and why. This unit covers the objectives, scope, classification and elements of cost, installation of a costing system, materials control and pricing, inventory management, labour cost, overheads, the cost sheet, job and contract costing, and process costing.
After this unit you can
- Explain the objectives, scope and classification of costs and the installation of a costing system
- Explain material control, pricing of issues, labour cost and overheads
- Prepare a cost sheet
- Apply job, contract and process costing
PTU syllabus topics
- Objectives
- scope
- classification and elements of cost
- installation of a costing system
- materials control concepts and pricing methods
- inventory management
- labour cost classification
- overhead collection and classification
- cost sheet preparation
- job/contract costing
- process costing features and types
- Cost of sales
+ selling and distribution overheads
- Cost of production
+ office and administration overheads
- Works cost
+ factory overheads
- Prime cost
Direct material + labour + expenses
Topic 1
Meaning, objectives and scope of cost accounting
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).
Exam tip
Advantages to mention: identifies profitable and unprofitable products, helps price fixing, controls wastage, aids budgeting and gives data for wage negotiations.
Topic 2
Classification of costs
By element
Material, labour, expenses
By nature/traceability
Direct (traceable to a unit) vs indirect (overheads)
By function
Production, administration, selling, distribution, R&D
By behaviour
Fixed, variable, semi-variable
By controllability
Controllable vs uncontrollable
By time
Historical vs predetermined (standard)
For decision-making
Marginal, differential, opportunity, sunk, imputed
- 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.
Topic 3
Installation of a costing system
- 1
Study the product, process and organisation
- 2
Decide objectives and the costing method
Job, process, batch, contract, operating
- 3
Determine cost centres and cost units
- 4
Design forms and records
Material requisitions, time cards
- 5
Decide treatment of overheads
- 6
Integrate or reconcile with financial accounts
- 7
Train staff and introduce gradually
- Practical difficulties: resistance from staff, lack of top management support, cost of installation, shortage of trained personnel — overcome by education, simple system design and gradual implementation.
Topic 4
Materials control and inventory management
Reorder level
Maximum consumption × Maximum reorder period
Minimum level
Reorder level − (Normal consumption × Normal reorder period)
Maximum level
Reorder level + Reorder quantity − (Minimum consumption × Minimum reorder period)
Average level
(Minimum + Maximum) ÷ 2, or Minimum + ½ Reorder quantity
Danger level
Average consumption × Emergency delivery time
EOQ
√(2AO ÷ C) — A annual usage, O ordering cost per order, C carrying cost per unit per year
Example
Normal usage 100 units/week, minimum 50, maximum 150; reorder period 4–6 weeks (normal 5); EOQ 600. Reorder level = 150 × 6 = 900; minimum level = 900 − 100 × 5 = 400; maximum level = 900 + 600 − 50 × 4 = 1,300 units.
- ABC analysis: classify items by value — A (high value, few items, strict control), B (moderate), C (low value, many items, simple control).
- VED analysis: vital, essential, desirable (spares).
- Perpetual inventory system with continuous stock-taking; JIT inventory; inventory turnover ratio to spot slow-moving and dead stock.
Topic 5
Methods of pricing material issues
| Method | Basis | Effect when prices are rising |
|---|---|---|
| FIFO | Earliest purchases issued first | Lower cost of issues, higher closing stock and profit |
| LIFO | Latest purchases issued first | Higher cost of issues, lower closing stock (not allowed under AS-2/Ind AS 2) |
| Simple average | Average of prices, ignoring quantities | Rough results |
| Weighted average | Total cost ÷ total units after each receipt | Smooths fluctuations |
| Standard price | Predetermined price | Variances recorded separately |
Example
Opening 100 units @ ₹10; purchase 200 @ ₹12; issue 250. FIFO cost of issue = 100 × 10 + 150 × 12 = ₹2,800; closing 50 @ ₹12 = ₹600. Weighted average rate = (1,000 + 2,400) ÷ 300 = ₹11.33; issue cost = 250 × 11.33 = ₹2,833.
Topic 6
Labour cost classification
- Components of labour cost: wages, DA, bonus, employer's contribution to PF and ESI, leave pay, fringe benefits.
- Time-keeping (attendance) and time-booking (time spent on each job).
- Idle time: time paid but no work done. Normal idle time (tea breaks, change of shift) is included in labour cost or overheads; abnormal idle time (power failure, strikes, machine breakdown) is charged to the Costing P&L account.
- Overtime premium: extra over normal rate — charged to the job if at the customer's request; to overheads if due to general pressure; to Costing P&L if abnormal.
Topic 7
Overheads: collection, apportionment and absorption
- 1
Collection and classification
Standing order numbers, function-wise
- 2
Allocation
Whole overhead to one cost centre
- 3
Apportionment
Share common overheads on fair bases
- 4
Re-apportionment
Service departments to production departments (direct, step, repeated distribution, simultaneous equations)
- 5
Absorption
Charge to products using a rate
- 6
Under/over-absorption
Adjust via supplementary rate or Costing P&L
| Overhead | Basis of apportionment |
|---|---|
| Rent, rates, lighting, building depreciation | Floor area |
| Power | Horsepower × machine hours |
| Supervision, canteen, welfare | Number of workers |
| Insurance and depreciation of machinery | Value of machinery |
| Stores overheads | Value of material used |
Absorption rates
- Percentage of direct material, direct labour or prime cost.
- Labour hour rate — overheads ÷ direct labour hours.
- Machine hour rate — overheads ÷ machine hours (best for machine-intensive departments).
Machine hour rate
Example
Machine cost ₹2,00,000, scrap value ₹20,000, life 10 years, 1,800 working hours a year. Depreciation = 18,000 a year = ₹10/hour. Power 10 units/hour @ ₹6 = ₹60/hour. Repairs ₹9,000 a year = ₹5/hour. Share of rent and supervision ₹27,000 a year = ₹15/hour. Machine hour rate = 10 + 60 + 5 + 15 = ₹90.
Topic 8
The cost sheet
A cost sheet is a statement showing the various components of total cost of a product for a period, with cost per unit.
- 1
Direct material + direct labour + direct expenses = Prime cost
- 2
+ Factory overheads (± WIP adjustment) = Works (factory) cost
- 3
+ Office and administration overheads = Cost of production
- 4
+ Opening stock of finished goods − Closing stock = Cost of goods sold
- 5
+ Selling and distribution overheads = Cost of sales (total cost)
- 6
+ Profit = Sales
Example
Material ₹50,000, labour ₹30,000, direct expenses ₹5,000, factory overheads ₹15,000, office overheads ₹10,000, selling overheads ₹8,000; 1,000 units produced and sold at ₹150. Prime cost = ₹85,000; works cost = ₹1,00,000; cost of production = ₹1,10,000; cost of sales = ₹1,18,000; profit = 1,50,000 − 1,18,000 = ₹32,000; cost per unit = ₹118.
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.
Topic 9
Job and contract costing
- Job costing: each job (customer order) is a cost unit — printing, repair shops, furniture to order; a job cost sheet accumulates material, labour and overheads; batch costing treats a batch of identical units as a job.
Topic 10
Contract costing
Contract costing is used by builders and contractors for large, long-duration jobs (roads, buildings, bridges). Each contract is a cost unit; a separate Contract Account is prepared.
- Work certified: value of work approved by the architect/engineer; work uncertified: completed but not yet certified (at cost).
- Retention money: portion of the certified amount withheld by the contractee as security.
- Notional profit = Work certified + Work uncertified − Cost of work to date.
| Stage of completion | Profit taken to P&L |
|---|---|
| Less than 25% | Nil |
| 25% to 50% | 1/3 × Notional profit × Cash received ÷ Work certified |
| 50% to 90% | 2/3 × Notional profit × Cash received ÷ Work certified |
| Near completion (over 90%) | Estimated total profit × Work certified ÷ Contract price (and similar formulae) |
- Losses are recognised in full immediately (prudence).
Exam tip
Under AS-7 / Ind AS 115, revenue is recognised on the percentage-of-completion method — mention that the fractional rules are traditional costing conventions.
Topic 11
Process costing
Process costing is used where production passes through successive processes and the output of one process becomes the input of the next (chemicals, textiles, oil refining, paper).
- Normal loss: expected, unavoidable loss — cost absorbed by good units; scrap value credited to the process.
- Abnormal loss: loss above normal — valued at the cost of good units and transferred to the Abnormal Loss A/c.
- Abnormal gain: actual loss less than normal — debited to the process and credited to Abnormal Gain A/c.
Cost per unit of normal output
(Total cost − Scrap value of normal loss) ÷ (Input − Normal loss units)
Value of abnormal loss
Abnormal loss units × Cost per unit of normal output
Example
Input 1,000 units costing ₹20,000; normal loss 10% (scrap ₹2 per unit); actual output 850. Normal loss = 100 units (scrap ₹200). Cost per unit = (20,000 − 200) ÷ 900 = ₹22. Abnormal loss = 50 units × 22 = ₹1,100. Output transferred = 850 × 22 = ₹18,700.
- Equivalent production: WIP converted into completed units for computing cost per unit.
- Joint products and by-products: products obtained from the same process; joint costs apportioned (physical units, sales value).
Key terms
- Cost unit
- Unit of product or service for which cost is ascertained
- Job costing
- Costing each customer order separately
- Abnormal loss
- Loss beyond the normal expected level in a process
- Machine hour rate
- Overhead cost per hour of running a machine
- Notional profit
- Value of work done less cost to date on a contract
Quick revision
- Elements: material, labour, expenses; prime cost + overheads.
- Installation: study, method, cost centres, records, overheads, reconciliation.
- Stock levels, EOQ, ABC; FIFO/weighted average pricing.
- Overheads: allocate, apportion, absorb; machine hour rate.
- Job, contract (notional profit) and process costing (normal/abnormal loss).
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.State the objectives of cost accounting.
- Q2.What are the steps in installing a costing system?
- Q3.What is EOQ?
- Q4.What is idle time?
- Q5.What is job costing?
- Q6.How is abnormal loss treated in process costing?
Long-answer questions
- Q1.Explain the classification and elements of cost.
- Q2.Explain the installation of a costing system.
- Q3.Explain the methods of pricing material issues and overhead absorption.
- Q4.Explain process costing and contract costing with illustrations.
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