Cost Accounting and Financial Management notes

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8 INTERMEDIATE : PAPER - COST ACCOUNTING AND FINANCIAL INTERMEDIATE MANAGEMENT STUDY NOTES The Institute of Cost Accountants of India CMA Bhawan, 12, Sudder Street, Kolkata - 700 016First Edition : February 2013 Reprint of First Edition : October 2014 Published by : Directorate of Studies The Institute of Cost Accountants of India (ICAI) CMA Bhawan, 12, Sudder Street, Kolkata - 700 016 Printed at : Repro India Limited Plot No. 02, T.T.C. MIDC Industrial Area, Mahape, Navi Mumbai 400 709, India. Website : Copyright of these Study Notes is reserved by the Insitute of Cost Accountants of India and prior permission from the Institute is necessary for reproduction of the whole or any part thereof.Syllabus PAPER 8: COST ACCOUNTING AND FINANCIAL MANAGEMENT (CAFM) Syllabus Structure: The syllabus comprises the following topics and study weightage: A Cost Accounting – Prime Costs and Overheads 60% B Financial Management 40% B 40% A 60% ASSESSMENT STRATEGY There will be written examination paper of three hours OBJECTIVES To provide an in depth study of the Generally Accepted Cost Accounting Principles and Techniques for identic fi ation, analysis and classic fi ation of cost components to facilitate managerial decision making. To understand the concepts of Financial Management and its application for managerial decision making. Learning aims The syllabus aims to test the student’s ability to:  Understand and explain the conceptual framework of Cost & Management Accounting  Explain the basic concepts and processes in determination of products and services cost  Identify and apply the concepts of Financial Management Skill set required Level B: Requiring the skill levels of knowledge, comprehension, application and analysis. Section A : Cost Accounting – Prime Costs & Overheads 60% 1. General Purpose Cost Statement 2. Business Process Analysis – Cost Centre and Cost Allocation (a) Materials (CAS 6) (b) Employee Costs (CAS 7) (c) D irect expenses and problems connected therewith (CAS 10) (d) Overhead (with reference to all Cost Accounting Standards related to Overhead) Section B : Financial Management 40% 3. Overview of Financial Management 4. Tools for Financial Analysis & Planning 5. Working Capital Management and Leverage Analysis 6. C ost of Capital, Capital Structure Theories and Dividend Decisions 7. Capital Budgeting SECTION A: COST ACCOUNTING – PRIME COSTS & OVERHEADS 60 MARKS 1. General Purpose Cost Statement: Cost Accounting Standards (CASs) (issued by the Institute of Cost Accountants of India from time to time), Generally Accepted Cost Accounting Principles (GACAP) – Purpose, Objective and Applicability 2. Business Process Analysis – Cost Centre and Cost Allocation (a) Materials (CAS 6): (i) Proc urement of materials – classification and coding, inventory management and control, JIT (just in time), return to suppliers, pricing of receipts, Physical verification and related issues (ii) Scrap, wastage, pilferage, obsolescence, normal loss, abnormal loss (CASs related to above items) – framework (b) Employee Costs (CAS 7): (i) Employee routines, classification of Employee, time keeping, time booking, payroll preparation, disbursement of wages. Principles and methods of remuneration, Productivity Linked Incentive (PLI) Schemes (ii) Accounting control and reporting, Accounting for Employee Cost, Computation of Employee Cost rates, Idle time, Overtime, Employee turnover, Employee cost reporting (c) Direct expenses and problems connected therewith (CAS 10) (d) Overhead (with reference to all Cost Accounting Standards related to Overhead): (i) Classification of overheads; Overhead Cost Accounting (ii) Accounting and control of overheads, computation of pre-determined overhead recovery rates, treatment of over and under absorption of overhead costs. Reports of control of overhead costs (iii) Miscellaneous items of expenses – capacity costs, treatment of depreciation in costs Note : All related further pronouncements of CASs will also be applicable SECTION B : FINANCIAL MANAGEMENT 40 MARKS 3. Overview of Financial Management (a) F inancial Management – meaning, objectives, scope, related n fi ance disciplines, planning environment, key-decision areas (b) S ources of Finance ( Shares, Debentures, Debt, Public Deposits, Lease Financing, etc.); criteria for selecting sources of n fi ance including n fi ance for International Investments and Venture Capital Funds (c) O ther Financial services – Hire Purchase, Forfeiting, Bill Discounting, Factoring, Asset Securitization (d) F inancial Decision – Making – Emerging role of n fi ance managers (e) C ompliance of regulatory requirements in formulation of n fi ancial strategies (f) Role of Treasury Function in terms of setting Corporate objectives, Funds Management-National and International (g) C ontemporary developments – WTO, GATT, Corporate Governance, TRIPS, TRIMS, SEBI Regulations (as amended from time to time) (h) C oncepts of Value and Return – Time preference for money, Future Value, Present Value, Net Present Value (NPV) 4. Tools for Financial Analysis & Planning (a) Funds o fl w and Cash o fl w Analysis (b) Analysis Financial Ratio and Cash Flow Ratios – Ratios in the areas of performance, prot fi ability, n fi ancial adaptability, liquidity, activity, shareholder investment and n fi ancing, interpretation of ratios and limitations of ratio analysis (c) I dentic fi ation of information required to assess n fi ancial performance, Effect of short - term debt on the measurement of gearing 5. Working Capital Management and Leverage Analysis (a) Working Capital policies related to Inventory, Receivables, Payables, Cash and Marketable securities (b) Financing of working capital (c) C oncepts and nature of Leverages, Analysis of Operating and Financial Leverages, Operating Risk and Financial Risk and Combined Leverages (d) O perating leverages and Cost-Volume-Prot fi (CVP) analysis, Earning Before Interest and Tax (EBIT), Earning Per Share (EPS), Indifference point 6. Cost of Capital (a) M eaning, components, methods of determination of cost of capital related to debt, preference shares, equity shares, retained earnings, depreciation fund (b) Capital Asset Pricing Models (CAPM) (c) W eighted Average Cost of Capital and Marginal Cost of Capital 7. Capital Budgeting (a) Purpose, objective, process (b) Understanding different types of projects (c) T echniques of decision making: non-discounted and discounted cash flow approaches – payback period method, accounting rate of return, net present value, internal rate of return, modified internal rate of return, discounted payback period and profitability index. (d) Ranking of competing projects, ranking of projects with unequal lives. (e) M odeiling and forecasting cash o fl ws and n fi ancial statements based on expected values for variables-economic and businessContent SECTION – A : COST ACCOUNTING – PRIME COSTS & OVERHEADS Study Note 1 : General Purpose Cost Statementt 1.1 Evolution of Cost Accounting 1.1 1.2 Cost Accounting Concepts 1.7 1.3 Generally Accepted Cost Accounting Principles & Cost Accounting Standards 1.21 1.4 Cost Accounting Standards 1.25 Study Note 2 : Business Process Analysis 2.1 Materials (CAS-6) 2.1 2.2 Employee Costs (CAS-7) 2.55 2.3 Direct Expenses (CAS-10) 2.105 2.4 Overheads (CAS-3) 2.108 2.5 Treatment of Special Items 2.134 2.6 Cost Sheet 2.166 SECTION – B : FINANCIAL MANAGEMENT Study Note 3 : Overview of Financial Management 3.1 Objective of Financial Management 3.1 3.2 Key Decisions of Financial Management 3.5 3.3 Planing Environment 3.6 3.4 Functions of Financial Management 3.7 3.5 Sources of Finance 3.9 3.6 International Sources 3.13 3.7 Emerging Role of Finance Manager 3.23 3.8 Securities and Exchange Board of India Act. 1992 3.25 3.9 Future Value 3.32 3.10 Present Value 3.33 Study Note 4 : Tools for Financial Analysis and Planning 4.1 Funds Flow Statement 4.1 4.2 Cash Flow Statement 4.3 4.3 Ratio Analysis 4.37 4.4 Idntification of Information Required to Assess Financial Performance 4.62Study Note 5 : Working Capital Management and Leverage Analysis 5.1 Working Capital - Meaning & Defination 5.1 5.2 Kinds of Working Capital 5.2 5.3 Adequacies and Inadequacies of Working Capital 5.2 5.4 Danger of too high amount of Working Capital 5.3 5.5 Danger of inadequancies or low amount of Working Capital 5.3 5.6 Working Capital Cycle 5.3 5.7 Working Capital Financing 5.6 5.8 Inventory Management 5.22 5.9 Management of Receivable 5.23 5.10 Determinants of Credit Policy 5.25 5.11 Cash Management 5.32 5.12 Leverages 5.37 5.13 EBIT-EPS Indifference Point Level 5.38 5.14 Calculation of Indifference Point 5.39 Study Note 6 : Cost of Capital 6.1 Cost of Capital 6.1 6.2 Capital Structure 6.14 6.3 Dividend Decisions 6.31 Study Note 7 : Capital Budgeting 7.1 Capital Budgeting 7.1 7.2 Need of Capital Budgeting Decision 7.1 7.3 Significance of Capital Budgeting Decision 7.3 7.4 Process of Capital Budgeting 7.3 7.5 Investment Criterian - Method of Appraisal 7.4Section A Cost Accounting – Prime Costs & OverheadsStudy Note - 1 GENERAL PURPOSE COST STATEMENT This Study Note includes 1.1 Evolution of Cost Accounting 1.2 Cost Accounting Concepts 1.3 Generally Accepted Cost Accounting Principles (GACAP) 1.4 Cost Accounting Standards (CASs) 1.1 EVOLUTION OF COST ACCOUNTING th Way back to 15 Century, no accounting system was there and it was the barter system prevailed. It was th in the last years of 15 century Luca Pacioli, an Italian found out the double entry system of accounting th in the year 1494. Later it was developed in England and all over the world upto 20 Century. During these 400 years, the purpose of Cost Accounting needs are served as a small branch of Financial Accounting th except a few cases like Royal wallpaper manufactory in France (17 Century), and some iron masters th & potters in England (18 century) The period 1880 AD- 1925 saw the development of complex product designs and the emergence of multi activity diversified corporations like Du Pont, General Motors etc. It was during this period that scientific management was developed which led the accountants to convert physical standards into Cost Standards, the latter being used for variance analysis and control. During the World War I and II the social importance of Cost Accounting grew with the growth of each country’s defence expenditure. In the absence of competitive markets for most of the material required for war, the governments in several countries placed cost-plus contracts under which the price to be paid was cost of production plus an agreed rate of profit. The reliance on cost estimation by parties to defence contracts continued after World War II. In addition to the above, the following factors have made accountants to find new technique to serve the industry :- (i) Limitations placed on financial accounting (ii) Improved cost consciousness (iii) Rapid industrial development after industrial revolution and world wars (iv) Growing competition among the manufacturers (v) To control galloping price rise, the cost of computing the precise cost of product / service (vi) To control cost several legislations passed throughout the world and India too such as Essential Commodities Act, Industrial Development and Regulation Act...etc Due to the above factors, the Cost Accounting has emerged as a speacialised discipline from the initial th years of 20 century i.e after World War I and II. In India, prior to independence, there were a few Cost Accountants, and they were qualified mainly from I.C.M.A. (now CIMA) London. During the Second World War, the need for developing the profession in the country was felt, and the leadership of forming an Indian Institute was taken by some COST ACCOUNTING AND FINANCIAL MANAGEMENT I 1.1General Purpose Cost Statement members of Defence Services employed at Kolkata. However, with the enactment of the Cost and Works Accountants of India Act, 1959, the Institute of Cost and Works Accountants of India (Now called as Institute of Cost Accountants of India) was established at Kolkata. The profession assumed further importance in 1968 when the Government of India introduced Cost Audit under section 233B of the Companies Act, 1956. Many times we use Cost Accounting, Costing and Cost Accountancy interchangeably. But there are differences among these terms. As a professional, though we use interchangeably we must know the meaning of each term precisely. Cost Accounting : Cost Accounting may be defined as “ Accounting for costs classification and analysis of expenditure as will enable the total cost of any particular unit of production to be ascertained with reasonable degree of accuracy and at the same time to disclose exactly how such total cost is constituted”. Thus Cost Accounting is classifying, recording an appro priate allocation of expenditure for the determination of the costs of products or services, and for the presentation of suitably arranged data for the purpose of control and guidance of management. Cost Accounting can explained as follows :- Cost Accounting is the process of accounting for cost which begins with recording of income and expenditure and ends with the preparation of statistical data. It is the formal mechanism by means of which cost of products or services are ascertained and controlled. Cost Accounting provides analysis and classification of expenditure as will enable the total cost of any particular unit of product / service to be ascertained with reasonable degree of accuracy and at the same time to disclose exactly how such total cost is constituted. For example it is not sufficient to know that the cost of one pen is ` 25/- but the management is also inter ested to know the cost of material used, the amount of labour and other expenses incurred so as to control and reduce its cost. It establishes budgets and standard costs and actual cost of operations, processes, departments or products and the analysis of variances, profitability and social use of funds. Thus Cost Account ing is a quantitative method that collects, classifies, summarises and interprets information for product costing, operation planning and control and decision making. Costing : Costing is defined as the technique and process of ascertaining costs. The technique in costing consists of the body of principles and rules for ascertaining the costs of products and services. The technique is dynamic and changes with the change of time. The process of costing is the day to day routine of ascertaining costs. It is popularly known as an arithmetic process and daily routine. For example If the cost of producing a product say ` 200/-, then we have to refer material, labour and expenses accounting and arrive the above cost as follows: Material ` 100 Labour ` 40 Expenses ` 60 Total ` 200 Finding out the breakup of the total cost from the recorded data is a daily process. That is why it is called daily routine. In this process we are classifying the recorded costs and summarizing at each element and total is called technique. Cost Accountancy: Cost Accountancy is defined as ‘ the application of Costing and Cost Accounting principles, methods and techniques to the science, art and practice of cost control and the ascertainment of prot fi ability’ . It inc ludes the presentation of information derived there from for the purposes of managerial decision making. Thus, Cost Accountancy is the science, art and practice of a Cost Accountant. 1.2 I COST ACCOUNTING AND FINANCIAL MANAGEMENT(a) It is science because it is a systematic body of knowledge having certain principles which a cost accountant should possess for proper discharge of his responsibilities. (b) It is an art as it requires the ability and skill with which a Cost Accountant is able to apply the principles of Cost Accountancy to various managerial problems. (c) Practice includes the continuous efforts of a Cost Accountant in the field of Cost Accountancy. Such efforts of a Cost Accountant also include the presentation of information for the purpose of managerial decision making and keeping statistical records. Objectives of Cost Accounting The following are the main objectives of Cost Accounting :- (a) To ascertain the Costs under different situations using different techniques and systems of costing (b) To determine the selling prices under different circumstances (c) To determine and control efficiency by setting standards for Materials, Labour and Overheads (d) To determine the value of closing inventory for preparing financial statements of the concern (e) To provide a basis for operating policies which may be determination of Cost Volume relationship, whether to close or operate at a loss, whether to manufacture or buy from market, whether to continue the existing method of production or to replace it by a more improved method of production....etc Scope of Cost Accountancy The scope of Cost Accountancy is very wide and includes the following:- (a) Cost Ascertainment: The main objective of Cost Accounting is to find out the Cost of product / services rendered with reasonable degree of accuracy. (b) Cost Accounting: It is the process of Accounting for Cost which begins with recording of expenditure and ends with preparation of statistical data. (c) Cost Control: It is the process of regulating the action so as to keep the element of cost within the set parameters. (d) Cost Reports: This is the ultimate function of Cost Accounting. These reports are primarily prepared for use by the management at different levels. Cost reports helps in planning and control, performance appraisal and managerial decision making. (e) Cost Audit: Cost Audit is the verification of correctness of Cost Accounts and check on the adherence to the Cost Accounting plan. Its purpose is not only to ensure the arithmetic accuracy of cost records but also to see the principles and rules have been applied correctly. To appreciate fully the objectives and scope of Cost Accounting, it would be useful to examine the position of Cost Accounting in the broader field of general accounting and other sciences. i.e Financial Accounting , Management Accounting, Engineering and Service Industry. Cost Accounting and Financial Accounting: Financial Accounting is primarily concerned with the preparation of financial statements, which summarise the results of operations for selected period of time and show the financial position of the company at particular dates. In other words Financial Accounting reports on the resources available (Balance Sheet) and what has been accomplished with these resources (Profit and Loss Account). Financial Accounting is mainly concerned with requirements of creditors, shareholders, government, prospective investors and persons outside the management. Financial Accounting is mostly concerned with external reporting. Cost Accounting, as the name implies, is primarily concerned with determination of cost of something, which may be a product, service, a process or an operation according to costing objective of COST ACCOUNTING AND FINANCIAL MANAGEMENT I 1.3General Purpose Cost Statement management. A Cost Accountant is primarily charged with the responsibility of providing cost data for whatever purposes they may be required for. The main differences between Financial and Cost Accounting are as follows: Financial Accounting Cost Accounting a) It provides the information about the business a) It provides information to the management in a general way. i.e Profit and Loss Account , for proper planning, operation, control and Balance Sheet of the business to owners and decision making. other outside partners. b) It classifies, records and analyses the transac- b) It records the expenditure in an objective tions in a subjective manner, i.e according to manner, i.e according to the purpose for the nature of expense. which the costs are incurred. c) It lays emphasis on recording aspect without c) it provides a detailed system of control for attaching any importance to control. materials, labour and overhead costs with the help of standard costing and budgetary control. d) It reports operating results and financial d) It gives information through cost reports to position usually at the end of the year. management as and when desired. e) Financial Accounts are accounts of the whole e) Cost Accounting is only a part of the financial business. They are independent in nature. accounts and discloses profit or loss of each product, job or service. f) Financial Accounts records all the commercial f) Cost Accounting relates to transactions transactions of the business and include all connected with Manufacturing of goods and expenses i.e Manufacturing, Office, Selling services, means expenses which enter into etc. production. g) Financial Accounts are concerned with g) Cost Accounts are concerned with internal external transactions i.e transactions between transactions, which do not involve any cash business concern and third party. payment or receipt. h) Only transactions which can be measured in h) Non-Monetary information like No of Units / monetary terms are recorded. Hours etc are used. i) Financial Accounting deals with actual figures i) Cost Accounting deals with partly facts and and facts only. figures and partly estimates / standards. j) Financial Accounting do not provide j) Cost Accounts provide valuable information information on efficiencies of various workers on the efficiencies of employees and Plant & / Plant & Machinery. Machinery. k) Stocks are valued at Cost or Market price k) Stocks are valued at Cost only. whichever is lower. l) Financial Accounting is a positive science as l) Cost Accounting is not only positive science it is subject to legal rigidity with regarding to but also normative because it includes preparation of financial statements. techniques of budgetary control and standard costing. m) These accounts are kept in such away to m) Generally Cost Accounts are kept voluntarily meet the requirements of Companies Act as to meet the requirements of the management, per Sec 209 (1) (a) to (c)& Income Tax Act only in some industries Cost Accounting Sec 44AA. records are kept as per the Companies Act. 1.4 I COST ACCOUNTING AND FINANCIAL MANAGEMENTCost Accounting and Management Accounting: Management Accounting is primarily concerned with management. It involves application of appropriate techniques and concepts, which help management in establishing a plan for reasonable economic objective. It helps in making rational decisions for accomplishment of these objectives. Any workable concept or techniques whether it is drawn from Cost Accounting, Financial Ac counting, Economics, Mathematics and Statistics, can be used in Management Accountancy. The data used in Management Accountancy should satisfy only one broad test. It should serve the purpose that it is intended for. A Management Accountant accumulates, summarizes and analysis the available data and presents it in relation to specific problems, decisions and day-to-day task of management. A Management Accountant reviews all the decisions and analysis from management’s point of view to determine how these decisions and analysis contribute to overall organizational object ives. A Management Accountant judges the relevance and adequacy of available data from management’s point of view. The scope of Management Accounting is broader than the scope of Cost Accountancy. In Cost Accounting, primary emphasis is on cost and it deals with its collection analysis relevance interpretation and presentation for various problems of management. Management Accountancy utilizes the principles and practices of Financial Accounting and Cost Accounting in addition to other management techniques for efficient operations of a company. It widely uses different techniques from various branches of knowledge like Statistics, Mathematics, Economics, Laws and Psychology to assist the management in its task of maximising prot fi s or minimising losses. The main thrust in Management Accountancy is tow ards determining policy and formulating plans to achieve desired objective of management. Management Accountancy makes corporate planning and strategy effective. From the above discussion we may conclude that the Cost Accounting and Management Accounting are interdependent, greatly related and inseparable. Advantages of Cost Accounting Cost Accounting has manifold advan tages, a summary of which is given below. It is not suggested that having installed a system of Cost Accounting, a concern will expect to derive all the benefits stated here. The nature and the extent of the advantages obtained will depend upon the type, adequacy and efficiency of the cost system installed and the extent to which the various levels of management are prepared to accept and act upon the advice rendered by the cost system. The Cost Accounting System has the following advantages :- (i) A cost system reveals unprofitable activities, losses or inefficiencies occurring in any form such as (a) Wastage of man power, idle time and lost time. (b) Wastage of material in the form of spoilage, excessive scrap etc., and (c) Wastage of resources, e.g. inadequate utilization of plant, machinery and other facilities. (ii) Cost Accounting locates the exact causes for decrease or increase in the profit or loss of the business. It identifies the unprofitable products or product lines so that these may be eliminated or alternative measures may be taken. (iii) Cost Accounts furnish suitable data and information to the management to serve as guides in making decisions involving financial considera tions. (iv) Cost Accounting is useful for price fixation purposes. Although sale price is generally related more to economic conditions prevailing in the market than to cost, the latter serves as a guide to test the adequacy of selling prices. (v) With the application of Standard Costing and Budgetary Control methods, the optimum level of efficiency is set. (vi) Cost comparison helps in cost control. Comparison may be period to period, of the g fi ures in respect of the same unit or factory or of several units in an industry by employing Uniform Costs and Inter- Firm Comparison methods. Comparison may be made in respect of cost of jobs, process or cost centres. COST ACCOUNTING AND FINANCIAL MANAGEMENT I 1.5General Purpose Cost Statement (vii) A cost system provides ready figures for use by the Government, wage tribunals and boards, and labour and trade unions. (viii) When a concern is not working to full capacity due to various reasons such as shortage of demands or bottlenecks in production, the cost of idle capacity can readily worked out and repealed to the management. (ix) Introduction of a cost reduction programme combined with operations research and value analysis techniques leads to economy. (x) Marginal Costing is employed for suggesting courses of action to be taken. It is a useful tool for the management for making decisions. (xi) Determination of cost centres or responsibility centres to meet the needs of a Cost Accounting system, ensures that the organizational structure of the concern has been properly laid responsibility can be properly defined and fixed on individuals. (xii) Perpetual inventory system which includes a procedure for continuous stock taking is an essential feature of a cost system. (xiii) The operation of a system of cost audit in the organization prevents manipulation and fraud and assists in furnishing correct and reliable cost data to the management as well as to outside parties like share holders, the consumers and the Government. Limitations of Cost Accounting system Like any other system of accounting, Cost Accountancy is not an exact science but an art which has developed through theories and accounting practices based on reasoning and commonsense. Many of the theories cannot be proved nor can they be disproved. They grownup in course of time to become conventions and accepted principles of Cost Accounting. These principles are by no means static, they are changing from day to day and what is correct today may not hold true in the circumstances tomorrow. Large number of Conventions, Estimates and Flexible factors: No cost can be said to be exact as they incorporate a large number of conventions, estimations and flexible factors such as :- (i) Classific ation of costs into its elements. (ii) Materials issue pricing based on average or standard costs. (iii) Apportionment of overhead expenses and their allocation to cost units/centres. (iv) Arbitrary allocation of joint costs. (v) Division of overheads into fixed and variable. Cost Accounting lacks the uniform procedures and formats in preparing the cost information of a product/ service. Keeping in view this limitation, all Cost Accounting results can be taken as mere estimates. Installation of Cost System or Cost Accounting System From what has been stated in the preceding sections, it will be seen that there cannot be a readymade cost system suitable for a business. Such system has to be specially designed for an undertaking to meet its specific needs. Before installing a cost system proper care should be taken to study and taken into account all the aspects involved as otherwise the system will be a misfit and full advantages will not be realized from it. The following points should be looked into and the prerequisites satisfied before installing a cost system:- (i) The nature, method and stages of production, the number of varieties and the quantity of each product and such other technical aspects should be examined. It is to be seen how complex or how simple the production methods are and what is the degree of control exercised over them. (ii) The size, layout and organisation of the factory should be studied. 1.6 I COST ACCOUNTING AND FINANCIAL MANAGEMENT(iii) The methods of purchase, receipt, storage and issue of materials should be examined and modie fi d wherever considered necessary. (iv) The wage payment methods should be studied. (v) The requirements of the management and the policy adopted by them towards cost control should be kept in view. (vi) The cost of the system to be installed should be considered. It is needless to emphasize that the installation and operation of system should be economic. (vii) The system should be simple and easy to operate. (viii) The system can be effectively run if it is appropriate and properly suited to the organisation. (ix) Forms and records of original entry should be so designed and to involve minimum clerical work and expenditure. (x) The system should be so designed that cost control can be effectively exercised. (xi) The system should incorporate suitable procedure for reporting to the various levels of management. This should be based on the principles of exception. 1.2 COST ACCOUNTING CONCEPTS Cost: Cost is a measurement, in monetary terms, of the amount of resources used for the purpose of production of goods or rendering services. Cost in simple, words, means the total of all expenses. Cost is also defined as the amount of expenditure (actual or notional) incurred on or attributable to a given thing or to ascertain the cost of a given thing. Thus it is that which is given or in sacrificed to obtain something. The cost of an article consists of actual outgoings or ascertained charges incurred in its production and sale. Cost is a generic term and it is always advisable to qualify the word cost to show exactly what it meant, e.g., prime cost, factory cost, etc. Cost is also different from value as cost is measured in terms of money whereas value in terms of usefulness or utility of an article. Elements of Cost Elements of Cost Material Labour Expenses Direct Material Direct Labour Direct Expenses Indirect Material Indirect Labour Indirect Expenses Direct Material + Direct Labour + Direct Expenses = Prime Cost Indirect Material+ Indirect Labour + Indirect Expenses = Overheads COST ACCOUNTING AND FINANCIAL MANAGEMENT I 1.7General Purpose Cost Statement Direct Material Cost Direct material cost can be den fi ed as ‘The Cost of material which can be attributed to a cost object in an economically feasible way’. Direct materials are those materials which can be identified in the product and can be conveniently measured and directly charged to the product. Thus, these materials directly enter the product and form a part of the finished product. For example, timber in furniture making, cloth in dress making, bricks in building a house. The following are normally classified as direct materials :- (i) All raw materials, like jute in the manufacture of gunny bags, pig iron in foundry and fruits in canning industry. (ii) Materials specic fi ally purchased for a specic fi job, process or order, like glue for book binding, starch powder for dressing yarn. (iii) Parts or components purchased or produced, like batteries for transistor-radios. (iv) Primary packing materials like cartons, wrappings, card-board boxes, etc. Indirect Material Cost Materials, the costs of which cannot be directly attributed to a particular cost object. Indirect materials are those materials which do not normally form a part of the finished product. It has been defined as “materials which cannot be allocated but which can apportioned to or absorbed by cost centres or cost units”. These are: (i) Stores used in maintenance of machinery, buildings, etc., like lubricants, cotton waste, bricks and cements. (ii) Stores used by the service departments, i.e., non-productive departments like Power House, Boiler House and Canteen, etc., and (iii) Materials which due to their cost being small, are not considered worthwhile to be treated as direct materials. Direct Labour / Employee Cost The cost of employees which can be attributed to a cost object in an economically feasible way. In simple words, it is that labour which can be conveniently identified or attributed wholly to a particular job, product or process or expended in converting raw materials into finished goods. Wages of such labour are known as direct wages. Thus it includes payment made to the following groups of labour: (i) Labour engaged on the actual production of the product or in carrying out of an operation or process. (ii) Labour engaged in adding the manufacture by way of supervision, maintenance, tool setting, transportation of material etc. (iii) Inspectors, analysts etc., specially required for such production. Indirect Labour/ Employee Cost The labour / employee cost which cannot be directly attributed to a particular cost object. The wages of that labour which cannot be allocated but which can be apportioned to or absorbed by cost centres or cost units is known as Indirect Labour. In other words paid to labour which are employed other than on production constitute indirect labour costs. Example of such labour are: charge-hands and supervisors; maintenance workers; men employed in service departments, material handling and internal transport; apprentices, trainees and instructors; clerical staff and labour employed in time ofc fi e and security office. Direct or Chargeable Expenses Direct expenses are expenses relating to manufacture of a product or rendering a service which can be identified or linked with the cost object other than direct material cost and direct employee cost. Direct expenses include all expendi ture other than direct material or direct labour that is specifically 1.8 I COST ACCOUNTING AND FINANCIAL MANAGEMENTincurred for a particular product or process. Such expenses are charged directly to the particular cost account concerned as part of the prime cost. Examples of direct expenses are: (i) Excise duty; (ii) Royalty; (iii) Architect or Supervisor’s fees; (iv) Cost of rectifying defective work; (v) Travelling expenses to the city; (vi) Experimental expenses of pilot projects; (vii) Expenses of designing or drawings of patterns or models; (viii) Repairs and maintenance of plant obtained on hire; and (ix) Hire of special equipment obtained for a contract. Indirect Expenses Indirect expenses are expenses which cannot be allocated but which can be apportioned to or absorbed by cost centres or cost units such as rent, insurance, municipal taxes, general manager salary and canteen and welfare expenses, power and fuel, cost of training new employee lighting and heating, telephone expenses, etc., Overheads Overheads comprise of indirect materials, indirect employee cost and indirect expenses which are not directly identifiable or allocable to a cost object . Overheads may defined as the aggregate of the cost of indirect material, indirect labour and such other expenses including services as cannot conveniently be charged directly to specific cost units. Thus overheads are all expenses other than direct expenses. In general terms, overheads comprise all expenses incurred for or in connection with, the general organization of the whole or part of the undertaking, i.e., the cost of operating supplies and services used by the undertaking and includes the maintenance of capital assets. Prime Cost The aggregate of Direct Material, Direct Labour and Direct Expenses. Generally it constitutes 50% to 80% of the total cost of the product, as such, as it is primary to the cost of the product and called Prime Cost. Cost Object Cost object is the technical name for a product or a service, a project, a department or any activity to which a cost relates. Therefore the term cost should always be linked with a cost object to be more meaningful. Establishing a relevant cost object is very crucial for a sound costing system. The Cost object could be defined broadly or narrowly. At a broader level a cost object many be named as a Cost Centre, where as at a lowermost level it may be called as a Cost Unit. Cost Centre CIMA defines a cost centre as “a location, a person, or an item of equipment (or a group of them) in or connected with an undertaking, in relation to which costs ascertained and used for the purpose of cost control”. The determination of suitable cost centres as well as analysis of cost under cost centres is very helpful for periodical compari son and control of cost. In order to obtain the cost of product or service, expenses should be suitably segregated to cost centre. The manager of a cost centre is held responsible for control of cost of his cost centre. The selection of suitable cost centres or cost units for which costs are to be ascertained in an undertaking depends upon a number of factors such as organization of a factory, condition of incidence of cost, availability of information, requirements of costing and management policy regarding selecting a method from various choices. Cost centre may be production cost centres operating cost centres or process cost centres depending upon the situation and classifica tion. Cost centres are of two types-Personal and Impersonal Cost Centre. A personal cost centre consists of person or group of persons. An impersonal cost centre consists of a location or item of equipment or group of equipments. In a manufacturing concern, the cost centres generally follow the pattern or layout of the departments or sections of the factory and accordingly, there are two main types of cost centres as below :- COST ACCOUNTING AND FINANCIAL MANAGEMENT I 1.9General Purpose Cost Statement (i) Production Cost Centre: These centres are engaged in production work i.e engaged in converting the raw material into finished product, for example Machine shop, welding shops...etc (ii) Service Cost Centre: These centres are ancillary to and render service to production cost centres, for example Plant Maintenance, Administration...etc The number of cost centres and the size of each vary from one undertaking to another and are dependent upon the expenditure involved and the requirements of the management for the purpose of control. Responsibility Centre A responsibility centre in Cost Accounting denotes a segment of a business organization for the activities of which responsibility is assigned to a specific person. Thus a factory may be split into a number of centres and a supervisor is assigned with the responsibility of each centre. All costs relating to the centre are collected and the Manager responsible for such a cost centres judged by reference to the activity levels achieved in relation to costs. Even an individual machine may be treated as responsibility centre for cost control and cost reduction. Profit Centre Profit centre is a segment of a business that is responsible for all the activities involved in the production and sales of products, systems and services. Thus a profit centre encompasses both costs that it incurs and revenue that it generates. Profit centres are created to delegate responsibility to individuals and measure their performance. In the concept of responsibility accounting, profit centres are sometimes also responsible for the investment made for the centre. The profit is related to the invested capital. Such a profit centre may also be termed as investment centre. Cost Unit Cost Unit is a device for the purpose of breaking up or separating costs into smaller sub divisions attributable to products or services. Cost unit can be defined as a ‘Unit of product or service in relation to which costs are ascertained’. The cost unit is the narrowest possible level of cost object. It is the unit of quantity of product, service of time (or combination of these) in relation to which costs may be ascertained or expressed. We may, for instance, determine service cost per tonne of steel, per tonne-kilometre of a transport service or per machine hour. Sometimes, a single order or contract constitutes a cost unit which is known as a job. A batch which consists of a group of identical items and maintains its identity through one or more stages or production may also be taken as a cost unit. A few typical examples of cost units are given below: Industry / Product Cost Unit Automobile Number of vehicles Cable Metres / kilometres Cement Tonne Chemicals / Fertilizers Litre / Kilogram / tonne Gas Cubic Metre Power - Electricity Kilowatt Hour Transport Tonne-Kilometre, Passenger-Kilometre Hospital Patient Day Hotel Bed Night Education Student year Telecom Number of Calls BPO Service Accounts handled Professional Service Chargeable Hours 1.10 I COST ACCOUNTING AND FINANCIAL MANAGEMENTCost Allocation When items of cost are identia fi ble directly with some products or departments such costs are charged to such cost centres. This process is known as cost allocation. Wages paid to workers of service department can be allocated to the particular department. Indirect materials used by a particular department can also be allocated to the depart ment. Cost allocation calls for two basic factors - (i) Concerned department/product should have caused the cost to be incurred, and (ii) exact amount of cost should be computable. Cost Apportionment When items of cost can not directly charge to or accurately identifiable with any cost centres, they are prorated or distributed amongst the cost centres on some predetermined basis. This method is known as cost apportionment. Thus we see that items of indirect costs residual to the process of cost allocation are covered by cost apportionment. The predetermination of suitable basis of apportionment is very important and usually following principles are adopted - (i) Service or use (ii) Survey method (iii) Ability to bear. The basis ultimately adopted should ensure an equitable share of common ex penses for the cost centres and the basis once adopted should be reviewed at periodic intervals to improve upon the accuracy of apportionment. Cost Absorption Ultimately the indirect costs or overhead as they are commonly known, will have to be distributed over the final products so that the charge is complete. This process is known as cost absorption, meaning thereby that the costs absorbed by the production during the perio d. Usually any of the following methods are adopted for cost absorption - (i) Direct Material Cost Percentage (ii) Direct Labour Cost Percentage (iii) Prime Cost Percentage (iv) Direct Labour Hour Rate Method (v) Machine Hour Rate, etc. The basis should be selected after careful maximum accurancy of Cost Distribution to various production units. The basis should be reviewed periodically and corrective action whatever needed should be taken for improving upon the accuracy of the absorption. Conversion Cost This term is defined as the sum of direct wages, direct expenses and overhead costs of converting raw material to the finished products or converting a material from one stage of production to another stage. In other words, it means the total cost of producing an article less the cost of direct materials used. The cost of indirect materials and consumable stores are included in such cost. The compilation of conversion cost is useful in a number of cases. Where cost of direct materials is of fluctuating nature, conversion cost is used to cost control purpose or for any other decision making. In contracts/jobs where raw materials are on account of the buyers conversion cost takes the place of total cost in the books of the producer. Periodic comparison/review of the conversion cost may give sufficient insight as to the level of efficiency with which the production unit is operating. Cost Control Cost Control is defined as the regulation by executive action of the costs of operating an undertaking, particularly where such action is guided by Cost Accounting. Cost control involves the following steps and covers the various facets of the management: Planning: First step in cost control is establishing plans / targets. The plan/target may be in the form of budgets, standards, estimates and even past actual may be expressed in physical as well as monetary terms. These serves as yardsticks by which the planned objective can be assessed. Communication: The plan and the policy laid down by the management are made known to all those responsible for carrying them out. Communication is established in two directions; directives are issued by higher level of management to the lower level for compliance and the lower level executives report performances to the higher level. COST ACCOUNTING AND FINANCIAL MANAGEMENT I 1.11General Purpose Cost Statement Motivation: The plan is given effect to and performances starts. The performance is evaluated, costs are ascertained and information about results achieved are collected and reported. The fact that costs are being complied for measuring performances acts as a motivating force and makes individuals endeavour to better their performances. Appraisal and Reporting: The actual performance is compared with the predetermined plan and variances, i.e deviations from the plan are analyzed as to their causes. The variances are reported to the proper level of management. Decision Making: The variances are reviewed and decisions taken. Corrective actions and remedial measures or revision of the target, as required, are taken. Advantages of Cost Control The advantages of cost control are mainly as follows (i) Achieving the expected return on capital employed by maximising or optimizing profit (ii) Increase in productivity of the available resources (iii) Reasonable price of the customers (iv) Continued employment and job opportunity for the workers (v) Economic use of limited resources of production (vi) Increased credit worthiness (vii) Prosperity and economic stability of the industry Cost Reduction Profit is the resultant of two varying factors, viz., sales and cost. The wider the gap between these two factors, the larger is the profit. Thus, profit can be maximised either by increasing sales or by reducing costs. In a competition less market or in case of monopoly products, it may perhaps be possible to increase price to earn more profits and the need for reducing costs may not be felt. Such conditions cannot, however, exist paramount and when competition comes into play, it may not be possible to increase the sale price without having its adverse effect on the sale volume, which, in turn, reduces profit. Besides, increase in price of products has the ultimate effect of pushing up the raw material prices, wages of employees and other expenses- all of which tend to increase costs. In the long run, substitute products may come up in the market, resulting in loss of business. Avenues have, therefore, to be explored and method devised to cut down expenditure and thereby reduce the cost of products. In short, cost reduction would mean maximiza tion of profits by reducing cost through economics and savings in costs of manufacture, administration, selling and distribution. Cost reduction may be defined as the real and permanent reduction in the unit costs of goods manufactured or services rendered without impairing their suitability for the use intended. As will be seen from the defini tion, the reduction in costs should be real and permanent. Reductions due to windfalls, fortuities receipts, changes in government policy like reduction in taxes or duties, or due to temporary measures taken for tiding over the financial difficulties do not strictly come under the purview of cost reduction. At the same time a programme of cost reduction should in no way affect the quality of the products nor should it lower the standards of performance of the business. Broadly speaking reduction in cost per unit of production may be affected in two ways viz., (i) By reducing expenditure, the volume of output remaining constant, and (ii) By increasing productivity, i.e., by increasing volume of output and the level of expenditure remains unchanged. These aspects of cost reduction are closely linked and they act together - there may be a reduction in the expenditure and the same time, an increase in productivity. 1.12 I COST ACCOUNTING AND FINANCIAL MANAGEMENT

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