COST CLASSIFICATION FOR DECISION MAKING

Subject: Cost Accounting Submitted To: Ms. Shweta Kumari Date: 5th April 2011

GROUP MEMBERS
NAME ROLL NUMBER

Jyoti N. Ker Monica Sinha Pratibha Sharma Gomthi Thevar Ruchita Mishra Preeti Meshram Varsha Jawak Sanket Ashinkar Suparna Samanta Rachit Laad Neha Sinha

01021 01022 01023 01092 01025 01026 01027 01028 01100 01030 01034

TABLE OF CONTENT
TOPIC PAGE NUMBER

Introduction Objective Literature Review Cost Basic Rules For Classification Of Costs Basis Of Classification For Management Decision Making Research Design Company Contacted Tentative Cost Sheet Answers To The Questions Conclusion

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INTRODUCTION
Individuals, corporations, and governments make important decisions every day. To make the best decisions, they need to accurately weigh the relative benefits and costs of various alternatives. For example, the decision to purchase a home involves a comparison of the positive and negative aspects of each potential site in order to choose the one that meets a household's needs at an affordable price. Businesses go through a similar process when they decide on new production processes or a location for a factory. Sometimes, though, choices affect others in ways that create conflict. The smokestack emissions from a new factory, for instance, might soil laundry drying on the clotheslines of neighboring households. If the factory is required to replace the soiled clothes or purchase dryers for the affected households, then the business might choose to relocate elsewhere. Alternatively, if the households know that there will be a factory nearby with damaging emissions, they might pick a different place to live. The identification of the responsible party in such cases is typically considered a legal question, but the example shows how difficult it can be to make satisfying decisions in the absence of information on the full range of costs and benefits of the relevant choices.

OBJECTIVE

To study the various cost classifications. To analyze how it will help in decision making for any organization. The
main objective of this project is to study how management take decisions on the basis of the various costs incurred in the organisation.

LITERATURE REVIEW
COST 1 Cost: Cost is a measurement, in monetary terms, of the amount of resources used for the purpose of production of goods or rendering services. Manufacturing of goods or rendering services involves consumption of resources. Cost is measured by the sacrifice made in terms of resources or price paid to acquire goods and services. The type of cost is often referred in the costing system depends on the purpose for which cost is incurred. For example material cost is the price of materials acquired for manufacturing a product.

Cost Centre: Any unit of Cost Accounting selected with a view to accumulating all cost under that unit. The unit may be a product, a service, division, department, section, a group of plant and machinery, a group of employees or a combination of several units. This may also be a budget centre. Cost Centre or Cost Object is the logical sub-unit for collection of cost. Cost Centre may be of two types personal and impersonal cost centres. Personal cost centre consists of a person or a group of persons. Cost centres which are not personal cost centres are impersonal cost centres. Again Cost centres may be divided into broad types i.e. Production Cost Centres and Service Cost Centres. Production Cost Centres are those which are engaged in production like Machine shop, Welding shop, Assembly shop etc. Service Cost centers are for rendering service to production cost centre like Power house, Maintenance, Stores, Purchase office etc.

Cost unit is a form of measurement of volume of production or service. This unit is generally adopted on the basis of convenience and practice in the industry concerned.

Examples of Cost Units: Power Cement MW MT

Automobile - Number etc

BASIC RULES FOR CLASSIFICATION OF COSTS

1. Classification of cost is the arrangement of items of costs in logical groups having regard to their nature (subjective classification) or purpose (objective classification). 2. Items should be classified by one characteristic for a specific purpose without ambiguity. 3. Scheme of classification should be such that every item of cost can be classified.

BASIS OF CLASSIFICATION
1. Nature of expense 2. Relation to object traceability 3. Functions / activities 4. Behaviour fixed, semi-variable or variable 5. Management decision making 6. Production Process 7. Time period Classification of cost is the process of grouping the components of cost under a common designation on the basis of similarities of nature, attributes or relations. It is the process of identification of each item and the systematic placement of like items together according to their common features. Items grouped together under common heads may be further classified according to their fundamental

differences. The same costs may appear in several different classifications depending on the purpose of classification.

Cost is classified normally in terms of a managerial objective. Its presentation normally requires sub-classification. Such sub-classification may be according to nature of the cost elements, functional lines, areas of responsibility, or some other useful break-up. The appropriate sub-classification depends upon the uses to be made of the cost report.

CLASSIFICATION OF COSTS

By Nature of expense: Costs should be gathered together in their natural groupings such as material, labour and other expenses. Items of costs differ on the basis of their nature. The elements of cost can be classified in the following three categories: i) Material ii) Labour iii) Expenses

Material Cost is the cost of material of any nature used for the purpose of production of a product or a service.

Material cost includes cost of procurement, freight inwards, taxes & duties, insurance etc directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks, refunds on account of modvat, cenvat, sales tax and other similar items are deducted in determining the costs of material.
Labour Cost means the payment made to the employees, permanent or temporary, for their services. Labour cost includes salaries and wages paid to permanent employees, temporary employees and also to employees of the contractor. Here, salaries & wages include all fringe benefits like Provident Fund contribution, gratuity, ESI, overtime, incentives, bonus , ex-gratia, leave encashment, wages for holidays and idle time etc. Expenses are other than material cost or labour cost which are involved in an activity. Expenditure on account of utilities, payment for bought out services, job processing charges etc. can be termed as expenses.

By Relation to Cost Centre:

Classification should be on the basis of method of allocation of cost to a cost unit. If expenditure can be allocated to a cost centre or cost object in an economically feasible way then it is called direct otherwise the cost component will be termed as indirect. According to this criterion for classification, material cost is divided into direct material cost and indirect material cost, labour cost into direct labour cost and indirect labour cost and expenses into direct expenses and indirect expenses. Indirect cost is also known as overhead.

Direct cost has three components direct material cost, direct labour cost and direct expenses and indirect cost has three componentsindirect material, indirect labour cost and indirect expenses. Sum of all direct costs is called prime cost. Direct material Cost is the cost of material which can be directly allocated to a cost centre or a cost object in a economically feasible way. Raw materials consumed for production for a product or service which are identifiable in the product or service form the direct material cost. Direct Material cost includes cost of procurement, freight inwards, taxes & duties, insurance etc directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks, refunds on account of modvat, cenvat, salex tax and other similar items are deducted in determining the costs of direct material. Direct Labour Cost is the cost of wages of those workers who are readily identified or linked with a cost centre or cost object. Here, the wages of the workers include the fringe benefits include all fringe

benefits like Provident Fund contribution, gratuity, ESI, overtime, incentives, bonus , ex-gratia, leave encashment, wages for holidays and idle time etc. for the purpose of calculation of direct labour cost.

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Direct Expenses are the expenses other than direct material or direct labour which can be identified or linked with the cost centre or cost object. Examples of direct expenses are expenses for special moulds required in a particular cost centre hiring charges for tools and equipments for a cost centre royalties in connection to a product Job processing charges etc

Indirect Material is the cost of material which cannot be directly allocable to a particular cost centre or cost object. Materials which are of small value and cannot be identified in or allocated to a product/service are classified as indirect materials. Consumable spares and parts Lubricants etc. Examples:

Indirect labour cost is the wages of the employees which are not directly allocable to a particular cost centre. Examples of indirect labour: Salaries of staff in the administration and accounts department Salaries of security staff etc

Indirect expenses are the expenses other than of the nature of material or labour and cannot be directly allocable to a particular cost centres. Indirect expenses are not being allocable to a particular cost centre. Examples insurance, taxes and duties,

By functions/activities:
Costs should be classified according to the major functions for which the elements are used into the following four major functions: 1. Production 2. Administration

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3. Selling 4. Distribution and 5. Research & Development Expenditure.

Production Cost is the cost of all items involved in the production of a product or service. It includes all direct costs and all indirect costs related to the production. Production overhead is the indirect costs involved in the production process. Production overhead is also termed as factory overhead or manufacturing overhead. Examples of Production overhead: 1. Salaries for staff for production planning, technical supervision, factory administration etc 2. normal idle time cost 3. expenses for stores management 4. security expenses in the factory 5. labour welfare expenses 6. dispensary and canteen expenses 7. depreciation of plant and machineries 8. repair and maintenance of factory building and plant & machineries 9. insurance 10. quality control etc.

Administration costs are expenses incurred for general management of an organization. These are in the nature of indirect costs and are also termed as administrative overhead. Examples of items to be included in Administrative overhead:

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1. Salaries of administrative and accounts staff 2. general office expenses like rent, lighting, rates and taxes, telephone, stationery, postage etc 3. bank charges 4. audit fees 5. legal expenses

6. Depreciation & repair and maintenance of office building etc.

Selling costs are indirect costs related to selling of products or services and include all indirect cost in sales management for the organization. Selling Costs include all costs relating to regular sales and sales promotion activities. Examples of expenses which are included in selling cost are : 1. Salaries, commission and travelling expenses for sales personnel 2. advertisement cost 3. Legal expenses for debt realization 4. market research cost 5. royalty on sale after sales service cost etc. Distribution Costs are the cost incurred in handling a product from the time it is completed in the works until it reaches the ultimate consumer. Distribution costs are the costs incurred for distribution of product to customers. Examples of distribution costs: Note 1. Primary packaging cost is included in production cost whereas secondary packaging cost is distribution cost. 2. In exceptional cases, for example in case of heavy industries equipment supply, installation cost at delivery site for heavy equipments which involves assembling of parts, testing etc is included in production cost but not distribution cost. For example. Installation cost of a gas turbine at plant site is included in the cost of production of gas turbine. Transportation cost cost of warehousing saleable products Cost of delivering the products to customers. etc

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Research & Development Costs are the cost for undertaking research to improve quality of a present product or improve process of manufacture, develop a new product, market research etc and commercialization thereof. Research Cost comprises the cost of development of new product and manufacturing process; improvement of existing products, process and equipment; finding new uses for known products; solving technical problem arising in manufacture and application of products etc. Development cost includes the cost incurred for commercialization / implementation of research findings.

By Behavior:
Costs are classified based on behaviour as fixed cost, variable cost and semi-variable cost depending upon response to the changes in the activity levels.

Fixed Cost is the cost which does not vary with the change in the volume of activity costs. Examples for fixed cost: salaries, rent, audit fees, depreciation etc. in the short run. These costs are not affected by temporary fluctuation in activity of an enterprise. These are also known as period

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Variable Cost is the cost of elements which tends to directly vary with the volume of activity. Variable cost has two parts (a) Variable direct cost; and (b) Variable indirect costs. Variable indirect costs are termed as variable overhead. Examples of variable cost are materials consumed, direct labour, sales commission, utilities, freight, packing, etc. Semi Variable Costs contain both fixed and variable elements. They are partly affected by fluctuation in the level of activity. Examples of semi-variable cost: Factory supervision, maintenance, power etc. Note :

1. The characteristics of fixed costs are:

(1) Fixed amount within an output range (2) Fixed cost per unit decreases with increased output

2. The characteristics of variable Cost are:

(1) The variable cost varies directly with volume of activities or production (2) variable cost remains constant per unit within a range of activity.

FOR MANAGEMENT DECISION MAKING

Costs are classified for the purpose of management decision making under different circumstances as under:

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Marginal cost is the aggregate of variable costs, i.e. prime cost plus variable overhead. Marginal cost per unit is the change in the amount at any given volume of output by which the aggregate cost changes if the volume of output is increased or decreased by one unit. Marginal cost is used in Marginal Costing system. For determining marginal cost, semi-variable costs, if any, are segregated into fixed and variable cost. Then, variable costs plus the variable part of semi-variable costs is the total marginal cost for the volume of production in consideration. Example :
A. B. 1. 2. 3. 4. 5. Production Cost Material Cost Labour cost Fixed Cost Variable Production & Fixed Cost (Rs lakhs) 45,000 units Variable Cost (Rs lakhs) 4.50 2.45 2.30

4.80

Selling overheads Semi variable Cost 3.20 2.00 ( after segregation fixed and variable part) C. Total Marginal Cost 11.25 D. Marginal Cost Per Unit Rs. 25.00

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Differential Cost is the change in cost due to change in activity from one level to another. Differential Cost is found by using the principle which highlights the points of differences in costs by adoption of different alternatives. This technique is used in export pricing, new products and pricing goods sought to be promoted in new markets, either within the country or outside. The algebraic difference between the relevant costs at two levels of activities is the differential cost. When the level of activity is increased, the differential cost is known as incremental cost and when the level of activity is decreased, the decrease in cost is known as decremental cost.

Output Unit in Lakhs (a) 1.00 (b)1.20 0.80

Differential Unit in lakhs 0.20 0.20 ( b) (a) ( a) (c)

Total Cost (Rs lakhs) 30.00 35.00 26.00

Differential cost ( Rs lakhs) 5.00 - 4.00

Differential cost per unit ( Rs) 25.00 - 20.00

( +) ( -)

Incremental cost Decremental cost

Opportunity Cost is the value of the alternatives foregone by adopting a particular strategy or employing resources in specific manner. It is the return expected from an investment other than the present one. The opportunity cost is considered for selection of a project or justification of investment, studying viability of an investment option. Example : A machine is currently being used to produce product P. the machine is Rs 60000. It can also be used to produce product Q which can fetch Rs 60,000 profit. Then the opportunity cost of using

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Replacement Cost is the cost of an asset in the current market for the purpose of replacement. Replacement cost is generally used for determining the optimum time of replacement of an equipment or machine in consideration of maintenance cost of the existing one and its productive capacity. Relevant Costs are costs relevant for a specific purpose or situation. In the context of decision making relating to a specific issue, only those costs which are relevant are considered. A particular cost item may be relevant in a decision making and may be irrelevant in some other decision making situation. For example, present depreciated cost of machine is relevant in case of decision of its sale but it is irrelevant in case of decision of its replacement.

Imputed Costs are hypothetical or notional costs, not involving cash outlay, computed only for the purpose of decision making. In economics, imputed indicates an ascribed or estimated value when there is no criteria of absolute monetary value for such purpose. the wages or salaries of owner are imputed. opportunity costs. paid is an example of imputed cost. Sunk Costs are historical costs which are incurred i.e. sunk in the past and are not relevant to the particular decision making problem being considered. Sunk costs are those that have been incurred for a project and which will not be recovered if the project is terminated. While considering the replacement of a plant, the depreciated book value of the old asset is irrelevant as the amount is a sunk cost which is to be written off at the time of replacement. In national income estimation wages of housewives are imputed. Similarly, in farming operations, Imputed costs are similar to Interest on internally generated fund, which is not actually

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Normal Cost is a cost that is normally incurred at a given level of output in the conditions in which that level of output is achieved. Normal cost includes those items of cost which occur in the normal situation of production process or in the normal environment of the business. The normal idle time is to be included in the ascertainment of normal cost.

Abnormal Cost is an unusual or a typical cost whose occurrence is usually irregular and unexpected and due to some abnormal situation of the production. Abnormal cost arises due to idle time for some heavy break down or abnormal process loss. They are not considered in the cost of production for decision making and charged to profit & loss account.

Avoidable Costs are those costs which under given conditions of performance efficiency should not have been incurred. Avoidable costs are logically associated with some activity or situation and are ascertained by the difference of actual cost with the happening of the situation and the normal cost. When spoilage occurs in manufacture in excess of normal limit, the resulting cost of spoilage is avoidable cost. Cost variances which are controllable may be termed as avoidable cost. Unavoidable Costs are inescapable costs which are essentially to be incurred, within the limits or norms provided for. It is the cost that must be incurred under a programme of business restriction. nature and inescapable. It is fixed in

RESEARCH DESIGN
Research methodology This report is based on primary as well secondary data, however primary data collection was given more importance since it is overhearing factor in attitude studies. One of the most important uses of research methodology is that it helps in identifying the problem, collecting, analyzing the required information

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data and providing an alternative solution to the problem .It also helps in collecting the vital information that is required by the top management to assist them for the better decision making both day to day decision and critical ones. Data collection method: PRIMARY DATA: - The primary data was collected by, interviewing the Vice president of Mission Pharmaceutical Ltd. SECONDARY DATA: - The secondary data was collected by books and internet.

Interview Questions Q. 1. How cost help in decision making? Q. 2. Is the format of cost sheet same for all the industry? Q. 3. How often you maintain cost sheet? Q. 4. How does it help in deciding the production units in the plant? Q. 5. What are the direct cost and the indirect cost incurred by your company? Q. 6. What do you mean by the exceipient cost?

COMPANY CONTACTED
Mission Pharmaceutical Ltd. began its journey in 1992 with a staff of 5 people. Today it is growing organisation with a multi locational business operation having approx 500 employees on its roll, direct marketing operations in 3 countries, product registrations in 11 countries and exports to 14 countries with 2 international tie-ups. Approvals from various regulatory bodies and

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recognition from Government of India for exports of formulation are some of the things they have achieved. They are still a closely held company with focus on international markets. In volume terms they currently process approx. 16 million units a day. Under development are a number of new molecule formulations, registration process in 9 more countries, setting up of a new manufacturing area and new corporate head quarters in Mumbai. They have been provided the tentative cost sheet of an Antibacterial cream, Gentamicin Cream 15 gm. In the cost sheet the details about raw material and packaging related information is provided. CONTACT PERSON: Mr. Ramchandra Mishra DESIGNATION: Vice President Technical

TENTATIVE COST SHEET

Date : 01/04/2009 Location : M/s Brassica- Boisar Product Name : Gentamicin Cream 15 gm Std. Batch Size : 200 Kgs. Filled Volume : 15.1 gm

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98% Yield : 12980 x 15 gm. Sr . N o.

Name of the Material Raw Materials Gentamicin Sulphate USP Chlorocresol BP/IP Cetomacrogol 1000 BP/IP Cetostearyl Alcohol BP/IP White Soft Paraffin BP/IP Light Liquid Paraffin BP/IP Sodium Di Hydrogan Phosphate BP/IP Sodium Hydroxyde Pallets BP/IP Packing Materials

Uni t

Qty

Bas ic 0.3 5 200 0 105 80 75 45

Ex. Duty

Sal es Tax

Total

Net Rate

Batch Cost 0.1 8

1 2 3 4 5 6

Kgs Kgs Kgs Kgs Kgs Kgs

0.35 0.2 6.2 14.4 30 14

0.35 206 10.81 5 8.24 7.725 4.635

0.35 66.1 8 3.47 2.65 2.48 1.49

0.35 2272. 18 119.2 9 90.89 85.21 51.12 227.2 2 227.2 2

0.35 2066. 18 108.4 7 82.65 77.48 46.49 206.6 2 206.6 2

0.35 413.24 672.54 1190.1 2 2324.4 5 650.85

0.4 2

7 8

Kgs Kgs

0.68 0.4 Total 136 30 136 30 136 30 500 35 136 30 3 200 Total 0.18 0.42 3.39

200 200

20.6 20.6

6.62 6.62

140.5 82.65 7824. 62 23233. 68 12391. 29 1689.7 2 1084.7 4 1988.7 3520.2 5 86.78 55.79 44050 .96 3.3 9

0.6

1 2 3 4 5 6 7 8

A1- Tubes Inner Cartons Leaflets Shrinks 190 mm Shipper 400 Isomet Gama Rediation BOPP Tape Strapping Roles

Nos Nos Nos Nos Nos Nos Roll s Mtr .

1.6 5 0.8 8 0.1 2 2.1 55 0.2 5 28 0.2 7

0.169 95 0.090 64 0.012 36 0.216 3 5.665 0.025 75 2.884 0.027 81

0.05 0.03 0 0.07 1.82 0.01 0.93 0.01

1.87 1 0.14 2.39 62.48 0.28 31.81 0.31

1.7 0.91 0.12 2.17 56.82 0.26 28.93 0.28

3.3 9

Raw Material Cost Exceipients Cost Packing Material Cost

Rs. Rs. Rs.

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CC+PC Total

Rs. Rs.

0.75 4.75

ANSWERS TO THE QUESTIONS Q. 1. How cost help in decision making? Ans. It depends on the product, profit and sales. As the volume increases per unit price falls and margin increases. This is how it helps in decision making. Q. 2. Is the format of cost sheet same for all the industry? Ans. Yes, it is almost same. Q. 3. How often you maintain cost sheet? Ans. It depends upon the product and varies accordingly. Generally it is maintained for 3 to 6 months. Q. 4. How does it help in deciding the production units in the plant? Ans. The minimum and the maximum sales and it also depend upon the cost of raw material. As the cost of raw material increases price per unit increases, Margin decreases. Q. 5. What are the direct cost and the indirect cost incurred by your company? Ans. In case of direct cost we have raw material and labour who are actually indulged in the production process and in case of indirect cost we have factory overheads. Q. 6. What do you mean by the exceipient cost? Ans. It is the main crux of the cost sheet with which the cost sheet is incomplete.

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CONCLUSION Thus we can conclude by saying that the importance of understanding different kinds of cost in cost accounting cannot be understated. Cost accounting, as stated several times before, consists of various decisionmaking tools. Each tool requires different kinds of cost information. Without a good understanding of different kinds of cost and cost behavior, it is highly unlikely any specific tool could be used in a meaningful way to improve the quality of decisions. For making proper decisions related to cost aspect it is necessary that all the elements related to a specific cost be studied well by a particular company in order to minimise their unit per cost with maximum production. Even mission Pharmaceutical ltds profits and sales depend on the cost which they select for the production process. Hence we can say that cost is an important aid for an cost accountant in an organisation which helps him to make various important decisions related to production of a particular product since a wrong cost selected for decision making have an high chance of decreasing the profits and sales of a company whereas costs properly classified for decision making ultimately leads to increase in sales and profit of the company. Finally both the financial and cost accountant must have a sound understanding of the varied and complex ramifications of cost. From a cost accountant viewpoint, a faulty understanding of cost may cause cost sheet to be incorrectly prepared and an inadequate understanding or use of costs will result in poor decisions.

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