Nature of cost and cost Accounting

Cost accounting refers to systematic set of procedures for identifying, classifying, allocating, aggregating and reporting costs and cost information relating to the production of goods or provision of services and comparing them with the budgeted or standard costs. Cost accounting also involves analysis of variances between the actual and standard costs of a cost unit as well as the assessment of profitability of a cost unit.

Cost object

Any activity for which a separate measurement of costs is desired is known as a cost object. It is anything for which cost is to be calculated or which makes a person/firm to incur cost. Examples of cost object include product or service line, a geographical territory, a process, a department or a distribution channel.

Cost unit

A cost unit is a unit of quantity of product, service, or time (or a combination of these) in relation to which costs may be ascertained or expressed. In other words, a cost unit is a standard or unit of measurement of the goods manufactured or services rendered. A cost unit may be expressed in terms of number, length, area, weight, volume, time, or value. For example, per piece, per kilogram, per ton, per gallon, per route, per batch, or per bag of cement.

Responsibility centres

Usually, managers in an organisation are given responsibility for a particular aspect of operations or activity. These are called responsibility centres. A responsibility centre is an organisation unit headed by a manager or any other appointed person like supervisor or foreman, who is responsible for its activities and results. It is a unit with its clear goals, and objectives, staff, policies and procedures. It is therefore a subset of a business. Typical responsibility centres include cost centres, revenue centres, profit and investment centres.

Cost centres

A cost centre is a department or unit in which costs information is collected and costs established to determine the cost of output produced or service rendered. Classification of cost centres is considered to be important in an organization as they enable the management to easily prepare budgets and conduct various analyses. Examples of cost centres include a department, a machine or group of machines, overhead costs such as rent, electricity (which later shall be allocated to each department).

Revenue centres

A department or division within the organization in which revenues are established is called a revenue centre. Managers under this department need information relating to revenues only and there is no measurement of cost or profit. For example, the revenue accountant in a school is only responsible for recording and controlling the different incomes that are received from tuition fees or other revenue sources.

Profit centres

Unlike cost and revenue centres, a profit centre is a department or division within the organisation which is accountable for both cost and revenues. Manager under profit centre wants information regarding both revenues and costs. Managers in profit centres are evaluated on the profit margin achieved by the department.

Investment centres

An investment centre is a department in which the manager is responsible not only for the costs of the division and the revenues that it earns, but also, for decisions relating to the capital investment, and possibly for financing. The performance of an investment manager is usually measured by the returns/ profitability of investments made

Cost accounting is a mechanism of accounting by which costs of services or products are ascertained and controlled for different purposes. Its major goal is to determine the methods by which expenditure on materials, labour and overhead are ascertained, recorded, classified and allocated. This is necessary so that the cost of products and/or services may be accurately established. Specifically the objectives of cost accounting are explained as follows:

1. Ascertainment of cost: The basic objective of cost accounting is to ascertain the cost of a product, process, operation, job, contract, service or unit of production. This facilitates the management to establish the unit cost or the standard cost for the product or each component of the product.
2. Determination of selling prices: Cost accounting helps an organization to set selling prices for its products or services. It involves gathering of cost data which enables the management to analyse the total cost of a product/service and be able to decide the selling price. Thus, the process ensures the selling prices are not set below the full cost per unit.
3. Ascertain performance of a business: Cost accounting enables the management to ascertain the performance or profitability of the business. This can be done in terms of product or department. It makes unit cost information available to the management for them to determine the amount of profit earned by every product, thereby allocating the scarce resources to most profitable products.
4. Determining and controlling efficiency: Cost accounting facilitates the comparison between standard costs and actual costs. Usually actual costs are expected to be lower or at least equal to the standard costs. An analysis conducted to compare the standard costs and actual costs is called variance analysis. The variance is said to be favourable when actual costs are lower than the standard costs, and unfavourable/ adverse variance, when standard costs are lower than the actual costs. Variance analysis enables the management to identify sources of efficiency from the favourable variances or inefficiency from adverse variances. Once the management detects areas of weaknesses, appropriate measures can be taken promptly to eliminate the inefficiencies.
5. Planning and budgetary control: Cost accounting assists the management in planning process including the preparation of the organisation's budget for its activities. It facilitates the availability of historical cost data which can be used as a basis for future projections. Future costs and projected profit can also be easily estimated. The projections may provide insightful information regarding the need to acquire additional facilities and/ or raise additional finance for operational improvement.
6. Decision making: Cost accounting helps the management in making short and long term decisions. It enables the presentation of relevant data in a systematic manner and hence speeds up the decision making by the management. This, includes; make-or-buy decision, sell-or-process-further decision, and adding or dropping a product line.

In cost accounting, cost may be categorized in different ways to cater for the purpose of the reports to be produced at a given moment. Costs may be categorised into classes which are useful for planning, budgeting, and cost control, while other costs may be categorised into classes useful for making short-term and long-term decisions.

Generally costs are classified according to:

1. function,
2. nature,
3. timing of charges
4. behavior,
5. relevance; and
6. responsibility

Classification by function

1. Manufacturing costs: Are the costs incurred in manufacturing products for sale. They include, cost of the raw materials, factory cost and factory supervisors' salaries. Others are rental costs for the factory building and the cost of depreciation of factory machinery.
2. Administration costs: Are the costs of providing administration services for the company. Examples are executives' salaries, legal expenses, office rental costs, the costs of heating/cooling and lighting for the administration offices, the depreciation costs of equipment used by the administration departments and costs of office stationery.
3. Selling and distribution costs: Are the costs incurred in creating demand for products or services and securing firm contracts and orders from customers and those relating to delivering goods to customers. Examples include: selling and distribution departments' wages and salary; sales commissions for sales representatives; advertising costs, fuel costs and vehicle repair costs for the delivery vehicles; and depreciation for the delivery vehicles. Costs that do not fall into these classifications might be categorized as general overheads or even classified on their own for example research and development costs and financing costs. Research costs are the costs incurred by the management in searching for new or improved products, whereas development costs are those relating to production of a new or improved product and the commencement of full manufacture of the product. Financing costs are costs incurred to finance the business, such as loan interest, and bank overdraft charges. Finance costs might be included in general administration costs.

Classification by nature

Direct costs: Are costs that can be traced in full to the product or service. Direct cost is directly attributable to a specific cost object. Direct cost are further categorised into direct materials, direct labour and direct expenses as follows:

1. Direct material costs: consist of raw materials and components produced or purchased from an external supplier used directly in the manufacture of a product or the provision of a service. For example, timber in manufacturing furniture, leather in manufacturing shoes.
2. Direct labour costs: human efforts used in production which can be specifically and exclusively identified in making a product or provide a service. Example of direct labour costs are the wages for machine tool operators in a machine shop. These costs can be established by measuring the time taken for a job, or the time taken in direct production work.
3. Direct expenses: expenses which are incurred on a specific product other than direct material cost and direct labour cost. Direct expenses include cost of hiring tools or equipment for production and maintenance costs of tools, fixtures used in production. The total of direct materials, direct labour and direct expenses is referred to as prime costs.

Indirect costs

Are also known as overheads. These cannot be identified specifically and exclusively with the making of a product or rendering of a service. Overheads can be further categorised into production and nonproduction overheads. Production overheads include all the costs of manufacturing apart from direct costs. They consist of indirect labour, indirect materials and other indirect expenses. Non-production overheads include administration and selling as well as distribution overheads.

Conversion cost

Is the sum of direct labour and manufacturing overhead costs. It represents the cost of converting raw materials into finished products.

Classification by timing of charges against sales value

Product costs

Are the costs incurred in relation to production of product and charged against the revenue when the product is sold i.e. cost of goods sold. Product costs are usually included in the value of inventory. These costs are also known as inventoriable costs.

Period costs

Are all other costs which are expensed as they are incurred, hence are charged against sales revenue in the period in which the revenue is earned. Unlike product cost, period costs are not included in the value of inventory. Non-manufacturing costs like selling, general and administrative expenses are period costs.

Classification by behavior

Costs may be classified into fixed and variable costs based on their behavior towards changes in the activity levels of product. The volume of activity may be the units of sales, the units of production, total labour hours worked, and machine hours worked. This distinction is important as it helps managers to make crucial decisions such as manufacturing a component inhouse or buying it from outside vendors. It also helps to decide whether to continue the business or shut down.

Fixed costs

Are costs which remain constant at each level of production. Total fixed costs do not change with the changes in activity level or output. These include costs such as rent of office building, depreciation of building and machinery, corporate taxes, salaries for the management, interest on loans and legal or audit fees. Fixed costs can be categorized into total fixed costs and unit fixed costs (fixed cost per unit).

Total fixed costs

The total fixed cost usually remain constant over a certain period of time, regardless of the volume of production or sale. For example, if the firm pays rent at TZS 300,000 per month for the factory building, such rent will be paid as agreed, regardless of whether a firm produces any goods or services. Figure below provides the graphical presentation of fixed cost behaviour.

Figure: Graphical presentation of total fixed cost

As presented in figure, a company's total fixed costs don't vary with the volume of production. Fixed costs are also unavoidable. As long as the firm continues to exist, it must incur fixed costs. Most of fixed costs are indirect, that they generally cannot be traced directly to the units produced.

For example, suppose Kilimani Company has a fixed cost of TZS 10,000,000 per month to rent the machine it uses to produce bricks. If the company does not produce any bricks for the month, it still needs to pay the TZS 10,000,000 for rent of the machine. But even if it produces one million bricks per month, its fixed cost will still remain the same.

The more fixed costs a company has, the more revenue a company needs in order to break even, which means it needs to work harder to produce and sell its products. To break-even means to be in a situation where total revenue equals to total costs.

Fixed cost per unit

While total fixed costs remain the same at all levels of production, the fixed costs per unit change on the basis of the number of units produced. So, when production level increases, the fixed costs per unit drop. In this way, a company may achieve economies of scale by increasing production, hence lowering costs. For example, assume again that Kilimani Company has to pay TZS 10,000,000 per month to rent the machine it uses to produce bricks. The normal production rate per month is 40,000 bricks. As such, the fixed cost of the machine rent is TZS 250 per brick produced. If the firm increases production to 50,000 bricks per month, the fixed cost per unit will fall to TZS 200. A graphical presentation of fixed cost per unit behaviour is presented in figure

Figure: Graphical presentation of fixed cost per unit

Variable costs

Are costs whose total change in a direct proportion with changes in activity level. The change is the same amount for each additional unit of product that is manufactured or each additional unit of service that is rendered. Variable costs are directly associated with the number of goods or services produced. This means, a company's total variable costs increase and decrease with its production volume.

Examples of variable costs include, cost of raw materials, and direct labour cost. Others are utility bills, commissions on sale and costs of packaging materials. Variable costs are also categorized into total variable costs and variable costs per unit.

Variable costs per unit

The variable cost per unit remains the same over a period of time. When production volume goes up or goes down, the variable cost per unit will remain the same. Suppose that Kilimani Company incurs the following costs to produce each brick:

Sands cost – 150 Cement cost – 450 Water cost – 100 Labour charge – 120

The variable cost per unit of brick will therefore be TZS 820. Variable cost per unit remains constant at all levels of activity. The graphical presentation of variable cost per unit behaviour is presented in figure

Figure: Graphical presentation of variable cost per unit

Total variable costs

The total variable costs changes in a direct proportion with the level of production. If production increases by 15% for example, the total variable costs will also increase by 15%. Similarly, if production level doubles, the total variable costs also double. For example, if the company produces 5,000 bricks, at a cost of TZS 820 per unit, its total variable cost will be TZS 4,100,000. But, if the company doesn't produce any bricks, it won't have any variable costs, hence its total variable cost will equal zero. Similarly, if the company produces 10,000 bricks, the cost will rise to TZS 8,200,000. Figure presents the linear behaviour of total variable costs

Figure: Graphical presentation of total variable costs

Semi-variable costs

Apart from fixed costs and variable costs, there also exist some costs which have elements of both fixed and variable costs. These are called semi variable costs. It is a cost that remains fixed up to a certain level of production and changes with the change in the volume of production beyond this level. The fixed part is the base level cost that is always incurred, while as the variable portion of the cost is an additional cost which changes as the volume of production changes.

An example of semi-variable cost is the popular charges made by mobile network providers on minutes and internet packages. For example, a mobile networks may provide 5 GB of internet at TZS 10,000 per month. This TZS 10,000 is a fixed cost per month which will not change unless user consumes more data than 5 GB. In case the data usage exceeds 5 GB in a month, and has a balance of money in the phone, then each extra MB consumed will be charged separately. The charges on extra MBs will represent the variable costs. This charge will be proportional to the amount of extra data that were used. Electricity usage charges may also be provided under certain tariff zones, beyond which extra charges apply. For example a user under a certain tariff zone might be given a certain number of units per month, for a certain charge. If this customer exceeds the given units in a month, extra charges per extra unit consumed will be applied.

The semi-variable costs can thus be separated into two parts. The fixed cost portion and the variable portion:

Semi-variable cost = Fixed cost + variable cost

Variable cost per unit = change in cost/change in output

Note: The semi-variable cost is also called the mixed cost or semi-fixed cost.

Classification by their relevance

1. Standard cost: The standard cost is a predetermined unit cost of production or operating. It is a target cost that is desired. The standard cost forms a basis for variance analysis as it is compared with the actual cost to measure the performance of an organization or its division.
2. Incremental cost (or differential cost): The incremental cost is the difference in costs between two or more alternatives. For example to manufacture product X we need material A which costs TZS 500,000, alternatively, material B which costs TZS 650,000 may be used. The incremental cost in this case is the difference i.e TZS 150,000.
3. Sunk cost: A sunk cost is a past cost which is not relevant in decision making. For example amount spent to acquire machinery. They have already been incurred and total cost will not be affected by any decision made now or in the future.
4. Relevant costs: These are expected future costs that will be incurred in pursuing two or more alternative courses of action. The incremental costs are considered to be relevant for decision making. Relevant costs are also known as differential or avoidable costs
5. Opportunity cost: An opportunity cost is the net revenue (or benefit) forgone by rejecting an alternative. For example, a transportation company which has a choice of using its buses or renting it out for TZS 1,000,000, will incur an opportunity cost of TZS 1,000,000 if it will decide to use the bus