COST AND COST CONTROL

DEFINITION OF COST AND TOTAL COST

v  Cost:-  It is the amount of expenditure incurred an any product.

v  Cost is the expenditure made in the manufacture and sale of a product.

v  The producer has to buy materials, labour, equipments, parts and services to manufacture the product, to run the administration and to sell the product to the final consumer. All these mean costs to the producer.

v  These costs are incurred from to their manufacture into the finished products, up to the final stage of its sales to the consumer. There are two concepts of cost covering:- 

(1) manufacturing cost which includes the administrative cost                 

(2) marketing cost which is also called the selling cost or distribution cost.

v  When the total cost is divided by the number of units of the product, the resultant figure gives the cost of the product per unit (per unit cost)

v   Per unit cost  =            Total cost

Total number of units of product

                                                                Total cost

ELEMENTS AND COMPONENTS OF COST

ð  No item of expenditure should be left, while calculating the total cost of any product, therefore, this total cost is divided into different headings known as “Elements of cost”.

ð  For easy and accurate calculations, the total cost of product manufactured can be divided into three main “Elements”. These are:

Components of cost:-

ð  The various components of cost are:-

(1)   Prime cost:- It consists of direct material cost, direct labour cost and direct expenses. It is also named as “Direct cost”.

i.e. Prime cost = Direct material cost + Direct labour cost + Direct expenses

(2)   Factory cost:- It consists of prime cost and factory expenses. It is also named as “Works cost”

i.e. Factory cost = Prime cost + Factory expenses

(3)   Office cost:- It consists of factory cost and administrative expenses. It is also named as “manufacturing cost” or “cost of production”

i.e. Office cost = Factory cost + Administrative expenses

(4)   Total cost:- It includes office cost and selling and distribution expenses.

i.e. Total cost = Office cost + Selling expenses + Distribution expenses

FUNCTIONAL CLASSIFICATION OF COST WITH SPECIAL REFERENCE TO TEXTILE INDUSTRY

ð  Moreover, depending on the relationship of cost with volume or activity, cost can be classified as under:-

(1)   Variable costs:-  These costs vary directly with the changes in volume or activity. e.g. raw materials, direct materials etc.

(2)   Semi-variable costs:- Costs which vary with volume or activity but not in direct proportion, are termed as semi-variable costs. e.g. cost of supervision, wages of service department etc.

(3)   Fixed costs:- These are the costs which do not vary with changes in volume or activity but are incurred largely as a function of time. e.g. salaries of administration, rent, building insurance etc.

DEFINITION AND THEORY OF COSTING WITH CALCULATION OF COSTS

ð  Costing:- costing has been defined by the Institute of Cost and Works Accountants, England as: “The technique and process of ascertaining costs.” Whereas, Wheldon has defines the Costing as:-

ð  “Costing is the classifying, recording, and appropriate allocation of expenditure for the determination of the costs of products or services; and for presentation of suitably arranged data for the purpose of control, and guidance of management.”

ð  Aims of Costing:- the important aims of costing are:-

(1)   To determine the exact cost of each article.

(2)   To determine the cost incurred during each operation to keep control over workers’ wages.

(3)   To provide information, to certain the selling price of the product.

(4)   To supply information for detection of wastage.

(5)   It helps in reducing the total cost of manufacture.

(6)   It suggests changes in design when the cost is higher.

Calculation of costs:-

ð  Calculation of Material cost:- for the calculation of material cost following procedure should be adopted:

(a)    Calculate the volume of each component by applying the mensuration. For the calculation of volume, necessary machining allowance must be added on the sides which are required to be machined.

(b)   Add the volume of all components to get the total volume of the product.

(c)    Multiply this volume by the density to get the weight of the material.

(d)   Multiply the cost per unit weight to the total weight of the material to get cost of the material.

ð  Calculation of Labour cost:- for the purpose of calculation of labour cost, estimator must have knowledge of all the operations carried out for the production of the product and tools and machines used for production.

ð  Estimator should also take the advice of production department about the correct estimated time for each operation. He should also consider various allowances like:

(a)    Set up time

(b)   Operation time

(1)   Handling time

(2)   Machine time

(c)    The tear down time

(d)   Miscellaneous allowances

(1)   Personal allowances

(2)   Fatigue allowances

(3)   Tool changing and grinding allowances

(4)   Measurement checking allowances

(5)   Other allowances for cleaning, oiling, getting stocks etc.

ð  Total costing is calculated including components of costs also.  

PROFIT AND PROFITABILITY

ð  The profit of a firm equals the total sale proceeds minus the cost of production.

ð  It is residual part of the total sale proceeds left over after paying off all the items of expenditure in the cost of production including rent on land, wages of labour, interest on borrowed capital and salaries of management and organisation etc.

ð  But, out of this profit, later on certain adjustment is to be made.

ð  We are to subtract not only actual cost but also certain imputed cost in order to obtain “gross profit” Owner’s capital and owner’s labour is to be paid although they have not been actually paid.

ð  These costs should be added to the actual costs. in addition, certain tax obligations might have arisen during the course of the year but it is not essential for us to pay them up during that year.

ð  These can be paid next year also, but to arrive at a correct figure of gross profits we should add those tax payments on the cost side.

ð  The value of the existing stock is also obtained and this should also be deducted to obtain the true value of Gross Profits.

ð  To obtain “Net Profits”, we are required to make still certain adjustments.

ð  From the gross profit, deduct depreciation charges and the cost of new investment during that period.

ð  The final position is called as “net profits”.

ð  It can be summarised in the following ways:

(1)   Residue             = Actual Receipts during a period  -  Actual payments made

                             during that period.

(2)   Gross Profit      = Residue  -  Imputed charges of owner’s labour and capital  -

                             Tax obligations  -  Value of balance stock.

(3)   Net Profit          = Gross Profit  -  Value of capital equipment added during the

                              period  -  Depreciation charges.

PROFITABILITY

ð  The volume of profit made by any industry is regarded as a primary measure of its success. There are many reasons for the stress on profits.

ð  The survival of the industry depends upon its ability to earn profits as profits provide a conversant basis for analysis.

ð  Maximisation of profits is the sole criterion of success and efficiency would be defeating in the long run from the point of view of industry itself.

ð  As we are concerned with our ultimate customers, who are the final judge of the quality of the products, and who must be given what they want.

ð  Also must be continuously satisfied and must be provided the very best value for their money.

ð  It may be pointed out that though the industry may not aim at profit maximisation, every effort is made to achieve sufficient profits to cover the economic risk and thus to avoid loss.

ð  As Peter Drucker has put, “It is the first duty of business to survive. The guiding principle of managerial economics is not the maximisation of profits, it is the avoidance of loss.”

ð  This is the time of both owner and manager are danger in the case of continual losses.

ð  While there may be other objectives and goals of the industry, it does aim at achieving a planned rate of profit and seeks to improve its profit performance over time.

ð  Low profit is seldom an aim of company. It is rather the result of poor management, failing to achieve the profit it would like to achieve.

ð  Measurement of Profitability:- rate of return on the capital employed indicates the end result of a concern activities/capital employed is defined as net block plus net work.

Net work capital = Difference of current assets and current liabilities

Rate of return  =  Net Profit        X         Net sales

                              Net Sales                   Capital employed

Gross Profit  =  Profit before tax

Net Profit  =  Profit after tax

Rate od return  =  Percentage of profit before tax to capital employed

DEPRECIATION

ð  Whenever any machine or equipment performs useful work, its wear and tear is bound to occur.

ð  This can be minimised up to some extent by proper care and maintenance but cannot be totally prevented.

ð  Its efficiency also reduces with the lapse of time and at one time it becomes uneconomical to be used further and needs replacement by another new unit.

ð  Therefore, we can say efficiency and value of machine or asset constantly reduces with the lapse of time during use, which is known as “Depreciation”.

ð  So some money must be set aside yearly from the profits, so that when that equipment becomes uneconomical, it can be replaced by the new one.

ð  Therefore, the initial cost of machine plus installation charges + repair charges - scrap value is charged against overheads and spread over the machine’s useful life.

ð  For this purpose, depreciation account for the complete plant or individual equipment is opened in the company’s books and is known as “Depreciation Fund” or “Sinking Fund”.

ð  This amount id deducted yearly from the profits and kept separate to have sufficient money for replacement at the end of useful life.

ð  The other causes of depreciation are physical decay, accidents, deferred maintenance and neglect, inadequacy etc.

ð  For further understanding depreciation can be classified as under:

OBSOLESCENCE

ð  Suppose a factory owner purchase a machine for his production shop but after some duration a better machine comes in the market, whose production rate is very high and is much economical.

ð  Although the old machine is efficient but becomes out of fashion and uneconomical due to the new better machine which has come in the market.

ð  This is known as “Obsolescence”. Consideration of this fact is of much importance and some money should also be set aside from the profits for this cause.

ð  Hence “Obsolescence” is the depreciation of existing machinery or asset due to new and better invention, design, equipment or process etc.

ð  It is very difficult problem for estimator to provide for the on cost on obsolescence, because nobody can say when a revolutionary change is coming in the market.

ð  But it is a general practice to reduce the life of machine so as to account the effect of obsolescence. Now the depreciation and obsolescence charges are calculated on the reduced life.

ð  Suppose an estimator expects the life of machine as 20 years then the depreciation rate will be 100/20=5%.

ð  By considering obsolescence also, its life may be taken as 15 years. Then the combined depreciation and obsolescence charges will be 100/15=6.66% instead of 5%.

ð  Therefore, the difference will be obsolescence charges. 

BREAK EVEN ANALYSIS

ð  This is also known as cost analysis. Break even analysis is concerned with finding the point at which revenues and costs are exactly equal.

ð  This point is known as BREAK EVEN point. Thus this is a volume of output at which neither a profits is made nor a loss is incurred.

ð  Therefore production or sale must not be allowed to fall beyond this point.

ð  This analysis can be carried out either algebraically or graphically.

ð  A break even chart is a graphical representation of the relationship between costs and revenue at a given time, and determines the breakeven point and profit potential under varying conditions of output and cost.

ð  Functions of breakeven chart:-

(1)   To represent economical position of production on graph.

(2)   To for tells likely profits or losses at various levels of output.

(3)   To help the management to decide the production level.

(4)   To indicate margin of safety.

ð  Break even volume is the number of units of a product which must be sold to earn enough revenue just to cover all expenses.

ð  The breakeven point (BEP) is reached when sufficient number of units have been sold so that the total contribution margin of the units sold is equal to the fixed costs.

B.E.P.  =                     Fixed Costs__________                   

                Selling Price – Variable cost per unit

ð  Multi product firms are not in a position to measure the BEP in terms of any common unit of product.

ð  In these firms it is convenient to determine their BEP in terms of total rupee sales. In this case BEP would be the point where the contribution  margin would equal to fixed costs contribution margin is expressed as a ratio to sales.

B.E.P.  =         Fixed costs__

                Contribution ratio