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
