Sale of goods on approval or return is a conditional sale where the buyer has the option to either accept or return the goods after a certain period of time. If the buyer approves the goods, the sale is finalized, and ownership is transferred. If the buyer returns the goods, no sale is recognized, and the goods remain the property of the seller.

Transaction type:

1. No immediate sale: The goods are delivered to the buyer, but no sale is recognized at this point.
2. Ownership retention: The seller retains ownership of the goods until the buyer approves them.
3. Return option: The buyer can return the goods within the stipulated approval period without obligation.
4. Sales recognition: The sale is recorded only when the buyer signals approval or the approval period expires without a return.

This type of sale is typically formalized in contracts, stipulating the approval period, the return process, and conditions under which the transaction becomes final.

Accounting for Sale of Goods on Approval or Return Basis

When it comes to accounting for sales on approval or return, proper treatment ensures that financial statements reflect an accurate picture of the company’s sales and inventory position. Below are the key steps in the accounting process for such transactions.

1. When Goods are Sent on Approval

At the time of sending the goods to the buyer, ownership is not transferred, so it is not treated as a sale in the seller’s books. The goods are still considered part of the seller’s inventory. A memo entry or special record is maintained to track the goods sent.

• No journal entry for sales at this point since ownership has not been transferred.

2. When the Buyer Approves the Goods (Sale Confirmed)

If the buyer approves the goods or does not return them within the specified period, the sale is recognized. The sale and the cost of goods sold (COGS) are recorded at this point.

• Journal Entry for Recording the Sale:
  • Debit: Accounts Receivable / Cash (for the sale amount)
  • Credit: Sales Revenue (for the sale amount)
• Journal Entry for Recording the Cost of Goods Sold:
  • Debit: Cost of Goods Sold (COGS)
  • Credit: Inventory (for the cost price of goods)

3. When the Goods are Returned by the Buyer

If the buyer decides to return the goods within the approval period, no sale is recorded. The goods are simply returned to inventory, and the memo or special record is updated to reflect the return.

• No journal entry for sales cancellation since the sale was never recognized. The inventory is restored, and no financial impact occurs other than updating the stock records.

4. When the Buyer Partially Approves the Goods

In cases where the buyer approves some goods and returns others, a partial sale is recorded for the approved goods, and the rest are returned to inventory.

Journal Entry for Partial Sale:

• • Debit: Accounts Receivable / Cash (for the approved portion)
  • Credit: Sales Revenue (for the approved portion)

Journal Entry for Recording Partial COGS:

• • Debit: Cost of Goods Sold (for the cost of approved goods)
  • Credit: Inventory (for the cost of approved goods)

5. When the Approval Period Expires without Buyer’s Response

If the buyer does not communicate approval or return within the stipulated time frame, the goods are deemed accepted, and the sale is recorded on the expiration date.

Journal Entry for Sale:

• • Debit: Accounts Receivable / Cash
  • Credit: Sales Revenue

Journal Entry for COGS:

• • Debit: Cost of Goods Sold
  • Credit: Inventory

Example of Accounting Entries:

Let’s consider an example to illustrate the accounting entries for a sale on approval basis:

• On July 1, ABC Ltd. sends goods worth $5,000 (costing $3,000) to a customer on approval. The customer has 30 days to either approve or return the goods.
• On July 15, the customer approves the goods, and the sale is finalized.

1. When Goods are Sent on Approval (July 1):

• Memo Entry: No journal entry is passed in the books as ownership has not yet transferred. However, a note or memo entry records that goods have been sent.

2. When the Customer Approves the Goods (July 15):

Journal Entry to Record Sale:

• • Debit: Accounts Receivable $5,000
  • Credit: Sales Revenue $5,000

Journal Entry to Record COGS:

• • Debit: Cost of Goods Sold $3,000
  • Credit: Inventory $3,000

If the customer had returned the goods within the approval period, no entry would have been required, and the goods would simply be returned to inventory.

Importance of Proper Accounting for Sale of Goods on Approval:

Proper accounting treatment of sales on approval or return basis is important for several reasons:

• Accurate Financial Reporting:

Revenue is only recognized when it is earned, ensuring that the company’s income statement reflects true sales figures.

• Inventory Management:

Goods sent on approval remain part of the company’s inventory until the sale is finalized, helping in accurate stock valuation.

• Compliance with Accounting Standards:

Adhering to the matching principle and revenue recognition criteria is essential for compliance with accounting standards, such as Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).

• Risk Management:

Since ownership remains with the seller until approval, it reduces the seller’s risk of revenue overstatement or misrepresentation of financial performance.

Here are simple problems on the accounting equation and adjusting entries in table format:

Problem 1: Accounting Equation

Problem 2: Adjusting Entries

These tables represent basic examples of how the accounting equation and adjusting entries operate in practice.

Adjusting entries are journal entries made at the end of an accounting period to update account balances before preparing financial statements. They ensure that revenues and expenses are recorded in the correct period according to the accrual basis of accounting. These entries help in correcting omissions and including items like accrued income, outstanding expenses, prepaid expenses, and unearned income. Adjusting entries are necessary to present a true and fair view of financial statements. Therefore, they play an important role in ensuring accuracy and completeness in financial accounting systems and business operations overall today.

Purpose of Adjusting Entries

• To Follow Accrual Basis of Accounting

Adjusting entries are needed to ensure that accounting follows the accrual basis of accounting. Under this system, income and expenses are recorded when they are earned or incurred, not when cash is received or paid. Many transactions remain incomplete at the end of the accounting period. Adjusting entries help record these pending items properly. This ensures financial statements reflect true business performance. Therefore, adjusting entries are essential for applying accrual accounting correctly and maintaining accuracy in financial reporting systems and business operations overall today.

• To Match Revenues and Expenses

One major need for adjusting entries is to follow the matching principle. Expenses must be recorded in the same period as the revenues they help generate. Without adjustments, expenses and incomes may appear in different periods, leading to incorrect profit calculation. Adjusting entries ensure proper matching of costs and revenues. For example, salary for the last month must be recorded even if unpaid. Therefore, adjusting entries are necessary to ensure correct profit or loss calculation in accounting systems and business financial reporting overall today.

• To Record Accrued Income

Adjusting entries are needed to record income that has been earned but not yet received in cash. Such income is called accrued income. Without adjustment, revenue would be understated and financial statements would be incomplete. For example, interest earned but not received must be recorded at year-end. Adjusting entries ensure such incomes are included in the correct accounting period. Therefore, they are essential for proper income recognition and accurate financial reporting in accounting systems and business operations overall today.

• To Record Outstanding Expenses

Many expenses are incurred during an accounting period but not paid by the end of it. These are called outstanding expenses. Adjusting entries are required to record such expenses in the books. Without these entries, expenses would be understated and profit would be overstated. For example, unpaid rent or salaries must be recorded. Therefore, adjusting entries are needed to ensure correct expense recognition and accurate financial statements in accounting systems and business operations overall today.

• To Record Prepaid Expenses

Adjusting entries are needed to account for prepaid expenses, which are payments made in advance for future benefits. Only the portion related to the current period should be treated as expense, while the remaining is shown as an asset. Without adjustment, expenses may be overstated. For example, prepaid insurance must be adjusted over time. Therefore, adjusting entries ensure proper allocation of expenses and accurate financial reporting in accounting systems and business operations overall today.

• To Record Unearned Income

Unearned income refers to money received before earning it, such as advance rent or advance payment for services. Adjusting entries are needed to convert unearned income into earned income over time. Without adjustment, revenue may be overstated. These entries ensure correct classification between liability and income. Therefore, adjusting entries are essential for proper revenue recognition and accurate financial reporting in accounting systems and business operations overall today.

• To Ensure Accurate Financial Statements

Adjusting entries are necessary to prepare accurate financial statements such as the Profit and Loss Account and Balance Sheet. Without adjustments, financial statements may not show true financial position. They help correct errors, omissions, and incomplete records. This ensures reliability and transparency in reporting. Therefore, adjusting entries are essential for preparing correct and fair financial statements in accounting systems and business operations overall today.

• To Improve Decision Making

Accurate financial information is important for management decision making. Adjusting entries ensure that all incomes and expenses are properly recorded, giving a true picture of business performance. This helps managers plan budgets, control costs, and evaluate performance effectively. Investors and stakeholders also depend on accurate reports. Therefore, adjusting entries are necessary for supporting better decision making in financial accounting systems and business operations overall today.

Types of Adjusting Entries

Ledger is a principal book of accounts where all business transactions, after being recorded in journals, are classified and posted under individual account heads. It is often called the “book of final entry” because it summarizes all financial information related to a particular account, such as cash, sales, purchases, etc. Each ledger account has two sides: Debit (Dr.) and Credit (Cr.). The ledger helps in preparing the Trial balance and financial statements. It ensures that all similar transactions are grouped together, making it easier to track financial performance and balances. Examples of ledger accounts include Cash Account, Sales Account, and Capital Account. Maintaining a ledger is essential for accuracy and completeness in the accounting process.

Example of a Ledger

Let’s consider a simple example of a Cash Ledger for a small retail business:

In this example, the Cash account shows the initial balance, cash inflows from sales, and outflows for purchases and expenses, with the running balance calculated after each transaction.

Objectives of Ledger

1. Classification of Transactions

The primary objective of a Ledger is to classify financial transactions according to their respective accounts. Transactions initially recorded in the Journal are transferred to individual accounts such as cash, sales, purchases, debtors, creditors, capital, assets, and expenses. This account-wise classification makes financial information organized and easier to understand. It enables accountants to identify all transactions relating to a particular account and provides a structured basis for determining balances and preparing subsequent accounting records.

2. Determining Account Balances

A major objective of the ledger is to determine the balance of individual accounts. By comparing the total debit and credit entries, the accountant can identify whether an account has a debit or credit balance. For example, the cash ledger shows the available cash balance, while the debtor ledger indicates amounts receivable. These balances provide essential information for preparing the Trial Balance and evaluating the financial position and performance of the business.

3. Providing Complete Account Information

The ledger aims to provide complete information regarding transactions affecting each individual account. Unlike the journal, which records transactions chronologically, the ledger groups similar transactions together. This enables users to examine the complete history of an account during an accounting period. Information relating to sales, purchases, expenses, assets, liabilities, and income can therefore be reviewed conveniently. This facilitates account monitoring and provides detailed information for financial analysis and decision-making.

4. Facilitating Preparation of Trial Balance

The ledger serves as the primary source for preparing the Trial Balance. After posting all journal transactions, the balances of individual ledger accounts are extracted and listed in the trial balance. Comparing total debit and credit balances helps check the arithmetical accuracy of bookkeeping. Although a balanced trial balance does not guarantee the absence of every accounting error, ledger balances provide the essential information needed for this important stage of the accounting cycle.

5. Supporting Preparation of Financial Statements

Another objective of the ledger is to provide information required for preparing Financial Statements. Revenue and expense account balances contribute to determining profit or loss, while asset, liability, and capital balances help determine the financial position. Accurate ledger balances therefore form the foundation for preparing the Income Statement, Balance Sheet, and other financial reports. The ledger connects detailed bookkeeping records with summarized financial information presented to management and other stakeholders.

6. Monitoring Assets and Liabilities

The ledger helps management monitor assets and liabilities by maintaining separate accounts for resources owned and obligations owed by the business. Accounts such as cash, inventory, machinery, loans, creditors, and receivables provide information about financial resources and commitments. Regular examination of these accounts helps management understand changes in financial position and maintain appropriate control over organizational resources. Thus, the ledger supports effective monitoring of the business’s financial structure.

7. Facilitating Error Detection and Control

A properly maintained ledger helps in identifying certain accounting errors and irregularities. Since transactions are classified into individual accounts, unusual balances, incorrect postings, missing entries, or discrepancies can be examined more easily. Account reconciliation and comparison with supporting records further strengthen financial control. Although the ledger cannot detect every type of accounting error, systematic maintenance improves the possibility of identifying mistakes and supports effective internal control and verification procedures within the organization.

8. Supporting Financial Analysis and Decision-Making

The ledger provides detailed account-wise information that supports financial analysis and managerial decision-making. Management can examine sales, expenses, receivables, payables, cash, and other accounts to understand financial trends and operational activities. Such information can assist in cost control, budgeting, cash management, credit management, and performance evaluation. Therefore, the ledger is not merely a bookkeeping record; it also provides organized financial information that can help management plan operations and make informed decisions.

Nature of a Ledger

1. Principal Book of Accounts

The ledger is considered the principal book of accounts because it contains classified records of all major financial transactions of a business. Although transactions are first recorded in the journal, they are subsequently transferred to appropriate ledger accounts. It contains accounts relating to assets, liabilities, capital, income, and expenses. The ledger therefore occupies a central position in the accounting system and provides the account-wise information required for preparing the trial balance and financial statements.

2. Classified Nature

A fundamental characteristic of a ledger is its classified nature. Transactions are grouped according to the accounts they affect rather than being maintained only in chronological order. For example, all transactions affecting cash are recorded in the Cash Account, while credit transactions involving customers are recorded in individual debtor accounts. This classification makes accounting information systematic and accessible. It allows accountants and management to understand the complete effect of transactions on individual accounts.

3. Account-Wise Record

The ledger maintains financial information on an account-wise basis. Separate accounts are opened for different items such as cash, machinery, sales, purchases, creditors, debtors, capital, salaries, and rent. All transactions affecting a particular account are collected in that account. This characteristic makes it possible to determine the balance and movement of individual accounts. Account-wise recording therefore provides a detailed and organized representation of the financial activities of the business.

4. Secondary Book of Entry

The ledger is generally regarded as a secondary book of entry because transactions are first recorded in the journal or subsidiary books before being posted to the ledger. The journal provides the chronological record, while the ledger provides the classified record. Information is transferred from these books through the process of posting. Thus, the ledger depends on the initial accounting records but plays a more significant role in determining account balances and preparing financial statements.

5. Basis of Trial Balance

The ledger is the principal source for preparing the Trial Balance. After all relevant transactions are posted, the balances of ledger accounts are extracted and arranged in the trial balance. The comparison of debit and credit totals provides a check on the arithmetical accuracy of the double-entry records. Therefore, the ledger has a direct relationship with the trial balance and represents an essential stage between transaction recording and the preparation of financial statements.

6. Balance-Oriented Nature

An important feature of the ledger is its balance-oriented nature. Individual ledger accounts are periodically balanced by comparing their debit and credit totals. The resulting balance may represent an asset, liability, income, expense, capital, receivable, or payable position. These balances summarize the net effect of transactions affecting each account. They provide essential information for preparing accounting reports and help management understand the financial position and performance of different aspects of the business.

7. Permanent and Systematic Record

The ledger serves as a systematic and relatively permanent record of classified financial information. Once transactions are posted and accounts are maintained properly, the ledger provides a historical record of the financial activities of the organization. It can be referred to for verification, auditing, account reconciliation, financial analysis, and future reference. Proper preservation of ledger records also supports accountability and helps organizations maintain evidence of their financial transactions over accounting periods.

8. Essential Part of Double-Entry System

The ledger is an essential component of the Double-Entry Accounting System because the debit and credit effects of transactions are ultimately accumulated in individual accounts. Every transaction posted to the ledger maintains the principle that corresponding debit and credit effects should be recorded. The resulting account balances contribute to the preparation of the trial balance and financial statements. Therefore, the ledger provides the structural foundation for applying double-entry principles throughout the accounting cycle.

Structure of a Ledger

Structure of a Ledger typically includes the following key Components:

1. Account Title: The name of the account, such as Cash, Accounts Receivable, Inventory, Accounts Payable, Sales Revenue, etc.

2. Date: The date of each transaction recorded in the ledger.

3. Description: A brief explanation of the transaction.

4. Debit Column: The amount that is debited to the account for each transaction.

5. Credit Column: The amount that is credited to the account for each transaction.

6. Balance: The running balance of the account after each transaction is recorded, indicating whether the account has a debit or credit balance.

The format of a ledger entry is typically organized as follows:

Types of Ledgers

Importance of Ledgers

1. Systematic Classification of Transactions

The Ledger provides a systematic method of classifying financial transactions under separate accounts. Transactions initially recorded in the Journal are transferred to individual accounts such as cash, sales, purchases, debtors, creditors, assets, liabilities, and expenses. This account-wise classification makes financial information organized and accessible. It enables accountants to identify all transactions related to a particular account without examining every journal entry separately, thereby improving the efficiency of accounting and record-keeping.

2. Determination of Account Balances

The ledger helps determine the balance of individual accounts by comparing their debit and credit entries. It provides information about cash balances, amounts receivable from customers, amounts payable to suppliers, expenses incurred, and other financial items. These balances help management understand the current position of specific accounts. Accurate account balances are also essential for preparing the Trial Balance and subsequent financial statements, making the ledger an important component of the accounting cycle.

3. Basis for Trial Balance

The Trial Balance is prepared using the balances extracted from ledger accounts. The ledger therefore provides the fundamental information required to check the arithmetical accuracy of bookkeeping. By comparing total debit and credit balances, accountants can identify certain errors or discrepancies in recording and posting. Although a balanced trial balance does not guarantee complete accuracy, ledger balances provide an essential basis for verifying accounting records before preparing the financial statements.

4. Preparation of Financial Statements

Ledgers provide the information necessary for preparing Financial Statements. Balances of revenue and expense accounts help determine the profit or loss, while asset, liability, and capital accounts help determine the financial position of the business. The ledger therefore connects detailed transaction records with summarized financial reports. Accurate ledger maintenance ensures that financial statements are based on properly classified and balanced accounting information, thereby improving the reliability of financial reporting.

5. Effective Financial Control

The ledger supports financial control by providing detailed information about individual accounts. Management can monitor cash, inventory, receivables, payables, expenses, and other financial resources through their respective ledger accounts. Regular review and reconciliation can reveal unusual transactions, discrepancies, or unexpected balances. This information helps management control expenditure, safeguard assets, and ensure proper use of financial resources. Consequently, the ledger contributes to stronger internal control and better financial administration.

6. Facilitation of Auditing

The ledger is an important source of evidence during auditing. Auditors can examine individual accounts and trace transactions from ledger records back to journal entries and supporting documents. This process helps verify the authenticity, classification, and accuracy of recorded transactions. Properly maintained ledgers create a useful audit trail and facilitate the examination of financial statements. Therefore, ledger records support transparency, accountability, and the verification of financial information.

7. Assistance in Financial Analysis

Ledger accounts provide detailed information that can be used for financial analysis. Management can examine individual revenue, expense, asset, liability, receivable, and payable accounts to identify financial trends and changes. Analysis of ledger information can assist in evaluating costs, sales performance, cash management, credit management, and profitability. Since transactions are classified account-wise, the ledger makes it easier to obtain specific financial information needed for evaluating different areas of business operations.

8. Support for Decision-Making

Accurate ledger information supports managerial decision-making by providing detailed and reliable financial data. Management can use account balances and transaction histories when making decisions about expenses, credit policies, investments, financing, resource allocation, and business operations. For example, information from debtor and creditor accounts can assist in managing working capital. Thus, the ledger transforms individual transaction records into useful account-wise information that contributes to effective financial planning and business management.

The implementation of a cost accounting system is an important step for a growing small business. Implementation begins with identification of the correct costing system for the business, moves on to deployment of the system and finishes with post-deployment support to train employees on how to use the system effectively. Best practices in cost-system implementation focus on all three parts of the implementation process.

(i) Management Apathy:

If management is not really convinced of the advantages of the costing system or if it has somehow been made to accept the system against its will, it will merely tolerate it and not encourage it properly. This will lead others also to withhold their cooperation and, therefore, the system may never operate effectively. The reports may all be correct and prompt but probably no one will look at them.

(ii) Hostility from Line Staff:

Line staff people often believe that firstly they know how to run their business and, therefore, they do not need anyone to tell them what information they need and, secondly, that they cannot waste their time in “form filling”. They may also be afraid that proper information will expose some of their mistakes or that the new system will make them less useful than before in the eyes of the management. There is a tendency to resent anything new unless it is patently to one’s advantage.

(iii) Structure of Authority:

The cost accounting system may be based on formal authority structure whereas in reality the structure may be quite different. If, for example, trade union leaders have a great deal of influence on the various decisions, the system may run into difficulties it is not likely that the organisation chart will show the authority of the union leaders.

(iv) Changed Circumstances:

Business often undergoes rapid changes the market may change and the production process may change; management ideas change also. If the costing system is not adapted to the changed circumstances, it will cease to be effective. For example, if a cotton textile mill is converted into a mill producing man-made fibres, the Cost Accounting system must also be suitably changed.

(v) Indifference:

Often a part of the system breaks down; if it is not quickly set right, it will affect the whole system. For example, if issues of material are not properly watched and kept under control, the whole materials control system may break down. Also there may be delay in the flow of information and report may be delayed. If this is not corrected the whole decision-making and control system may be vitiated. The same will be the result if there are serious errors in report. It is, therefore, necessary that someone should watch the actual operation of the system continuously and carefully.

(vi) Low Status of Cost Accountant:

The cost accountant will often have to collect and furnish information which may not be liked by someone. If the cost accountant occupies a very junior position, he may not be able to do his work without fear or favour and, therefore, the information supplied by him may not lead to the correct decision. It is essential that the cost accountant should be a high ranking official, having direct access to the top management. He must also be assisted by a properly trained and adequate staff.

(vii) Lack of Clarity about Priorities and Objectives:

If the Cost Accounting staff is not clear about the end uses to which costing information will be put, they may not go about their task in the correct manner; they may even send the wrong sort of or inadequate information. Because of all these difficulties, it is necessary to proceed slowly, taking everyone along. An educative process for all concerned is essential to see that the costing system is accepted and operated sincerely.

Direct Cost

Direct costs can be easily identified as per the expenditure on cost objects. So, for example, if we pick how much expenditure a business has had on purchasing the raw materials inventory, we will be able to directly point out.

Indirect Cost

In the case of indirect costs, the challenge is that we can’t identify the costs as per the cost object. So, for example, if we try to understand how much rent is given for sitting the machinery in a place, we won’t be able to do it because the rent is paid for the entire space, not for a particular place.

The essential difference between direct costs and indirect costs is that only direct costs can be traced to specific cost objects. A cost object is something for which a cost is compiled, such as a product, service, customer, project, or activity. These costs are usually only classified as direct or indirect costs if they are for production activities, not for administrative activities (which are considered period costs).

Prime Cost

Prime costs are a firm’s expenses directly related to the materials and labor used in production. It refers to a manufactured product’s costs, which are calculated to ensure the best profit margin for a company. The prime cost calculates the direct costs of raw materials and labor that are involved in the production of a good. Direct costs do not include indirect expenses, such as advertising and administrative costs.

Prime cost = Direct raw materials + Direct labour

Production Cost

Production costs refer to all of the direct and indirect costs businesses face from manufacturing a product or providing a service. Production costs can include a variety of expenses, such as labor, raw materials, consumable manufacturing supplies, and general overhead.

Direct Labor Costs

Direct labor consists of the fully burdened cost of all labor directly involved in the production of goods. This usually means those people working on production lines or in work cells. Other types of production labor are recorded within the category of factory overhead costs.

Direct Material Costs

Direct materials consists of those materials consumed as part of the production process, including the cost of normal scrap that occurs as part of the process.

Factory Overhead Costs

Factory overhead consists of those costs required to maintain the production function, but which are not directly consumed on individual units. Examples are utilities, insurance, materials management salaries, production salaries, maintenance wages, and quality assurance wages.

Administration Cost

Administrative expenses refer to the costs incurred by a company or organization that include, but are not limited to, the salaries and benefits of the administrative workers within the company or organization, as well as rent and managerial compensation. Also known as General and Administrative expenses, the costs are categorized separately from Sales & Marketing and Research costs.

1. Administrative Expenses

• Managerial team
• IT team
• Executive compensation
• Rent of equipment and buildings

2. Non-Administrative Expenses

• Manufacturers
• Developers
• Engineers
• Sales Team

Selling and Distribution Cost

The term ‘distribution‘ is widely used in relation to the whole operation of getting goods into the hands of the consumer, and thus covers the two functions of sales promotion and delivery. The expression ‘distribution costs’, however, may be considered as relating only to delivery.

Selling Costs: The cost incurred in promoting sales and retaining customers. Selling expenses are those expenses which are incurred to promote sales and service to customers. Thus, selling overhead includes Salesmen’s Salaries, Commission, Travelling expenses, Cost of advertisement, Posters, Cost of price list and catalogue, Debt collection charges, Bad debts, Free gift, Showrooms expenses, After-sale service, Legal expenses for recovering debt, etc.

Distribution Costs: The cost of the process which begins with making the packed product available for dispatch and ends with making the reconditioned returned empty package available for re-uses. Distribution expenses, on the other hand, are those which are incurred for warehousing and storage, packing for goods sent and making the goods available for delivery to customers. So, in broader sense of the item, distributions expenses include- Cost of storing, Cost of warehousing, Cost of packing, Cost of delivery, and Cost of preparation of challan.

Fixed Cost

In accounting and economics, fixed costs, also known as indirect costs or overhead costs, are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be recurring, such as interest or rents being paid per month. These costs also tend to be capital costs. This is in contrast to variable costs, which are volume-related (and are paid per quantity produced) and unknown at the beginning of the accounting year. Fixed costs have an effect on the nature of certain variable costs.

For example, a retailer must pay rent and utility bills irrespective of sales. As another example, for a bakery the monthly rent and phone line are fixed costs, irrespective of how much bread is produced and sold; on the other hand, the wages are variable costs, as more workers would need to be hired for the production to increase. For any factory, the fix cost should be all the money paid on capitals and land. Such fixed costs as buying machines and land cannot be not changed no matter how much they produce or even not produce. Raw materials are one of the variable costs, depending on the quantity produced.

Fixed cost is considered an entry barrier for new entrepreneurs. In marketing, it is necessary to know how costs divide between variable and fixed costs. This distinction is crucial in forecasting the earnings generated by various changes in unit sales and thus the financial impact of proposed marketing campaigns. In a survey of nearly 200 senior marketing managers, 60 percent responded that they found the “variable and fixed costs” metric very useful. These costs affect each other and are both extremely important to entrepreneurs.

Variable Cost

A variable cost is a cost that varies in relation to either production volume or the amount of services provided. If no production or services are provided, then there should be no variable costs. If production or services are increasing, then variable costs should also increase.

Types of Variable Costs

Direct materials are considered a variable cost. Direct labor may not be a variable cost if labor is not added to or subtracted from the production process as production volumes change. Most types of overhead are not considered a variable cost.

Semi-variable Cost

In such mixed cost, the fixed part will occur irrespective of the production level; even in the case of zero production activities, a fixed cost will still occur. However, the variable part of such costs is dependent on the level of production work carried by the entity and increases in proportion to the production levels. That means that semi-variable costs can be calculated by adding the fixed costs and the variable costs (based on the level of production).

Period Cost

Period costs are costs that cannot be capitalized on a company’s balance sheet. In other words, they are expensed in the period incurred and appear on the income statement. Period costs are also called period expenses.

Product Cost

Product cost refers to the costs incurred to create a product. These costs include direct labor, direct materials, consumable production supplies, and factory overhead. Product cost can also be considered the cost of the labor required to deliver a service to a customer. In the latter case, product cost should include all costs related to a service, such as compensation, payroll taxes, and employee benefits.

Product cost appears in the financial statements, since it includes the manufacturing overhead that is required by both GAAP and IFRS. However, managers may modify product cost to strip out the overhead component when making short-term production and sale-price decisions. Managers may also prefer to focus on the impact of a product on a bottleneck operation, which means that their main focus is on the direct materials cost of a product and the time it spends in the bottleneck operation.

Product Cost Calculation

The cost of a product on a unit basis is typically derived by compiling the costs associated with a batch of units that were produced as a group, and dividing by the number of units manufactured. The calculation is:

Product unit cost = (Total direct labor + Total direct materials + Consumable supplies + Total allocated overhead) ÷ Total number of units

Explicit Cost

Explicit cost is valuable if you’re trying to create long-term strategic goals for a company or simply assessing its profitability. Learning how this metric varies from implicit costs can help you understand, determine and establish the total economic cost. Explicit costs can be easily determined and invaluable for decision-making in a business or department.

Important

Calculating profit: Once a company pays all its explicit costs, the profit is the remaining monetary value on the general ledger.

Performing long-term strategic planning: Explicit cost helps calculate a company’s profitability. It’s a key metric for long-term strategic planning because it allows a business to predict its profits for a specific period.

Implicit Cost

In economics, an implicit cost, also called an imputed cost, implied cost, or notional cost, is the opportunity cost equal to what a firm must give up in order to use a factor of production for which it already owns and thus does not pay rent. It is the opposite of an explicit cost, which is borne directly. In other words, an implicit cost is any cost that results from using an asset instead of renting it out, selling it, or using it differently. The term also applies to foregone income from choosing not to work.

Implicit costs also represent the divergence between economic profit (total revenues minus total costs, where total costs are the sum of implicit and explicit costs) and accounting profit (total revenues minus only explicit costs). Since economic profit includes these extra opportunity costs, it will always be less than or equal to accounting profit.

Although implicit costs are non-monetary costs that usually do not appear in a company’s accounting records or financial statements, they are nonetheless an important factor that must be considered in bottom-line profitability. Implicit costs distinguish between two measures of business profits accounting profits versus economic profits.

• Accounting profits are a company’s profits as shown in its accounting records and financial statements (such as its income statement). However, accounting profits, which are calculated as total revenues minus total expenses, only reflect actual cash expenses that a company pays out – its explicit costs.
• Economic profits take into consideration both explicit and implicit costs. Therefore, while a company may show a positive net accounting profit, it may actually be a losing economic enterprise when its implicit costs are factored into the profitability equation

Historical Cost

Historical cost is the price paid for an asset when it was purchased. Historical cost is a fundamental basis in accounting, as it is often used in the reporting for fixed assets. It is also used to determine the basis of potential gains and losses on the disposal of fixed assets.

Historical Cost Adjustments

According to the accounting standards, historical costs require some adjustment as time passes. Depreciation expense is recorded for longer-term assets, thereby reducing their recorded value over their estimated useful lives. Also, if the value of an asset declines below its depreciation-adjusted cost, one must take an impairment charge to bring the recorded cost of the asset down to its net realizable value. Both concepts are intended to give a conservative view of the recorded cost of an asset.

Other Types of Costs

Historical cost differs from a variety of other costs that can be assigned to an asset, such as its replacement cost (what you would pay to purchase the same asset now) or its inflation-adjusted cost (the original purchase price with cumulative upward adjustments for inflation since the purchase date).

Historical cost is still a central concept for recording assets, though fair value is replacing it for some types of assets, such as marketable investments. The ongoing replacement of historical cost by a measure of fair value is based on the argument that historical cost presents an excessively conservative picture of an organization.

Current Cost

Current cost is the cost that would be required to replace an asset in the current period. This derivation would include the cost of manufacturing a product with the work methods, materials, and specifications currently in use. The concept is used to generate financial statements that are comparable across multiple reporting periods.

Future or Predetermined Cost

A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange.

The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.

These costs are computed in advance of the actual spending. And it usually includes all specifications with regards to the cost in question. In manufacturing firms, they are estimated for raw materials, labor and Overheads. When the actual costs are included during the period, the actual is compared with the predetermined to get the variance. A favorable variance means the actual cost is lower while an unfavorable variance implies that the actual cost was higher.

The term is also used in standard costing. In this situation, the standard cost is said to be the predetermined cost which is then compared with the actual cost. Variance is used to understand the cost item. So that adjustments can be made.

Using predetermined cost improves management efficiency. It also reduces the cost of production. Furthermore, it serves as a key performance indicator. A manager spending above the predetermined cost may imply that he or she is not performing well in terms of managing the entity’s finance.

Opportunity Cost

The opportunity cost of a particular activity is the value or benefit given up by engaging in that activity, relative to engaging in an alternative activity. More simply, it means if you chose one activity (for example, an investment) you are giving up the opportunity to do a different option. The optimal activity is the one that, net of its opportunity cost, provides the greater return compared to any other activities, net of their opportunity costs. For example, if you buy a car and use it exclusively to transport yourself, you cannot rent it out, whereas if you rent it out you cannot use it to transport yourself. If your cost of transporting yourself without the car is more than what you get for renting out the car, the optimal choice is to use the car yourself.

Formula and Calculation of Opportunity Cost

Opportunity Cost = FO−CO

Where:

FO=Return on best forgone option

CO=Return on chosen option