Tag: Job Costing

Management Notes

Cost Centre, Working, Types, Benefits

indiafreenotesby indiafreenotes2

A Cost centre is a location, department, or function within an organization where costs are collected and controlled. It represents the smallest segment of responsibility where a manager is accountable for costs incurred. Examples include the production department, maintenance section, or sales office. Cost centres may be classified as personal (related to persons), impersonal (related to places or equipment), production centres, or service centres. By maintaining cost centres, organizations can analyze efficiency, assign accountability, and exercise control over expenses. Thus, a cost centre is a vital tool for monitoring performance and ensuring effective cost management.

How a Cost Center Works?

  • Collection of Costs

A cost centre works by systematically collecting all costs incurred within a specific department, location, or function. Direct costs such as wages, raw materials, and machine expenses are directly assigned to the cost centre. Indirect costs like electricity, rent, and administrative expenses are allocated based on suitable bases such as floor area, machine hours, or labor hours. This method ensures that every expense is traced to the appropriate segment of the business. By consolidating costs at the cost centre level, management gains visibility into how resources are consumed and where financial control is required.

  • Control and Accountability

The functioning of a cost centre also involves exercising control and assigning accountability. Each cost centre is usually headed by a manager or supervisor responsible for monitoring expenses and ensuring efficiency. Reports are generated to compare actual costs against standards or budgets, highlighting variances. This allows corrective actions to be taken when costs exceed limits. By assigning responsibility, cost centres promote discipline and accountability in resource usage. Hence, cost centres not only record costs but also create a framework where managers are answerable, encouraging efficient practices and reducing wastage within the organization.

  • Production Cost Centre

A production cost centre is directly engaged in manufacturing or producing goods and services. It includes departments or sections where the actual conversion of raw materials into finished products takes place. Examples include the machining department, assembly line, and welding shop. Costs like direct materials, direct labor, and production overheads are collected here. Since production cost centres contribute directly to output, efficiency in these centres significantly affects product cost and profitability. Managers are responsible for controlling resources, minimizing wastage, and ensuring maximum productivity. Thus, production cost centres are the backbone of the manufacturing process.

  • Service Cost Centre

A service cost centre is one that provides support services to production cost centres or other departments, rather than directly producing goods. Examples include the maintenance department, power house, stores, and personnel or HR departments. Costs incurred in these centres, such as electricity, repairs, or staff welfare, are eventually apportioned or allocated to production cost centres. Their role is essential in ensuring smooth production operations by supplying necessary utilities and services. Though they do not add direct value to the product, service cost centres indirectly enhance efficiency, reduce downtime, and maintain the overall effectiveness of the production system.

Types of Cost Centers:

  • Personal Cost Centre

A personal cost centre is one where costs are collected and controlled in relation to a person or group of persons. For example, a sales manager’s office, a works manager’s department, or an administrative head’s office can be treated as personal cost centres. The responsibility for cost control is assigned to these individuals. This helps in evaluating the accountability of managers and supervisors in managing expenses. By linking costs to persons, businesses can monitor how effectively individuals utilize resources, identify inefficiencies, and promote accountability. Thus, personal cost centres ensure responsibility-based control within an organization.

  • Impersonal Cost Centre

An impersonal cost centre is one where costs are accumulated in relation to a location, equipment, or item of plant rather than a person. Examples include machine shops, power houses, maintenance workshops, or stores. Here, costs are assigned to machines or processes, and managers responsible for these centres monitor the efficiency of resource usage. This type of cost centre is particularly important in manufacturing industries where costs can be tracked to specific machines or operations. Impersonal cost centres help in understanding machine performance, allocating overheads, and ensuring that physical resources are utilized in the most cost-effective manner.

  • Production Cost Centre

A production cost centre is directly involved in manufacturing or producing goods and services. It includes departments where raw materials are processed into finished products, such as machining, assembling, or welding departments. All direct costs and related overheads are accumulated here to calculate the cost of production. These centres are responsible for converting resources into outputs efficiently. Since they directly affect production volume, quality, and profitability, control over production cost centres is vital. Managers in these centres aim to minimize waste, reduce downtime, and improve operational efficiency, thereby ensuring lower costs and higher productivity for the organization.

  • Service Cost Centre

A service cost centre supports production cost centres or other departments without being directly involved in manufacturing. Examples include the maintenance section, personnel department, power supply unit, and canteen. Costs incurred in these centres are first collected and then apportioned or allocated to production cost centres. While service centres do not directly add value to the product, they ensure smooth production operations and efficiency. For example, the maintenance centre reduces machine downtime, while the HR department manages employee welfare. Hence, service cost centres play an indirect yet crucial role in reducing costs and maintaining organizational effectiveness.

Benefits of Cost Centers:

  • Better Cost Control

Cost centres help organizations exercise better control over expenses by dividing the business into smaller responsibility areas. Each cost centre collects costs for specific activities, departments, or equipment, enabling managers to track where money is being spent. By comparing actual costs with standard or budgeted figures, variances can be identified and corrected. This process ensures resources are used efficiently, and unnecessary expenses are reduced. Cost centres also promote accountability since managers are directly responsible for controlling costs in their areas. Ultimately, this structured approach improves financial discipline and ensures operations are managed more effectively.

  • Performance Measurement

Cost centres provide a clear framework for evaluating the performance of departments, processes, and managers. By linking costs to specific centres, it becomes easier to measure efficiency and identify areas of improvement. Managers can assess whether resources are being used productively and whether operations align with organizational goals. This system promotes accountability, as individuals responsible for cost centres are directly answerable for cost control. Additionally, performance reports generated from cost centres encourage healthy competition among departments. Thus, cost centres not only measure productivity but also motivate employees and managers to achieve higher standards of efficiency and output.

  • Accurate Cost Allocation

One of the key benefits of cost centres is accurate allocation of costs to different products, services, or activities. Instead of lumping all expenses together, cost centres divide costs according to functions such as production, maintenance, or sales. This ensures that overheads are fairly distributed and the true cost of production is known. With accurate allocation, management can determine correct product pricing, assess profitability, and avoid misleading cost data. This precision also helps in decision-making, such as choosing between products or improving efficiency in costly areas. Hence, cost centres bring accuracy and fairness in cost distribution.

  • Aid in Decision–Making

Cost centres provide detailed cost information that helps management in making rational and informed decisions. Decisions such as expanding a department, discontinuing a product line, or investing in new machinery require precise cost data. By isolating costs within specific centres, managers can evaluate the financial impact of alternatives more effectively. For instance, knowing the exact maintenance costs of a department helps decide whether outsourcing would be cheaper. This reduces guesswork and ensures choices are based on reliable figures. Hence, cost centres are an essential tool for both short-term operational and long-term strategic decision-making.

  • Facilitates Budgeting and Planning

Cost centres make budgeting more effective by providing detailed historical cost data. Budgets can be prepared for each cost centre, setting clear financial targets for departments or activities. During operations, actual expenses are compared with these budgets, and deviations are analyzed. This helps management identify cost overruns and take corrective actions. Cost centres also help forecast future costs, making planning more realistic and achievable. By breaking down budgets at a departmental level, organizations can ensure better resource allocation and avoid overspending. Thus, cost centres play a vital role in structured financial planning and control.

  • Enhances Efficiency and Accountability

By creating cost centres, organizations can assign responsibility for costs to specific managers or supervisors, enhancing accountability. Each individual knows the limits within which they must operate, encouraging careful use of resources. Regular performance reviews motivate employees to improve efficiency and reduce waste. Cost centres also highlight areas of inefficiency, allowing corrective measures such as process improvements or better training. This not only lowers costs but also boosts overall productivity. Hence, cost centres ensure both efficiency in operations and accountability at all levels of management, ultimately contributing to higher profitability and organizational success.

Management Notes

Cost concepts, Classification of Costs

indiafreenotesby indiafreenotes6

Cost, as defined by various reputable sources such as the Chartered Institute of Management Accountants and Anthony and Wilsch, refers to the expenditure incurred or the measurement in monetary terms of resources used for a specific purpose. The Committee on Cost Terminology of the American Accounting Association adds to this definition by emphasizing that costs are monetary outlays incurred or potentially to be incurred in achieving management objectives, whether it be in manufacturing products or rendering services.

In essence, cost encompasses all expenses related to the production and sale of goods or services. It represents the total outgoings or changes incurred in activities associated with production and sale. These expenses are quantified in terms of monetary units.

Classification of Cost

Classification of costs implies the process of grouping costs according to their common characteristics. A proper classification of costs is absolutely necessary to mention the costs with cost centres. Usually, costs are classified according to their nature, viz., material, labour, over-head, among others. An identical cost figure may be classified in various ways according to the needs of the firms.

The above classification may be outlined as:

topic 1.1

The classification of cost may be depicted as given:

1. According to Elements

Under the circumstances, costs are classified into three broad categories Material, Labour and Overhead. Now, further subdivision may also be made for each of them. For example, Material may be subdivided into raw materials, packing materials, consumable stores etc. This classification is very useful in order to ascertain the total cost and its components. Same classification may also be made for labour and overhead.

2. According to Functions

The total costs are divided into different segments according to the purpose of the firm. That is why costs are grouped as per the requirements of the firm in order to evaluate its functions properly. In short, the total costs include all costs starting from cost of materials to the cost of packing the product.

It takes the cost of direct material, direct labour and chargeable expenses and all indirect expenses under the head Manufacturing/Production cost.

At the same time, administration cost (i.e. relating to office and administration) and Selling and Distribution expenses (i.e. relating to sales) are to be classified separately and to be added in order to find out the total cost of the product. If these functional classifications are not made properly, true cost of the product cannot accurately be ascertained.

3. According to Variability

Practically, costs are classified according to their behaviour relating to the change (increase or decrease) in their volume of activity.

These costs as per volume may be subdivided into:

(i) Fixed Cost;

(ii) Variable Cost;

(iii) Semi-variable Cost

Fixed Costs are those which do not vary with the change in output, i.e., irrespective of the quantity of output produced, it remains fixed (e.g., Salaries, Rent etc.) up to a certain limit. It is interesting to note that if more units are product, fixed cost per unit will be reduced, and, if less units are produced, obviously, fixed cost per unit will be increased.

Variable Costs, on the other hand, are those which vary proportionately with the volume of output. So the cost per unit will remain fixed irrespective of the quantity produced. That is, there is no direct effect on the cost per unit if there is a change in the volume of output (e.g. price of raw material, labour etc.,).

On the contrary, semi-variable costs are those which are partly fixed and partly variable (e.g. Repairs of building).

4. According to Controllability

Costs may, again, be subdivided into two broad categories according to the performance done by any member of the firm.

(i) Controllable Costs; and

(ii) Uncontrollable Costs.

Controllable Costs are those costs which may be influenced by the decision taken by a specified member of the administration of the firm or, it may be stated, that the costs which at least partly depend on the management and is controllable by them, e.g. all direct costs, direct material, direct labour and chargeable expenses (components of Prime Cost) are controllable by lower management level and is done accordingly.

Uncontrollable Costs are those which are not influenced by the actions taken by any specific member of the management. For example, fixed costs, viz., rent of building, payment for salaries etc.

5. According to Normality

Under this condition, costs are classified according to the normal needs for a given level of output for a normal level of activity produced for such output.

They are divided into:

(i) Normal Costs; and

(ii) Abnormal Costs.

Normal Costs are those costs which are normally required for a normal production at a given level of output and which is a part of production.

Abnormal Costs, on the other hand, are those costs which are not normally required for a given level of output to be produced normally, or which is not a part of cost of production.

6. According to Time

Costs may also be classified according to the time element in it. Accordingly, costs are classified into:

(i) Historical Costs; and

(ii) Predetermined Costs.

Historical Costs are those costs which are taken into consideration after they have been incurred. This is possible particularly when the production of a particular unit of output has already been made. They have only historical value and cannot assist in controlling costs.

Predetermined Costs, on the other hand, are the estimated costs. Such costs are computed in advanced on the basis of past experience and records. Needless to say here that it becomes standard cost if it is determined on scientific basis. When such standard costs are compared with the actual costs, the reasons of variance will come out which will help the management to take proper steps for reconciliation.

7. According to Traceability

Costs can be identified with a particular product, process, department etc. They are divided into:

(i) Direct (Traceable) Costs; and

(ii) Indirect (Non-Traceable) Costs.

Direct/Traceable Costs are those costs which can directly be traced or allocated to a product, i.e. it includes all traceable costs, viz., all expenses relating to cost of raw materials, labour and other service utilised which can be traced easily.

Indirect/Non-Traceable Costs are those costs which cannot directly be traced or allocated to a product, i.e. it includes all non-traceable costs, e.g. salary of store-keepers, general administrative expenses, i.e. which cannot properly be allocated directly to a product.

8. According to Planning and Control

Costs may also be classified into:

(i) Budgeted Costs

(ii) Standard Costs

Budgeted Costs refer to the expected cost of manufacture computed on the basis of information available in advance of actual production or purchase. Practically, budgeted costs include standard costs, both are predetermined costs and their amount may coincide but their objectives are different.

Standard Costs, on the other hand, is a predetermination of what actual costs should be under projected conditions serving as a basis of cost control and, as a measure of product efficiency, when ultimately aligned actual cost. It supplies a medium by which the effectiveness of current results can be measured and the responsibility for derivations can be placed.

Standard Costs are predetermined for each element, viz., material, labour and overhead.

Standard Costs include:

(i) The cost per unit is determined to make an estimated total output for the future period for:

(a) Material;

(b) Labour; and

(c) Overhead.

(ii) The cost must depend on the past experience and experiments and specification of the technical staff.

(iii) The cost must be expressed in terms of rupees.

9. According to Management Decisions

  • Marginal Cost:

Marginal Cost is the cost for producing additional unit or units by segregation of fixed costs (i.e., cost of capacity) from variable cost (i.e. cost of production) which helps to know the profitability. Moreover, we know, in order to increase the production, certain expenses (fixed) may not increase at all, only some expenses relating to materials, labour and variable expenses are increased. Thus, the total cost so increased by the production of one unit or more is the cost of marginal unit and the cost is known as marginal cost or incremental cost.

  • Differential Cost:

Differential Cost is that portion of the cost of a function attributable to and identifiable with an added feature, i.e. the change in costs as a result of change in the level of activity or method of production.

  • Opportunity Cost:

It is the prospective change in cost following the adoption of an alternative machine, process, raw materials, specification or operation. In other words, it is the maximum possible alternative earnings which might have been earned if the existing capacity had been changed to some other alternative way.

  • Replacement Cost:

It is the cost, at current prices, in a particular locality or market area, of replacing an item of property or a group of assets.

  • Implied Cost:

It is the cost used to indicate the presence of arbitrary or subjective elements of product cost having more than usual significance. It is also called notional cost, e.g., interest on capital —although no interest is paid. This is particularly useful while decisions are taken regarding alternative capital investment projects.

  • Sunk Cost:

It is the past cost arising out of a decision which cannot be revised now, and associated with specialised equipment’s or other facilities not readily adaptable to present or future purposes. Such cost is often regarded as constituting a minor factor in decisions affecting the future.

Management Notes

Elements of Cost: Material, Labour and expenses, Direct Material cost

indiafreenotesby indiafreenotes2

Cost accounting classifies costs into three primary elements: Material Cost, Labor Cost, and Overhead Cost. These elements help in cost analysis, budgeting, and decision-making.

Material Cost:

Material cost refers to the cost of raw materials used in the production of goods or services. It is further classified into Direct Material Cost and Indirect Material Cost.

  • Direct Material Cost includes materials that can be directly identified with a specific product, such as wood for furniture or steel for machinery.

  • Indirect Material Cost consists of materials that support production but are not directly traceable to a single product, such as lubricants, cleaning supplies, or small tools. Proper material cost management ensures cost efficiency and minimal wastage.

Labor Cost:

Labor cost is the expense incurred for human effort in production. It is categorized into Direct Labor Cost and Indirect Labor Cost.

  • Direct Labor Cost includes wages paid to workers who are directly involved in production, such as machine operators, carpenters, and welders. Their work directly contributes to the final product.

  • Indirect Labor Cost includes wages of employees who support production but do not directly create products, such as supervisors, security guards, and maintenance staff. Efficient labor cost control enhances productivity and reduces overall production expenses.

Overhead Cost:

Overhead costs include all expenses other than direct material and direct labor. These costs are essential for production but cannot be directly linked to a specific unit. Overheads are classified into Factory Overheads, Administrative Overheads, Selling & Distribution Overheads.

  • Factory Overheads: Expenses like machine depreciation, power, and factory rent.

  • Administrative Overheads: Costs related to management, office rent, and salaries of executives.

  • Selling & Distribution Overheads: Marketing expenses, transportation, and commission on sales. Proper overhead allocation helps businesses determine product pricing and cost control.

Direct Material Cost:

Direct Material Cost refers to the expense incurred on raw materials that are directly used in the production of a specific product or service. These materials can be easily traced to a particular unit of production and significantly impact the total cost of goods manufactured.

For example, in the automobile industry, steel, tires, and engines are direct materials for car manufacturing. Similarly, in the furniture industry, wood and nails used to make chairs and tables are considered direct materials.

Characteristics of Direct Material Cost:

  1. Directly Identifiable: Materials are specifically assigned to a particular product.

  2. Variable in Nature: Costs fluctuate based on production volume.

  3. Major Cost Component: Forms a substantial part of the total product cost.

  4. Requires Proper Control: Effective procurement and inventory management help reduce material wastage and optimize costs.

Importance of Direct Material Cost:

  • Affects Product Pricing: Higher material costs increase product prices.

  • Impacts Profit Margins: Efficient material usage improves profitability.

  • Influences Production Planning: Ensures material availability for continuous operations.

Management Notes

Cash Volume Profit Analysis

indiafreenotesby indiafreenotes3

Cost-Volume-Profit (CVP) analysis is a managerial accounting tool used to study the relationship between a company’s sales volume, revenues, costs, and profits. CVP analysis helps businesses make informed decisions regarding pricing, sales mix, and other operational factors. This analysis is useful for businesses of all sizes and industries.

Components of CVP analysis are:

Sales Volume (Q):

Sales volume is the total quantity of goods or services sold within a given period.

Sales Revenue (R):

Sales revenue is the total amount of revenue generated from the sale of goods or services. It is calculated by multiplying the sales volume by the selling price per unit (P).

R = P × Q

Variable Costs (VC):

Variable costs are costs that vary with changes in sales volume or level of activity. Examples of variable costs include direct materials, direct labor, and variable overhead costs. The total variable costs (TVC) can be calculated by multiplying the variable cost per unit (VCu) by the sales volume (Q).

TVC = VCu × Q

Fixed Costs (FC):

Fixed costs are costs that do not vary with changes in sales volume or level of activity. Examples of fixed costs include rent, depreciation, salaries, and property taxes. The total fixed costs (TFC) remain constant regardless of the sales volume.

Contribution Margin (CM):

Contribution margin is the amount of revenue available to cover the fixed costs and generate a profit. It is calculated as the difference between sales revenue and total variable costs.

CM = R – TVC

Break-Even Point (BEP):

The break-even point is the level of sales volume at which the total revenues equal the total costs. At this point, the business is neither making a profit nor incurring a loss. The break-even point can be calculated by dividing the total fixed costs by the contribution margin per unit (CMu).

BEP = TFC / CMu

The above formulas can be used to perform a variety of CVP analysis calculations. Some of the most common CVP analysis applications are:

Determining the Sales Volume required to break even:

To determine the sales volume required to break even, the business must first calculate its contribution margin per unit and divide it into the total fixed costs.

BEP = TFC / CMu

Once the break-even point is calculated, the business can determine the level of sales volume required to cover all of its costs and break even.

Determining the Sales Volume required to achieve a target profit:

To determine the sales volume required to achieve a target profit, the business must first calculate its contribution margin per unit. Then, it should subtract the target profit from the total fixed costs and divide the result by the contribution margin per unit.

Target Sales Volume = (TFC + Target profit) / CMu

The business can then use this information to set sales targets and pricing strategies to achieve the desired level of profit.

Evaluating the impact of changes in sales volume on profits:

By analyzing the relationship between sales volume, costs, and profits, businesses can evaluate the impact of changes in sales volume on their profitability. For example, they can calculate the contribution margin and net profit for different levels of sales volume and determine the most profitable sales mix.

Evaluating the impact of changes in selling prices on profits:

By analyzing the relationship between selling prices, costs, and profits, businesses can evaluate the impact of changes in selling prices on their profitability. For example, they can calculate the contribution margin and net profit for different selling prices and determine the optimal pricing strategy.

Evaluating the impact of changes in variable costs on profits:

By analyzing the relationship between variable costs, selling prices, and profits, businesses can evaluate the impact of changes in variable costs on their profitability. For example, they can calculate the contribution margin and net profit for different variable costs and determine the optimal cost structure.

Evaluating the impact of changes in the sales mix on profits:

By analyzing the relationship between different products’ sales volume, selling prices, and variable costs, businesses can evaluate the impact of changes in the sales mix on their profitability. For example, they can calculate the contribution margin and net profit for different product mixes and determine the most profitable sales mix.

Evaluating the impact of changes in fixed costs on profits:

By analyzing the relationship between fixed costs, sales volume, and profits, businesses can evaluate the impact of changes in fixed costs on their profitability. For example, they can calculate the break-even point and net profit for different levels of fixed costs and determine the optimal cost structure.

Assumptions of Cash Volume Profit Analysis

Following are the assumptions of CVP Analysis:

(i) No. of Units – Only Driver for Costs and Revenues

It assumes that the total variable costs and revenues would increase or decrease only due to a change in no. of units. There are no factors that will affect it.

(ii) Costs – Either Variable or Fixed

This assumption says that all the costs are either variable or fixed. In other words, it says that there are no semi-variable or semi-fixed costs.

(iii) No Change in Price, Variable Cost, and Fixed Costs

CVP analysis assumes that there are no changes in the price and variable cost per unit irrespective of change in time period and relevant range. If we see closely, it is neglecting the chances of changes in prices due to inflation, economic conditions etc. Also, neglecting the bulk order discounts and small order premiums.

Importance of Cash Volume Profit Analysis

If you are offered a business idea wherein you sell chairs. The first thing few things that will strike your mind is

  • Required initial investment
  • Amount of sales required to breakeven
  • Assess whether you are capable of achieving that sale

This analysis is important because it answers the second most important question. This is not a one time question as well. This is a regular assessment. A businessman has to keep checking whether he is reaching the milestones set as per cost volume profit analysis. This will guide his decision-making process relating to increases in fixed costs, the speed of business operations etc.

Advantages of Cash Volume Profit Analysis

(i) Helps managers find out a breakeven point, target operating income etc.

(ii) Cost Volume Profit technique is used to evaluate investment proposals

(iii) Sets the base for planning the marketing efforts of a business

(iv) Helps in setting up the basis for budgeting activity

Disadvantages of Cash Volume Profit Analysis

(i) In a current dynamic business environment, the costs and prices can’t remain constant throughout the year. A manager is forced to react and make necessary changes in prices and costs due to change in economic conditions, customer bargaining powers, competitors etc.

(ii) All costs cannot be classified as fixed or variable. There is a significant list of costs which are neither fixed nor variable but are semi-variable or semi-fixed. Say, for example, a utility or electricity invoice contains rent as a component which remains constant irrespective of the change in usage of no. of electricity units.

(iii) No. of units cannot be the only driver of total costs and revenues. There are other factors also that impact the prices as well as costs. The raw material price reduction can reduce the variable cost and therefore the customers with knowledge of this change will demand a reduction in prices as well. Similarly, the entrance of a new big player in the market forces all the firms in the market to reduce their cost or compromise or bear loss of customers.

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