Finance Aspect-cost of capital

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Chapter 1

Basic Cost Concepts

Learning Objectives

 To understand the meaning of different costing terms

 To understand different costing methods

 To have a basic idea of different costing techniques

 To understand the meaning of cost sheet

In order to determine and take a dispassionate view about what lies beneath the surface of

accounting figures, a financial analyst has to make use of different management accounting

techniques. Cost techniques have a precedence over the other techniques since accounting

treatment of cost is often both complex and financially significant. For example, if a firm

proposes to increase its output by 10%, is it reasonable to expect total cost to increase by less

than 10%, exactly 10% or more than 10%? Such questions are concerned with the cost behavior,

i.e. the way costs change with the levels of activity. The answers to these questions are very

much pertinent for a management accountant or a financial analyst since they are basic for a

firm’s projections and profits which ultimately become the basis of all financial decisions. It is,

therefore, necessary for a financial analyst to have a reasonably good working knowledge about

the basic cost concepts and patterns of cost behavior. All these come within the ambit of cost

accounting.

Meaning of Cost Accounting

Previously, cost accounting was merely considered to be a technique for the ascertainment of

costs of products or services on the basis of historical data. In course of time, due to competitive

nature of the market, it was realized that ascertaining of cost is not so important as controlling

costs. Hence, cost accounting started to be considered more as a technique for cost control as

compared to cost ascertainment. Due to the technological developments in all fields, cost

reduction has also come within the ambit of cost accounting. Cost accounting is, thus, concerned

with recording, classifying and summarizing costs for determination of costs of products or

services, planning, controlling and reducing such costs and furnishing of information to

management for decision making.

According to Charles T. Horngren, cost accounting is a quantitative method that accumulates,

classifies, summarizes and interprets information for the following three major purposes:

 Operational planning and control

 Special decisions

 Product decisions

According to the Chartered Institute of Management Accountants, London, cost accounting is the

process of accounting for costs from the point at which its expenditure is incurred or committed

to the establishment of the ultimate relationship with cost units. In its widest sense, it embraces

the preparation of statistical data, the application of cost control methods and the ascertainment

of the profitability of the activities carried out or planned.

Cost accounting, thus, provides various information to management for all sorts of decisions. It

serves multiple purposes on account of which it is generally indistinguishable from management

accounting or so-called internal accounting. Wilmot has summarized the nature of cost

accounting as “the analyzing, recording, standardizing, forecasting, comparing, reporting and

recommending” and the role of a cost accountant as “a historian, news agent and prophet.” As a

historian, he should be meticulously accurate and sedulously impartial. As a news agent, he

should be up to date, selective and pithy. As a prophet, he should combine knowledge and

experience with foresight and courage.

Objectives of Cost Accounting

The main objectives of cost accounting can be summarized as follows:

1. Determining Selling Price

Business enterprises run on a profit-making basis. It is, thus, necessary that revenue

should be greater than expenditure incurred in producing goods and services from which

the revenue is to be derived. Cost accounting provides various information regarding the

cost to make and sell such products or services. Of course, many other factors such as the

condition of market, the area of distribution, the quantity which can be supplied etc. are

also given due consideration by management before deciding upon the price but the cost

plays a dominating role.

2. Determining and Controlling Efficiency

Cost accounting involves a study of various operations used in manufacturing a product

or providing a service. The study facilitates measuring the efficiency of an organization

as a whole or department-wise as well as devising means of increasing efficiency.

Cost accounting also uses a number of methods, e.g., budgetary control, standard costing

etc. for controlling costs. Each item viz. materials, labor and expenses is budgeted at the

commencement of a period and actual expenses incurred are compared with budget. This

greatly increases the operating efficiency of an enterprise.

3. Facilitating Preparation of Financial and Other Statements

The third objective of cost accounting is to produce statements whenever is required by

management. The financial statements are prepared under financial accounting generally

once a year or half-year and are spaced too far with respect to time to meet the needs of

management. In order to operate a business at a high level of efficiency, it is essential for

management to have a frequent review of production, sales and operating results. Cost

accounting provides daily, weekly or monthly volumes of units produced and

accumulated costs with appropriate analysis. A developed cost accounting system

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Chapter 1 Basic Cost Concepts Learning Objectives To understand the meaning of different costing terms To understand different costing methods To have a basic idea of different costing techniques To understand the meaning of cost sheet In order to determine and take a dispassionate view about what lies beneath the surface of accounting figures, a financial analyst has to make use of different management accounting techniques. Cost techniques have a precedence over the other techniques since accounting treatment of cost is often both complex and financially significant. For example, if a firm proposes to increase its output by 10%, is it reasonable to expect total cost to increase by less than 10%, exactly 10% or more than 10%? Such questions are concerned with the cost behavior, i.e. the way costs change with the levels of activity. The answers to these questions are very much pertinent for a management accountant or a financial analyst since they are basic for a firm’s projections and profits which ultimately become the basis of all financial decisions. It is, therefore, necessary for a financial analyst to have a reasonably good working knowledge about the basic cost concepts and patterns of cost behavior. All these come within the ambit of cost accounting. Meaning of Cost Accounting Previously, cost accounting was merely considered to be a technique for the ascertainment of costs of products or services on the basis of historical data. In course of time, due t ...
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