Cost methods and variances of costing

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According to Lucey.T (1996) costing is the establishment of budgets, standard costs and actual costs of operations, process, activities or product and analysis of variances, profitability or the social use of funds.

Direct costs are the costs that can be specifically identified with a specific unit in an effective manner. It can be further classified as follows:

Direct material cost - e.g. Cloth is a direct material in shirt production.

Direct labour cost - e.g. Wages for employee who engaged in printing.

Direct Expense - e.g. Royalty payment.

All direct costs are commonly known as "prime cost"

Indirect cost

Indirect costs are the costs that cannot be specifically identified with a specific unit in an effective manner. These costs are commonly refereed as "overheads" these are classified such as:

Indirect material cost - e.g. staples used in book binding.

Indirect labour cost - e.g. wages for the cleaner.

Indirect expenses - e.g. rent.

Classification of cost system

Cost information is very important to achieve various kinds of objectives such as decision making, inventory valuation or control. These information cannot use in a similar way for all objectives. Therefore costs are classified in different ways.

According to the behaviour cost can be classified as

Fixed cost

Variable cost

Semi variable cost

Fixed cost

Costs that are remain unchanged with the level of activity for a specific period of time. In other word in short run these costs are not changes with the changes in production volume. E.g. rent and rates, manager salary.

Cost

(In £)

Fixed Cost

10,000

Volume

500 1000 1500

Variable cost

Cost changes in direct proportion with the volume of activity. E.g. direct material, direct labour.

Cost

(In £) Variable Cost

2000

1500

1000

500

Volume

50 100 150

Semi variable cost

Cost contains both fixed and variable components. Costs are fixed in specific level and becoming variable after the level exceeded. E.g. Telephone charged, salesman remuneration

Cost

(In £) Semi variable cost

2000

1500

1000

500

Volume

50 100 150

According to the functions cost can be classified as production cost, administration cost, selling and distribution cost.

Production cost is the cost incurred for the manufacturing activities. It consist the direct material cost, direct labour cost and factory overheads.

Administration costs are the costs incurred in management activities, accounting and administration services.

Selling and distribution costs are the costs incurred for selling and deliver to the customers. Costs such as order, deliver charges are included.

Pricing

Pricing is method used by the companies to set their prices. All the companies use different types of pricing policy to cover their costs and profits.

Marginal costing

According to Lucey,(1996) the accounting system in which variable costs are charged to cost units and the fixed costs of the period are written off in full against the aggregate contribution its special value is in decision making.

Marginal costing considering the variable cost as a total production cost for the decision making. Marginal It is used by the management for the internal decision making. Only variable cost charged to cost unit.

{Total cost = Variable cost}

Advantages of marginal costing

Marginal costing is very simple to understand.

Very useful method for short term decision making. Because of the separation of variable and fixed cost it provides relevant information about the cost for the decision making.

Cost control is facilitated in practically.

Disadvantages of marginal costing

Sometimes it will give the misleading results.

It does not suit for the long term profit plan. Marginal costing technique disregards the use of recovering fixed cost so it is not useful for long run continuity of the business.

Absorption costing

Absorption costing is costing method which takes both the variable cost and the fixed cost as a total cost of production. According to the SSAP 9 absorption costing method is approved to taken into account for the external reporting. All costs are charged to cost unit.

{Total cost = fixed cost + variable cost}

Advantages of absorption costing

It is consider the fixed cost also for the calculation of the production cost

This is the accepted method to prepare the financial account for the external use

Ensure the costs are fully recovered

It avoids the fictitious losses

Disadvantages of absorption costing

It is not effective for the management to use for the decision making

Complex and time consuming

Cost variances

Variance represents the difference between the standard cost and the actual cost. When actual results better than the standard a favourable variance arises. When standard results better than the actual an adverse variance will arise.

Direct material price variance

Difference between the actual material cost and standard material cost is direct material price variance. When the standard cost of direct material is higher than the actual cost it is favourable. It may cause when the substitute material used, discount by buying in bulk. When the actual material cost is higher than the standard it is adverse. It may cause because of inefficient forecast, inferior quality of material used. The management should take efficient decision to the better performance.

Direct material usage variance

The difference between the actual quantity of material used and standard quantity of material is direct material usage variance. When the standard quantity is higher than the actual it is favourable. Results when efficient material used because wastage is minimized. Actual quantity is higher than the standard quantity it is adverse. It may cause because of inefficient material usage that means wastages of material.

Direct labour rate variance

The difference between the standard rate for labour and actual rate for labour is direct labour rate variance. When the standard rate is higher than the actual it is favourable.It obtain through the strong wage bargaining power of the management, if cheap labour employed. When actual rate is higher than the standard quantity it is adverse. It may cause when there is labour shortage or shortage of skilled labour.

Direct labour efficiency variance

The difference between the standard hours for the production and actual hours worked for the production is labour efficiency variance. When the standard hour is higher than the actual it is favourable. It obtain when efficiency workforce hired, when employees motivated. Actual hour is higher than the standard quantity it is adverse. It causes when the workers demotivated, or, low efficiency workforce.

Responsibility accounting

In a large organization it is difficult to manage all the performance of the organization by the centralized team. It is impossible to manage all performance by a single segment. So the organization separated in to variance segment. So for each segment is manage by separate management. The responsible person for the each segment will control the performance of that particular segment. It will reduce work load and the responsibility also. The separated segment is known as responsibility centre. Responsibility centre include revenue centre, cost centre, profit centre and investment centre.

Cost centre

A cost centre is a place, a location, a department in a large organization whereby all costs are gathered. Here the all costs are identified and collected by the responsible management and make the decision using those costs. Relevant steps will be taken to control the costs.

Revenue centre

Revenue centre is a place, a location, a department in a large organization where all the revenues are collected.

Profit centre

Profit centre is a place, a location, a department where all the revenues and costs are collected and measure profit. Manager of this segment is responsible for the performance.

Investment centre

Investment centre is a place, a location, a department in a large organization where all the investment process are controlled by the investment manager.

Conclusion

We have explained about the costing and classification of cost system in different ways for the decision making. Pricing policy also explained using marginal and absorption costing. We have examined and compared marginal and absorption costing. Cost variances also explain through the critical analysis. Finally, responsibility account is explained.

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