Cost Accounting Basics

Cost Accounting Basics

🟢 Lite — Quick Review (1h–1d)

Rapid summary for last-minute revision before your exam.

Cost accounting records, classifies, analyses and allocates the costs of products, services, departments or projects so management can plan, control and reduce expenditure. It serves internal users, unlike financial accounting which serves external stakeholders.

• Prime cost = Direct materials + Direct labour + Direct expenses (Rs).
• Total production cost = Prime cost + Manufacturing overheads (Rs).
• Cost per unit = Total production cost ÷ Units produced.
• Overhead absorption rate = Estimated overheads (Rs) ÷ Estimated activity base (hours or units).
• Selling, distribution and admin overheads are expensed in the period, not absorbed into inventory (IAS 2 equivalent treatment).
• Always reconcile cost profit with financial profit — they differ on stock valuation, depreciation and notional costs.

🟡 Standard — Regular Study (2d–2mo)

Standard content for students with a few days to months.

Cost classification

Costs are grouped three ways: by element (materials, labour, expenses), by behaviour (fixed, variable, semi-variable) and by traceability (direct vs indirect). A cost object is anything costs are assigned to, while a cost unit is a standard measure of output (e.g. one tonne, one patient-day). A cost centre is a location or function (a factory, a department) where costs are accumulated.

Building up cost

The costing pyramid starts from direct costs, adds manufacturing overheads, and arrives at total production cost. Prime cost excludes any overhead; total cost includes overhead absorption at a pre-set rate.

Overhead allocation and absorption

Overheads are first allocated to cost centres, then apportionment spreads service-centre costs across production centres using suitable bases (floor area, machine value, labour hours). Absorption adds the overhead to units via labour, machine or activity-based rates.

Item	Formula	Notes
Prime cost	DM + DL + Direct expenses	Excludes any overhead
Total production cost	Prime cost + Manufacturing overheads	Used for inventory valuation
Cost per unit	Total cost ÷ Units produced	Sensitive to volume with fixed overhead
Overhead absorption rate	Estimated overheads ÷ Estimated activity	Choose a base that correlates with the cost driver

• Apply the high-low method to split a semi-variable cost into fixed and variable components.
• Under IAS 2, only production costs (direct + fixed/variable production overheads) capitalise into inventory.
• Reconcile cost profit to financial profit by adjusting for opening/closing stock valuation differences and notional costs.

🔴 Extended — Deep Study (3mo+)

Comprehensive coverage for students on a longer study timeline.

Material and labour control

Material issues are priced using FIFO, LIFO, weighted average or standard price. In exam questions, FIFO usually gives the lowest closing-stock value when prices are rising. Labour costing tracks timekeeping, idle time and overtime: idle time is usually absorbed as overhead, while overtime premium is written off to the period unless specifically requested by a customer.

Standard costing variances

Material variance splits into price variance (Actual price − Standard price) × Actual quantity and usage variance (Actual quantity − Standard quantity) × Standard price. Labour mirrors this with rate and efficiency variances. Always total them into a combined material or labour variance as a check.

CVP and relevant costing

Contribution = Sales − Variable cost. Break-even units = Fixed cost ÷ Contribution per unit. Margin of safety = Budgeted sales − Break-even sales, expressed as a percentage. For short-term decisions, only avoidable cost and opportunity cost are relevant — sunk cost is ignored.

Decision factor	Treatment
Avoidable cost	Include — it disappears if the decision is taken
Opportunity cost	Include — the benefit forgone
Sunk cost	Exclude — already incurred and irrecoverable
Notional cost	Exclude from financial profit reconciliation

Common traps and worked check

• Confusing prime cost with total cost by forgetting overhead absorption.
• Using a single rate for fixed and variable overheads when output fluctuates — under- or over-absorption results.
• Forgetting to exclude selling and admin overheads from inventory valuation.

Practice prompts: (1) A factory produces 5,000 units. Direct materials Rs 250,000; direct labour Rs 150,000; direct expenses Rs 20,000; manufacturing overheads absorbed Rs 180,000. Compute prime cost, total production cost and cost per unit. (2) Budgeted fixed cost Rs 600,000; selling price Rs 250; variable cost per unit Rs 150. Calculate break-even units and margin of safety at 6,000 units sold.

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