6.

0 Estimation and Costing

When a new firm is getting started, the owner
has to spend on land, building, machineries,
materials, etc. So he has to evaluate how much
is his investment and what will be the profit.

Cost is the amount of expenditure incurred on a given product.

Accounting method of recording business transactions in a proper way
as to show
The true state of affairs of a business at a particular instant of time
Deficiency or surplus which has accrued (an accounting expense recognized in the
books before it is paid for. It is a liability) during a specific time period.
Costing is the technique of ensuring the costs of given products. It
involves
1. Classifying, recording and proper allocation of expenditure for the
determination of costs of products or services.
2. Relation of these costs to sales values
3. Ensuring profitability

 Cost accounting is necessary because it gives information for

Determining, classifying and analyzing the cost and income of a business
enterprise.
Determining the prices to be quoted to customers.
Forming basis for managerial decisions that have to do with (like make or buy
decision, introducing new product, etc)
Cost control through accumulation and utilization of cost data.
Profitability of products
Budgeting (planning, co-coordinating and controlling through budgets)
Continuation of business
Proper matching of costs with revenues
Control of materials and supplies
Wages and overhead costs

Objectives of costing
To regulate selling, wrt the condition of demand and
supply.
To take a decision whether to make or buy a product
by considering the cost in each case.
To establish standards against which actual costs can
be compared.
To estimate the costs as accurately as possible to
avoid loss from low quotations or loose business
from high quotations.
To ascertain which products pay and which do not
pay.
To provide definite check on the financial records.

Elements of cost are Material, Labour and Expenses

Material cost It is the cost of commodities supplied to an undertaking.
These are of two types
1.
Direct material cost
2.
Indirect material cost
Direct materials those which when processed through various stages,
form the main product or component part of main product. These
are used for salable product or its use is directly essential for the
completion of that product. These are called as Productive
materials. Ex. H.S.S. bit for making a turning tool for lathe, ex Fe,
Ni, Cr, etc. to make alloy steels.
Indirect materials these are those materials which are essentially needed
for helping direct materials to be converted into final products. Ex.
Lubricants, oils, greases, coolants,cotton waste, sand paper,etc.

Labour cost It is the cost of remuneration (wages, salaries, commissions,

bonus, etc.) of the employees of a company. there are two types Direct
labour cost
Indirect labour cost
Direct labour cost the workers who actually work and process the different
materials manually or with the aid of machines are known as direct labour.
They are also called as Productive Labour. Their wages can be directly
charged to the job they are manufacturing.
A direct labourer is one who converts direct material into salable product.
Ex. Wages of a welder fabricating a structure.
Indirect labour cost any other labour, which helps the productive labour in
performing their duties is called Indirect labour. Their wages can not be
charged directly to a particular job. Ex. Foreman, supervisor, inspector, etc.

Expenses It refers to all charges other than those incurred as

direct result of employing workers or obtaining material.
These are classified into two categories
Direct expenses and Indirect expenses
Direct Expenses are those which can be charged directly
to a particular job and incurred for that specific job only.
Ex. Cost of a special jig on a job. Ex. Costs of special
layouts, designs or single purpose machine tools or other
equipments for completion of a production order.
Indirect expenses are called as overhead charges on
costs, indirect charges, secondary costs or supplementary
costs. Ex. Rent on building, insurance premium, telephone
bill, etc. These may be fixed or variable expenses.

Overheads
These are expenses other than direct expenses.
An overhead is the cost of indirect material and indirect
labour including services. These are further classified as
1. Factory or manufacturing or production overhead
2. Administration overhead
3. Selling overhead
4. Distribution expenses
5. R & D overhead

Production overhead (Factory expenses)

It includes all indirect expenses incurred by the concern from
the receipt of production order until its completion i.e.
being ready for dispatch to customer.
Factory expense is called Works on Cost. It is the overhead
expenditure made on actual operation of plant like Indirect
Material and Indirect Labour.

Types of production overheads are

1.
2.
3.
4.
5.
6.

Building expenses Rent, insurance, repairs, heating and

lighting, depreciation, etc.
Indirect labour Supervisors, foremen, machine setters,
shop clerk, shop inspector, maintenance men, worker,
etc.
Water, fuel, and power (steam, gas,electric, pneumatic
and hydraulic)
Consumable stores like cotton waste, grease, etc.
Plant maintenance and depreciation
Expenses towards security, recreation, employment
office, etc.)

Administration overhead
It consists of expenses incurred in the direction, control and
administration of an enterprise. These overheads include
all the expenditure made on salaries of general office staff
and executive staff, telephone charges, depreciation
charges etc. These are called as Establishment on cost or
office expenses.
Ex. Office rent, salaries, wages of staff, insurance, legal costs,
taxes, postage and telephone, audit fees, bank charges. Etc.

Selling overhead consists of expenses in order to

maintain and increase the volume of sales. It includes all
expenses direct or indirect which are necessary to persuade
consumers to buy.
Ex. Advertisement
Salaries and commission of sales personnel, agents
Rent of sales room or offices.
Consumer service and service after sales.

Distribution overhead
It covers all expenses connected with transportation of
products to customers and storing them.
Ex. Warehouse charges
Cost of transporting goods
Loading and unloading charges
Maintenance of delivery vehicles.
Salaries of clerks and labourers
Depreciation, etc.

Research and development overhead

Includes all expenses towards research and

development. It depends on nature of
product or service being produced.

Components of cost

Prime cost = Direct material cost + Direct labour cost +

(Variable) Direct expenses

Factory Cost = Prime cost + Factory overhead

= Direct material cost +Direct labour cost +
(variable) direct expenses + Factory
overhead
Total cost = Factory cost + Selling overhead +
Distribution overhead + Administrative
overhead
Selling Price = Total cost Profit or Loss

EX. A factory produces 100 switches. The material cost is Rs.

710, Labour cost is Rs. 310, Cost of tool is Rs. 100, Factory
overhead is 150% of the labour cost, office on cost is 30% of
factory cost. Selling price of each switch is Rs.2 . Find
whether there is profit or not to the firm.
Soln : Prime cost = Direct material cost + direct labour cost
= 710 + 310 = Rs. 1020
Factory overhead = 150% of labour cost = 1.5 x 310 = 465
Factory expenses = Factory overhead + tool cost
= 465+100 = 565
Factory cost = Prime cost + Factory expenses
= 1020 + 565 = 1585

Office on cost = 30% of factory cost

= 0.3 x 1585 = 475.5
Selling cost = Factory cost + Office on cost
= 1585 + 475.5 = 2060.5
Cost of each switch = 2060.5/100 = 2.060
Selling price = 2
Hence there is a loss of Rs. 0.6 per switch.

A factory producing 150 electric bulbs a day, involves direct

material cost of Rs. 250, direct labour cost of Rs. 200 and
factory overheads of Rs. 225. Assuming a profit of 10% of
the selling price and selling on cost (overhead) 30% of the
factory cost, calculate selling price of one bulb.

Factory cost = Direct material cost + direct

labour cost + factory overheads
= 250 + 200 + 225 = 675
Total cost = Factory cost + selling overhead
= 675 +(675x30100)
= 877.50

Depreciation is the reduction in the value or effective

economic life of a product arising from the passage of time,
use or wear and tear.

It is the method of spreading the cost of a long

term asset over the life or expected years of usage
of the asset.
It is applied to fixed assets like buildings, plant,
machinery and vehicles which suffer natural
deterioration in the course of time.
It is the annual charge reflecting the decline in
value of an asset due to such causes as wear, teat,
action of elements, outdated, etc.

Causes of depreciation

Physical causes
Custom or usage
Abnormal occurrences
Technological development and charges
(a) physical causes
1. wear and tear due to friction, pull, impact, fatigue,
twisting, etc.
2. Lack of maintenance and timely repairs of fixed assets
3. Action of chemical elements on the component parts.
4. Passage of time

b) Custom or usage It is usually put on vehicles on the rate of

wear and tear expected every year.
c) Abnormal occurrences due to accidents, defects in
materials, contingent occurrences like cracks in pressure
vessels, etc.
d) Technological developments like new equipments
superceding existing ones make existing obsolete,
change in manufacturing methods, etc.

Methods to calculate depreciation

Straight line method

Reducing balance method
Production based method per unit and per hour
Repair provision method
Annuity method
Sinking fund method
Endowment policy method
Sum of digits method

Straight line method

This method provides for depreciation by means of equal
periodic charges over the assumed life of the asset.
This is also called as fixed installment method or
proportional method.
C-S
Annual depreciation charge = ADC =
N
C is the original cost of the asset
S is scrap value or residual value at the end of its useful life.
N is serviceable life in years

A melting unit for a steel foundry was purchased for 30000.

An additional 5000 was spent on its erection and
commissioning. The estimated value after 10 years was 7000.
Calculate annual rate of depreciation. Find the depreciation
fund collected at the end of 7 years after purchase of melting
unit.

C = 30000 + 5000 = 35000

S = 7000
N = 10 years
ADC = (35000-7000)/10 = 2800
Depreciation fund collected at the end of 7 years
= 7 x 2800 = 19600

Sum of digits method provides depreciation by means of

differing periodic rates calculated as follows
If N is estimated life of a machine, rate is calculated for
each period as a function in which denominator is always
sum of series 1+2+3++N. Numerator for the first period
is N, for second, N-1, for third, N-2,etc.
It is used for motor vehicles
It makes decision to sell and repurchase before estimated
time, easier and faster.

Ex. Cost of a vehicle is 1,90,000. The scrap value after 5

years is estimated as 40000. Using SOD methods, calculate
the depreciation rate every year.

Denominator = 1+2+3+4+5 = 15
Numerators are 5, (5-1), (5-2),(5-3),(5-4)
Depreciation charge for
Year 1 = (5/15) of (190000-40000) = 50000
Year 2 = (4/15) of 1,50,000 = 40,000
Year 3 = (3/15) of 150000 = 30000
Year 4 = (2/15) of 150000 = 20000
Year 5 = (1/15) of 150000 = 10000

Production based methods 1. Production unit method

2. Production hour method
This provides a means of fixed rate per unit of production
calculated by dividing the value of asset by estimated no
of units to be produced during its life.
Value of asset
Rate of depreciation =
No of units of production
Ex. A machine costing 2 lac has a residual value of 1 lac after
10 years of service. The estimated rate of production is 8
units per hour. Calculate rate of depreciation. Assume a 50
week year and a 46 hour week.

2lac 1 lac
Rate of dep =
10 x 50 x 46 x 8
2. Production hour method provides a means of fixed rate
per hour of production.
Value of asset
Rate of dep =
No of production hours

A m/c costing 15000 has a scrap value of 5000 at the end of

10 years of its serviceable life. If the machine runs for 2100
hours per year, calculate the dep rate per hour of the m/c and
total annual dep.

15000-5000
Rate of dep per hour of machine=

0.476
10 x 2100

Annual dep = .476 x no of hours/year

=.478 x 2100 = 1000