6.0 Estimation and CostingWhen 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 timeDeficiency or surplus which has accrued (an accounting expense recognized in the books before it is paidfor. It is a liability) during a specific time period.Costing is the technique of ensuring the costs of given products. It involvesClassifying, recording and proper allocation of expenditure for the determination of costs of products or services.Relation of these costs to sales valuesEnsuring profitability

Cost accounting is necessary because it gives information forDetermining, 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 productsBudgeting (planning, co-coordinating and controlling through budgets)Continuation of businessProper matching of costs with revenuesControl of materials and suppliesWages and overhead costs

Objectives of costingTo 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 ExpensesMaterial cost It is the cost of commodities supplied to an undertaking. These are of two typesDirect material costIndirect material costDirect 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 costDirect 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 categoriesDirect expenses and Indirect expensesDirect 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 overhead2. Administration overhead3. 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 areBuilding 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 depreciationExpenses 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 overheadIt covers all expenses connected with transportation of products to customers and storing them.Ex. Warehouse chargesCost of transporting goodsLoading and unloading chargesMaintenance of delivery vehicles.Salaries of clerks and labourersDepreciation, etc.

Research and development overheadIncludes 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 expensesFactory Cost = Prime cost + Factory overhead = Direct material cost +Direct labour cost + (variable) direct expenses + Factory overheadTotal cost = Factory cost + Selling overhead + Distribution overhead + Administrative overheadSelling 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. 1020Factory overhead = 150% of labour cost = 1.5 x 310 = 465 Factory expenses = Factory overhead + tool cost = 465+100 = 565Factory cost = Prime cost + Factory expenses = 1020 + 565 = 1585

Office on cost = 30% of factory cost = 0.3 x 1585 = 475.5Selling cost = Factory cost + Office on cost = 1585 + 475.5 = 2060.5Cost of each switch = 2060.5/100 = 2.060Selling price = 2Hence 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 = 675Total 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 depreciationPhysical causesCustom or usageAbnormal occurrencesTechnological 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. Abnormal occurrences due to accidents, defects in materials, contingent occurrences like cracks in pressure vessels, etc.Technological developments like new equipments superceding existing ones make existing obsolete, change in manufacturing methods, etc.

Methods to calculate depreciationStraight line methodReducing balance methodProduction based method per unit and per hourRepair provision methodAnnuity methodSinking fund methodEndowment policy methodSum of digits method

Straight line methodThis 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 - SAnnual depreciation charge = ADC = NC is the original cost of the assetS 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 = 35000S = 7000N = 10 yearsADC = (35000-7000)/10 = 2800Depreciation 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 followsIf 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 vehiclesIt 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 = 15Numerators are 5, (5-1), (5-2),(5-3),(5-4)Depreciation charge for Year 1 = (5/15) of (190000-40000) = 50000Year 2 = (4/15) of 1,50,000 = 40,000Year 3 = (3/15) of 150000 = 30000Year 4 = (2/15) of 150000 = 20000Year 5 = (1/15) of 150000 = 10000

Production based methods 1. Production unit method 2. Production hour methodThis 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 assetRate of depreciation = No of units of productionEx. 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 lacRate 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 assetRate 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=0.47610 x 2100

Annual dep = .476 x no of hours/year =.478 x 2100 = 1000