MANAC — Foundations: Cost Concepts, Overhead Mechanics & Cost Sheet

What this file is: This is the prerequisite layer for Sessions 9, 10, and 12. It covers the concepts taught in the initial sessions — elements of cost, classification, departmentalization, overhead collection, distribution, and absorption — that those later sessions assume you already know. Every concept here has a direct link to where it reappears in the advanced sessions. Every abbreviation is expanded on first use.

Table of Contents

1. Why Cost Accounting Exists
2. Elements of Cost
3. Classification of Costs
4. Prime Cost vs Overhead (OH)
5. Cost Objects and Cost Centres
6. The Cost Sheet — Full Structure
7. Items Excluded from Cost Accounts
8. Overhead (OH) Accounting — The Three-Stage Process
9. Stage 1 — Collection of Overheads
10. Stage 2 — Distribution / Apportionment
11. Stage 3 — Absorption of Factory Overheads
12. Predetermined Overhead Rates
13. Normal vs Actual Capacity
14. Over and Under Absorption of Overheads
15. Other Overheads — Admin, Selling & Distribution
16. Terminology & Definitions (Full Abbreviation Reference)
17. Connections to Sessions 9, 10, and 12
18. Revision Sheet

1. Why Cost Accounting Exists

Financial accounting tells you whether the firm made a profit. It does not tell you which product made the profit, which department is inefficient, or what price to charge for a new order.

Cost accounting fills that gap. Its purposes:

• Ascertain the cost of each product, job, service, or activity
• Control costs by comparing actual with estimated/standard
• Aid decisions — pricing, make/buy, product mix, capacity expansion, outsourcing
• Motivate managers through cost centre accountability

Cost accounting is the internal information system that sits beneath financial reporting. It does not follow GAAP (Generally Accepted Accounting Principles) — it follows whatever logic makes decisions better.

Link to later sessions: Sessions 9 and 10 ask whether your cost information is good enough to make strategy decisions. Session 12 asks how cost structure translates into profit. All of that depends on having accurate cost data — which starts here.

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2. Elements of Cost

Every cost is composed of three and only three elements:

Each element has two forms:

The critical rule: Direct or indirect is relative to the cost object. If a firm makes only one product, almost everything can be treated as direct. The moment there are multiple products, shared resources become indirect and allocation is unavoidable.

Total Cost Structure

Total Cost
├── Direct Costs (Prime Cost)
│   ├── Direct Material (DM)
│   ├── Direct Labour (DL)
│   └── Direct Expenses (DE)
└── Indirect Costs (Overhead / OH)
    ├── Indirect Material
    ├── Indirect Labour
    └── Indirect Expenses

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3. Classification of Costs

Costs can be classified along five dimensions. Each classification serves a different managerial purpose.

3.1 By Element (What the cost is made of)

Material, Labour, Expenses — see Section 2.

3.2 By Traceability (Direct vs Indirect)

Already covered in Section 2. The key insight: the same cost can be direct for one cost object and indirect for another.

3.3 By Function (Where in the business it arises)

3.4 By Behaviour (How cost responds to volume changes)

Important nuance from professor: Costs remain truly fixed or variable only within the relevant range. For large changes in output, almost all costs become semi-variable — if a factory starts running a second shift, "fixed" costs step up.

Fixed costs — two sub-types (important for Session 12):

• Committed fixed costs — long-term decisions; hard to reverse (depreciation, insurance, executive salaries)
• Discretionary fixed costs — annual management decisions; can be adjusted (advertising, training, R&D)

3.5 By Controllability

Why this matters: Performance evaluation must distinguish controllable from uncontrollable costs. Holding a manager accountable for costs they cannot control destroys motivation and produces bad data.

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4. Prime Cost vs Overhead (OH)

4.1 Prime Cost

Prime Cost (PC) = Direct Materials (DM) + Direct Labour (DL) + Direct Expenses (DE)

Prime cost is the directly attributable core of product cost. It is the first lever of operational control at product level — product managers own it.

4.2 Overhead (OH)

Overhead (OH) = Indirect Materials + Indirect Labour + Indirect Expenses

All indirect costs. They require allocation because they cannot be traced to a single product economically.

CIMA (Chartered Institute of Management Accountants) definition of overhead: "The total cost of indirect materials, indirect labour and indirect expenses."

4.3 Why the Distinction Matters

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5. Cost Objects and Cost Centres

5.1 Cost Object

A cost object is anything for which management wants to measure cost separately:

• A product or product line
• A department or cost centre
• A customer or customer segment
• A project, channel, or geography

You cannot control or improve what you cannot measure. Defining cost objects is the starting point of every costing system.

5.2 Cost Centre

A cost centre is a location, person, or item of equipment for which costs can be accumulated. It is a subdivision of the cost object concept — typically a department or machine.

Types:

• Production cost centres — directly involved in making the product (machining, assembly, finishing)
• Service cost centres — support the production centres (stores, maintenance, HR, boiler room)

The critical flow: Service centre costs → Production centres → Products

This flow is the subject of Stage 2 (secondary distribution) in Section 10. It is the mechanical foundation for everything in Sessions 9 and 10 about ABC (Activity-Based Costing) vs traditional allocation.

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6. The Cost Sheet — Full Structure

The cost sheet is the systematic accumulation of costs from raw materials through to the selling price. It serves two purposes: (1) ascertain total product cost, and (2) identify which block of cost is responsible for any deviation.

6.1 Exhaustive Cost Sheet Format

                                                Total    Per Unit
                                                  ₹         ₹

Opening Stock of Direct Raw Materials (RM)
+ Purchases
+ Carriage Inward
+ Import duties, octroi, customs duty
- Closing Stock of Direct RM
= COST OF DIRECT MATERIALS CONSUMED

+ Direct (Productive) Wages
+ Direct Expenses
                                               ──────   ──────
= PRIME COST
                                               ──────   ──────

Add: Factory / Works Overheads:
  Indirect materials
  Indirect wages
  Leave wages and overtime premium
  Fuel and power / coal
  Factory rent and rates
  Insurance (factory premises, plant)
  Factory lighting and heating
  Supervision
  Works stationery
  Canteen and welfare expenses
  Repairs and maintenance
  Haulage and internal transport
  Works salaries
  Depreciation of plant and machinery
  Drawing office salaries
  Technical director's fees
  Laboratory expenses
  Works telephone
Less: Sale of scrap
+ Opening Stock of Work-in-Progress (WIP)
- Closing Stock of WIP
                                               ──────   ──────
= WORKS / FACTORY COST (Cost of Manufacturing)
                                               ──────   ──────

Add: Office and Administrative Overheads:
  Office salaries
  Director's fees
  Office rent and rates
  Office stationery and printing
  Depreciation of office equipment and furniture
  Audit fees, legal charges
  Postage, telephone
  Office lighting
  Director's travelling expenses
                                               ──────   ──────
= COST OF PRODUCTION
                                               ──────   ──────

+ Opening Stock of Finished Goods
- Closing Stock of Finished Goods
                                               ──────   ──────
= COST OF GOODS SOLD (COGS)
                                               ──────   ──────

Add: Selling and Distribution Overheads:
  Advertising and sales promotion
  Salesmen's salaries and travel
  Showroom expenses
  Bad debts
  Packing expenses
  Carriage outward
  Commission of sales agents
  Cost of catalogues
  Delivery van expenses
  Warehouse expenses
  Sales manager's salary
  Cost of mailing literature
                                               ──────   ──────
= COST OF SALES (Total Cost)
                                               ──────   ──────
+ PROFIT
                                               ──────   ──────
= SALES
                                               ══════   ══════

6.2 Managerial Accountability — Who Owns Which Block

6.3 Gross Profit (GP) vs Net Profit

• Gross Profit (GP) = Sales − COGS

  • Measures manufacturing efficiency
  • Comparable across firms (similar production basis)
  • Used in Session 12's absorption vs variable costing comparison

• Net Profit = Sales − Cost of Sales

  • After all overheads including selling and admin
  • Reflects total business model efficiency

6.4 Treatment of Scrap

Scrap (cuttings, trimmings, borings from metal/timber) can usually be sold. Its realisable value is deducted from factory overheads or factory cost in the cost sheet — not treated as separate income.

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7. Items Excluded from Cost Accounts

Not everything that appears in financial accounts belongs in cost accounts. The following are excluded because they are either financing decisions, profit appropriations, or abnormal/arbitrary items:

1. Pure finance matters:

• Interest paid and received
• Dividend received on investments
• Rent received
• Profit or loss on sale of company property or investments

2. Appropriation of profits:

• Income tax provision
• Dividends paid to shareholders
• Transfers to sinking fund or reserve fund
• Excessive depreciation (to create secret reserves)
• Goodwill or other fictitious assets written off

3. Arbitrary or abnormal items:

• Excessive salary paid to a particular person
• Abnormal wastage or losses

Why this matters: Including finance costs or profit appropriations in product cost would distort the cost used for pricing and decisions. Cost accounts should reflect operational reality, not capital structure or tax planning choices.

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8. Overhead (OH) Accounting — The Three-Stage Process

Why this section exists: Overheads are real costs but they cannot be directly traced to products. Every overhead allocation system — from the simplest single rate to full ABC (Activity-Based Costing) — follows the same three-stage logic. Understanding this process is the prerequisite for understanding why Sessions 9 and 10 are about choosing the right allocation basis.

The three stages are:

Stage 1: COLLECTION
Identify and accumulate all overhead costs for the period
        ↓
Stage 2: DISTRIBUTION (Primary + Secondary)
Spread overheads over departments
  Primary: Factory-wide costs → all departments (production + service)
  Secondary: Service department costs → production departments only
        ↓
Stage 3: ABSORPTION
Charge production department overheads to individual products/jobs
using an appropriate rate

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9. Stage 1 — Collection of Overheads

9.1 What Collection Means

Collection is the process of recording each item of overhead cost in the accounting records. Source documents used:

• Stores Requisition (for indirect materials)
• Wages Sheet (for indirect labour)
• Cash Book (for cash expenses)
• Purchase Orders and Invoices
• Journal Entries
• Other registers and records

9.2 Departmentalization — Why It Helps

Rather than treating the factory as a single pool, overheads are collected by department (cost centre). Benefits:

• Better estimation of indirect expenses
• Enables fair charging to departments based on actual usage
• Creates accountability — each department manager is responsible for their overhead
• Enables the secondary distribution step (service dept → production dept)

Some factory expenses are confined to a specific department (can be allocated directly):

• Wages paid to indirect workers in that department
• Normal idle wages in that department
• Depreciation and repair of plant specific to that department
• Insurance of plant specific to that department

Some expenses are incurred by the factory as a whole and must be apportioned across departments using a suitable basis.

9.3 Special Treatment of Key Factory Overhead Items

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10. Stage 2 — Distribution / Apportionment

Distribution spreads overhead costs over departments. It has two sub-stages:

10.1 Primary Distribution — Factory-Wide Costs to All Departments

What it is: Apportioning factory-wide overhead expenses to both production departments and service departments, using bases that reflect benefit received.

Comprehensive basis of apportionment table:

Language note: The word "allocate" should be used only when the basis is exact. If it is an estimate, use "apportion" or "distribute."

10.2 Secondary Distribution — Service Department Costs to Production Departments

After primary distribution, service department (SD) costs must be transferred to production departments (PD) — because only production department costs can eventually be charged to products.

Service departments provide support to production departments. Their costs must therefore end up in the product cost. The question is: how?

Basis of apportionment — by service type:

10.3 Three Methods of Secondary Distribution

Method 1 — Direct Method

What it does: Allocates each service department's costs directly to production departments only, ignoring any services that service departments render to each other.

Mechanism: The total cost of each service department is apportioned to production departments in proportion to the benefit each production department receives.

Advantage: Simple and quick.

Limitation: Ignores the fact that service departments also serve each other (e.g., the maintenance department also maintains the stores department's equipment). This can lead to inaccuracy when inter-service usage is significant.

Service Dept A costs → Production Dept X and Y only
Service Dept B costs → Production Dept X and Y only
(Inter-service usage ignored)

Method 2 — Step-Ladder (Step-Down) Method

What it does: Allocates service department costs sequentially — first the service department that serves the most other departments (and receives the least service from others) is distributed to all remaining departments, then the next, and so on until all service departments are cleared.

Mechanism:

1. Rank service departments by the extent of service they provide to others (most to others first)
2. Apportion the first SD's costs to all other departments (production + remaining service departments)
3. That SD is now "closed." Move to the next SD in the ranking.
4. Continue until all service departments are distributed into production departments.

Advantage: Accounts for some inter-service relationships (partial recognition).

Limitation: Once a service department's costs are distributed, it receives no further charges even if it continues to provide services to later-distributed departments. Still an approximation.

SD A (distributes most) → PD X + PD Y + SD B (then A is closed)
SD B → PD X + PD Y only (A is already closed)

Method 3 — Simultaneous Equation Method (Reciprocal / Mutual Allocation)

What it does: Recognises that service departments mutually serve each other and computes the true cost of each service department including all inter-service transfers, using simultaneous equations.

When to use: When service departments provide significant services to each other and the direct or step-down methods would materially misallocate costs.

Mechanism:

Set up equations where the total cost of each service department equals its direct costs plus the share it receives from other service departments. Solve simultaneously.

Worked Example (from professor's slides):

Factory has 2 production departments (A, B) and 2 service departments (X, Y).

Direct costs: X = ₹3,000, Y = ₹2,000

Apportionment proportions:

Step 1 — Set up equations:

Let total cost of X = x, total cost of Y = y

• x = 3,000 + 0.20y (X gets 20% of Y's total)
• y = 2,000 + 0.10x (Y gets 10% of X's total)

Step 2 — Solve:

Substitute y into the first equation:

• x = 3,000 + 0.20(2,000 + 0.10x)

• x = 3,000 + 400 + 0.02x

• 0.98x = 3,400

• x = ₹3,469.39

• y = 2,000 + 0.10(3,469.39) = 2,000 + 346.94 = y = ₹2,346.94

Step 3 — Apportion to production departments:

Key insight: The simultaneous equation method gives the most accurate result when inter-service usage is material. ABC (Activity-Based Costing) in Sessions 9 and 10 is conceptually similar — it traces costs through activities to products with as much causal accuracy as possible.

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11. Stage 3 — Absorption of Factory Overheads

What absorption is: After Stage 2, production departments have a total overhead pool. Absorption is the process of charging that pool to individual products, jobs, or cost units using an appropriate rate. This is where the strategic choices in Sessions 9 and 10 originate — choosing the right absorption base is the same problem as choosing the right cost driver in ABC.

11.1 Six Methods of Absorption

Method 1 — Direct Materials Cost Basis

Rate: Factory OH / Direct Materials (DM) cost × 100 = % of DM

Applied: % × DM cost for the job/product

Assumption: Overhead consumption is proportional to material cost.

Works when: Simple single product; stable material prices; material cost is the dominant cost.

Fails when: Jobs with identical material costs but very different labour or machine intensity get the same overhead charge.

Example:

• DM = ₹40,000 | DL = ₹30,000 | OH = ₹20,000
• Rate = 20,000/40,000 = 50% of DM
• An order with DM = ₹8,000 → OH charged = ₹4,000

Method 2 — Direct Wages (DL Cost) Basis

Rate: Factory OH / Direct Labour (DL) cost × 100 = % of DL

Assumption: There is a logical connection between labour cost and overhead — labour activity gives rise to factory expenses.

Works when: Labour-intensive processes; labour cost is a major component; wages rates are similar across jobs.

Fails when: High-wage skilled labour jobs get more overhead than low-wage jobs even if they consume identical machine resources.

Example:

• DM = ₹60,000 | DL = ₹40,000 | OH = ₹10,000
• Rate = 10,000/40,000 = 25% of DL
• An order with DL = ₹6,000 → OH charged = ₹1,500

Method 3 — Prime Cost Basis

Rate: Factory OH / Prime Cost (PC) × 100 = % of PC

Assumption: Both materials and labour give rise to overheads; both should be taken into account.

Limitation: Still does not distinguish between machine-intensive and labour-intensive work. Two jobs with identical prime costs but different production methods get identical overhead.

Illustrative problem (from professor's slides):

Job-2 presumably takes far more time than Job-1, yet both get the same overhead charge. This is exactly the distortion problem that Sessions 9 and 10 address.

Method 4 — Unit of Production Basis

Rate: Factory OH / Units of production

Useful only when: A single homogeneous product is produced. Breaks down completely with multiple products.

Method 5 — Machine Hour Rate (MHR)

Most important method for machine-intensive production and the direct predecessor of ABC.

Rate (MHR): Factory OH / Machine hours (MH) = ₹ per MH

Applied: MHR × MH consumed by the job

Two versions:

Machinist's wages: NOT included in MHR — they form part of direct wages for the specific job.

Machine hours to include:

• Normal productive hours
• Setting and idle time (when the machine is occupied but not running at full output)
• Trial run hours

Works best when: Machine-intensive production; jobs with similar DM/DL but very different machine time.

Practical note from professor: MHR and DLHR (Direct Labour Hour Rate) are not competitive — they are complementary. For machine-driven work use MHR; for labour-driven work use DLHR. For good results, use a combination of all three: MHR + DLHR + % on direct wages.

Example (from professor's slides — Machine B):

MHR = Total annual machine cost / Estimated production hours (3,600)

Method 6 — Direct Labour Hour Rate (DLHR)

Rate: Factory OH / Total Direct Labour Hours (DLH) = ₹ per DLH

Applied: DLHR × DLH worked on the job

Works best when: Labour is the chief factor in manufacturing; machines are not used extensively.

Advantage: Data on DLH is readily available from time sheets.

Cannot be used when: Machines are used extensively — because labour hours do not reflect machine consumption.

11.2 Comparison of Absorption Methods

The link to Sessions 9 and 10: All six traditional methods use a single base (or at most two in combination). Sessions 9 and 10 show what happens when this single-base approach is used in a multi-product environment where overhead consumption is driven by different activities for different products. The solution — ABC — simply extends the logic of MHR from one pool to multiple activity pools, each with its own driver.

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12. Predetermined Overhead Rates

12.1 What They Are and Why They Exist

A predetermined overhead rate (POHR) is computed at the start of the period using estimated overhead and estimated activity, and then applied throughout the period.

POHR = Estimated overhead for the period / Estimated activity for the period

Why not use actual overhead rates?

Three reasons:

1. Timeliness: Actual overhead rates can only be computed at period end when all costs are known. You need to cost jobs as they are completed — not wait until December to price a job produced in March.

2. Seasonal fluctuation: Overhead costs fluctuate monthly (e.g., heating is higher in winter). Using monthly actual rates would make identical jobs appear to cost differently in summer vs winter — a distortion of no operational significance.

3. Capacity fluctuation: If production volume fluctuates, fixed overhead per unit changes. Low-volume months would appear more expensive than high-volume months even with identical costs — misleading for pricing and decisions.

12.2 Normal Cost System vs Actual Cost System

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13. Normal vs Actual Capacity

Why this matters: The denominator used to set the POHR (Predetermined Overhead Rate) determines the fixed OH per unit — and therefore the product cost and pricing. Using actual output (which fluctuates) instead of normal capacity creates unstable unit costs.

13.1 Four Capacity Concepts

13.2 Why Normal Capacity for Overhead Absorption

Using normal capacity as the POHR denominator means:

• Fixed OH per unit is stable across periods — not artificially high in low-output months
• Selling prices set on this basis are defensible — not inflated by idle capacity costs
• If actual output is lower than normal, the resulting under-absorption signals idle capacity (a management issue) rather than inflating product costs

Arguments for normal capacity from professor's slides:

1. Cost per unit can be effectively linked to changes in manufacturing efficiency
2. If prices are based on actual output costs, prices will be high when output is low — customers bear the cost of inefficiency
3. Normal-based costs avoid inflating unit prices for unutilised capacity

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14. Over and Under Absorption of Overheads

Why this section exists: Because POHR is based on estimates, the overhead actually absorbed into products will almost never exactly equal the overhead actually incurred. The difference — over or under absorption — must be identified and treated correctly. This is directly tested in the OH Allocation practice problems.

14.1 Definitions

Applied / Absorbed overhead = POHR × Actual activity (hours/units worked)

Under-absorption (Under-recovery): Overhead actually incurred > overhead absorbed into products

Over-absorption (Over-recovery): Overhead absorbed into products > overhead actually incurred

14.2 Causes of Over/Under Absorption

1. Error in estimating overhead for the period
2. Error in estimating the activity level (hours, units)
3. Wrong method of absorption chosen
4. Change in proportion of machine work vs labour work
5. Seasonal fluctuation in overhead costs
6. Under or over utilisation of capacity

14.3 Treatment of Over/Under Absorbed Overhead

Three options depending on the amount and cause:

Option 1 — Write off to Costing Profit and Loss Account:

• Use when the amount is small (immaterial)
• Or when due to abnormal reasons (defective planning, extraordinary events)
• Simply debit/credit the costing P&L — it does not adjust product costs

Option 2 — Supplementary Rate (spread over WIP, Finished Goods, and COGS):

• Use when the amount is material and due to normal causes (volume or cost estimate being slightly off)
• Compute a supplementary rate = Under/over absorbed OH / Units produced
• Apportion across WIP (Work-in-Progress), Finished Goods Stock, and Cost of Sales in proportion to units in each

Option 3 — Carry forward to next year:

• Use when fluctuation is expected to reverse in the next period
• Example: seasonal overhead absorbed unevenly across months

14.4 Worked Example 1 (from professor's practice questions)

Given:

• Predetermined rate: ₹25 per man-day
• Actual overhead incurred: ₹41,50,000
• Actual man-days worked: 1,50,000
• Units produced: 40,000 | Units sold: 30,000
• Analysis: 60% of unabsorbed OH = defective planning; 40% = increase in OH costs

Step 1 — Compute absorbed and unabsorbed:

Step 2 — Analyse causes:

Step 3 — Spread normal under-absorption:

• Units sold: 30,000 | Units in closing stock: 10,000 | Ratio: 3:1

Supplementary rate = ₹1,60,000 / 40,000 units = ₹4 per unit

14.5 Key Rule

If under/over absorption is immaterial → close directly to COGS

If material → allocate proportionately across WIP, Finished Goods, and COGS

If due to abnormal reasons → charge to Costing P&L (not product cost)

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15. Other Overheads — Admin, Selling & Distribution

15.1 Office and Administrative Overheads

Debate: Should admin expenses be part of product cost or period cost?

View 1 (popular): Admin is a period cost — incurred with time, not with production volume — so debit to Cost of Sales account.

View 2: Admin benefits production just like fixed factory OH — so treat it as part of production cost.

View 3 (compromise): Admin is concerned with both production and sales, so apportion between production and sales departments; the production share is added to factory OH.

Practice: Admin is typically added to cost of production on the basis of wages or works cost (the traditional approach).

15.2 Selling and Distribution Overheads

These are incurred in taking the finished product from factory to customer. They include advertising, salesmen's salaries, carriage outward, showroom costs, delivery vans.

Treatment: Added to cost of goods sold to arrive at cost of sales — the last block before profit in the cost sheet.

Basis of apportionment to products/territories:

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16. Terminology & Definitions (Full Abbreviation Reference)

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17. Connections to Sessions 9, 10, and 12

→ Session 9 (Overhead Allocation Methods + ABC)

→ Session 10 (Destin Brass Case)

→ Session 12 (Absorption vs Variable + CVP)

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18. Revision Sheet

Must-Remember Concepts

• Cost = Material + Labour + Expenses (each direct or indirect)
• Prime Cost = DM + DL + DE
• Overhead = Indirect Material + Indirect Labour + Indirect Expenses
• Three-stage OH process: Collect → Distribute → Absorb
• Primary distribution: factory-wide costs → all departments (using apportionment bases)
• Secondary distribution: service dept costs → production depts (3 methods)
• Absorption: production dept costs → products (6 methods)
• POHR exists because: timeliness + seasonal smoothing + capacity smoothing
• Use normal capacity for POHR — not actual, not theoretical

Key Apportionment Bases (High-Frequency Exam Content)

Service Department Allocation Methods

Over/Under Absorption Treatment

POHR Formula

POHR = Estimated overhead ÷ Estimated activity (normal capacity)

Absorption methods and their rates:

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