MEE1014

INDUSTRIAL ENGINEERING AND MANAGEMENT

Dr JAYAKRISHNA K
Associate Professor
School of Mechanical Engineering
VIT University
jayakrishna.k@vit.ac.in
9894968596
Module II

Elements of cost:
Determination of Material cost - Labour cost – Expenses - Types of cost –
Cost of production – Over-head expenses– break even analysis - Problems.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Introduction

The cost of any product or service is the sum of various segments of the cost. Such
segments are treated as elements of cost

Example :

The cost of a chair prepared out of a piece of wood involves following cost
elements:

• Cost of raw materials (piece of wood)

• Labor cost (wages paid to operator)

• Overhead cost (Building and other services required for manufacturing chairs)

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Introduction

It is basics in cost accounting. If elements of cost is known, one can find the cost
of product.

Element of cost provides the complete structure in which we can identify our total
cost.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Classification of Costs

According to
• Nature
• Function
• Behaviour
• Identifiably
• Association with products
• Controllability
• Normality
• Time
• Relevance and
• Other costs
Dr K Jayakrishna, Associate Professor, SMEC-VIT
 According to nature of elements

One of the main functions of cost accounting is to classify the costs. Costs may be
classified according to its elements. We can distinguish three basic elements in the
manufacturing cost of any product or services.
The three main elements of costs are

 Material

 Labour

 Expense

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Elements of Costs

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Material

Material indicates principal substances used in production.

Examples are: cotton, jute, iron-ore, and silicon. The cost of material is further
divided in to direct and indirect materials

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Direct Material

Direct materials refer to the cost of materials which become a major part of the
finished product. They are raw materials that become an integral part of the
finished product and are conveniently and economically traceable to specific units
of output.

Some examples of direct materials are: raw cotton in textiles, crude oil to make
diesel, steel to make automobile bodies.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Indirect Material

These are materials which are used ancillary to manufacture and cannot be traced
in to the finished product. These form a part of manufacturing overhead.

Examples are glue, thread, nails, consumable stores, printing and stationary
material

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Labour

Labour is the physical or mental effort expended on the production of an item. It is

the active factor of production as against material which is a passive factor. The
cost of labour further divided into direct and indirect labour.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Direct Labour

Direct labour is defined as the labour associated with workers who are engaged in
the production process. It the labour costs for specific work performed on a
product that is conveniently and economically traceable to end products. Direct
labour is expended directly upon the materials comprising the finished product.
Examples are the labour of machine operators and assemblers

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Indirect Labour

This includes wages paid for all labour which is not directly engaged in changing
the shape or composition of raw materials. It cannot be traced directly to the
product. Lick indirect materials, indirect labour forms part of the manufacturing
overheads.

Examples of indirect labour cost are wages paid to foremen, supervisors,

storekeepers, time-keepers, salaries of office executives and the commission
payable to sales representatives.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Direct Expenses

Direct expenses include any expenditure other than direct material and direct
labour directly incurred on a specific cost unit (product or job). Such special
necessary expenses can be identified with cost units and are charged directly to the
product as part of the prime cost.

Some examples of direct expenses are:

(a) Cost of special layout, designing or drawings;

(b) Hire of tools or equipment for a particular production or product;

(c) Maintenance costs of such equipments.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Indirect Expenses

Indirect expenses are those incurred for the business as a whole rather than for a
particular order, job or product.

Examples of such expenses are rent, lighting, insurance charges.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Overhead Expenses

Overheads may be defined as the aggregate of indirect material, indirect labour and
indirect expenses. Thus, all indirect costs are overheads. These cannot be
associated directly with specific products. Hence, the amount of overhead has to be
allocated and apportioned to products and services on some reasonable basis. The
synonymous term is “burden”.

Overheads may be subdivided in to following groups:

a)Factory overheads.

b) Administrative overheads.

c) Selling and distribution overheads.

Dr K Jayakrishna, Associate Professor, SMEC-VIT
 Factory Overhead Expenses

Factory overhead also called manufacturing expenses or factory burden may be

defined as the cost of indirect materials, indirect labour and indirect expenses.
Examples of such items are lubricants, cotton waste, hand tools, works stationery.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Selling overhead expenses

Selling overhead is also known as marketing or selling overhead.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Distribution overhead expenses

Distribution expenses usually begin when the factory costs end. Such expenses are
generally incurred when the product is in saleable condition. It covers the cost of
making sales and delivering/dispatching products. These costs include advertising,
salesmen salaries and commissions, packing, storage, transportation, and sales
administrative costs.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Administrative overhead expenses

Administrative overhead includes costs of planning and controlling the general

policies and operations of business enterprises.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Fixed Cost

Fixed cost is the cost which does not change in total for a given time period despite
wide fluctuations in output or volume of activity.

Example: Rent, Property taxes, Supervising salaries, depreciation on office

facilities, advertising, insurance etc..

Fixed cost can be further classified into three types:

 Committed cost

 Managed cost

 Discretionary cost

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Variable Cost

Variable costs are those costs that vary directly and proportionately with the
output. There is a constant ratio between the change in the cost and change in the
level of output. Direct materials cost and direct labour cost are the costs which are
generally variable costs.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Mixed Cost

Mixed costs are made up of fixed and variable elements. They are combination of
semi-variable costs and fixed costs.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Mixed Cost

Mixed costs are made up of fixed and variable elements. They are combination of
semi-variable costs and fixed costs.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Prime Cost

𝑷𝒓𝒊𝒎𝒆 𝑪𝒐𝒔𝒕
= 𝐷𝑖𝑟𝑒𝑐𝑡 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 + 𝐷𝑖𝑟𝑒𝑐𝑡 𝑙𝑎𝑏𝑜𝑢𝑟 𝑐𝑜𝑠𝑡
+ 𝐷𝑖𝑟𝑒𝑐𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 (𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒)

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Factory Cost

𝑭𝒂𝒄𝒕𝒐𝒓𝒚 𝑪𝒐𝒔𝒕 = Prime cost + factory overhead

𝑭𝒂𝒄𝒕𝒐𝒓𝒚 𝑪𝒐𝒔𝒕
= Direct material cost + Direct labour cost + Direct expenses(variable)+
Factory overhead

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Total Cost

Total cost = Factory cost

+ Selling overhead
+ Distribution overhead
+ Administrative overhead

Selling Price = Total cost + Profit or Loss

Dr K Jayakrishna, Associate Professor, SMEC-VIT

Problem 1:
From the following data, find
a) Material cost
b) Prime cost
c) Direct cost
d) Factory cost
e) Administrative overheads
f) Cost of production
g) Selling and distribution overheads
h) Total cost or cost of sales
i) Selling price
Assume a net profit of Rs. 10,000.
Dr K Jayakrishna, Associate Professor, SMEC-VIT
 Rs.
1 Material in hand (April 1, 2015) 60,000
2 material purchased 2,50,000
3 Director’s fees 3,500
4 Advertising, etc. 12,000
5 Depreciation on sales department car 1,200
6 Printing and stationary charges 300
7 Plant depreciation 5,000
8 Wages of direct workers 70,000
9 Wages of indirect (factory) workers 10,000
10 Rent of factory building 5,000
11 Postage, telephone and telegraph 200
12 Water and electricity for factory 1,000
13 Office salaries 2,000
14 Rent of the office 500
15 Rent of the show room 1,500
16 Commission of salesman 2,500
17 Sales department car expenses 1,500
18 Material in hand (March 31, 2016) 50,000
19 Variable direct expenses 750
20 Plant repair and maintenance 3,000
21 Heating, lighting and water for office use 2,500
22 Cost of distributing goods 2,000
Dr K Jayakrishna, Associate Professor, SMEC-VIT
Sl. Rs. Type of cost
1 Material in hand (April 1, 2015) 60,000 Direct cost
2 New material purchased 2,50,000 Direct cost
3 Director’s fees 3,500 Administrative overhead
4 Advertising, etc. 12,000 Selling & Distribution overhead
5 Depreciation on sales department car 1,200 Selling & Distribution overhead
6 Printing and stationary charges 300 Administrative overhead
7 Plant depreciation 5,000 Factory or Production overhead
8 Wages of direct workers 70,000 Direct cost
9 Wages of indirect (factory) workers 10,000 Factory or Production overhead
10 Rent of factory building 5,000 Factory or Production overhead
11 Postage, telephone and telegraph 200 Administrative overhead
12 Water and electricity for factory 1,000 Factory or Production overhead
13 Office salaries 2,000 Administrative overhead
14 Rent of the office 500 Administrative overhead
15 Rent of the show room 1,500 Selling & Distribution overhead
16 Commission of salesman 2,500 Selling & Distribution overhead
17 Sales department car expenses 1,500 Selling & Distribution overhead
18 Material in hand (March 31, 2016) 50,000 Direct cost (-)
19 Variable direct expenses 750 Direct cost
20 Plant repair and maintenance 3,000 Factory or Production overhead
21 Heating, lighting and water for office use 2,500 Administrative overhead
22 Cost of distributing goods 2,000 Selling & Distribution overhead
Solution :
(a)Material cost
= Cost of material in hand on April 1, 2015
- Cost of material in hand on March 31, 2016
+ Cost of new material purchased
= 60,000 – 50,000 + 2,50,000 = Rs. 2,60,000

(b) Prime Cost

= Direct material cost
+ Direct labor cost
+ direct expenses
= 2,60,000 + 70,000 + 750 = Rs. 3,30,750

(c) Direct Cost

It is same as Prime Cost

(d) Factory Cost

=Prime cost + Production overhead (Sl.no. 7,9,10,12,20)
= 3,30,750 + 5,000 + 10,000 + 5,000 + 1,000 + 3,000
= Rs. 3,54,750
Dr K Jayakrishna, Associate Professor, SMEC-VIT
(e) Administrative Overheads (Sl.no. 3,6,11, 13, 14, 21)
= 3,500 + 300 + 200 + 2,000 + 500 + 2,500
= Rs. 9,000

(f) Cost of Production = Factory Cost + Administrative overhead

= 3,54,750 + 9,000
= Rs. 3,63,750

(g) Selling & Distribution Overhead (Sl.no. 4, 5, 15, 16, 17, 22)
= 12,000 + 1,200 + 1,500 + 2,500 + 1,500 + 2,000
= Rs. 20,700

(h) Total Cost or Cost of Sales

= Cost of production + Selling & Distribution overhead
= 3,63,750 + 20,700
= Rs. 3,84,450

(i) Selling Price = Cost of sales + Profit

= 3,84,450 + 10,000
= Rs. 3,94,450
Dr K Jayakrishna, Associate Professor, SMEC-VIT
Problem 2
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 the selling price of one electric bulb.
Solution:
Factory cost = Direct material cost + Direct labour cost + Factory overheads
= Rs.250 + 200 + 225 = Rs. 675
Total cost = Factory cost + Selling overhead (i.e., on cost)
= Rs.675 + Rs. 675 X 30 / 100
= Rs. 877.50 …………………… (i)

Dr K Jayakrishna, Associate Professor, SMEC-VIT

Also, Total cost = Selling price – Profit

= S.P. -- S.P. X 10/100 …..(ii)

Equating (i) and (ii) above

S.P. – S.P. X 10/100 = Rs. 877.50

Therefore,

Selling price = Rs. 975

Hence the selling price of one electric bulb

= Rs. 975 / 150

= Rs. 6.50

Dr K Jayakrishna, Associate Professor, SMEC-VIT

Problem 3
Calculate the selling price of one fountain pen from data given below.

No. of fountain pens = 135

Labour cost = Rs.200

Material cost = Rs.160

Factory overheads = 35% of Prime cost

Administration & selling overheads = 20% of factory cost

Profit = 10% of total cost

Dr K Jayakrishna, Associate Professor, SMEC-VIT

Problem 4
A drill press costs Rs.6,000. A discount of 25% of this price is given to the distributor. If
labour cost, Material cost and factory overheads are as 4:1:2; and selling expenses are 25%
of the factory cost, calculate the profit of the factory for one drill press. Assume factory
overheads of Rs.800.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Break-Even Analysis

Break-even Analysis (BEA) is a graphical representation of the cost-volume

relationship.

Break-even Point (BEP) represents the level of output at which there is no profit
and no loss.

Profit is the difference between total revenue and total production cost
𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑 × 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑 × 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Break-Even Analysis

Total cost consists of VC and FC

VC varies with the volume of production but, FC remains fixed.

VC changes in response to changes in volume of production

VCs and Volume of production is proportional.

Examples include the cost of direct labour, raw materials and sales commissions.

FCs do not change in response to changes in volume or acitvity.

Examples include the costs of depreciation, supervisory salaries and maintenance

expenses.
Dr K Jayakrishna, Associate Professor, SMEC-VIT
 Break-Even Analysis
Assumptions

BEA or cost –volume-profit (CVP) analysis has the following assumptions:

1. The changes in the level of revenues and costs arise due to the changes in the
number of products/or services units produced and sold. A cost driver is any factor
that affects, a revenue driver is any factor that affects revenue.

2. Total costs can be divided into a fixed component and a component that is variable
with respect to the level of output.
 VCs includes (a) Direct materials (b) Direct labour (c) Direct chargeable expenses

 Variable overheads includes (a) Variable part of factory overheads (b) Administration overheads
(c) Selling and distribution overheads.
Dr K Jayakrishna, Associate Professor, SMEC-VIT
 Break-Even Analysis
Assumptions

3. There is a linear relationship between revenue and cost. When put in a graph, the
behaviour of total revenue and total cost is linear, that is y = mx+c holds good,
which is the equation of a straight line, where y is revenue and x is the cost, m is the
coefficient of cost representing profit, c is a constant.

4. The unit SP, units VCs and FCs are constant.

5. The theory of CVP is based upon the production of a single product. However, of
late, management accounts are functioning to give a theoretical and a practical
approach to multi-product CVP analysis.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Break-Even Analysis
Assumptions

6. The CVP analysis either covers a single product or assumes that the sales mix of
multiple products will remain constant as the level of total units sold changes.

7. All revenues and costs can be added and compared without taking into account the
value of money.

8. The theory of CVP is based on the technology that remains constant.

9. The theory of price elasticity is not taken into consideration.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Break-Even Analysis

Margin of Safety, contribution margin (CM) and profit volume ratio are the important
terms and help in the decision-making process.

Margin of Safety: The margin of safety is the difference between the expected level of
sales and a break-even sales. It may be expressed in units or rupees of sales.

Contribution margin: it is the difference between the SP and the VC per unit. It
measures the amount each unit sold contributes to cover FCs(first) and increase profit
(once FCs are covered). The relationship is as SP – VC.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Break-Even Analysis

Contribution margin ratio: This ratio expresses the contribution of every sales rupee in
covering FCs (first) and operating profit (second). It is calculated using the formula:

𝑺𝑷 − 𝑽𝑪
𝑺𝑷

Angle of incidence, ø : It is the angle at which the total revenue line intersects the total
cost line.

Profit-volume ratio: It is the ratio of contribution and sales.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Break-Even Analysis

Sales Revenue
Profit at full capacity

Total Costs
Costs and revenue

Angle of incidence, ø If margin of safety is

positive, production is
above break even.
BE

Profit
Variable Costs If margin of safety is

Safety margin
Loss

negative, production is
below break even.

Fixed Costs

0 Output
Current
Break-even point Full Capacity
Output

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Break-Even Analysis
Calculation of BEP

The BEP can be calculated in terms of physical units and in terms of sales turnover.

BEP in terms of physical units: The number of units required to be sold to achieve the
BEP can be calculated using the formula:

𝐹𝐶
𝐵𝐸𝑃 =
𝑆𝑃 − 𝑉𝐶
Where FC is the fixed cost, VC is the variable cost, SP is the selling price, C is the
contribution per unit (C =SP – VC). On the x-axis , BEP is presented in terms of physical
units.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 Break-Even Analysis
Calculation of BEP

BEP in terms of sales volume: BEP in terms of sales volume can be calculated using the
formula:

𝐹𝐶
𝐵𝐸𝑃 = × 𝑆𝑃
𝑆𝑃 − 𝑉𝐶
Where FC is the fixed cost, VC is the variable cost, SP is the selling price, C is the
contribution per unit. On the y-axis , BEP is presented in terms of sales volume.

Dr K Jayakrishna, Associate Professor, SMEC-VIT

Problem 1

A Company XYZ sold an auto component of 1000 units of a product of with variable cost of Rs.10 per unit. Each unit
contributes 20 percent of its revenue to the company's FCs and profits. The company wants to reduce the products price
by 10 percent. Calculate how many more units the company is required to sell at the 10 percent reduction to earn the
same profit as before the price reduction.
Solution:
Let x be the selling pricein rupees per unit of the product. Contribution to the FC and profit is 0.20x. Now
X = 0.20x+10
X=12.5
The selling price is reduced by 10 percent. Now selling price = 0.9 × 12.5 = Rs.11.25/unit.
We have,

𝐹𝐶 + 𝑃
𝑄=
𝑆𝑃 − 𝑉𝐶

𝐹𝐶 + 𝑃
𝑄𝑛𝑒𝑤 =
𝑆𝑃𝑛𝑒𝑤 − 𝑉𝐶

Dr K Jayakrishna, Associate Professor, SMEC-VIT

 𝑄 𝑆𝑃𝑛𝑒𝑤 − 𝑉𝐶
=
𝑄𝑛𝑒𝑤 𝑆𝑃 − 𝑉𝐶

11.25 −10
= 12.5 −10

= 0.555

𝑄
𝑄𝑛𝑒𝑤 =
0.555
1000
=
0.555

= 1800 units

Dr K Jayakrishna, Associate Professor, SMEC-VIT

Problem 2
From the given information about information about a company, calculate the break-even point and the
turnover required to earn a profit of Rs.50000, Fixed overheads are Rs.250000; selling price is Rs.25;
and variable cost per unit is Rs.5. If the company earns a profit of Rs.50000, express the margin of safety
available to it.
Solution:
Contribution per unit (S-V) = Rs.(25-5) = Rs. 20 per unit
Fixed overheads = Rs. 250000

𝐹𝑖𝑥𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
Break−even point =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

250000
Break−even point =
20
Break−even point = 12500 𝑢𝑛𝑖𝑡𝑠 𝑜𝑟 𝑠𝑎𝑙𝑒𝑠 𝑜𝑓 𝑅𝑠. 312500
Dr K Jayakrishna, Associate Professor, SMEC-VIT
Problem 2
Solution:
Turnover required to earn a profit of Rs. 50000

𝐹𝑖𝑥𝑒𝑑 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠 + 𝑃𝑟𝑜𝑓𝑖𝑡

𝑄=
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

𝑅𝑠. 250000 + 50000

𝑄=
20
𝑄 = 15000 𝑢𝑛𝑖𝑡𝑠 𝑜𝑟 𝑠𝑎𝑙𝑒𝑠 𝑜𝑓 𝑅𝑠. 375000
Margin of safety
Actual sales = 15000 units or Rs. 375000
Sales at Break-even point = 12500 units or Rs.312500
Margin of safety = Actual sales – Sales at BEP = 2500 units of Rs. 62500

Dr K Jayakrishna, Associate Professor, SMEC-VIT