INTRODUCTION OF FINANCE

Finance is the study of funds and management. Its general areas are
business finance, personal finance and public finance. It also deals with
the concepts of time, money, risk and the interrelation between the given
factors. It is basically focused on how the money is spent and budgeted.
Finance is a monetary resource allows businesses to purchase items that
will create goods for production and other services. The budget is the
documentation of the entire entrepreneurship.
A personal finance is related to how much money is needed by an
individual. It is concerned on financial resources and its usage. There are
various factors that affect decisions in handling personal finance which
are financing durable goods, paying for education, monthly bills, secured
loans, minimal debt obligations, health insurance and retirement plans.
Studying finance will lead you in wiser decisions making on your
financial funds. It can help you identify risks and benefits if you are
planning to put up your own business. Finance discipline requires you
certain abilities and trainings which can be developed over a period of
time. Finally, it will certainly help you in financially secured life.

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MEANING OF FINANCE
The word Finance is derived from an old French word Finer , meaning
thereby to pay, settle or finish. It other words, the term Finance means
money or provision of funds as and when needed. According to
F.ZW.Paish, finance may be defined as, the provision of money at the
time it is wanted.

BUSINESS FINANCE
MEANING
Business finance means financing of business activities. A business needs
funds at every step to bring a business into existence and to operate a
business. In other words, all activities of business, be it plant and
machinery

acquisition,

production,

marketing,

human

resource,

purchases, research and development, continuation to complete. Without

money, no business can be run efficiently, effectively and profitably.

APPROACHES OF BUSINESS FINANCE

The various authorities have viewed the term business finance differently.
For the purpose of exposition, the approach to the study of business
finance may be grouped into two categories:
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1. Traditional Approach
The traditional approach of business finance is concerned with raising
of funds used in an organization. This category encompasses
instruments, institutions, practices through which funds are raised and
legal and accounting relationship between an enterprise and its
sources of funds. The authorities of this approach ignored the function
of efficient employment of finance. The utilization of administering
resources was considered outside the preview of the finance function.
As per this approach, the following aspects only were included in the
finance function.
a) Estimation of requirements of finance.
b) Arrangement of funds from financial institutions.
c) Arrangement of funds through financial instruments such as shares,
debentures, bonds and loans and
d) Looking after the accounting and legal work connected with the
raising of funds.
The traditional approach to business finance had a narrow view to the
extent of controlling the sources and application of funds. The subject
of business finance was treated from the investors viewpoint only,

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placing emphasis on the long term financial problems and ignored the
important and typical problems of working capital management.
2. Modern Approach
The modern approach lays emphasis is not only on the raising of funds
but also on their effective utilization. This approach determines the
total amount of funds required for the firm, allocating these funds
efficiently to the various assets, obtaining the best mix of financing
and applying financial tools and techniques order to ensure a proper
use of the funds. Thus, the emphasis of modern approach of business
finance has been shifted from rising of funds to the effective and
judicious utilization of funds.
The modern approach of business finance is analytical way of looking
into the financial problems of the firm. An existing modern theory of
financial management is expressly concerned with the relationship
between profitability and the volume of capital used, depicting the
clear shift from controlling the sources and application of funds to the
function of efficient and effective use of funds. The modern approach
in business finance is of decision-making relating to various facts of
financial planning and control.

SIGNIFICANCE OF BUSINESS FINANCE

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The significance/importance/need for business finance arises for the

following purposes:
1. Acquire fixed asset
Every business firm whether manufacturing or trading needs finance
to acquire fixed assets. Manufactures need finance to acquire land and
building, plant and machinery and vehicles for distribution goods.
2. Purchase raw-materials/goods
Manufactures require finance to acquire raw-materials, and
consumable stores for production. Traders need finance to acquire
goods for distribution.
3. Acquire services of human resource
Manufactures need finance to pay their workers, supervisor, manages
and other staff employed by them. Traders require finance to pay their
employed by them.
4. Meet other operating expenses
Every organization needs finance to meet day to day other operating
expenses like payment of electricity bills, water bills, telephone bills,
traveling and conveyance of staff, postage and telephone telegram
expenses and so on.
5. Adopt modern technology
With fast changing technology, business firms need finance to
modernize their plans and machineries, production methods and
distribution methods. An enterprise may decide to replace outdated
and obsolete assets with new assets to operate more economically.

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FINANCE FUNCTION
MEANING
In the context, as a study of subject, the business finance and finance
function of business are inter changeably used. Business finance or
finance

function

embraces

all

theories,

procedures,

institution

instruments, problems and policies that are involved in the acquisition

and use of money by business enterprises.

DEFINITION
Business finance or finance function may be defined as the process of
retaining, providing and managing of all the funds to be used in
connection with business activity. It is an activity concerned with
planning, raising, controlling and administrating of funds used in the
business.

FINANCIAL MANAGEMENT
MEANING
Financial management is that specialized functional area of general
management, is primarily concerned with the management of financial
aspects of an enterprise. The business finance or finance function centers
around the financial management of fund raising and using them
effectively. Thus, the financial management deals with procurement of

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funds and their effective utilization with an intention to maximize wealth

of the owners of the business.

DEFINITIONS
Financial management can be defined as Planning, Organising,
Directing and Controlling the financial activities to achieve the ultimate
goal of an organization, i.e., maximizing wealth of the firm for its
owners.

NATURE AND CHARACTERISTICS OF FINANCIAL

MANAGEMENT
The following are main features of financial management:
1. Financial management is the management of finances of an
organization in order to achieve its objectives.
2. Financial management is that area of general management which is
concerned with the timely procurement of adequate finance from
various sources and its utmost effective utilization for the attainment
of organizational objectives.
3. Financial management is an area of finance which is concerned
primarily with financial decision making within an organistion.
4. Financial management involves planning, organizing, directing and
controlling of financial activities in an organization.
5. Financial management is concerned with optimal procurement and
effective utilization of funds in an manner that the risk, uncertainty,
cost and control considerations are properly balanced in given
situation.
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6. Financial management is concerned with managerial decision making.

Decision making is futuristic and requires information and criterion.
Information is deduced from accounting. Criterion demands logic
which emanates from economics.
7. Financial management is continuous administrative function. In the
present day system of complex business environment it has become an
administrative function which is associated with acquiring of funds
and its judicious application.
8. Financial management is also deals with how much profit share
should be kept for expansion and how much be distributed as divided
among shareholders.
FUNCTIONS / DECISIONS OF FINANCIAL MANAGEMENT
Financial management as an integral part of the overall management is
primarily concerned with acquisition of funds and their effective
utilization with an intention to maximize the earnings and wealth of the
owners (shareholders) of the company. In this background, the following
major aspects/functions are taken up in detail under the study of financial
management:
A. Managerial Finance Functions/Decisions
Managerial finance function include all those financial decisions of
importance require specialized managerial skills. The important
managerial functions are given below:
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1. Financing Decision
This decision/function related to the procurement of funds or
collection of capital for various investment proposals. In simple
words, it is related to the pattern of financing. Broadly, financing
decision/function is concerned with the determination of capital
needs and the sources of raising total funds required by the firm
through the issue of different types of securities, e.g., shares,
debentures, borrowing from banks and financial institutions etc
This decision/function involves the following issues:
a) Ascertainment of total funds requirement.
b) Categorization of fund requirement into long-term fund
requirement, medium and short-term fund requirement.
c) Determination of sources for fund raising, i.e., financial
instruments-equity shares, preference shares, debentures, bonds
etc
d) Analysis and examination of various sources of funds, and their
cost of capital, degree of risk and control.
2. Investment Decision
This decision/function related to selection of assets in which funds
are to be invested by the company. In other words, investment
decision relate to the total amount and assets to be held and their
composition in the form of fixed and current assets.
Investment alternatives are numerous. Resources are scarce and
limited. They have to be rationed and discretely used. Thus,
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investment decision/function is concerned with the careful

evaluation of various alternative investment opportunities (project)
available to the company and selection of best opportunity.
The investment decision result in purchase of assets. Assets can be
classified into the following two broad categories:
Long-term investment decisions long- term assets.
Short-term investment decisions short-term assets.
Long-term Investment Decisions:
The long-term investment decisions relate to fixed assets, which
are generally referred to as Capital Budgeting Decisions. The
fixed assets are long term in nature. Basically, fixed assets
create earnings to the company. They give benefit in future.
Short-term Investment Decisions
The short-term investment decisions relate to current assets,
which

are

generally

referred

to

as

Working

Capital

Management. The current assets are short-term in nature.

The financial management has to allocate the available scares
resources among cash and cash equivalents, receivables and
investors. Though these current assets do not directly contribute
to the earnings, their existence is necessary for proper, efficient
and optimum utilization of fixed assets.
This decision/function involves the following issues:
a) Ascertainment of total volume of funds available with the
company.
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b) Measurement of risk and uncertainty associated with the

investment proposals.
c) Selection of capital investment proposals.
d) Prioritizing of investment decisions.
e) Allocation of funds through capital rationing.
3. Dividend Decision
The term dividend refers to the portion of profit, (after tax),
which is distributed to share holders of the company. It is a reward
or compensation to them for their investment made in the firm. The
dividend can be declared from the current profits or accumulated
profits.
The decision/function is concerned with decision regarding
distribution of earnings among share holders of the company. The
object of financial management is to increase the maximum wealth
of the company, and give maximum satisfaction to its owners. It is
a challenging job for a financial management to establish dividend
policy of the company i.e. to what extent the profits is to be
distributed and to be retained so as there is no adverse effect in the
current and future market price of shares of the company.
This decision/function involves the following issues:
a) Ascertainment of divisible profits of the company.
b) Determination of dividend and retention policy of the firm.

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c) Analysis and evaluation of impact of levels of dividend and

retention of earnings on the market value of the share, and
future earnings of the company.
d) Consideration of the liquidity of the company.
e) Reconsideration of distribution and retention policies in boom
and recession periods.
4. Liquidity Decision(Working Capital Management Decision)
Liquidity decision is concerned with the management of current
assets. Basically, this is called working capital management.
Working capital refers to funds to be invested in the business for a
short period usually up to one year. It is also known as short-term
capital or circulating capital. Working capital management
concerned with the management of all the items of working capital,
i.e., management of current assets and current liabilities. It deals
with examination, evaluation and decision regarding each and
every aspect/component of working capital. A proper balance must
be maintained between liquidity and profitability of the company.
This is the key area for financial management. The strategy is in
ensuring a continuous process as the conditions and requirements
of business change, time to time. In accordance with the
requirements of the firm, the liquidity has to vary and in

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consequence, the profitability changes. This is the major dimension

of liquidity decision or working capital management.
This decision/function involves the following issues:
a) Determination of requirement of total working capital.
b) Determination of optimum level of investment in each
components of working capital.
c) Determination of sources and mode of financing of working
capital.
d) How to gear working capital with the change its circumstances,
seasons and operating level.
B. Incidental Finance Functions
The incidental finance functions are those functions of clerical or
routine which are necessary for the execution of taken by the
management. Some of the important incidental finance functions are:
a) Supervision cash receipts and payments, and the safeguarding of
cash balance.
b) Proper custody and safeguarding of securities, insurance policies
and other valuable documents.
c) Record keeping of financial transactions and reporting.
d) Cash planning and credit management.

SIGNIFICANCE

IMPORTANCE

OF

FINANCIAL

MANAGEMENT
1. Implementation of business plans
In every business organization, where funds are involved, sound
financial management is necessary. It makes funds available at the

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right time and uses them in an optimum way for implementation of

business plans.
2. Achieve objectives
The ultimate goal of every business organization is profit
maximization and wealth maximization. Financial management also
aims towards the same objective and hence it is important.
3. Business survival
Financial management gains prime importance, since finance is
critical for the survival of an organization. Finance is needed for the
working of all departments.
4. Financial decision making
The primary concern of financial management is considered to be
rational matching of funds of there uses in the light of appropriate
decision criteria.
5. Appraisal of business decisions
Almost all business decisions are appraised from the point of view of
financial management, making the financial management a key player
in the decision making process of an organization.
6. Helps co-ordination
All the functional areas of business organization have financial
implications. Financial management helps helps to co-ordinate them
and eliminate wastages.
7. Reduce risk and uncertainty

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Financial management involves planning financial activities, and also

preparing for future financial uncertainties. Hence, it helps to face the
uncertain financial situations and there will be lesser risk.
8. Measurement of business performance
It is general belief that profitability of business is an index of sound
operation of all business activities. Financial management helps to
find out the performance of business activities in terms of profitability
of business.
9. Pervasiveness
Financial management is necessary for all the types of organizations,
whether profit or non-profit. It is required to all functions and
departments within the organization.

GOALS/OBJECTIVES OF FINANCIAL MANAGEMENT

Financial management is mainly concerned with the procurement of
funds and judicious use of these funds with an intention to protect and
safeguard the economic interest/welfare i.e., maximize the earnings
(profit) and wealth (value of equity shares) of the owners (share holders)
of the company. There are two conflicting goals/objectives are to be
achieved by financial management:
1. Profit maximization
2. Wealth maximization
1. Profit maximization

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Profit earning is generally regarded as the main objective of business

firm. The term profit refers to the amount of income earned by the
business firm, which is due to its owners (share holders). Profit
earning or profitability refers to a situation where output exceeds
inputs i.e., the value created by the use of input resources. Profitability
is an operational concept.
Each company collects its finances by way of issue of shares to the
public. Investors (shareholders) invest it shares with hope of getting
more dividends for their investment in the company.
It is possible only when the companys earn maximum profits out of
its available resources.
If the company fails to distribute higher dividend, people will not be
keen to invest their money in such company, and persons who have
already invested, will like to sell their stocks. Therefore, it is the
objective of financial management is to safeguard the economic
interest/welfare of shareholders by deciding maximum profits or fair
profits in the form of dividend. Thus, profit maximization refers,
earning maximum profits out of its available organizational resources.
2. Wealth maximization

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The primary objective of financial management is to maximize the

wealth to the owners (shareholders). Wealth of the owner is the market
value of equity shares.
Wealth maximization means maximization of the market price or
value of equity shares of the company. In other hoards, maximize the
value of the firm to its owners (equity share holder) i.e,. to maximize
the market price or value of equity shares. Share holders wealth will
be maximized if the market price/value of share is maximized, hence
wealth maximization is also termed as value maximization. Market
price or value of shares serves as a yard stick of the performance of a
company. Therefore, wealth maximization of the firm is the most
appropriate objective of the financial management. Thus, wealth
maximizations is to be more precise objective of financial
management.
The wealth maximization goal/objective considers:
a) Present and prospective earnings of the company.
b) Time pattern of return i.e., time value of money.
c) Intrinsic value of the assets of the company.
d) Risk associated with the operation of company.
e) Financial leverage adopted by the company.
f) Dividend policy of the company.
g) Long run and short run profits, both
h) Social objectives of business.
i) Political environment of the country.
j) Market rumors.
k) Masses psychology,etc.
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COST
The ICMA, London has defined cost as the amount of expenditure
(actual or notional) incurred on or attributable to a specified thing or
activity.

COSTING
Wheldon has defined costing as, the classifying, recording and
appropriate allocation of expenditure for the determination of costs, the
relation of these costs to sales value and the ascertainment of profitability.

COST ACCOUNTING
The CIMA of UK defined as the process of accounting for costs from
the point at which expenditure is incurred or committed to the
establishment of its ultimate relationship with cost centres and cost units.

COST ACCOUNTANCY
According to the CIMA of UK the application of costing and cost
accounting principles methods and techniques to the science, art and
practice of cost control and the ascertainment of profit ability.

OBJECTIVES OF COST ACCOUNTING

1) Ascertainment of cost

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This is the primary objective of cost accounting.

For cost

ascertainment different techniques and systems of costing are used

under different circumstances.
2) Control of cost
Cost accounting aims at improving efficiency by controlling and
reducing cost.

This objective is becoming increasing important

because of growing competition.

3) Guide to business policy
Cost accounting aims at serving the needs of management in
conducting the business with at most efficiency. Cost data provide
guidelines for various managerial decisions like make or buy, selling
below cost, utilization of idle plant capacity, introduction of a new
product etc.
4) Determination of selling price
Cost accounting provides cost information on the basis of which
selling prices of products or service may be fixed. In periods of
depreciation, cost accounting guides in deciding the extent to which
the selling prices may be reduced to meet the situation.
5) Measuring and improving performance
Cost accounting measures efficiency by classifying and analyzing cost
data and then suggests various steps in improving performance so that
profitability is increased.

ADVANTAGES OF COST ACCOUNTING

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1) Reveals profitable and unprofitable activities

A system of cost accounting reveals profitable and unprofitable
activities. On this information, management may take steps to reduce
idle time, under-utilization of plant capacity, spoilage of materials etc.
2) Helps in cost control
Cost accounting helps in controlling costs with special techniques like
standard costing and budgeting control.
3) Helps in decision making
It supplies suitable cost data and other related information for
managerial decision-making, such as introduction of a new product
line, determining export price of products, make or buy etc.
4) Guides in fixing selling prices
Cost is one of the most important factors to be considered while fixing
prices. A system of cost accounting guides the management in the
fixation of selling prices, particularly during depression period when
prices may have to be fixed below cost.
5) Helps in inventory control
Perpetual inventory system which is an integral part of cost
accounting helps in the preparation of interim profit and loss account,
level setting etc are also used in cost accounting.
6) Aids in formulating policies
Costing provides such information as enables the management to
formulate production and pricing policies and preparing estimates of
contracts and tenders.
7) Helps in cost reduction

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It helps in the introduction of a cost reduction programme and finding

out new and improved ways to reduce costs.
8) Reveals idle capacity
A concern may not be working to full capacity due to reasons such as
shortage of demand, machine breakdown or other bottlenecks in
production. A cost accounting system can easily work out the cost of
idle capacity so that management may take immediate steps to
improve the position.
9) Checks the accuracy of financial accounts
Cost accounting provides a reliable check on the accuracy of financial
accounts with the help of reconciliation between the two at the end of
the accounting period.
10) Presents frauds and manipulation
Cost audit system, which is a part of cost accountancy, helps in
preventing manipulation and frauds and thus reliable cost data can be
furnished to management and others.

DISADVANTAGES OF COST ACCOUNTING

1) It is unnecessary
It is argued that maintenance of cost records is not necessary and
involves duplication of work. It is based on the premise that a good
number of concerns are functioning prosperously without any system
of costing. This may be true, but in the present world of competition,
to conduct a business with utmost efficiency, the management needs to

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know detailed cost information for its decision-making. Only a cost

accounting system can serve this need of the management and thus
help in the more efficient conduct of a business.
2) It is expensive
It is pointed out that installation of a costing system is quite expensive
which only large concerns can afford. It is also argued that installation
of the system will involve additional expenditure which will lead to a
diminution of profits. In this respect, it may be said that a costing
system should be treated as an investment and the benefits derived
from the system must exceed the amount spent on it. It should not
prove a burden on the finances of the company.
3) It is inapplicable
Another argument sometimes put forward is that modern methods of
costing are not applicable to many types of industry. This plea is not
very apt. the fault lies in an attempt to introduce a readymade costing
system in a firm. A costing system must be specially designed to meet
the needs of the business. Only then the system will work successfully
and achieve the objectives for which it is introduced. In fact,
applications of costing are very wide. All types of activities,
manufacturing and non-manufacturing, should consider the use of cost
accounting.
4) It is a failure
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The failure of a costing system in some concerns is quoted as an

argument against its introduction in other undertakings. This is a very
fallacious argument. If a system does not produce the desired results,
it is wrong to jump to the conclusion that the system is at fault. The
reasons for the failure should be probed. In order to make the system a
success, the utility of the system should be explained and the
cooperation of the employees should be sought by convincing them
that the system is for the betterment.

METHODS OF COSTING
1) Job order costing
According to CIMA, UK applies where work is undertaken to
customer special requirements. Cost unit in job order costing is a job
or work order for which costs are separately collected and
accumulated. A job, big or small, comprises a specific quantity of a
product to be manufactured as per customers specifications. The
industries where this method is used include printing press, repair
shops, interior decorators, painters etc.
2) Contract costing or terminal costing
This is a variation of job costing and therefore, principles of job
costing apply to this method. The difference between job and contract
is that job is small and contract is big. It is well said that a contract is a
big job and a job is a small contract. The cost unit here is a contract
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which is of a long duration and may continue over more than one
financial year. Contract costing is most suited to construction of
buildings, dams, bridges and roads, ship building etc.
3) Batch costing
Like contract costing, this is also a variation of job costing. In this
method, the cost of a batch or group of identical products is a cost unit
for which costs are ascertained. This method is used in companies
engaged in the production of readymade garments, toys, shoes and
tubes, component parts etc.
4) Process costing
As distinct from job costing, this method is used in mass production
industries manufacturing standardized products in continuous
processes of manufacturing. Costs are accumulated for each process or
department. Here raw material has to pass through a number of
processes in a particular sequence to completion stage. In order to
arrive at the unit cost, the total cost of a process is passed on to the
next process as raw material. Textile mills, chemical works, sugar
mills, refineries, soap manufacturing etc may be cited as examples of
industries which employ this method.
5) Operation costing
This is nothing but a refinement and a more detailed application of
process costing. A process may consist of a number of operations and

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operation costing involves cost ascertainment for each operation

instead of a process.
6) Single, output or unit costing
This method of cost ascertainment is used when production is uniform
and consist of a single or two or three varieties of the same product.
Where the product is produced in different grades, costs are
ascertained grade-wise. As the units of output are identical, the cost
per unit is found by dividing the total cost by the number of units
produced. This method is applied in mines, quarries, brick-kilns, steel
production, flour mills etc
7) Operating or service costing
This method should not be confused with operation costing. Operating
costing is used in manufacturing products. For example, transport
understandings

(road

transport,

railways,

airways,

shipping

companies) electricity companies, hotels, hospitals, cinema etc., use

this method. The cost units are passenger-kilometer or tone-kilometer,
kilowatts hour, a room per day in a hotel, a seat per show in cinema
etc. This method is a variation of process costing.
8) Multiple or complete costing
It is an application of more than one method of cost ascertainment in
respect of the same product. This method is used in industries where a
number of components are separately manufactured and then

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assembled into final product. For example, in a television company,

manufacture of different component parts may require different
production methods and thus different methods of costing may have to
be used. Assembly of these components into final product still requires
another method of costing. Other examples of industries which make
use of this method are air-conditioners, refrigerators, scooters, cars,
locomotive works etc.

TECHNIQUES OF COSTING
1) Standard costing
This is a very technique to control the cost. In this technique, standard
cost is predetermined as a target of performance and actual
performance is measured against the standard. The difference between
standard and actual costs is analyzed to know the reasons for the
difference so that corrective actions may be taken.
2) Budgetary control
Closely allied to standard costing is the technique of budgetary
control. A budget is an expression of a firms plan in financial form
and budgetary control is a technique applied to the control of total
expenditure on materials, wages and overhead by comparing actual
performance with planned performance. Thus, in addition to its use in

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planning, the budget is also used for control and co-ordination of

business operations.
3) Marginal costing
This is a technique of profit planning. In this technique, separation of
costs into fixed and variable (marginal) is of special interest and
importance. This is so because marginal costing regards only variable
costs as the products. Fixed cost is treated as period cost and no
attempt is made to allocate or apportion this cost to individual cost
centres or cost units. It is transferred to costing profit and loss account
of the period. This technique is used to study the effect on profit of
changes in volume or type of output.
4) Total absorption costing
It is a traditional method of costing whereby total costs (fixed and
variable) are charged to products. This is in complete contrast to
marginal costing where only variable costs are changed to products.
Although until recently this was the only technique employed by cost
application.
5) Uniform costing
This is not a separate technique or method of costing like standard
costing or process costing. Uniform costing simply denotes a situation in
which a number of firms adopt a uniform set of costing principles. It has
been defined by CIMA as the use by several undertakings of the same

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costing principles and/or practices. This helps to compare the

performance of one firm with that of other firms and thus to derive of
anyones better experience and performance.

CLASSIFICATION OF COSTS
There are various ways of classifying costs as given below
1) Classification into Direct and Indirect Costs
Costs are classified into direct costs and indirect costs on the basis of
their identify ability with cost units or jobs or processes or cost centre.
Direct cost
These are those costs which are incurred for and conveniently
identified with a particular cost unit, process or department. Cost of
raw materials used and wages of machine operator are common
examples of direct costs. To be specific, cost of steel used in
manufacturing a machine can be conveniently ascertained. It is,
therefore, a direct cost. Similarly, wages paid to a tailor in a
readymade garments company for stitching a piece of trouser is a
direct cost because it can be easily identified in the cost of a
trouser.
Indirect cost
These are general costs and are incurred for the benefit of a number
of cost units, processes or departments. These costs cannot be
conveniently identified with a particular cost unit or cost centre.

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Depreciation of machinery, insurance, lighting, power, rent,

managerial salaries, materials used in repairs etc are common
examples of indirect cost.
For example, depreciation of machine for stitching a piece of
trouser cannot be known and thus it is an indirect cost.
2) Classification into Fixed and Variable Costs
As on basis of behavior or variability, costs are classified into fixed,
variable and semi-variable.
Fixed cost
These cost remain constant in total amount over a wide range of
activity for a specified period of time; i.e. these do not increase or
decrease when the volume of production changes.
For example, building rent, managerial salaries remain constant
and do not change with change in output level and thus are fixed
costs. But fixed cost per unit decreases when volume of
production increases and vice versa, fixed cost per unit increases
when volume of production decreases.
Variable cost
These costs tend to vary in direct proportion to the volume of
output. In other words, when volume of output increases, total
variable cost also increases, and vice versa, when volume of output
decreases, total variable cost also decreases. But, the variable cost
per unit remains fixed.
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Semi-variable or semi-fixed costs (mixed cost)

These costs include both a fixed and a variable component; i.e,
these are partly variable. A semi-variable cost has often a fixed
element below which it will not fall at any level of output. The
variable element in semi-variable costs changes either at a constant
rate or in lumps.
For example, introduction of an additional shift in the factory will
require additional supervisors and certain costs will increase by
jumps.
3) Classification into Controllable and Non-controllable costs
From the point of view of controllability, costs are classified into
controllable costs and non-controllable costs.
Controllable Costs
These are the costs which may be indirectly regulated at a given
level of management authority. Variable costs are generally
controllable by department heads. For example, cost of raw
material may be controlled by purchasing in larger quantities.
Non-controllable costs
These are those costs which cannot be influenced by the action of a
specified member of an enterprise. For example, it is very difficult
to control costs like factory rent, managerial salaries etc
4) Classification into historical costs and pre-determined costs

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On the basis of time of computation, costs are classified into historical

costs and pre-determined costs
Historical costs
These are past costs which are ascertained after these have been
incurred. Historical costs are thus nothing but actual costs. These
costs are not available until after the completion of the
manufacturing operations.
Pre-determined costs
These are future costs which are ascertained in advance of
production on the basis of a specification of all the factors affecting
cost. These costs are extensively used for the purpose of planning
and control.
5) Classification into Normal and Abnormal costs
Normal cost
Normal cost may be defined as cost which is normally incurred on
a expected ones at a given level of output. This cost is a part of cost
of production.
Abnormal cost
Abnormal cost is that which is not normally incurred at a given
level of output. Such cost is over and above the normal cost and is
not treated as a part of the production. It is charged to costing profit
and loss account.

ELEMENTS OF COST
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A cost is composed of three elements, it is material, labour and expenses.

Each of these elements may be direct or indirect.

1. Material cost
According to CIMA, UK, material cost is the cost of commodities
supplied to an undertaking. Materials may be direct or indirect.
Direct materials
Direct material cost is that which can be conveniently identified
with and allocated to cost units. Direct materials generally become
a part of finished products. For example cotton used in textile mill
is direct material.
Indirect material
These are those material which cannot be conveniently identified
with individual cost units. These are minor importance, such as
Small and relatively inexpensive item which may become a part
of the finished product, example: pins, screws, nuts and bolts,
thread etc
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 Those items which do not physically become a part of finished

products., example: coal, lubricating oil and grease, sand paper
used in polishing, soap etc
2. Labour cost
This is the cost of remuneration (wages, salaries, commission, bonus,
etc) of the employees of an undertaking (CIMA)
Direct labour
Direct labour cost consist of wages paid to workers directly
engaged in converting raw materials into finished products. These
wages can be conveniently identified with a particular product, job
or process. Wages paid to a machine operator is a case of direct
wages.
Indirect labour
It is of general character and cannot be conveniently identified with
a particular cost of units. In other words, indirect labour is not
directly engaged in production operation but only to assist or help
in production operation.
3. Expenses
All cost other than material and labour are termed as expenses. It is
defined as the cost of service provided to an undertaking and the
national cost of the use of owned assets. (CIMA)
Direct expenses
According to CIMA, UK, direct expenses are those expenses
which can be identified with and allocated to cost centres or units.
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These are those expenses which are specifically incurred in

connection with a particular job or cost unit. Direct expenses are
known as chargeable expenses.
Indirect expenses
All direct cost, other than indirect materials and indirect labour
cost, are treated as indirect expenses. These cannot be conveniently
identified with a particular job, process or work order and are
common to cost units or cost centers.
Prime cost
This is the aggregate of direct material cost, direct labour cost
and direct expenses. Thus,
Prime cost = direct material +direct labour +direct expenses
Overhead
This is the aggregate of indirect material cost, indirect labour
cost and indirect expenses. Overhead is also known as on cost.
Thus
Overhead = indirect material + indirect labour + indirect
expenses
Overhead are divided into production overhead, office overhead
and selling overhead as follow:
Production overhead
Also known as factory overhead, works overhead or manufacturing
overhead, these are those overheads which are concerned with the

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production function. It includes indirect materials, indirect wages

and indirect expenses in producing goods or services,
Indirect material
Example: coal, oil, grease etc, stationary in factory office,
cotton waste, brush, sweeping broom etc.
Indirect labour
Example: works managers salary, salary of factory, office staff,
salary of inspector and supervisor, wages of factory sweeper,
wages of factory watchman.
Indirect expenses
Example: factory rent, depreciation of plant, repair and
maintenance of plant, insurance of factory building, factory
lighting and power, internal transport expenses.
Office and administration overhead
This is the indirect expenditure incurred in general administrative
function, it is in formulating policies, planning and controlling
functions, directing and motivating the personnel of an
organization in the attainment of its objectives. These overheads
are of general character and have no direct connection with
production or sales activities. This category of overhead is also
classified into
Indirect material
Example: stationary used in general administrative office,
postage, sweeping broom and brush, etc
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 Indirect labour
Example: salary of office staff, salary of managing director,
remuneration of directors of the company.
Indirect expenses
Example: rent of office building, legal expenses, office lighting
and power, telephone expenses, depreciation of office furniture
and equipments, office air conditioning, sundry office expenses.
Selling and distribution overhead
Selling overhead is the cost of promoting sales and retaining
customers. It is defined as the cost of seeking to create and
stimulate demand and of securing orders. Examples are
advertisements, sample and free gifts, salaries and salesman, etc.
Distribution cost includes all expenditure incurred from the time
the product is completed until it reaches its destination. It is
defined as the cost of sequence of operation which begins with
making the packed product available for dispatch and ends with
making the reconditioned returned empty packages, if any,
available for re-use. Examples are carriage outwards, insurance of
goods in transit, upkeep of delivery vans, warehousing, etc.
Indirect material
Example: packing material, stationary used in sales office, cost
of samples, price list, catalogues, oil, grease, etc., for delivery
vans etc.
Indirect labour
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Example: salary of sales manager, salary of sales office staff,

salary of warehouse staff, salary of drivers of delivery vans etc.
Indirect expenses
Example: advertising, travelling expenses, showroom expenses,
carriage outwards, rent of warehouse, bad debts, insurance of
goods in transit etc.

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