The Hindu Business Line : The crux of cost centres

COSTS are ascertained by cost centres, cost units or by both. A cost centre is a location, person or item of equipment (or group of these) in or connected with an undertaking, in relation to which costs may be ascertained and used for the purposes of cost control.

Types of cost centre: By analysing the definition, it becomes obvious that cost centres are of various types:

Impersonal cost centre consists of a location or item of equipment (or group of these) and personal cost centre consists of a person or a group of persons.

In a manufacturing concern, cost centres may be either production or service related. In production cost centres, there may be operation and process cost centres. Operation cost centre is a cost centre which consists of those machines and/or persons which carry out the same operation. Process cost centre consists of a continuous sequence of operations. A cost centre may be a particular workbench, machine or group of machines of one type or activity.

A cost centre may be determined according to location which may be a division, department, sales area, stockyard, tool room, administrative office, and so on. Costs are accumulated in respect of a person who may be a works manager, sales manager, purchase manager, personnel manager, finance manager or that of a foreman, store-keeper, sales man, section officer, and so on.

The purposes of cost centres are as follows:

Recovery of costs: Costs are accumulated in respect of location, person or an item of equipment and then distributed over the products for the recovery of costs which have been incurred.

Control of costs: Cost centres are helpful in controlling costs in such a way that they try to locate responsibility by location, person or equipment. Thus the manager of a cost centre will try to control costs in respect of his area of responsibility. Hence cost centres are also called as "responsibility centres".

Service costing

LET US consider two examples of service costing — `boiler house costing' and `hospital costing'.

Service costing is also called operating costing. Operating cost is defined as the cost of providing a service (ICWA definition). This system is useful to service, rather than manufacturing, organisations.

The following are the features common to both boiler house and hospital costing: a) service to customers; b) a large amount of total capital is invested in fixed assets and less amount is required as working capital; c) the distinction between fixed and variable costs is important; and d) operating costs are classified and compiled under: a) operating and running costs; b) maintenance costs; c) fixed costs.

Boiler house: The purpose of boiler house costing is to ascertain the cost of steam produced, that is, the cost of a cubic-metre of steam produced.

Hospital costing: The main function of a hospital is to render medical services to patients. It consists of several departments such as outpatient, inpatient, wards, pathology, operations, intensive care unit, scanning, X-ray, dispensary, ambulance and administration, and so on. The cost of service of each department is to be ascertained separately:

Out-patient — per out-patient; in-patient — per patient-day; wards — per patient-bed per day

Purchase cost

A COMPANY has the option to procure a particular material from two sources:

Source I assures that defectives will not be more than 2 per cent of supplied quantity.

Source II does not give any assurance, but on the basis of past experience of supplies received from it, it is observed that defective percentage is 2.8 per cent.

The material is supplied in lots of 1,000 units. Source II supplies the lot at a price, which is lower by Rs 100 as compared to Source I. The defective units of material can be rectified for use at a cost of Rs 5 per unit.

You are required to find out which of the two sources is more economical (CA (Inter) May, 2001).

Answer: Right source of buying:

Lot — 1,000 units

Source I: Defectives, 2 per cent of 1,000 = 20 units

Cost of rectification: 20 x 5 = Rs 100

Source II: Defectives, 2.8 per cent of 1,000 = 28 units

Cost of rectification: 28 x 5 = Rs 140

Less: Lower price = Rs 100

Net cost = Rs 400

Hence, Source II is more economical.

WC requirement

PREPARE working capital requirement from the following information:

Average collection period — 60 days

Average payment period — 75 days

Inventory holding period — 90 days (calculated with reference to cost of goods sold)

Cash and bank balance — 2.5 per cent of sales

Sales — Rs 20,00,000, gross profit — 25 per cent

Credit purchases — one-third of cost of goods sold

The company expects 50 per cent sales increment during the next year: (Assume one year = 360 days). (CA (Inter) November 1992)

Answer: Working Notes:

Sales — Rs 20,00,000

50 per cent sales increment — Rs 10,00,000

Total — Rs 30,00,000

Gross profit at 25 per cent — Rs 7,50,000

Cost of goods sold — Rs 22,50,000

Inventory = Cost of goods sold x 90/360 = 22,50,000 x 90/360 = Rs 5,62,500

Debtors = Sales x 60/360 = 30,00,000 x 60/360 = Rs 5,00,000

(Assumption: all sales are on credit)

Credit purchases = one-third of cost of goods sold = Rs 7,50,000

Creditors = 7,50,000 x 75/360 = Rs 1,56,250

Solution: Statement of working capital requirement

Current assets (CA):

Inventory — Rs 5,62,500

Debtors — Rs 5,00,000

Cash and bank, 2.5 per cent of Rs 30,00,000 — Rs 75,000

Total CA — Rs 11,37,500

Less: Current liabilities (CL)

Creditors — Rs 1,56,250

Working capital requirement (CA - CL) — Rs 9,81,250

(Edited extracts from Cost Accounting and Financial Management. Book courtesy: Kitab Mahal, Allahabad. www.indiabookfair.com)

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