What is Costing: An Overview

Costing means evaluating or assessing the cost of a product or job in monetary terms.

It is the process of identifying and analysing the expenses involved in producing a product.

Production involves multiple expenses that vary in nature. So, the cost accountant should identify the expenses directly related to the product's manufacturing.

For example, there are raw materials, power and fuel, buildings, machinery, tools and equipment, salaries and wages, expenses incurred in administration and marketing, etc.

The costing department tries to accurately identify the costs directly related to the product by setting aside expenses that are not a part of the direct cost.

Definition of Costing

Based on the above facts, costing can be defined as "an accurate and systematic process of computing the cost of a product or service".

How to Calculate the Cost

To put it in simple terms, Costing is done by adding the value of all the factors of production directly related to the production and then dividing the total cost by the quantity produced. 

For example, consider the simple case of going to a movie. It could be a wonderful example.

Here, the cost of the movie does not comprise only the ticket price. 

• To watch the movie, you have to travel there by public transportation or your own vehicle. So you incur round-trip fare charges or fuel for your vehicle. 
• Then, if you have to eat there, the cost of food is also incurred. This is because eating out is costlier than home-cooked food. 
• Then the value of your time spent watching it may also be added if you are a very busy person and your other work is hampered if you get stuck in traffic jams, etc.
• Any other costs can also be added, like financial disturbance, mental disturbance, deterioration of health due to the movie.
•  So all these factors can add up to the cost of your movie, and literally it will become a great price paid for watching that movie. 
• This is how costing is to be done

Stages Involved in Costing

Bifurcate Direct Costs and Indirect Costs

Trace and Allocate

Aggregate & Divide to obtain Unit Price 

• First, you will need to identify and locate all the elements that affect the cost of your object. Thereafter, bifurcate the expenses into Direct and Indirect.
• Then you will need to determine the actual quantity of each element that affects your particular object. It involves tracing which cost impacts the production process. Allocate that cost to the product's cost.
• If there are four elements used to make, say, 100 units of a particular product, your cost per unit will be one-hundredth of the sum of the values of those 4 elements.
• When there are many stages of production, you can calculate the cost for each stage by considering the expenses incurred for that stage separately. This is known as process-wise cost.
• When there are many products with the same elements of expenses or factors involved, you will calculate the cost by identifying the proportionate share of expenses for each product. This is known as product-wise cost.

Consumer Surplus and Producer Surplus

Consumer Surplus Meaning and Explanations

Consumer surplus is the difference between what consumers are willing to pay for a product and the actual market price they are paying. It is measured in monetary value in economics. The payment made will always be lower than the price they would have otherwise paid.

It is equal to the degree of extra utility derived by the consumer for which he has not paid any money or value.

So, consumer surplus is an extra advantage gained or money saved by the consumer. 

It is a measurement of the extra satisfaction the consumer derives from that product. 

Here, the consumer does not mind paying an increased price for that product, because he derives much more satisfaction from it than he is actually paying to procure it.

For example, a consumer goes to the market to purchase sugar expecting the price to be Rs.50 per kg. But when he actually purchases it, he finds that he is charged only Rs. 35 per kg. So, it is assumed that the consumer has derived a surplus satisfaction of Rs.15 which is his consumer surplus.

• Buyers always think in terms of the extra satisfaction they derive whenever buying goods. 
• They always look for products that provide higher satisfaction and then bargain to pay a much lower price than the actual utility they derive.
• So, generally, consumers always enjoy some amount of consumer surplus from most of their purchases.
• So, when prices increase, consumer surplus decreases, and when prices fall, consumer surplus increases.

Graphically, consumer surplus can be described as the area below the demand curve and above the price line if you colour that portion in the bottom graph.

Producer Surplus Meaning and Explanations

Just like consumers enjoy surplus satisfaction from their purchases, the producers of a product or the suppliers of it also enjoy extra benefits. 

It is equal to the extra income they get by selling goods at a price higher than what they would otherwise have been forced to sell. 

• The producers may be willing to sell their products at a lower price than the current market price in order to carry on their business rather than wind up. 
• But, by selling their goods at the current market price, they are enjoying extra income. 
• This extra amount of income that they are receiving by selling the product at the current market price (say 'x') instead of selling it otherwise at a lower price (say 'y') is their surplus. 
• So they are enjoying a producer surplus of (x-y) amount multiplied by the quantity sold. 
• This money is their "producer surplus". 

The above is illustrated in the graph below.

The blue line indicates the demand curve. The red line indicates the supply curve.

Both lines intersect at a point where the price level is Rs.500, at the Price-3 point. This is the point where demand and supply are equal.

If you draw a line from the intersection point to the Y-axis (a vertical line), the consumer surplus will be equal to the total satisfaction he enjoys along this line up to the tip of the demand curve at Rs.1000.

Similarly, the producer surplus will be equal to the total satisfaction between the lines at the price level of 500 and the price level 200 above the supply curve. 

(I was unable to shade these portions with a color to make them clear for you.)

Graph for Consumer Surplus and Producer Surplus

(View it in an enlarged size for a clear view.)

I hope you are clear now about the concepts of Consumer Surplus and Producer Surplus. You may clear any doubts by asking in the comments section.

Law of Diminishing Returns Explained

When you are discussing the "Law of Diminishing Returns", you should not get confused with the "Law of Diminishing Marginal Utility".

The law of diminishing returns is used in production and in assessing factors of production, whereas the law of diminishing utility is used to study consumer needs and their satisfaction.

Definition of The Law of Diminishing Returns

According to the law of diminishing returns, adding more of a factor of production while other factors remain constant will eventually result in diminishing returns after a certain point of production.

This is because of the fact that production involves a proportional mixture of all factors. If anything gets increased out of proportion, it will yield a negative result. 

This law of "Diminishing Returns" is also known as the Law of Diminishing Marginal Returns.

Production will increase up to a certain point only when you go on increasing any factor of production, with no corresponding changes in other factors. But, after that point, if you go on increasing the factor further, then the additional yield or marginal return begins to fall and eventually, on reaching a certain point, the marginal returns can be negative figures.

Illustration of the Law of Diminishing Marginal Returns

Consider a factory employing new labour to increase production while keeping other factors of production the same. 

Up to some point, the production will increase. After a point is reached, if it goes on recruiting further labour, the efficiency of labourers will drop, and the marginal increase in production will fall. 

Ultimately, even their original level of production can drop. This is illustrated in the chart below.

Number of Labour	Production in MT	Marginal Production in MT
1000 (initial strength)	5000	5000
1200	6000	1000
1300	6500	500
1400	6200	(-)300
1500	5500	(-)700
1600	4800	(-)700

In the example above, you can see that when the labor strength is increased to 1200, the factory produces 6000 MT (marginal increase in production is 1000 MT). When you employ 200 additional laborers, production increases by 1000 tonnes. So, 200 laborers contributed to an increase of 1000, i.e., 500 tonnes per 100 laborers. The next recruitment of another 100 laborers yielded 500 tonnes of additional production. So, marginal return remained the same. 

But when an additional 100 laborers were employed, making the total labor strength 1400, the marginal return fell by 300 tonnes. At 1500 strength, the marginal return even decreased by another 700 MT. Then your manager went on employing further labor carelessly, with some false hopes of increasing the production without touching other factors of production. And, the result was a drop in the initial production of 5000 MT. They could produce only 4800 MT at a labour strength of 1600.

The best marginal return you achieved in the above case came from employing an additional 200 units of labor. After that recruitment, you should stop increasing labor and focus on improving the other factors of production.

Law of Diminishing Marginal Utility: How Do They Fix Prices?

In economics, it is generally observed that if you go on consuming more of anything, the satisfaction or utility that you derive from an extra unit gradually decreases. If you go on consuming in spite of this diminishing utility, a point may arise where your satisfaction from one more extra unit is zero, and thereafter it will go into negative figures. 

Ultimately, your total utility decreases with each extra unit of consumption. It can be harmful or even dangerous to you if you continue consuming those products.

Example for Diminishing Marginal Utility

For example, take a plate of meals. From the first plate of meals, suppose you get the utmost satisfaction, say 100 percentage. If you go for another plate, you may get 60% satisfaction, and from a third plate you may get only 30%. If you take one more round, then it may not give you any more utility, and it may provide a negative result from that meal. You may even begin to vomit and get sick.

So, automatically, you will stop consuming more of that product even at a second or third round itself.

How do Producers Fix/Determine the Prices of Products

Hotels and Restaurants assume this law of diminishing utility as their safe point when they run full meal menus or buffet systems. (You must be aware that full meals or buffets do not have any restrictions on how much food you eat). As they are confident that nobody can eat (excessively) more than up to a certain limit, they can be free of any losses in their business. 

They can safely fix their prices at an assumed average that falls between the minimum and maximum capacities of customers' intake of food. The rate gets determined through this law of diminishing marginal utility.

Calculation of Full-Meals Price

Suppose a person consumes an entire four-plate meal.

In the above example of meals, the marginal utilities for each extra plate are as follows:
1st plate 100 points, 

2nd plate 60 points, 

3rd plate 30 points, 

4th plate 0 points. 

So, the total utility derived from four plates is (100+60+30+0) = 190 points.

Now, suppose each person has different capacities for eating. One person eats only one plate. The second takes two plates of meals.  The third one consumed three plates. The 4th and 5th customers had two plates of meals each.

The above assumptions are only for calculation purposes. Don't think that a person eats two plates or three plates of meals in a single sitting. Even during buffet dinners, it can't be imagined (where we see people eating lavishly). Think of the plate as another serving of food.

There are 5 people in the example above; the total number of plates consumed is 10. Now, you will have to calculate the price of food by determining the average, which comes to 10/5 = 2 times. The price per person can be set at 2 times the cost of one meal plate, which can be a safer price from the point of view of the restaurant's management. 

So, if the average cost of food cooked per plate was Rs 30, the restaurant can fix the price per meal as twice Rs 30, which amounts to Rs 60.

In this way, the law of diminishing utility can be a very useful determining factor for fixing prices.

Scarcity, Utility, Marginal Utility, and Total Utility: How to Measure Utilities

What Does Scarcity Mean?
Scarcity means a lack of enough quantity of anything. It refers to a situation where your requirements are far more than available goods. So, you experience a shortage of items or resources to satisfy your demands. This shortage is referred to as scarcity.

In economics, this shortage or scarcity of resources forces you to make decisions and choose things carefully to get the utmost satisfaction from the limited options available. 

The resources are either limited or not fully available for use, thereby leading to scarcity because of the unlimited wants of human beings.

Utility in Economics 

Utility, in Economics, refers to the quantum of satisfaction derived by consumers while consuming goods or services. 

Consumer satisfaction is a major factor determining all the demand and supply activities of consumers. Prices are set based on the utility that goods provide to consumers.

How to Measure Utility

• Utility is measured in terms of the degree of a consumer's willingness to pay a certain amount of money to gain that utility.
• It is rather an assumption that the product has a certain amount of utility equal to the price paid by the consumer to have it.
• The consumer is ready to pay an increased amount of price to obtain that level of satisfaction, as he wants to get it instead of changing to other products or services. This means that he is getting a good level of utility from that good or service. So the product has that much amount of utility that he is willing to pay to have it.
• Utility is measured under different algorithms.

Now, let us take a look at those different categories of utility before measuring the marginal and total utilities of some products/goods.

Total Utility

Total utility refers to the total quantity or measurement of satisfaction derived by a consumer by purchasing different numbers of units of the product. If you consume one unit, you will get a certain level of satisfaction. If you get another unit, the level will increase. So the total satisfaction derived goes on increasing as you go on adding more units. This total satisfaction derived is known as the total utility of that product for you.

Marginal Utility

Marginal utility refers to the extra amount of satisfaction derived by you when you consume one more unit of anything. 

Normally, a consumer will derive more satisfaction from the first unit that he consumes. As he goes on increasing his consumption, the extra unit that he purchases will not give him as much satisfaction as he derived from the previous unit. So the extra satisfaction is decreased gradually as he increases his quantity. This quantum of extra satisfaction is known as the marginal utility of that product to him.

For example, take the case of your child eating a chocolate bar. The first candy will give him the utmost satisfaction. The second candy may not be so appealing, as he already got satisfied by the first candy. If you give him a third and a fourth one, he may not want to eat it anymore. On the other hand, if you give only one candy and then a cup of ice cream or milkshake, he can derive the same amount of satisfaction from both the candy and the ice cream or milkshake. So his total utility will be more than what he gets by eating 3 or 4 choco bars.

Example - 1

Chocó bar candy	Utility/ Marginal utility	Total Utility
First candy	60	60
Second candy	30	90
Third candy	20	110
Fourth candy	10	120

Example -2

Item	Utility/ Marginal utility	Total Utility
Chocó bar candy	60	60
Ice cream	60	120

From the above two examples, you are able to see that in the first example you are getting 120 units of utility by consuming 4 candies, whereas you are able to get the same amount of 120 units of utility by eating one chocobar and one ice cream only, as per 2nd example.

Now, suppose one choco bar costs $1, and one cup of ice cream also costs $1.

So, in example 1, you are paying $4 to get 120 units of utility, whereas in example 2, you will be paying only $2 to get the same satisfaction of 120 units of utility.

Now, we come to know that additional units of consumption of the same product will go on decreasing the satisfaction. This is known as diminishing marginal utility. The total satisfaction will increase up to a certain extent, and then it may cease to increase after a point. In the above example, if you take another candy, the marginal utility can be zero units, and so total utility will remain the same as 120 units only.

On the other hand, if you shift to other products, your utility will be greater because the utility from other products will be more than that got from consuming the same product in most cases.

So utility plays a major role in economics while fixing the prices of commodities.

Definition & Classification of Wants: Needs, Comforts and Luxuries

To understand wants, one should recognise the difference between Wants and Desires.

Human beings have many desires. They can desire the ownership of a good house, a car, luxurious furniture and clothing, and large bank balances. 

But having a desire is different from the capacity to satisfy the desire. Here comes the difference between desires and wants.

Definition of Wants

Wants can be defined as desires that are backed by the purchasing capacity of the person desiring. So all desires are not wants. To be treated as a want, your desire must be capable of being satisfied.

Desires can be satisfied when you have the purchasing power in terms of money or kind. So, wants are different from desires.

Even though you can not satisfy all desires, your purchasing capacity can convert some of those desires into wants. 

Consumers' actions are motivated by the desire or instinct to satisfy their wants. But their funds may force them to choose among different desires and needs.

In Economics, this activity of satisfying needs or wants governs the various business activities and business decisions of producers and manufacturers of goods. 

Markets also respond accordingly and are completely controlled by these changing needs and wants of people.

Consumers act according to the urgency of wants. Most urgent wants are satisfied first, then lesser emergency wants, and lastly, superfluous wants are satisfied (if affordable).

Some desires are to be satisfied compulsorily, and they become their needs.

Basically, all desires are broadly classified into needs and wants.

Wants vs Needs

Let us look into the difference between Needs and Wants.

Needs:

Needs are those without which one can not survive. For example: food, clothes, and shelter. These are the most basic requirements for anyone to survive. One may manage without them for one or two days. But ultimately, he needs these items to survive. So these items are categorised as Needs.

Wants:

Wants contain a wider choice of requirements to satisfy their desires. Wants can include needs also. But needs can not include wants. You can survive without having or satisfying most of these wants desired by you. For example, costly food, a bicycle or bike, a movie or TV set, a mobile, etc. All these are wants. But they can not be needs. You can still survive without these items.

So, the major distinction between Needs and Wants is the ability to survive.

Classification of Wants into Three Groups

In Economics, wants are classified into Necessities, Comforts, and Luxuries.

Necessities or Necessaries
Necessaries are just like needs. You can't live without satisfying these necessities. Food is necessary to survive. Water is a necessity for living. Similarly, you need air to breathe and survive. So all these are classified as necessities because you can't survive without them. According to this assumption, food, clothes, and shelter fall under necessities.

Comforts
A comfort is something which gives you relief. A fan gives you comfort in breathing the air. An extra side dish of food gives you comfort in eating your food more enjoyably. A bicycle provides you relief in travelling. All these items can be treated as comforts. They are not necessities as you can live without them. They are needed only to aid your living conditions.

Luxuries
Luxuries are those which are even more superfluous than comforts. They provide you with much more comfort in your life and are very costly, and are of a high-standard living. A luxurious bungalow or a stay in a five-star hotel, very costly food with wide varieties of dishes, a high-definition LED TV, an air conditioner, Aeroplane travel, etc., all these can be examples of luxuries. These items give you a very superior standard of living which is not at all necessary under ordinary circumstances for your survival. So these are termed as luxuries.

Needs and Wants Change According to Circumstances

The above explanations of necessities, comforts, and luxuries are a view generally accepted by all economists under normal circumstances. 

But what is regarded as comfort or luxury may be at times considered as a necessity under certain different circumstances.

For example, if you are burning up at a temperature of 50 degrees Celsius, then a cool breeze from an air conditioner can become a necessity for survival. So, in this case, the air conditioner may become a necessity for you.

So, comforts and luxuries can sometimes become necessities under specific circumstances.

With the advancement of technology and changing habits of people, this classification of human wants may also undergo changes. 

Many items of comfort and luxury may now be regarded as necessities. Mobile phones, color TVs, coolers, and even ACs have become part of everyday life in most homes. They have become a necessity for most people.

Fund Flow Statements & How to Prepare a Fund Flow Statement

What is a Fund Flow Statement?
Fund Flow Statement is a financial document that depicts and explains the changes in working capital and financial position of any company during a period as compared with another period.

Why is it Prepared?
Fund Flow Statements are prepared to study and explain the changes in working capital and finances in any period. It explains the reasons for an increase or decrease in the working capital and the finances of the company by revealing changes between two periods and different account heads for a better understanding and management of funds.

How to Prepare Fund Flow Statement?

Fund flow statements are prepared by deriving the amounts of increase or decrease in figures of balance sheets comparing two accounting periods and putting those figures in a statement.

A fund flow statement contains two parts: Sources of Funds and Application of Funds. 

You can prepare it in a single-column statement or in a double-column one.

In a single-column format, first mention all sources of funds and then the applications.

In a double-column format, the left side will show sources of funds, and the applications of funds are shown on the right side. Both totals will match as you will be describing the whole utilisation of resources.

Sources of Funds

Under this head, you will be showing the following figures.

• Shares and debentures issued for cash (including bank cheques, drafts, money transfers, etc.) 
• Amount received through long-term loans. Short-term loans are not taken as they are part of working capital.
• Amount received through sale of fixed assets and investments, etc.
• Gross Profit or funds generated from business operations during the year. This amount is calculated differently through the indirect method by taking the net loss during the year and back calculating the gross funds in a format described below separately in the worksheet
• Decrease, if any, in the working capital. This figure is also calculated by deriving the changes between working capital of two years as per explanation given below separately in a worksheet.

Application of Funds 
Coming to application of funds, the following figures generally appear in a funds flow statement.

• Purchase of Fixed Assets and Investments made during the year on actual payment basis.
• Payments made against redemption of debentures, shares and loan repayments. 
• Tax and dividend payments made during the year. (No provisions for dividend or tax should have been made in current liabilities in this case)
• Increase in working capital, if any. (If there is a decrease in working capital, it is taken as Source of Fund and an increase in working capital is taken as Application of Fund).

So, the format for Fund Flow Statement will be something like this:

Fund Flow Statement of XYZ Company

Sources of Funds	Amount	Application of Funds	Amount
Issue of shares/debentures		Purchase of Fixed assets and Investments
Long term loan receipts during the year		Redemption of Debentures, Shares
Sale of fixed assets/investments		Repayment of Loans
Fund generated from business operations @	as per    worksheet	Tax and Dividend payments
Decrease in working capital  (* as per below  worksheet)		Increase in working capital   (* as per below worksheet)
TOTAL		TOTAL

Regarding the Annexures of the above statement, two worksheets are to be prepared for Funds generated from Business Operations and for the Increase or Decrease in Working Capital. They are prepared as per the worksheets given below. All other figures are taken directly from the Balance Sheet in the above columns.

Worksheet for funds generated from business operations (for above marked@)

You will proceed from Net Profit of the year and back calculate as follows:

Net Profit/ Income                                                 Add (Items shown as expense) Depreciation Loss on sale of Fixed assets Loss on sale/ encashment of investments Deferred Revenue Expenditure Provision for Tax Provision for Dividend Other losses written off TOTAL Less: (Items shown as Income) Profit on sale of assets Profit on Investments Reserves & Provisions written back, if any Other fictitious income shown, if any  Actual Fund generated from operations

50000 10000   2000   1000   2500   1500   3000     500 20500 70500   5000   3000   5000     500 13500 57000

Worksheet for Increase/ Decrease in Working Capital (marked * in fund flow)

Particulars	Previous Year (2012-13)	Current Year (2013-14)	Increase / Decrease
A. Current Assets
Inventories	1200	1500	(+) 300
Sundry Debtors	500	650	(+) 150
Cash & Bank Balances	50	75	(+)   25
Loans & Advances	300	405	(+) 105
Other Current Assets	30	20	(-)   10
TOTAL (A)	2080	2650	(+) 570
B. Current Liabilities
Liabilities (for expenses, creditors & customer advances)	1050	1200	(+) 150
Provision for Tax	350	450	(+) 100
Provision for Dividend	300	360	(+)   60
Others	100	90	(-)    10
TOTAL (B)	1800	2100	(+) 300
Net Working Capital (A – B)	280	550	(+) 270

Note:

If net working capital increases, it is treated as an application of funds because funds are used to increase inventories. On the other hand, when working capital decreases, it is a source of funds because you are saving money by spending less.