What is Cost Accounting? Definition, Basics, Examples
As a business owner, knowledge of your business accounting can help you reduce and eliminate your costs, and help boost productivity. One type of accounting that serves as a valuable tool for lowering your costs and determining the price for your product or service is cost accounting.
In this article, you will familiarize yourself with the concept of cost accounting, and the various types and methods of cost accounting. You will also learn about the major differences between cost accounting and financing accounting and the role of a cost accountant.
Let’s get started.
What Is Cost Accounting?
Cost accounting is the process of recording, reporting, and analyzing the cost process of a company's cost item. It is an internal accounting analysis tool used to review a company's expenses to make efficient financial decisions.
With cost accounting, a company can determine all the costs associated with carrying out a business activity e.g production. From there, it will be able to break down these costs and decide how to optimize business activities and processes based on cost efficiency.
Cost accounting is a branch of managerial accounting that is very important for budgeting. It is only after identifying where money is being lost that the company can stop non-profitable activities and expand into profitable activities.
For example, through cost accounting, you can find out what department is overstaffed. You can then decide to lay off the unneeded labor or reassign them to another department if possible.
Types of Costs in Cost Accounting
Businesses incur various types of costs in their day-to-day operations. Understanding these costs will go a long way in determining what method of cost accounting they will use in preparing cost reports. Some of these costs include:
1. Direct Costs
Direct costs are costs that can be specifically traced from units of production. They include cost, raw materials, labor cost, and distribution costs. One-time costs like machinery purchase and periodic costs like rent are not included as direct costs.
2. Indirect Costs
Indirect costs are costs that can not be attributed to a cost object. They can not be added to the cost of production because they do not necessarily guarantee the production of an item. Overhead costs like rent, utility bills, and fixed costs like machinery are examples of indirect costs.
3. Fixed Costs
Fixed costs are costs that stay the same during production irrespective of the amount of production that takes place, especially in the short term. For example, the monthly rent paid for a land lease cannot change when you exceed or fall short of your target.
4. Variable Costs
As opposed to fixed costs, variable costs will increase as the level of production increases. Packaging costs are a good example of variable costs. Variable costs usually go hand in hand with direct costs.
5. Operating Costs
Operating costs are costs that are incurred in the day-to-day running of a business. They do not directly affect the level of production but without them, a business cannot operate. Maintenance costs, taxes, and utility bills are some examples of operating costs.
6. Opportunity Costs
Opportunity costs are only used when determining which option out of multiple choices of investment is most viable. The investment opportunity not pursued is the opportunity cost.
7. Sunk Costs
Sunk costs are expenses that are not recoverable. They are regarded as irrelevant to future budgetary decisions. Generally, failed investments are considered sunk costs.
8. Controllable Costs
Controllable costs are costs that a manager has virtually total power to regulate. Some of these costs are not necessarily avoidable though, and the level of commitment to them can decide the success of the business. Examples include advertising costs, employee bonuses, and office supplies.
9. Marginal Costs
Marginal cost is defined simply as the cost of deciding to increase output by an additional unit. By calculating the marginal cost of an additional unit, managers can decide whether it is economically efficient to go ahead with the production.
Cost Accounting vs Financial Accounting
Cost accounting and financial accounting are both types of accounting that have the following in common:
- They are maintained based on the double-entry system of accounting
- Disclose the profit or loss of the business
- Record the direct costs and indirect costs of the business
- Assist management in making future business policies and managerial decisions.
Although cost accounting and financial accounting are prepared on similar principles, there exist differences between them.
- Focus: Cost accounting is an accounting system, through which a company reports and analyzes the various costs incurred in the business during production. Financial accounting, on the other hand, is a branch of accounting that focuses on the documentation, summarizing, and reporting of transactions taking place in business operations for a period of time. It involves creating financial statements such as balance sheets and income statements which companies will use to show their financial performance over a period of time and the overall financial position of the company.
- Purpose: Cost accounting is executed to seek how the costs incurred in business operations can be reduced while financial accounting is done to document the company's cash flow over a period reliably and understandably.
- Target Audience: Financial accounting and cost accounting are prepared for different target audiences. Cost accounting reports are created for use internally. The information is used by managers and decision-makers in a company to make business efficient decisions to reduce costs. Financial accounting, on the other hand, is a transparency exercise mainly meant for external use. Companies use financial accounting to show the profitability of their operations to outside sources which may include investors, creditors, customers, and regulatory agencies.
- Mandatory Requirement or Not: Although their primary function is to help managers in their decision-making process, cost accounting information can also be used in creating financial accounting reports. This does not mean cost accounting is compulsory in all companies, although performing it will improve a company's cost behavior. Companies, as long as they are public, are however required to carry out financial accounting.
- Rules of Practice: Another difference between cost accounting and financial accounting is the rules of practice. Because cost accounting is an internal purpose used by managers to determine the cost-efficiency of their operations, it does not have a regulatory board. Instead, what you have are different methods of cost accounting that managers can pick from depending on their suitability to their kind of business. Financial accounting, on the other hand, is governed by principles. In the United States of America, companies are mandated to carry out financial accounting per the guidelines in the Generally Accepted Accounting Principles (GAAP). By following these principles, companies can provide information from a common template, giving users a good basis for comparison.
- Time Interval: In cost accounting, the cost and profit are usually reported and analyzed in short intervals e.g monthly, for a specific job, batch, product, or process. In financial accounting, expenditure and profit over a year are usually analyzed simultaneously. As a result, historical costs are used when recording costs in financial accounting while various types of costs can be used for cost accounting.
Cost Accounting Methods
Cost accounting methods can be used to refer to the various methods and processes used by companies for the analysis and presentation of costs. Companies differ in their setups, modes of production, profit targets, and duration of targets. Since cost accounting is not constrained by rules, they are encouraged to use the best possible method to determine actual costs of production.
For example, companies that operate on short-term production cycles will primarily focus on direct costs like raw material. In contrast, long-term production activities usually require companies to also include indirect costs like overhead.
Types of Costing
When performing cost accounting, accountants have to first figure out what type of costing process to use. The costing process will then determine the method of cost accounting. Examples of costing include:
1. Job Costing
This method collects and accumulates costs associated with specific units of production. All direct costs specific to a job are allocated to the jobs after it has been completed. It is done by companies who produce based on customer demand and usually complete the job in a short period.
2. Process Costing
Process costing is a costing technique used on cost items that go through multiple production stages. This type of costing aims to know the cost of each stage in the process of producing an item.
Car manufacturers are good examples of companies that use process costing. A vehicle goes through stamping, welding, painting, and assembly stages before it is completed.
3. Unit Costing
This method aims to work out the cost of each unit of output and how various types of costs contribute to the total cost of the unit. It is used by companies who have a standard cost for each unit produced e.g brick manufacturers.
4. Batch Costing
This method of costing is when multiple units of the same item are produced simultaneously. Batch costing is typically used by companies that seek continuity in the production process.
Batches may be divided based on a set target output or workers' shifts. Pharmaceutical and confectionery companies are examples of industries that make use of batch costing
5. Contract Costing
Contract costing follows a similar costing process to job costing but over a longer time frame. This method of costing is mainly used for construction contracts, like road construction.
Approaches to Cost Accounting
There are many approaches to cost accounting but the following are some of the more common approaches:
1. Standard Cost Accounting
Standard cost accounting is a cost accounting method used by managers to determine the difference between the actual cost of production and the standard cost of production.
Standard costs are costs that should have been incurred to produce goods based on calculated estimations. These estimates are informed by either the past experience of the company or market research conducted by management.
In contrast, the actual cost is the real amount expended in the production of a cost item. Costs included when using standard costing include variable costs and periodic fixed costs like rent.
Calculating standard costs is a good tool for budgeting, but managers need to understand that for various reasons costs will always fluctuate. When comparing standard costs with actual costs, there is almost always a difference between the two.
The difference between both costs is called variance and can be positive or negative. A negative variance means less profit than anticipated during budgeting.
Standard cost accounting is done largely with the aim of future reference. Therefore, no matter the standard cost assigned to the items, the company still has to pay actual costs if it wishes to proceed with production.
Determining costing variance allows a manager to pinpoint the particular areas where there are cost differences and the reasons for the differences. By analyzing it, the manager can know which added costs are avoidable and how to avoid them.
2. Activity-based Cost Accounting
Activity-based costing (ABC) is a cost accounting technique used to ascertain the cost of activities involved in the production of an item. Under this method, costing accountants try to allocate overhead and indirect costs that are not included in standard costing.
All activities involved in production are divided based on their individual costs. The cost of each activity is then allocated according to their actual consumption of costs. To find the costs of these activities, ABC traces their impact on resource consumption and costing final outputs. Any activity that is relevant to the final cost of an object is seen as a cost driver for that object.
Direct cost drivers like raw materials are quite easy to allocate to products, but it is more difficult to accurately identify how each activity contributes to indirect costs. A good example of an ABC application would be finding out how employees split their time on the job. Their salaries are then divided by the time spent on each activity to determine the cost of that activity.
Activity-based costing can be very useful in identifying and eliminating ineffective production processes. However, it is a tedious method that is unsuitable for companies operating on a day-to-day basis. Activity-based cost accounting is usually for companies where an item goes through different stages of production, like automobile companies.
3. Life-cycle Cost Accounting
Life cycle cost accounting (LCCA) is an accounting technique that calculates the total cost to be incurred over the whole life of an asset. The total cost of any asset bought is not just the amount paid to acquire the said asset.
Apart from the initial investment, there will be additional finance charges and some other costs necessary to keep the asset operational. At the end of its life cycle, the asset is either sold or destroyed.
The selling price is known as the salvage value and is subtracted from the total cost of that asset. For example, when a company acquires an asset e.g a truck, the amount paid to buy the truck will only be part of the truck's overall life cycle cost. You also need to consider that over the period the truck will be used, maintenance costs, car insurance, gas, and other costs to keep the car operational will be incurred.
Unlike other costing methods which analyze the profitability of an investment on a period basis, life cycle costing traces cost and revenues over several periods. Companies that use life cycle costing are those that place an emphasis on long-term planning so that their accumulated profits over several years are maximized.
Properly conducted life cycle cost accounting is usually 80% or more accurate. As a result, if any extra costs are incurred, they can be easily absorbed.
When calculating the whole life cost of an asset, investors will typically include planning and acquisition costs, operating costs, preventative maintenance costs, rehabilitation costs, and the cost of asset disposal.
The biggest benefit of lifecycle costing is foresight, making it an important tool for capital budgeting. With it, owners can sum up the total cost of owning and using an asset and reduce it to its present-day value. It is also important in situations where the opportunity cost of investing in a business opportunity has to be calculated.
Using life-cycle accounting also means you can aim for the highest possible value for your project. From there they can make pricing decisions and estimate their profit margins.
4. Lean Cost Accounting
Lean cost accounting is a method that aims to streamline production processes to eliminate waste, reduce error, speed up processes, and maximize productivity and profits. It is one of the more recent costing methods and was developed to keep in line with many modern industries prioritizing lean practices.
This method of cost accounting replaces traditional costing methods with value-based pricing. Instead of allocating costs to departments, lean accounting categorizes costs based on total value stream profits. Value streams are a set of actions that contribute to fulfilling a customer's demand, from the initial request to the customer's appraisal of the product or service.
Efficiency in lean accounting is not determined by the level of output. It is instead measured in terms of how much time customer satisfaction takes and the level of customer satisfaction.
The process of categorizing value streams is called value stream mapping. It involves a visual representation of all the steps involved in production with the main aim of finding areas of waste during production.
Any unavoidable added costs that are not in the value stream are regarded as business sustaining costs. Under lean accounting, potential areas of waste can be divided into eight.
- Product defects
- Excess processing i.e taking too long in production
- Waiting i.e downtime on production
- Inefficient inventory control
- Excess transportation costs
- Underutilized talent
- Wasted motion i.e unnecessary production practices
Lean accounting helps to improve financial management practices within an organization by optimizing production practices. For example, efficient inventory management means only the items needed in the warehouse are kept there.
This will not only reduce inventory holding costs but will also minimize downtime from having no storage space thereby preventing opportunity cost in terms of cash blocked in inventory.
5. Marginal Cost Accounting
Marginal cost accounting is an accounting method that examines the relationship between the level of production, costs, and expenses. It focuses on economies of scale and the additional cost of each new unit of production.
This costing method is more useful for short-term decisions as it focuses on variable costs. Fixed costs are still calculated as part of the total cost but they cannot change production cost meaning there is no marginal cost without variable costs.
The main aim of marginal costing is to determine the break-even point during production. Production reaches a break-even point when the total revenue of production equals total production costs.
Break-even point analysis is an important tool for price determination on products and services. If the marginal cost of producing one more unit is lower than the market price, the producer is in line to gain a profit from producing that item.
With the help of marginal cost accounting, a manager can decide whether getting new equipment or hiring more workers to meet extra demand is a smart decision in the short term.
6. Historical Cost Accounting
Historical cost accounting is a cost accounting method in which a company records the value of its assets in its financial statements based on the nominal price at which they were originally bought.
In this method, the company's estimation of the standard costs associated with the asset is irrelevant and only the actual costs are needed. Under the Generally Accepted Accounting Principles (GAAP), American companies are required to list their fixed assets in historical cost.
Companies that operate under the Generally Accepted Accounting Principles (GAAP) have to use the historical cost principle when showing their records. The principle states that accounting records on a company's balance sheet should be at original transaction prices and should be maintained to serve as the basis for values in the financial statements.
A major advantage of historical cost accounting is that reports are usually considered free of bias and easy to understand. The process for determining asset costs is straightforward. There is no tedious calculation as only the book value of the asset is needed. Costs are determined only after they are incurred, and are based on a company's past transactions.
However, historical cost accounting is only favorable in the short term where costs are not widely different. Due to inflation, the historical cost of an asset will not necessarily be accurate at a later point in time.
For example, a property bought twenty years ago for $50,000 is sure to have appreciated. But if the company operates under historical accounting principles, the property will still be recorded as $50,000 on the balance sheet. It makes the company appear less valuable than it actually is. Due to this discrepancy, some companies use a mark-to-market basis to record assets in their financial statements.
7. Throughput Cost Accounting
Throughput accounting is one of the more recent methods in cost accounting. It offers a very different take on cost efficiency from traditional methods like activity-based cost accounting. Throughput accounting is a principle-based and simplified management used to create an alignment between all production activities to maximize output.
To understand how throughput accounting works, you have to know what throughput is. Throughput is the amount of a product or service that a company can produce and deliver to a client within a specified period.
Throughput cost accounting aims to improve an organization’s efficiency by removing bottlenecks (production limitations) in the production process to maximize throughput. It is guided by the principle of a chain only being as strong as its weakest link.
Companies who use throughput accounting use it as a reflection of their operating realities. The reality is that maximum production capacity cannot be maintained throughout the life cycle of the company — machinery will undergo maintenance and employees will go on vacation.
Throughput accounting focuses on working around these limitations and is more focused on sustaining workflow than cutting costs. Once throughput is maximized, input and output will flow in the best possible way, allowing companies to reach revenue maximization.
The Role of a Cost Accountant
A cost accountant is the professional tasked by a company to document, analyze and report a company's cost process. With multifaceted organizations and production becoming the order of the day, understanding the exact cost of every activity involved in providing a product or service to a customer has become an important analysis tool in strategic planning.
Costing is an important tool of pricing for every company. It determines what price the company starts to see itself making a profit. Hence, using face value costs may not be enough to accurately show how much the company has incurred in the production of an item. This is why the role of a cost accountant is important.
Cost accountants are more than just number crunchers. Their duties include everything from planning budget and monitoring budget performance to setting standard unit costs based on research. They are also expected to assess the operating efficiency of all production activities and departments in an organization.
From their analysis, they should be able to tell which products and departments are most profitable as well as recommend changes to procedures that will improve the company’s cash flow. Cost accountants use accounting software and ERP software to carry out their tasks and roles.
Below is a list of functions a cost accountant is expected to perform in a company.
- Collect and verify data to determine the fixed and variable costs of business activities like rent, raw material purchases, and labor.
- Develop and maintain a cost accounting system that is well suited to the company's business activities.
- Analyze the effect of changes in the process of production and other business activities on cost.
- Calculate actual manufacturing costs and compare the actual costs to standard costs and recommend necessary cost-saving opportunities.
- Provide management with detailed reports analyzing and comparing the factors affecting prices and profitability of products or services and recommending cost-saving options.
- Performing physical inventory inspections and monitoring inventory management information systems.
- Ensure compliance with all laws related to taxes and finance.