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Cost Accounting: Everything You Need to Know

August 30, 2023
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Understanding the cash flow of your business – both in terms of incoming cash and expenditures – is crucial if you hope to succeed in any competitive modern market. That’s why you, as a business owner, need to understand cost accounting.

Cost accounting is an effective way to learn how your business is set up and how it uses money. Today, we’ll break down cost accounting, the types of cost accounting you can perform, and when you should practice cost accounting with specific examples.

What Is Cost Accounting

Cost accounting is managerial accounting that looks at a company’s production costs by considering the variable costs and fixed costs at each step of the production process. 

Cost accounting is not GAAP-compliant, so it can only be used for internal decision-making.

History Of Cost Accounting 

Modern cost accounting is believed to have started during the Industrial Revolution in the late 1700s when steel and metal manufacturers had to start tracking their fixed and variable costs to improve their production process. 

It allowed railroad and steel manufacturers to control costs, become more efficient, and make better pricing, investments, and development decisions. 

Since the onset of the 20th century, cost accounting has become widely used for better financial management. 

Principles Of Cost Accounting

Cost accounting systems are used to identify, measure, and record all fixed and variable costs associated with the production process. This information can be used to compare input costs to output results, which can help businesses make better financial decisions and improve their bottom line. Here's a breakdown of all the costs incurred in managing an organization:

  • Fixed costs, which do not vary based on your level of production. Leases and mortgage payments are good examples.
  • Variable costs, which are tied to your level of production. For instance, if you run a seasonal business, your variable costs will increase during the run-up to your peak season and then decline for the rest of the year.
  • Operating costs are any day-to-day expenses of running your company (e.g., short-term supply purchases, employee salaries, etc.). Tracking these expenses is always a good idea.
  • Direct costs are any costs that are associated with producing a product directly. For instance, if you run a restaurant business and spend five hours preparing meals, the direct costs of those finished products include the labor hours for your workers and the costs of the ingredients needed to create those meals.
  • Indirect costs are any costs that can't directly be linked to the production of products. A good example might be the bill for the ovens you use in your restaurant business to create delicious food.

Cost Accounting vs Financial Accounting

Cost accounting and financial accounting are two branches of accounting that track and report financial information about a business. However, they have different purposes and users.

Cost accounting systems are used to track and report the costs of goods or services produced or provided by a business. It is used by internal decision-makers, such as managers, to make decisions about pricing, production, and other aspects of the business. It is not GAAP compliant and cannot be used for external purposes.

Financial accounting is used to record and summarize the financial transactions of a business. It is used to prepare financial statements used by external stakeholders, such as investors, creditors, and government agencies, to assess the business's financial health.

Simply put, financial accounting deals with the broader financial picture of a company; cost accounting delves deeper into understanding and managing costs within the organization to enhance internal decision-making. - Helena Lauchli, Accountant. 

Elements Of Cost Accounting

The three elements of a cost accounting system are materials, labor, and overhead. 

Material

The input for production. It’s broken down into two groups: direct and indirect materials.

Direct materials are the raw materials used to make a product, which can be easily traced to the finished product. For example, the wood used to create a table is a direct material, while the glue used to hold the wood together is an indirect material.

Indirect materials are the materials used in the production process that cannot be easily traced to a specific product or job. They are typically used in small quantities and are not a significant part of the cost of the product. For example, the oil used to lubricate the machines in a factory is an indirect material. The oil is used in the production process, but it is not used in a specific product or job. 

Labor

Like materials, labor is also divided into direct and indirect labor costs.

The labor cost for workers directly involved in production or distribution is a direct labor cost. This includes salaries, wages, overtime, and bonuses. Employee benefits are also part of the total cost.

Indirect labor costs are costs for workers not directly involved in production or distribution. These costs are treated as overhead expenses, not labor expenses.

Overhead Expenses

Overhead expenses are the costs incurred in running a business for the production of goods or delivery of services but which cannot be attributed to a specific good or service.

Here are some other examples of overhead expenses:

  • Property taxes
  • Accounting fees
  • Legal fees
  • Marketing expenses
  • Shipping expenses
  • Repairs and maintenance
  • Training expenses

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Methods Of Cost Accounting

Depending on your needs and measurement goals, you might practice one or several methods of cost accounting. Some common costing methods include:

Standard Costing

In standard costing, predetermined costs are used to track and control the costs of goods and services produced or provided by a business. The standard costs are based on the optimal use of labor and raw materials to produce the good or service under normal operating conditions. Even though standard costs are assigned to these goods and services, the company still pays the actual costs. These actual costs are then compared to the standard costs to identify variances. Variances can be caused by several factors, such as changes in the cost of materials or labor or the production process.

The variance is unfavorable if the actual costs are higher than the standard ones. But if the actual costs are lower than the standard costs, then the variance is favorable. 

By using established price points, standard costing helps produce realistic spending plans. This helps bring strategic resource allocation in line with operational reality. - James Angel, Co-CEO & Co-Founder at DYL.com 

Activity-based Costing or ABC

Activity-based costing (ABC) is a costing method that identifies and assigns overhead costs to products or services based on the activities that consume those costs. Activities can refer to any event or task with a specific goal, such as setting up a machine for designing products, distributing finished goods, or operating machines. 

First, every activity associated with the production process is identified. These are then classified as value-added (necessary to produce the product or service) or non-value-added activities (do not add value to the product or service). Once these are identified, the next step is to estimate the cost of each activity. Finally, the costs of every individual activity are assigned to the products or services.  

In some industries, ABC is required by law. For example, in the financial services industry, ABC is required by the SEC. This ensures that financial services companies are accurately reporting their costs and that they are complying with all applicable regulations.Andrew Lokenauth, Fractional CFO 

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Marginal Costing

Marginal costing, also called cost-volume-profit analysis, determines the impact on the cost of a product when one additional unit is added into production. It is an extremely useful method for making decisions around pricing, production, and other short-term economic aspects.

Marginal costing enables managers to identify the varying levels of impact that different costs and volumes have on operating profit. Management can also use it to make informed decisions about pricing, product development, and marketing.

Lean Accounting 

Lean accounting is a cost accounting system that is based on the principles of lean manufacturing. Lean manufacturing is a production system that seeks to eliminate waste and inefficiency. Lean accounting follows this same philosophy by focusing on the costs that add value to the product or service and eliminating the costs that do not. 

For instance, an accountant can use lean accounting to identify and eliminate wasted time in the production process. Employees can use the saved time to focus on more value-added tasks.

Cost Accounting Formulas

Here’s a breakdown of the nine most important cost accounting formulas:

Break-Even Point

The break-even point is the point at which the total revenue equals the total cost. It is calculated by dividing the fixed cost by the unit cost.

Break-even point = Fixed cost / Unit cost

Contribution Margin

The contribution margin is the amount of money that each unit sold contributes to covering the fixed costs. It is calculated by subtracting the variable cost from the selling price.

Contribution margin = Selling price - Variable cost

Target Net Income

The target net income is the amount of profit that a business wants to make. It is calculated by adding the fixed cost and net target income and dividing it by the contribution margin per unit.

Target net income = (fixed cost + target net income) / (contribution margin per unit)

Gross Margin

The gross margin is the amount of money that remains after the cost of goods sold has been deducted from the sales revenue. It is calculated by subtracting the cost of goods sold from the sales revenue.

Gross margin = Sales revenue - Cost of goods sold

Pre-tax dollars needed for purchase

The pre-tax dollars needed for purchase is the amount of money that a business needs to spend to purchase a product or service before taxes are taken into account. It is calculated by diving the cost of an item by 1 - the tax rate.

Pre-tax dollars needed for purchase = cost of item / (1 - tax rate)

Price variance

The price variance is the difference between the actual price paid for an item and the standard price. It can be either favorable or unfavorable.

Price variance = (actual price - standard price) x number of items purchased

Efficiency variance 

The efficiency variance is the difference between the actual quantity used and the standard quantity. It can be either favorable or unfavorable.

Efficiency variance = actual quantity - standard quantity

Variable overhead variance

The variable overhead variance is the difference between the actual variable overhead cost and the standard variable overhead cost. It can be either favorable or unfavorable.

Variable overhead variance = (actual labor hours - budgeted labor hours) x budgeted overhead labor rate

Ending inventory

The ending inventory is the amount of inventory that a business has left at the end of a period. It is calculated by adding the beginning inventory to the purchases and subtracting the sales.

Ending inventory = beginning inventory + purchases - sales

How Does Cost Accounting Differ From Traditional Accounting Methods? 

Unlike general accounting, cost accounting is an internally focused, organization-specific method used to track and control costs. A cost accounting system can be more flexible than traditional accounting when dividing costs and inventory, but the specific methods and techniques used will vary depending on the organization.

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Cost Accounting Definition

Cost accounting is a system for identifying, measuring, and reporting the costs of goods and services. It is used by businesses to make informed decisions about pricing, budgeting, and profitability.

Why Is Cost Accounting Used? 

Cost accounting enables businesses to determine the following:

  • How money in the business is spent
  • How much money does the business truly earn when accounting for expenditures
  • Where a business might be losing money because of cost inefficiencies or other problems

With cost accounting, a manager or management team will identify all the variable and fixed costs associated with production processes. In many cases, cost accounting involves measuring and recording costs individually and then comparing them to the output (or profits) to measure financial performance. This enables board directors and business owners to make future solid business decisions.

Cost accounting systems are used to determine whether a potential business venture is really worth an investor’s time and money. They help a manager or business owner to know how they can improve their brand’s efficiency, profitability, and overall operations. 

Which Types of Costs Go Into Cost Accounting? 

While these costs vary depending on the type of industry and firm, specific cost categories typically included are direct, indirect, variable, fixed, and operating costs.

What Are Some Advantages Of Cost Accounting? 

Since cost-accounting methods are developed for a specific firm, they

  • Can be changed depending on the changing needs of an organization.
  • Help businesses make informed decisions about pricing and production.
  • Enables businesses to identify and control costs.
  • Ensure businesses can effortlessly track profitability.
  • Ensure compliance with government regulations.
Cost accounting helps organizations gain a deeper understanding of their cost structures, enabling them to identify cost-saving opportunities and reduce wastage. This leads to better cost control and increased profitability. - Helena Lauchli, Accountant

What Are Some Drawbacks Of Cost Accounting? 

Cost accounting and some of its associated techniques can be

  • Complex and time-consuming to implement.
  • Expensive to maintain in the long run as it requires specialized training and software.
  • Time-consuming to produce reports, which can delay decision-making.
  • Inflexible if business operations change at a rapid pace.
  • Tiresome to employees who may have to adapt to change constantly.
Cost accounting often involves estimates and assumptions (like overhead allocation), which may not always accurately reflect the true costs. This can lead to errors in decision-making if not properly managed. - Sherman Standberry at MyCPACoach

When To Use Cost Accounting 

There are many times when cost accounting could be a wise idea. Say that you run a small business and you are bleeding cash. Despite business booming better than ever and more customers coming to your brand, you can't turn a profit no matter what you try. Performing a cost accounting analysis is what you need.

By running an activity-based cost accounting analysis, you’ll determine exactly what the individual products and services you offer cost your brand in the long run. Through this analysis, for instance, you might discover that one of your products – which isn’t all that popular with your customers – costs your business much more money in terms of what it brings in.

Now that you have this information, you can remove that less-than-popular product and stop offering it. Not only do you save money as you don't have to create that expensive product, but you also boost your overall conversion rate since customers have fewer products to choose from.

This is just one hypothetical example of how cost accounting systems are used to maximize your brand and its monetary efficiency. Cost accounting gives you a detailed look at:

  • What things cost
  • Why do they cost what they do
  • What things cost in comparison with each other
  • What things bring to your business in terms of profit (especially when accounting for your expenditures)

This is all precious information, especially if you run a small business as a CEO or manager and must make tough financial decisions yourself.

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Wrapping Up

Cost accounting is one of the most effective analysis tools you can use as a business executive and startup entrepreneur. Through cost accounting, you can know exactly how your business spends its money and where you can make significant improvements. In the long run, you’ll be able to build your business to be stronger and more cost-effective than ever. 

Effortless expense management for all business spends. Earned time, saved costs, improved productivity, happy employees - achieve it all with a single software.

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