Cost Accounting: The Complete Guide

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 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 a business's financial transactions. It is used to prepare financial statements 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 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

Labor costs are another significant element in cost accounting, split into direct and indirect labor costs, depending on the nature of the work involved. 

• Direct labor costs refer to wages, salaries, bonuses, and benefits for employees directly involved in producing goods or delivering services. For instance, a chef in a restaurant who prepares performs direct labor because their work is directly tied to the finished product. 
• Indirect labor costs are associated with employees who support production but are not directly engaged. This includes workers like factory supervisors, maintenance staff, and administrative personnel. These costs are not directly linked to the goods produced and are treated as overhead 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 and legal fees
• Marketing and advertising costs
• Shipping and delivery expenses
• Repairs and maintenance costs for machinery 
• Training expenses for employees

Also Read:

• The Complete Guide to Manufacturing Expense Management

Methods Of Cost Accounting

Depending on your needs and measurement goals, you might practice one or several cost accounting methods. 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.

• An unfavorable variance occurs when actual costs exceed standard costs.
• A favorable variance occurs when actual costs are lower than standard costs.

“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 ignores the assumption that all the expenses should go to the product. Instead, it focuses on segregating the expenses to get finer details of information, which can show cause and effect and lead to better decision-making in the business. It, thus, also helps with decision-making as the managers can get more accurate figures for all production costs. Other advantages include a focus on activities and reduced costs.” -  Miles Brookes, Director of Tax Strategy – CoinLedger

Activity-Based Costing (ABC) identifies and assigns overhead costs to products or services based on the activities that consume these costs. Activities are tasks or events with specific goals that contribute to the production process, such as operating machinery, assembling parts, or distributing finished goods.

Steps in ABC:

1. Identify all activities in the production process.
2. Classify activities as value-added (necessary for production) or non-value-added (do not contribute to the final product).
3. Estimate the cost of each activity.
4. Assign the cost of each activity to the corresponding product or service.

This method offers detailed insights into the cost drivers and can help businesses improve their cost efficiency by eliminating non-value-added activities.

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

Also Read:

• Activity-Based Costing (ABC): A Guide for a Growing Business

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 to production. It is an extremely useful method for deciding 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.

Process Costing

Process costing is typically used by businesses that produce goods in large, continuous quantities, such as chemicals, textiles, or food products. This method assigns costs to each stage of the production process, rather than individual units, and then averages the total costs over the units produced. 

Process costing is ideal for businesses with homogenous products, as it helps determine the total cost of production for each stage and ensures accurate tracking of the cost flow through various departments. It’s essential for industries where the final product results from multiple, ongoing processes. 

Job Costing

Job costing, on the other hand, is used by businesses that produce products or services based on specific customer orders. Each job or project is unique, with its costs for materials, labor, and overhead. 

For instance, in construction or custom furniture manufacturing, each job may require different materials and labor. With job costing, the business tracks the direct and indirect costs associated with each project to ensure accurate pricing and profitability analysis for that specific job. 

Also Read:

• Job Costing: The Definitive Guide for Your Business

Cost Accounting Formulas

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

Break-Even Point

The break-even point is when 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

Example:

If your fixed costs are $10,000 and the unit cost of your product is $50, you would need to sell 200 units to break even.

Contribution Margin

The contribution margin is the amount of money 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

Example:

If a product sells for $100 and the variable cost is $40, the contribution margin is $60, meaning each unit contributes $60 toward covering fixed costs.

Target Net Income

The target net income is the profit 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)

Example:

If a company has fixed costs of $10,000, a contribution margin of $20 per unit, and a target net income of $5,000, it must sell 750 units to reach that profit.

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

Example:

If a company has sales revenue of $50,000 and the cost of goods sold is $30,000, the gross margin is $20,000.

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 dividing the cost of an item by 1 - the tax rate.

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

Example:

If an item costs $100 and the tax rate is 10%, the business must spend approximately $111.11 before applying taxes.

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

Example:

If the actual price per unit is $25 and the standard price is $20, with 500 units purchased, the price variance is $2,500 (unfavorable).

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

Example:

If the standard quantity for production is 1,000 units but only 900 units were produced, the efficiency variance is 100 units (favorable).

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

Example:

If actual labor hours were 1,500 and the budgeted labor hours were 1,200, with a budgeted overhead rate of $10 per hour, the variable overhead variance would be $3,000 (unfavorable).

Ending Inventory

The ending inventory is the amount of inventory 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

Example:

If the beginning inventory was $5,000, purchases during the period were $2,000, and sales were $3,000, the ending inventory would be $4,000.

Additional Cost Accounting Metrics

Beyond the formulas mentioned above, there are other essential metrics in cost accounting that provide further insights:

• Cost of Goods Sold (COGS): The direct costs attributable to producing the goods a company sells.
• Work In Progress (WIP): This metric represents the value of partially completed goods that are still in the production process.
• Return on Investment (ROI): A measure of the profitability of an investment, calculated by dividing the net profit by the initial investment cost.

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.

Also Read:

• Why Traditional Accounting Is No More

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

• It 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.

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.

Also Read:

• Q&A with CPA Wendy Barlin: 14 Accounting Questions For Small Business Financial Success

Common Cost Accounting Mistakes to Avoid

Cost accounting is a powerful tool, but it’s not without pitfalls. Here are some common mistakes to avoid:

• Misallocation Of Overhead Costs: One of the biggest mistakes in cost accounting is failing to correctly allocate overhead costs. Misallocated overhead can lead to inaccurate product costing, which affects pricing decisions and profitability. 
• Overcomplicating Cost Categories: Creating too many cost categories can complicate reporting and decision-making. It’s important to keep cost strategies streamlined and focused on the most impactful elements of the business. 
• Failure To Regularly Update Cost Data: Costs fluctuate over time. Failing to update cost accounting data–such as labor costs or material prices–can result in outdated and inaccurate financial information, leading to poor decision-making. 
• Inaccurate Costing Methods: Choosing the wrong costing method for your business or failing to apply the method correctly can lead to a distorted financial picture. Ensure that the costing method you choose aligns with your business model and production processes. 
• Ignoring Non-Value-Added Costs: Businesses sometimes overlook non-value-added activities that increase costs without adding value ot the final product. Identifying and minimizing these activities is crucial for maximizing efficiency. 

How to Implement Cost Accounting in Your Business

Implementing cost accounting in your business can be transformative, but it's important to approach it systematically. Here's a step-by-step guide:

1. Assess Your Business Needs: Identify the key areas where cost accounting will provide the most value. This could be in pricing, budgeting, or production optimization.
2. Choose the Right Costing Method: Depending on your business model, you might choose a method like job costing, process costing, or activity-based costing. Make sure it fits your operational needs.
3. Set Up a Cost Accounting System: Implement a software solution that tracks and reports costs efficiently. Many modern cost accounting systems integrate with financial accounting software to provide a comprehensive view of the business’s finances.
4. Train Your Team: Ensure your team understands the cost accounting process and how to input and interpret the data. Specialized training may be necessary depending on the complexity of the system you’re using.
5. Monitor and Adjust Regularly: Costs can change over time, so it’s essential to update your system regularly. Conduct periodic reviews to ensure the accuracy of your data and adjust your cost accounting methods as necessary to reflect changes in production or the market.

What Is Job Costing In Cost Accounting?

Job costing is a method used to track costs associated with specific jobs or projects. Each job is treated as a unique entity, and all costs–materials, labor, and overhead–are tracked separately for that specific job. Job costing is commonly used in industries where products or services are custom-made, such as construction or consulting. 

This method provides detailed insights into the profitability of individual projects, enabling businesses to set appropriate pricing and manage resources more efficiently. 

What Are Overheads In Cost Accounting?

Overheads are indirect costs that cannot be traced directly to producing a specific product or service. These costs are necessary to run the business but are not tied directly to any one item. Examples include rent, utilities, and administrative salaries.

Overhead costs are typically divided into two categories:

• Fixed Overhead: Costs that do not change with the production level, such as rent or insurance.
• Variable Overhead: Costs that vary with production levels, such as utility bills or indirect labor.

Overheads are crucial to factor into your cost accounting as they contribute to the overall cost structure of your business.

What Is Period Cost In Cost Accounting?

Period costs are expenses that are not directly tied to the production of goods or services and are expensed in the period in which they are incurred. Unlike product costs, which are associated with the cost of creating inventory, period costs are more aligned with the general operations of the business. Examples include administrative expenses, marketing costs, and rent.

Period costs are recorded on the income statement in the period they are incurred, regardless of when the product they are associated with is sold.

What Is Prime Cost In Cost Accounting?

Prime cost refers to the direct costs associated with the production of goods. It includes both direct materials and direct labor but excludes overhead costs. Prime cost provides a clear understanding of the expenses directly involved in manufacturing a product, making it useful for pricing and budgeting decisions.

Prime cost = Direct materials+Direct labor

Example:

If direct material costs for producing a product are $50 and direct labor costs are $30, the prime cost for that product would be $80.

Wrapping Up

Cost accounting is an invaluable tool for any business looking to manage its expenses effectively, optimize operations, and make informed financial decisions. By understanding the various methods and formulas of cost accounting, businesses can gain insights into their cost structure, track profitability, and identify areas for improvement.

Incorporating modern tools like Fyle, an expense management software, can significantly streamline some of the more complex cost accounting processes. 

Fyle’s integration with accounting systems can automate expense tracking, categorize costs accurately, and provide real-time visibility into employee spending. This not only helps reduce the manual effort involved in managing overhead and variable costs but also ensures more accurate and timely data for cost analysis.

Whether you're a small business owner or managing a large enterprise, implementing cost accounting, supported by tools like Fyle, can lead to smarter decision-making, better pricing strategies, and ultimately, a more profitable operation.