Cost Accounting – Explained, Defined, & Understood

Cost Accounting Explained

Cost accounting is the process of tracking, recording, and analyzing costs associated with a business. It provides decision-makers with information that can be used to improve profitability and manage expenses.

There are various cost accounting methods, but all follow the same basic principles. First, costs must be classified into categories such as raw materials, labor, overhead, marketing, and so forth. Second, costs must be assigned to specific products or services.

This can be done using various methods, such as tracing costs to individual production units or allocating costs across products based on sales volume.

Finally, once costs have been classified and assigned, they can be analyzed to identify trends and opportunities for cost reduction. Cost accounting is essential for any business that wants to remain competitive and achieve long-term success.

Table of Contents

• Cost Accounting- Explained, Defined, & Understood

• Cost Accounting Explained

• Cost Accounting Purpose

• The Role of a Cost Accountant

• Types of Costs- Cost Accounting

• Cost Accounting vs. Financial Accounting

• Types of Cost Accounting

• What Are Some Advantages of Cost Accounting?

• What Are Some Drawbacks of Cost Accounting?

• Cost Accounting Systems

• Formulas for Cost Accounting

• Important terms and principles cost accountants should know- Cost Accounting

• Cost Accounting Certification- Cost Accounting

What is cost accounting?

Cost accounting is an essential tool for managers in any organization. Managers can make more informed decisions about allocating resources by understanding the costs associated with various business activities.

Cost accounting can also help managers to identify opportunities for cost savings. In many organizations, cost accounting is used alongside other managerial tools, such as activity-based costing and budgetary control. Cost accounting can be a powerful tool for improving organizational efficiency and effectiveness when appropriately used.

What do we mean by cost accounting?

Cost accounting assigns costs to objects that typically include a company’s products, services, and other activities. Cost accounting is helpful because it can identify where a company spends its money, how much it earns, and where money is being lost.

To understand cost accounting, we must first understand what we mean by “costs.” Costs can be classified in various ways, but variable and fixed costs are the two most common methods. Variable costs are those costs that change in proportion to the level of activity within a company.

For example, if a company produces 100 widgets, the variable cost of producing those widgets will be lower than if the company produced 10,000. On the other hand, fixed costs are those costs that do not change in proportion to the level of activity within a company. For example, whether a company produces 100 or 10,000 widgets, the fixed cost of renting the factory space will remain the same.

Now that we have a general understanding of cost accounting and types of costs, let’s look at some specific examples of how cost accounting can be used within a business.

One everyday use of cost accounting is in pricing products and services. To price products and services accurately, companies need to know how much it costs them to produce them. Cost accounting can help companies determine these costs to set prices that will cover their costs and generate a profit.

Another everyday use of cost accounting is in the evaluation of business performance. For example, let’s say that a company wants to evaluate how its manufacturing process is performing.

Cost accounting can help the company determine how much it costs to produce each widget and compare those costs to the selling price of the widget. This comparison can help the company identify areas where it is losing money and make changes to improve its profitability.

As you can see, cost accounting can be a beneficial tool for businesses of all sizes. Cost accounting can provide valuable insights, whether pricing products, evaluating business performance, or trying to understand where your company is spending its money.

History of Cost Accounting

Modern cost accounting is thought to have started during the Industrial Revolution, which began in Great Britain in the late 1700s and spread to the United States around 1820.

The industrywide move to mass production brought new challenges in managing costs. Businesses needed to track not only direct variable costs but also indirect costs such as overhead. This led to the development of various cost accounting systems, including job costing, process costing, and activity-based costing.

More recently, businesses have focused on managing costs through value chain analysis and activity-based management. By understanding the total cost of each production stage, businesses can make more informed decisions about where to allocate resources.

As technology continues to evolve, that cost accounting will likely become increasingly sophisticated, providing businesses with ever-more accurate information about the actual cost of production.

The history of cost accounting is closely tied to the history of the Industrial Revolution. As businesses became more extensive and more complex, they needed a way to allocate their overhead costs to their products. This led to the development of cost accounting, enabling organizations to make better pricing, investments, and product development decisions.

In recent years, new types of cost accounting have emerged, such as activity-based accounting, lean accounting, and environmental cost accounting. These new approaches have helped organizations improve their decision-making and operational efficiency.

Cost Accounting- Explained, Defined, & Understood

Cost accounting is the accounting branch concerned with recording, classifying, summarizing, and allocating costs incurred. It also includes assigning these costs to specific products, processes, projects, or activities.

Cost accounting is used by businesses to make decisions about pricing, product mix, and managers’ compensation. The information generated by cost accounting can also be used for financial reporting and tax compliance. The main purpose of cost accounting is to provide information to help managers make decisions that will improve the organization’s financial performance.

The first step in cost accounting is identifying the costs relevant to the decision-making process. Relevant costs are those costs that will be affected by the decision.

For example, if a company is trying to decide whether to make or buy a part for its production process, the relevant costs would be the cost of materials, labor, and overhead for making the part and the purchase price of the part.

Once the relevant costs have been identified, they must be classified as either direct or indirect. Direct costs can be directly traced to the product or activity cost. For example, direct labor and direct materials are direct costs. Indirect costs cannot be directly traced to the product or activity cost. For example, indirect labor and indirect materials are indirect costs.

After identifying and classifying the relevant costs as direct or indirect, they must be summarized and allocated to the products, processes, projects, or cost activities. This process is called cost allocation.

Cost allocation is necessary because it provides information about where resources are used and how much they cost. It also provides information about how resources are being used to generate revenue.

Finally, cost allocation allows businesses to compare the cost of different products, processes, projects, or activities and decide which ones are most efficient and effective.

Consequently, businesses use cost accounting information to make decisions about pricing their products, managing their resources more effectively, and improving their overall financial performance.

Therefore understanding cost accounting principles is essential for anyone who wants to work in business or become a business owner. Not only does it provide insights into how businesses operate but also how to optimize them as well.

Cost accounting is about determining true product profitability

In business, the bottom line is often king. But to determine what the bottom line really is, cost accounting is essential. By allocating direct and indirect costs to products and services, businesses can get a clear picture of profitable ones.

This information is then used to decide pricing, production levels and where to cut costs. In other words, cost accounting is all about ensuring that a company’s products and services generate a profit.

Without cost accounting, it would be very difficult for businesses to determine which products are profitable and which are losing money. As a result, they would likely make many decisions that would ultimately lead to losses rather than profits.

In short, cost accounting is an essential tool for any business that wants to ensure its products are actually generating a profit.

Is cost accounting the same as management accounting?

Cost accounting and management accounting are two different but related fields of accounting. Cost accounting focuses on the cost of producing goods or services, while management accounting provides information that helps managers decide how to run their business. While there is some overlap between the two fields, they serve different purposes.

Cost accounting is concerned with tracking, analyzing, and managing the costs of producing goods or services. This information decides how to operate a business more efficiently and effectively.

On the other hand, management accounting provides information that helps managers decide how to run their business. This information can be used to strategically decide where to allocate resources, set prices, and make other decisions impacting the bottom line.

While cost and management accounting differ, they are both critical business tools. By understanding the costs of producing goods or services, businesses can make informed decisions about operating more efficiently and effectively. And by using management accounting information to make strategic decisions, businesses can improve their bottom line.

Who benefits from cost accounting?

Cost accounting benefits businesses of all sizes as it accurately portrays costs. This information is essential in making informed pricing, product development, and process improvement decisions.

Cost accounting also allows businesses to track their spending and identify areas where cost savings can be achieved. Ultimately, cost accounting helps businesses to improve their bottom line by reducing costs and increasing profits.

Small businesses, in particular, can benefit significantly from cost accounting as it can help them compete against larger businesses with more significant financial resources. By accurately knowing their costs, small businesses can price their products and services more effectively and decide where to allocate their limited resources.

Cost accounting also benefits employees as it provides a clear understanding of the costs associated with their work. This information can be used to negotiate salaries and bonuses and assess the feasibility of new projects. Employees who know the actual cost of their work are also better equipped to identify areas where cost savings can be achieved.

Cost accounting benefits businesses and employees by enabling informed decision-making, identifying cost savings opportunities, and increasing profits.

What is the cost accounting cycle?

The cost accounting cycle is a process that businesses use to track their expenses and calculate the cost of goods sold. This information is then used to make pricing and production decisions.

The cycle begins with recording data on raw materials, labor, and overhead costs. This data is then classified into direct, indirect, and manufacturing overhead.

Total cost is determined by adding up all individual costs in each category. Product cost is then calculated by adding the total cost of raw materials and direct labor. The selling price is set by considering the product cost, overhead costs, and desired profit margin.

Once the selling price is set, businesses use cost control methods to ensure that their actual costs do not exceed the budgeted costs. This may involve limiting the number of raw materials that can be used or the number of hours that can be worked.

Decisions are made based on the information collected during the cost accounting cycle. These decisions may include increasing production, changing pricing, or adding new products. The goal is to make decisions that will minimize costs and maximize profits.

A cost accounting cycle is an essential tool for businesses of all sizes. It helps them to understand where their money is going and makes it possible to make informed decisions about pricing, production, and other aspects of the business.

How Does Cost Accounting Differ From Traditional Accounting Methods?

In contrast to general or financial accounting, the cost accounting method is an internally-focused, firm-specific system used to implement cost controls. Cost accounting can be much more flexible and specific, particularly regarding the subdivision of costs and inventory valuation.

For example, a company might use a different costing method for each product to understand the associated costs better. Cost accounting methods and techniques vary from firm to firm and can become quite complex.

However, cost accounting aims to improve decision-making within the firm by providing accurate information about the costs of producing goods and services.

What Are Some Advantages of Cost Accounting?

There are several advantages to using cost accounting methods. One advantage is that cost accounting is highly customizable and adaptable. Managers appreciate this because it can be adapted, tinkered with, and implemented according to the changing needs of the business.

Unlike the Financial Accounting Standards Board (FASB)-driven financial accounting, cost accounting need only concern itself with insider eyes and internal purposes.

Management can analyze information based on criteria that it precisely values, which guides how prices are set, resources are distributed, capital is raised, and risks are assumed.

Another advantage of cost accounting is that it provides more accurate information for decision-making purposes. This is because cost accounting explicitly tracks the costs associated with each product or service.

This information is then used to decide pricing, production, and resource allocation. As a result, cost accounting can help managers make more informed decisions that save the company money in the long run.

Cost accounting has many advantages, making it an appealing choice for businesses. Its customization options allow managers to use it in a way that best suits their needs, and its accuracy makes it a valuable tool for decision-making purposes.

Cost accounting is a versatile and helpful tool that can benefit any business using it.

What are the limitations of cost accounting?

There are several critical limitations of cost accounting that businesses should be aware of:

1. Cost accounting is unnecessary for many businesses: There is no need to track production costs for businesses that don’t produce products or services for sale. This includes purely service-based businesses, such as consulting firms, law firms, and hair salons. Additionally, businesses that use elementary production processes may not need cost accounting.

2. Cost accounting is very costly: The cost accounting process can be pretty expensive. Businesses need to invest in software and hardware and train staff on how to use the system. Additionally, cost accounting requires ongoing maintenance and updates.

3. Costing results are often misleading: The results of cost accounting can be deceiving. This is because the costs assigned to products and services may not reflect the actual cost of production. Additionally, businesses may use different costing methods, leading to conflicting results.

What is cost accounting, for example?

Cost accounting is the process of allocating fixed and variable costs to produce a product or service. Fixed costs recur monthly regardless of production levels, such as rent, depreciation, and interest on loans or leases. Variable costs vary with production levels, including raw materials, direct labor, and shipping expenses.

To calculate the cost of producing a product or service, businesses must track fixed and variable costs. Fixed costs do not change with production levels, making them easier to track.

Variable costs, on the other hand, fluctuate with production levels and can be more challenging to track. To get an accurate picture of the cost of production, businesses must carefully monitor both types of expenses.

EXAMPLE OF COST ACCOUNTING

Company A has a manufacturing plant that produces Widgets. The company’s monthly fixed costs include rent for the factory, insurance, and property taxes. The company’s variable costs include raw materials, direct labor, and shipping expenses.

Company A would divide its total monthly fixed costs by the number of Widgets produced to calculate the cost of producing one Widget. For example, if the company’s monthly fixed costs were $10,000 and it produced 1,000 Widgets, the cost of producing one Widget would be $10.

Businesses must track fixed and variable expenses to understand their production costs accurately. By doing so, they can make informed decisions about where to allocate their resources and how to price their products or services.

What is the importance of cost accounting?

Cost accounting is essential because it provides managers with the information they need to decide how to allocate resources and manage costs.

By understanding the cost of producing a product or service, managers can make informed decisions about where to allocate resources and how to price their products and services. Additionally, cost accounting can help businesses identify areas where they can improve their operations and save money.

As businesses become more complex and globalized, cost accounting becomes even more critical. With the ability to track costs across multiple locations and different types of products and services, businesses can better understand their overall cost structure.

This information can then decide where to cut costs, allocate resources more efficiently, and price products and services to stay competitive. Without cost accounting, it would be challenging for businesses to make these strategic decisions.

Cost accounting is thus an essential tool for managers in today’s business world. Providing accurate information about production costs allows managers to make informed decisions to help their businesses succeed.

What are the basics of cost accounting?

Cost accounting is capturing, recording, and analyzing what it costs to produce or supply a product or service. This process will enable your business’s management to make better financial decisions and accurately eliminate inefficient costs and budgets.

There are three key elements to cost accounting:

1. Cost tracing involves tracing the costs associated with specific activities or products. This information can then be used to determine where money is being spent and identify areas for improvement.

2. Cost allocation involves allocating fixed and variable costs across different products or services. This information can be used to price products accurately and make informed decisions about production levels.

3. Cost analysis involves analyzing the cost data to identify trends and relationships. This information can improve decision-making, negotiate better prices with suppliers, and make other strategic decisions.

The basics of cost accounting will help you to understand where your money is going and identify opportunities to save costs. By implementing a cost accounting system, you can make more informed decisions about your business, leading to improved profitability.

Cost accounting is capturing, recording, and analyzing what it costs to produce or supply a product or service.

Cost accounting has three key elements:

• cost tracing,

• allocation, and

• analysis.

The basics of cost accounting will help you to understand where your money is going and identify opportunities to save costs.

What are the 4 types of cost accounting?

The four types of cost accounting are standard costing, activity-based, lean, and marginal costing.

Standard costing is the most common type of cost accounting. It involves setting a standard price for each production unit and then comparing the actual cost of production to that standard.

If the actual cost is higher than the standard, it is known as a “cost overrun.” If the actual cost is lower than the standard, it is known as “cost savings.”

Activity-based costing is a newer type of cost accounting that allocates costs based on the activities that go into producing a product or service.

For example, if a company makes widgets, activity-based costing would allocate the costs of widget production across the various activities required to make a widget, such as research and development, materials procurement, manufacturing, and marketing.

Lean accounting is a cost accounting specifically designed for companies that utilize lean manufacturing or other lean business practices. Lean accounting aims to provide managers with information that can help them improve the efficiency of their operations.

Marginal costing is a type of cost accounting focusing on the costs of producing one additional unit of a product or service. This information can be used to make decisions about pricing, production levels, and other aspects of business operations.

What are the types of cost accounting?

• Direct Costs.

• Indirect Costs.

• Fixed Costs.

• Variable Costs.

• Operating Costs.

• Opportunity Costs.

• Sunk Costs.

• Controllable Costs.

There are a variety of cost types that businesses must consider when making decisions. Direct costs, including raw materials, labor, and shipping, are easily identifiable.

Indirect costs, including overhead, marketing, and research & development, are more difficult to quantify. Fixed costs are expenses that remain constant regardless of production level, while variable costs fluctuate with changes in production.

Operating costs encompass all the costs associated with running a business, including direct and indirect costs. Opportunity costs represent the potential benefits that are forgone by choosing one course of action over another.

Sunk costs are past expenses that cannot be recovered, regardless of future outcomes. Controllable costs can be managed by management through decision-making; examples include direct labor and raw materials.

Components of Cost Accounting

Material Cost

Material cost is the total cost of all materials used in manufacturing a product. This includes the cost of raw materials, packaging, and other materials used in the production process. There are several different types of material costs, which can be classified based on their purpose or function.

Direct Materials

Direct materials are those directly involved in the manufacturing process and become a part of the finished product. Examples of direct materials include raw materials, packaging, and labels.

Indirect Materials

Indirect materials are not directly involved in manufacturing but are necessary for production. Examples of indirect materials include tools, equipment, and supplies.

Overhead Costs

Overhead costs are not directly related to the production of a product but are necessary for the business to function. Examples of overhead costs include rent, utilities, and insurance.

Material cost is an essential factor to consider when manufacturing a product. The total cost of all materials used in the production process can significantly impact the product’s final price. It is essential to carefully manage material costs to ensure that the final product is priced correctly and profitable for the business.

Labor Cost

Labor cost is the total amount of money a company spends on its employees in a given period. There are two types of labor costs: direct and indirect.

Direct Labor 

Direct labor costs are the wages paid to workers directly involved in producing a product or service. For example, if you own a manufacturing company, the workers who operate the machines to create your products would be considered direct labor.

Indirect Labor

Indirect labor costs are the wages paid to workers who are not directly involved in producing a product or service. For example, the workers who pack and ship your products would be indirect laborers if you own a manufacturing company.

The amount of labor cost can significantly impact a company’s bottom line. That’s why businesses need to keep track of their labor costs and find ways to reduce them when possible.

Expenses

Expenses are the costs that a company incurs to generate revenue. There are two main types of expenses: direct and indirect.

Direct Expenses

Direct expenses can be directly attributed to the production of goods or services. For example, if a company manufactures widgets, direct expenses would include the cost of materials and labor used to create the widgets.

Indirect Expenses

Indirect expenses cannot be directly attributed to producing goods or services. For example, indirect expenses would include the cost of rent, utilities, and office supplies.

Both direct and indirect expenses are essential when creating a cost accounting system. Direct expenses are necessary to produce goods or services, while indirect expenses support the operation of the business.

By understanding and tracking both types of expenses, a company can better understand its overall costs and make more informed decisions about generating revenue.

What are cost accounting areas of expertise?

Some of the expertise areas in cost accounting include the following:

Cost allocation- Cost Accounting

Managers can allocate costs by product line and per unit of production or hour of labor.

There are several different methods that managers can use to allocate costs. One common approach is to allocate costs by product line. This technique involves assigning all of the costs associated with a particular product to that product.

For example, if a company produces two types of products, each product would receive its share of its overhead costs based on its proportion of total production. Another common method is allocating costs per production unit or hour of labor.

This approach involves assigning a portion of the company’s overhead costs to each unit produced or hour worked. This technique is often used when significant production levels exist between different products or when labor rates vary widely between different departments.

Regardless of the approach used, cost allocation is essential for managers to understand and control the costs associated with their operations.

Profit drivers- Cost Accounting

Cost accounting helps businesses better understand their profit margin and what drives it.

Business owners must clearly understand their profit margins if they want to be successful. A big part is knowing the cost of goods sold (COGS). This includes direct costs like materials and labor and indirect costs like shipping and overhead.

Cost accounting can help business owners better understand their COGS and what drives it. This information is essential for pricing decisions and ensuring that the business generates enough revenue to cover its costs.

By carefully tracking and analyzing their COGS, business owners can identify opportunities to increase profits and grow their businesses.

Budgeting and forecasting- Cost Accounting

Calculating costs for individual activities helps businesses plan for future spending and forecast their finances for the future.

Budgeting and forecasting are essential tools for any business. They allow businesses to track their spending, set financial goals, and make informed decisions about future growth.

Regarding budgeting, one of the most important things to consider is the cost of individual activities. This includes things like labor costs, materials costs, and overhead costs.

By understanding the cost of individual activities, businesses can ensure they are not overspending in any area. This information can also be used to make informed pricing, production, and marketing decisions. In short, calculating the cost of individual activities is essential to effective budgeting and forecasting.

Cost Savings- Cost Accounting

Using cost accounting, businesses may be able to identify new efficiencies to save money.

Businesses use cost accounting to track the costs associated with producing a product or providing a service. By understanding where their money is being spent, businesses may identify areas where they can cut costs and improve efficiency.

For example, a company might realize it is spending too much on raw materials and decide to source cheaper materials from another supplier.

Or, a company might be spending too much on labor and decide to automate some of its production processes. In any case, cost accounting can help businesses to save money by identifying areas where they can be more efficient.

Quick decisions- Cost Accounting

Cost accounting can help managers respond quickly to changes in the market, such as when the cost of raw materials increases.

In today’s business world, being able to respond quickly to changes in the market is essential for success. Cost accounting can be a valuable tool in this regard, as it can help managers identify areas where costs must be reduced.

For example, if the cost of raw materials increases, cost accounting can help managers find ways to reduce other costs to stay within their budget.

In addition, cost accounting can also help managers to make quick decisions about where to allocate resources. By understanding the costs associated with different activities, managers can make informed decisions about where to invest resources to achieve the best return on investment. As a result, cost accounting can play a vital role in helping managers to respond quickly and effectively to changes in the market.

The Role of a Cost Accountant

Cost accountants are essential members of any organization that manufactures or sells products. They are responsible for tracking the cost of goods sold and allocating indirect costs such as marketing, overhead, and research and development. In addition, cost accountants provide valuable information to management by performing financial analysis and developing costing models.

Without the skills of a cost accountant, it would be difficult for an organization to make informed decisions about pricing, product mix, and investment decisions. As a result, cost accountants play a vital role in the success of any business that manufactures or sells products.

Cost accountants should be familiar with all cost accounting methods and software programs that support cost accounting functions.

Providing data for stable budget developments- Cost Accounting

A cost accountant is responsible for providing data that will stabilize budget development. They do this by working with other departments within the organization to understand where money is being spent and whether it aligns with its objectives. Cost accounting also involves understanding how products are made and the various components that go into them.

This information is then used to price products correctly and help decision-makers understand where money can be saved. In many organizations, cost accounting is a vital role that helps to keep budgets on track and ensure that products are priced correctly.

Using software to allocate indirect costs to internal processes

A cost accountant plays an essential role in any organization by helping to track and allocate expenses. A cost accountant’s essential task is maintaining accurate records of all indirect costs, such as overhead and general administration expenses.

This information is then used to allocate those costs to the various internal processes of the organization. This helps managers to see where money is being spent and identify areas where cost savings can be achieved.

In addition, a cost accountant may also be responsible for preparing reports that show the organization’s financial performance. Senior management can use these reports to make informed decisions about where to invest resources to achieve the best return on investment.

The cost accountant’s job is essential, and keeping up with all the changes in their field can be challenging. That said, there are some essential tools every professional should know about that will help them do their jobs more efficiently- like SAP ( software package), Oracle( database system), and JD Edwards.

These programs offer vendors and employees within any organization access to data-related business transactions, making these accounting professionals much less reliant on spreadsheets, for instance!

Detailed analysis of suitable cost drivers- Cost Accounting

Cost accounting is an essential tool for management decision-making. Its purpose is to ensure that resources are used efficiently and effectively to create maximum organizational value. A cost accountant is responsible for collecting and analyzing data to help determine the most efficient production and distribution methods.

In addition, cost accounting can be used to make pricing decisions, track inventory levels, and assess financial performance. As such, cost accountants play a vital role in ensuring that organizations operate financially responsibly. With the ever-changing business landscape, cost accounting is an essential tool that will continue to play a vital role in decision-making.

Evaluation of potential business ventures- Cost Accounting

A cost accountant is tasked with evaluating potential business ventures and determining the costs associated with each venture. This information is then used to decide which projects are worth pursuing and which are not. To succeed, a cost accountant must have a strong understanding of accounting and finance.

They must be able to analyze data and assess risk. Additionally, they must be excellent communicators, as they often need to explain their findings to non-financial decision-makers.

Those who excel in this role typically have strong analytical skills and keen attention to detail. They can think critically and adapt quickly to changing circumstances. If you want to pursue a career in cost accounting, you must develop these skills.

Cost Accounting vs. Financial Accounting

The main difference between cost accounting and financial accounting is the audience for each type of accounting. Cost accounting is typically used by management within a company as a decision-making tool, while financial accounting presents a company’s financial information to external sources like investors or creditors.

Financial statements include information about a company’s revenues, expenses, assets, and liabilities and can give outsiders a better picture of its overall financial health.

Cost accounting can benefit budgeting and setting up cost control programs, ultimately improving the company’s bottom line. Cost and financial accounting are essential in managing a business effectively.

Financial accounting is concerned with recording, summarizing, and reporting financial transactions to provide helpful information to external users such as shareholders and creditors.

Financial accounting is governed by generally accepted accounting principles (GAAP), which guide how financial statements should be prepared.

On the other hand, cost accounting focuses on providing management information that will help them make decisions about pricing, product mix, inventory levels, and capacity utilization.

Cost accounting does not have specific rules and guidelines but relies on management’s judgment about the most beneficial cost information. As a result, cost accounting methods can vary significantly from one company to another.

While cost and financial accounting are essential tools for decision-making, they serve different purposes. They should be used together to get a complete picture of a company’s financial situation.

Types of Cost Accounting

Standard Costing- Cost Accounting

Standard costing is a method that assigns “standard” costs, rather than actual costs, to the cost of goods sold (COGS) and inventory. The standard costs are based on the efficient use of labor and materials to produce the good or service under standard operating conditions, and they are essentially the budgeted amount.

Even though standard costs are assigned to the goods, the company still has to pay actual costs. Variance analysis is called variance analysis to assess the difference between the standard (efficient) cost and the actual cost incurred.

If the variance analysis determines that actual costs are higher than expected, the variance is unfavorable. The variance is favorable if it determines the actual costs are lower than expected.

 Two factors can contribute to a favorable or unfavorable variance: 1) Price variance is the difference between the actual price paid for an item and its standard price. 2) Efficiency variance is the difference between the actual quantity of an input used and its standard quantity multiplied by the standard price per unit.

Standard costing is a tool that can be used to help manage and control business costs. By understanding and analyzing variances, companies can make decisions that will help them improve their bottom line.

Activity-Based Costing- Cost Accounting

Activity-based costing (ABC) is a cost accounting system that assigns overhead costs to specific cost objects, such as goods or services. The ABC system is based on activities, events, work units, or tasks with a specific goal.

 These activities are also considered to be cost drivers and are the measures used as the basis for allocating overhead costs. ABC provides a more accurate allocation of overhead costs than traditional costing methods and can be used to improve decision-making and product pricing.

Activity-Based Costing (ABC) is an alternative to traditional overhead cost allocation methods. ABC involves performing an activity analysis to identify appropriate cost drivers rather than being based on a single generic measure, such as machine hours.

This provides greater accuracy and helpfulness when managers review the cost and profitability of their company’s specific services or products.

For example, cost accountants using ABC might pass out a survey to production line employees, who will then account for their time on different tasks. The costs of these specific activities are only assigned to the goods or services used. This gives management a better idea of where the time and money are being spent.

Thus, ABC provides a more nuanced understanding of overhead costs, allowing for more informed decision-making regarding pricing, product mix, and process improvement.

Activity-based costing is a method of allocating overhead that assigns indirect costs to products based on the activities that are required to produce them.

This approach can provide a more accurate picture of the actual cost of a product than traditional costing methods, which allocate overhead based on the number of units produced.

To illustrate this, assume a company produces both trinkets and widgets. The trinkets are very labor-intensive and require a lot of hands-on effort from the production staff.

 The production of widgets is automated, mainly consisting of putting the raw material in a machine and waiting many hours for the finished goods. It would not make sense to use machine hours to allocate overhead to both items because the trinkets hardly used any machine hours.

Under ABC, the trinkets are assigned more overhead related to labor, and the widgets are assigned more overhead related to machine use. This provides a more accurate representation of the actual cost of each product, which can be helpful for pricing and other decision-making purposes.

Lean Accounting- Cost Accounting

The main goal of lean accounting is to improve financial management practices within an organization by promoting waste minimization and productivity optimization.

This philosophy extends from lean manufacturing and production, which intends to reduce waste while maximizing productivity.

For example, if an accounting department can successfully cut down on wasted time, employees can refocus that saved time more productively on value-added tasks.

When using lean accounting methods, traditional costing approaches are replaced by value-based pricing and lean-focused performance measurements.

Financial decision-making is based on the impact on the company’s total value stream profitability. Value streams are the profit centers of a company – any branch or division that directly adds to its bottom-line profit.

 Lean accounting supports the overall goal of lean manufacturing by providing a framework for financial decision-making that promotes efficiency and waste reduction.

Marginal Costing- Cost Accounting

Marginal costing (sometimes called cost-volume-profit analysis) is the impact on the cost of a product by adding one additional unit into the production.

In business, decision-making is key to success. Of course, not every decision will be perfect, but using analytical tools can help give you the best chance for success. Marginal costing is a tool that can be used in short-term economic decisions.

As the name suggests, marginal costing looks at the impact on the cost of a product by adding one additional unit into production. This type of analysis can be used by management to gain insight into potentially profitable new products, sales prices to establish for existing products and the impact of marketing campaigns.

By understanding the impact of costs and volume on operating profit, management can make more informed decisions that could lead to increased profits. In today’s competitive business world, any advantage you can give yourself is worth its weight in gold.

Break-Even Analysis- Cost Accounting

The breakeven point is fundamental for businesses to understand because it represents the production level where revenue and expenses are equal.

Businesses must know their total fixed costs and contribution margin to calculate the breakeven point. The contribution margin is calculated as sales revenue minus variable costs and can be expressed per unit.

Once businesses have these two numbers, they can simply divide the fixed costs by the contribution margin to determine their breakeven point. Knowing the breakeven point is critical for businesses because it helps them understand how much production is necessary to make a profit.

Target costing- Cost Accounting

Target costing is a cost accounting technique companies can use to control production costs. The technique involves setting a target cost for a product, the maximum amount the company is willing to pay for production. If actual production costs start to exceed the target cost, then measures are taken to cut back on production to bring costs down.

This technique can benefit companies operating in very competitive environments with thin profit margins. By setting a hard limit on how much production costs can increase, target costing helps to ensure that a company remains profitable.

Lifecycle costing- Cost Accounting

Lifecycle costing estimates the total cost of ownership for a piece of equipment over its lifespan. This includes acquisition, installation, operation, maintenance, and disposal costs. In addition, Lifecycle costing considers indirect costs such as environmental impact and safety.

By understanding all the costs associated with a piece of equipment, companies can make more informed decisions about when to purchase new equipment. Lifecycle accounting can also help managers estimate the actual cost of production.

By considering all the expenses associated with a piece of equipment, lifecycle costing provides a more accurate picture of the actual cost of ownership.

Cost volume profit (CVP)- Cost Accounting

The marginal cost of a product or service is the additional cost of producing one more unit of that product or service. The marginal cost of production falls as production increases because the contribution of fixed costs decreases.

A CVP analysis, also known as breakeven analysis, uses the marginal production cost to calculate the number of units that must be sold to cover the production cost fully. CVP analysis is one of many activities cost accountants perform, and breakeven is a crucial metric for cost accounting.

 Businesses use CVP analysis to decide pricing, output levels, and mix of products and services. CVP analysis can also be used to evaluate business strategies and performance.

For example, suppose a company wants to increase sales by 10%. In that case, it can use CVP analysis to determine how many extra units it must sell to cover the additional costs associated with the increase in sales. In this way, CVP analysis is a helpful tool for decision-making in business.

CVP, or cost volume profit, is a tool that can be used to estimate the effect of changes in variable and fixed costs on company profits. For example, suppose a company is forced to discount a product heavily because of a market downturn.

CVP can help identify whether the discounting will cause the product to miss its breakeven target and whether reducing production and selling down inventory would help bring it toward break even.

Managers can then decide whether to continue producing the item at the same volume, cut production to reduce costs or stop producing it until the market improves. In this way, CVP is a valuable tool for making decisions about responding to marketplace changes.

Cost Accounting Systems

Organizations use cost accounting systems to track the costs of producing goods and services. There are two primary types of cost accounting systems: job order costing and process costing.

Job order costing is used when products are manufactured individually, while process costing is used when products are mass-produced using an assembly line.

In a job order system, the manufacturing costs for each product are tracked separately. This information can be used to determine the product’s selling price or assess the profitability of individual contracts. In a process cost system, the manufacturing costs are averaged across all products that pass through the production process.

This information helps make decisions about improving the production process’s efficiency. Cost accounting systems are essential for organizations that want to control production costs and optimize profitability.

Job order costing- Cost Accounting

Job order costing is an accounting system businesses use to track the costs of labor, materials, and overhead for each job. This method is commonly used by businesses that produce customized or diversified products or provide services where labor is the dominant expense.

For example, companies specializing in furniture manufacturing or plumbing and electrical services would likely use job order costing.

With this system, businesses can estimate and track the costs associated with each job, ensuring they can generate a profit. This information can also be used to help price future jobs more accurately. Ultimately, job order costing provides businesses with a valuable tool for managing their finances and ensuring profitability.

Process Costing- Cost Accounting

Process costing is an accounting method to assign production costs to products or services. This approach is often used by firms that mass-produce standardized products. Instead of estimating the cost of each item involved in the production process, process costing assumes that the unit cost of each item is the same.

As a result, production costs are allocated evenly across the company’s entire output. While this method is more straightforward and less time-consuming than other costing methods, it can lead to inaccuracies if there are significant differences in the cost of individual items.

Formulas for Cost Accounting

Cost accounting formulas assist businesses in evaluating production costs and making informed decisions about pricing and other strategic financial planning.

To make accurate predictions, businesses must track actual costs against budgeted amounts for specific periods. This analysis can be done manually, but it is more commonly done using accounting software that offers cost accounting functionality.

The most important cost accounting formulas include marginal, complete, and activity-based costing. By applying these formulas, businesses can better understand their overall cost structure and take steps to improve profitability. Cost accounting formulas can be a powerful tool for managing a business effectively when used correctly.

Break-even formula- Cost Accounting

The breakeven point is when a company’s sales cover its total production costs, fixed and variable. Equating the two determines whether a product is profitable (or not). The breakeven formula is:

Break even (in units) = Total Fixed Costs / Contribution Margin

To calculate the breakeven point, businesses divide their total fixed costs by their variable costs per unit. This will give them the number of units they need to sell to cover their costs. They can then multiply this number by their selling price to determine the equivalent breakeven point in sales.

For example, if a company has fixed costs of $750,000, variable costs per unit of $500, and a selling price of $600, it would need to sell 7,500 units to break even. This would be equivalent to $4.5 million in sales. By knowing their breakeven point, businesses can ensure that they are making a profit on each sale.

Contribution margin- Cost Accounting

The contribution margin is the difference between what a business charges for its products and their associated costs. It can be considered an indicator that shows how profitable each unit sold was, despite any fluctuations in pricing or other factors like transport prices, since these are taken out during production process analysis.

The contribution formula is:

Contribution Margin = Sales Revenue – Variable Costs

The mountain bike example shows a $100 contribution margin for each new bike.

Target net income- Cost Accounting

The goal of any business is to make a profit, and the target net income is the amount that a business wants to make in profit for a product or service in a given accounting period.

However, reaching that goal can be difficult, and it is vital to plan how many products or services need to be sold to make a profit. For example, let’s say that a mountain bike manufacturer aims to make $2 million in profit.

To reach that goal, the manufacturer must sell enough bikes to cover the cost of goods sold (COGS) and generate an additional $2 million in revenue. Therefore, the manufacturer needs to sell a total of $4 million worth of bikes to reach its target net income.

While breaking even is technically sound, it is always better to make a profit. With careful planning and execution, any business can reach its target net income.

The formula is:

Unit volume to achieve target net income = (fixed costs + target net income) / (contribution margin per unit)

Plugging in the mountain bike numbers: The numerator, 2,750 000 (750 thousand +2 million) divided by 100 equals 27 500 — several bikes that must be sold to reach $2 million. Selling this many at 600 Each would mean 16 595 938 dollars earned from sales if they were all hunted down and bought off-the-rack.

Gross Margin- Cost Accounting

Gross margin is essential for businesses because it provides insight into production costs relative to sales revenue. Companies can make informed decisions about pricing and cost-cutting measures by understanding gross margin.

A high gross margin indicates that a company is earning a good return on its investment, while a low gross margin may indicate that the company needs to take action to improve its bottom line.

 In addition to setting prices and making production decisions, businesses can use gross margins to benchmark their performance against competitors.

By comparing gross margins, companies can better understand where they stand in the marketplace and what steps they need to take to improve their financial performance.

The formula for gross margin is:

Gross margin = (net sales revenue – COGS) / net sales revenue

Pre-tax dollars needed for a purchase- Cost Accounting

Buying goods and services for business purposes is typically a tax-deductible expense. This means the purchase cost can be deducted from the company’s taxable income when declaring taxes in a subsequent accounting period. However, the purchase itself must be made with pre-tax dollars.

This means that the company must earn enough money to cover the cost of the items and the tax it must pay on its income before it can make the purchase. As a result, pre-tax dollars are typically necessary for business purchases.

The formula to calculate that amount is:

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

When a company needs to make a big purchase, it must consider taxes to determine how much the item will cost. For example, if a company needs to buy four new office computers for a total of $10,000, and the company’s tax rate on profits is 20%, the cost is $12,500.

This is because the cost must be divided by 0.80 (1 – 0.20) to account for the taxes that must be paid on the purchase. As a result, companies must be aware of their tax rate when making large purchases to budget accurately for the item’s actual cost.

Price Variance- Cost Accounting

The price variance is a valuable tool for budgeting and assessing profitability. If the actual cost of a product or service is less than the standard cost, this is a favorable variance, indicating greater profitability. On the other hand, if actual costs are higher than standard costs, this is an unfavorable variance, indicating loss.

Price variance analysis can help managers pinpoint areas where costs are higher than expected and improve efficiency. In addition, by comparing actual costs to standard costs, managers can identify trends that may indicate future problems.

As a result, price variance analysis can be a valuable tool for managing costs and ensuring profitability. The formula for price variance is:

Price variance = (actual unit cost – standard unit cost) x number of items purchased

Efficiency variance- Cost Accounting

Efficiency variances are a valuable tool for assessing operational effectiveness. They provide insights into whether an organization is meeting its expectations for output levels and can be expressed in terms of costs or other quantities such as hours.

The standard variance formula provides an everyday basis for calculating efficiency variances. These can then be further divided into sub-categories such as material yield variance, labor efficiency variance, and overhead efficiency variance.

By understanding and tracking efficiency variances, organizations can identify areas where improvements must be made to better meet their targets.

The formulas are:

Material yield variance = (actual unit usage – budgeted unit usage) x budgeted cost per unit

Labor efficiency variance = (actual per-unit labor hours – budgeted per-unit labor hours) x budgeted hourly labor cost

Overhead efficiency variance = (actual per-unit labor hours – budgeted per-unit labor hours) x budgeted overhead rate per unit

Variable overhead variance- Cost Accounting

Overhead costs are often the most considerable controllable expense for a company. To keep these costs under control, it is essential to monitor the variable overhead cost’s efficiency and overhead spending components. The overhead spending variance can be calculated by subtracting the actual overhead spending from the budgeted overhead spending.

On the other hand, the efficiency variance considers indirect costs such as office staff salaries and site security. This is done by subtracting the actual amount of indirect costs from the budgeted amount of indirect costs. By monitoring both of these components, companies can more effectively keep their variable overhead costs under control.

The formula is:

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

Variable overhead spending variance compares the actual overhead cost of production with the budgeted or expected cost. The formula is:

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

Ending inventory- Cost Accounting

Ending inventory refers to the value of finished goods that remain unsold at the end of an accounting period. Inventory includes raw materials, labor, and overhead for businesses that engage in production. Ending inventory appears on a company’s balance sheet as a current asset.

The ending inventory level is essential because it can impact a company’s working capital and, as a result, its ability to pay short-term obligations.

Too high and it ties up valuable resources that could be used elsewhere; too low could lead to stockouts and lost sales. Businesses, therefore, strive to strike a balance to maintain optimal levels of ending inventory.

 The basic formula is:

Ending inventory = beginning inventory + net purchases – the cost of goods sold

Net purchases account for goods purchased for a product or service, less anything returned, reduced in price due to a problem, or discounted, perhaps due to a promotion. The formula is:

Net purchases = purchases – returns – allowances – discounts

Important terms and principles cost accountants should know- Cost Accounting

Cost accounting is a branch of accounting that deals with the cost of producing goods and services. The main objective of cost accounting is to help managers make decisions by providing them with information about production costs. To do this, cost accountants use various costing methods, such as activity-based costing and lifecycle costing.

They also use specialized costing terminology, such as “cost driver” and “cost pool”” If you want to learn cost accounting, you must understand these concepts.

Matching principle- Cost Accounting

The matching principle is a fundamental concept in accounting that dictates how expenses and revenues should be matched. This principle states that your company’s revenue should be matched with the expenses related to that revenue.

For example, if you sell lamps in May, you create revenue for that month. The May revenue should match your expenses for the lamps sold in May. So, the cost of the lamp is matched with the sales proceeds for the lamp’s sale.

This concept is vital because it ensures that your financial statements accurately show your company’s profitability. Without matching expenses and revenues, it would be difficult to determine whether or not your business is making a profit. For this reason, a matching principle is an essential tool for all businesses.

Principle of conservatism- Cost Accounting

Several principles guide accounting decisions, and conservatism is one of the most important. This principle dictates that choices should be made to produce the least favorable financial result. In other words, when it comes to revenue, accountants should err on caution and delay recognition in the financial statements.

Expenses, meanwhile, should be posted as soon as possible. This approach generates financial statements that are less optimistic, hence the name conservative.

While it may not always produce the most favorable short-term results, conservatism helps ensure accuracy and avoid significant errors in judgment.

Contribution margin- Cost Accounting

As any business owner knows, making a profit is essential to success. One way to ensure profitability is to focus on contribution margin. This term refers to sales minus variable costs and is a crucial indicator of a company’s financial health.

By understanding contribution margin, business owners can make informed decisions about pricing, production, and other vital aspects of their operations.

In addition, contribution margin can be used to assess the financial performance of individual products or product lines. By tracking contribution margin over time, business owners can identify trends and take action to improve their bottom line.

Breakeven point formula

The breakeven point is the level of sales where your profit is zero. The breakeven formula is sales minus variable cost minus fixed cost. You multiply your sales per unit by units sold. You also multiply the variable cost per unit by the same units sold.

The breakeven point is the sales level that makes the formula equal to zero. This means that if you have a product that has a fixed cost of $100 and a variable cost of $10 per unit, you would need to sell 10 units to break even.

If you want to make a profit, you would need to sell more than 10 units. The breakeven point can be helpful when you are trying to determine how many units you need to sell to make a profit. It can also help you price your products by considering your fixed and variable costs.

Relevant range- Cost Accounting

The relevant range is the maximum level of use for a piece of machinery, equipment, or vehicle in your business. Going over the relevant range can cause the machine not to function as intended, costing more money in the long run.

It’s essential to be aware of the relevant range for the items in your business so that you can stay within limits and not have any unexpected cost increases. Knowing the relevant range can help you save money and keep your business running smoothly.

Cost Accounting Certifications- Cost Accounting

Several cost accounting certifications are available, but the CMA (Certified Management Accountant) is the most popular and well-recognized. To become a CMA, you must pass an Institute of Management Accountants (IMA) exam.

The CMA exam covers various topics, including financial accounting, cost accounting, managerial accounting, and financial management. It is a comprehensive exam that tests your knowledge and skills in all aspects of cost accounting.

While there is no specific experience required to take the CMA exam, it is recommended that candidates have at least two years of experience working in an accounting or finance-related field. Candidates who have less experience may find the exam more challenging.

Cost Accounting- Explained, Defined, & Understood- Recommended Reading

1. What are the limitations of standard costing?

2. Is standard costing the same as absorption costing?

3. Absorption Costing – What is it, Why it Matters

Updated: 5/20/2023