Cost accounting is a part of management that determines the actual cost associated with manufacturing a product or providing a service. The goal is to improve profit and efficiency. Cost accounting is an internal accounting system that benefits managers and employees.
Companies that implement cost accounting generally handle variable and fixed costs. Variable costs change with levels of production. For instance, if an ice cream company orders more dairy this month than last month to produce more, the supply cost likely increases. On the other hand, fixed costs are not affected by production. The rent for an ice cream company’s building is a fixed cost, since the amount of ice cream does not influence the monthly rent.
To know more about how cost accounting works, you have to understand the definition and the types of costs, methods, and systems involved. It also helps to know the differences between cost accounting and financial accounting.
Know cost accounting and explain the types of costs, methods, and systems used in cost accounting. It also explains the difference between financial accounting and cost accounting.
What is Cost Accounting?
Cost accounting involves analyzing a company’s total production costs for its products or services. It examines all variable and fixed expenses and is meant for internal management only. Businesses use costing information to make the best decisions and ensure each production area is financially effective and efficient.
The internal management team performs costing activities and is not seen by outside clients or institutions. There are no set standards cost accounting has to meet, so it has more flexibility than other accounting kinds.
How does Cost Accounting Work?
Each business has its own structure, so the cost accounting work differs. Usually, cost accounting is customizable. Business owners can choose systems that make the most sense for their type of business.
What are the Types of Costs?
The following are the most common types of cost accounting used by an organization’s internal finance or management team:
- Absorption Costing
- Historical Costing
- Marginal Costing
- Standard Costing
- Lean Costing
- Activity-based Costing
What are the Cost Accounting Methods?
There are two primary cost accounting methods companies use:
Job Order Costing
Job order costing is for companies that produce identical products. For example, suppose a company builds custom cars. In that case, the cost for each car will likely be different because each customer has a specific set of requirements. Since the product is unique, it is easier to track the cost of each order or service. This can be done on a per-project or job-order basis.
Process Costing
Process costing is for companies that make uniform products, such as cookies or soda. For a soda manufacturer, each soda costs about the same to produce. The production cost does not change as often for a company making bespoke products (anything specially made or designed for a particular person or customer). Therefore, companies use the process accounting method to assess the cost of an entire batch of soda and then assign a price to each soda based on that number.
What are the Elements of Cost Accounting?
There are three principal elements involved in cost accounting: materials, labor, and overhead.
Material
Materials serve as inputs to production. They are typically broken down into two groups (direct and indirect).
Direct Materials
Materials and parts used in production and reflected in a completed product. They can be subdivided into raw materials:
- Cotton for clothes or plastic for a phone case
- Work-in-progress, or products that are not yet complete
- Finished goods (products that are ready for sale)
Indirect Materials
Indirect materials are considered an overhead expense, and some examples include safety equipment and cleaning supplies. Keep in mind that only direct materials are shown on cost sheets.
Labor
Workers directly involved in the production or distribution of goods or delivery of services must be paid. Their salaries or wages might include overtime and bonuses, and employee benefits are also part of the total cost.
Like indirect materials, indirect labor costs are treated as an overhead expense, not a labor expense.
Expenses/Overhead
These are costs related to the production or distribution of goods or provision of services. However, they cannot be directly attributed to specific goods or services. Typical overhead costs include:
- Equipment set up
- Utility bills
- Facility costs
- Payroll taxes and pension contributions
- Depreciation of fixed assets
- Interest payments
What are the Advantages of Cost Accounting?
The advantages of cost accounting are based on the type, adequacy, and efficiency of cost accounting system installation. Also, management should accept the advice given by the cost accounting system. Advantages include the elimination of wastes, losses, and inefficiencies, cost reduction, and identifying the reasons for profit or loss. Others are using data to make or buy decisions, price fixation, cost control, and assisting the government.
What are the Drawbacks of Cost Accounting?
The drawbacks of cost accounting consist of only using past performances to make decisions for the future, and knowing the previous year’s cost is not the same in the succeeding year. Expenses are ascertained based on full utilization of capacity. So calculated costs are not always correct. Moreover, cost accounting does not solve the problems concerning work-study, time and motion study, and operation research. The installation of a cost accounting system requires the maintenance of numerous costing records (which may result in heavy expenditure).
What are the Examples of Cost Accounting?
Examples of cost accounting include direct materials, direct labor, indirect materials, overhead (sales & marketing and payroll taxes), utilities, depreciation, and interest costs. Rent and lease expenses are other relevant examples.
How does Cost Accounting Differ from Traditional Accounting Methods?
Traditional accounting calculates profits based on invoices sent or received. It does not matter whether you actually received or spent money. Cost accounting assigns average costs evenly to labor, materials, and overhead in the production process. This method is referred to as the standard cost accounting method. Activity-based accounting is another commonly used method that calculates costs based on the activity and effort used to produce a product or service. It can provide a more accurate portion of overhead costs.
Traditional accounting requires companies to keep records of all income and expenditures. This can include business assets you purchase (stock and equipment), payments to employees, and business vehicle and travel costs. Traditional accounting usually suits larger businesses more.
What is the Difference Between Cost Accounting and Financial Accounting?
Financial accounting focuses on preparing statements for company shareholders and interested parties outside the company. In contrast, cost accounting is internal. Company management and leaders use cost accounting to inform their decisions on improving the company’s operations.
Financial accounting focuses on taking the company’s financials and presenting them in a statement to show stakeholders and regulators. The report provides an overview of how the company is doing regarding company assets, liabilities, and shareholders’ equity.
Another significant difference is regulations and standards. Financial statements are governed by regulators and should abide by Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). Cost accounting is for the company’s use and not for external purposes. It is not limited to the regulations and standards of financial accounting.
What is the History of Cost Accounting?
Modern cost accounting likely began during the Industrial Revolution in Great Britain in the late 1700s. It spread to the United States around 1820. Before mass production, businesses tended to be small, and costs were principally direct variable costs (mostly labor and materials). Then, cost accounting was primarily a matter of managing cash flow.
During the Industrial Revolution, much larger and more complex businesses appeared. They produced industrial goods like steel for railroads. These companies had direct costs that could not easily be associated with the products they produced, which is now called overhead. Cost accounting became a way of helping organizations allocate overhead for production and make better choices about pricing, investments, and product development.
