What Is Cost Accounting? Definition, Examples and Types


Simply put, businesses use cost accounting as a way to keep track of their expenses.

By knowing how much it costs to produce products or render services, they can price their offerings accordingly and make a profit. Cost accounting can also help to identify areas where they are spending too much money and take steps to reduce their expenses.

Additionally, cost accounting can be used to track the profitability of individual products or services. This information can help make decisions about which products or services to continue offering and which ones to discontinue.

Thus, cost accounting can be a valuable tool for businesses in managing their finances and making strategic decisions about their product mix.

As a financial controller, you can greatly benefit from learning about and using cost accounting techniques in your work.

We have a lot to cover so let’s jump straight in.

What is Cost Accounting?

Cost accounting is the process of tracking, analyzing, and managing the costs incurred in the production of goods and services. It involves classifying, recording, and summarizing expenses to make informed decisions about where to allocate resources and how to control operations.

Cost accounting is a form of managerial accounting, and it is used just for internal purposes to give management the comprehensive cost information they need to not only manage current operations but plan for the future as well.

Examples of Cost Accounting

Cost accounting helps allocate resources to manufacturing products or providing services.

This involves creating listings of all the expenses associated with production, including components, labor, overhead, and shipping. Once all the costs are tallied, cost accountants work with managers to create a pricing strategy that will cover all the expenses and still allow the company to make a profit. For example, a company that manufactures gadgets might list the cost of the materials used to make each gadget, the labor required to assemble it, and the overhead costs associated with running the factory. The company would then need to set a price for each gadget that would cover all those costs and generate a profit.

Managers use cost accounting to make decisions about pricing, product mix, and investment strategies.

If a company wants to reduce costs, it can use cost accounting data to identify areas where spending can be reduced. Or, if a company wants to increase profits, it might use cost accounting data to find ways to increase revenue or decrease costs.

Cost accounting helps managers to make decisions about where to allocate resources to improve profitability.

For example, the finance department can use cost accounting to determine the cost of goods sold, overhead costs, and marketing expenses. By understanding the cost of each activity, the financial controllers and company managers can make informed decisions about where to cut costs and how to price the products.

Cost accounting is a complex process, but it is essential for any business that wants to be successful.

Elements of Cost Accounting

The internal management team uses cost accounting to identify all fixed and variable costs involved in the production process. Costs are first treated individually, then input costs are compared to output results to measure financial performance.

Some common types of costs that make elements of cost accounting:

Fixed Costs

Fixed costs are expenses that do not vary with production volume or sales revenue. Rent, equipment leases, and insurance premiums are good examples of fixed costs. While variable costs such as raw materials and labor fluctuate with production volume, fixed costs remain constant.

Understanding a company’s fixed costs is essential for accurately calculating the overall costs. It can help management make informed decisions about pricing products and services and where to allocate the resources.

Variable Costs

Variable costs are the costs that fluctuate in direct proportion to changes in production volume. For example, if a company produces 100 gadgets, it will incur variable costs for the materials and labor needed to create those gadgets. If the company produces 200 gadgets, it will incur twice as many variable costs.

Variable costs are important because they provide a way to track the relationship between production volume and expenses. This information is crucial in cost accounting to make decisions about pricing, production levels, and other factors that affect a company’s bottom line. Understanding the behavior of variable costs can help to make better predictions about overall expenses and develop more effective cost-control strategies.

Operating costs

Operating costs are the costs that are directly related to the company’s day-to-day operations. They can be fixed or variable. Operating costs are generally divided into three categories: direct materials, direct labor, and overhead.

Direct materials are the raw materials that are used to produce a product or service. Direct labor is the labor directly involved in producing a product or service. Overhead is all of the other costs that are necessary to run the company but are not directly related to producing a product or service. Allocating these costs properly is essential for accurate financial reporting.

Direct costs

Direct costs are those that can be directly attributable to the manufacture of a particular item. This includes materials, labor, and any other expenses that are necessary to produce the item. While indirect costs, such as overhead or marketing, are important to consider as well, direct costs are often seen as a more accurate measure of the true cost of production. As such, they play a vital role in cost accounting and decision-making.

Indirect Costs

Indirect costs are not directly associated with the production of a good or service but are expenses for the company. These can include things like rent, utilities, insurance, and consulting fees. While indirect costs may seem like small expenses, they can have a big impact on a company’s profitability.

Types of Cost Accounting

Standard Costing

Standard costing is a type of cost accounting that uses predetermined costs to value inventory and manufactured products. The standard costs are the budgeted amount to produce the good or service under ideal operating conditions.

It is generally used in manufacturing businesses, where it helps to track actual production costs and compare them to the costs that were originally expected. It’s called variance analysis, the difference between standard and actual numbers.

Standard costing can be useful for managerial decision-making, as it can help to identify areas where production costs are higher than expected.

Activity – Based Costing

In activity-based costing (ABC), costs are assigned to specific activities that a company carries out. The ABC costing method is a more precise way to attribute manufacturing overhead costs to products than the traditional methods of cost allocation.

Under ABC, each product/good is assigned manufacturing overhead based on its specific consumption of activities necessary to produce it. This approach provides an accurate estimate of the true cost of each product/good and, as a result, can give management better information for pricing and strategic decision-making purposes.

Lean Accounting

Lean accounting is an approach to financial management that is based on the principles of lean manufacturing and focuses on reducing waste and maximizing value by eliminating non-value-added activities like unnecessary overhead costs.

Lean accounting also promotes a culture of continuous improvement in which employees are empowered to identify and eliminate inefficiencies in their work. For example, when accounting departments find ways to save time, employees can put that extra time into more productive, high-value tasks. AP automation is a good tool to support lean accounting principles.

Marginal Costing

Marginal costing is a managerial accounting technique that ascribes a variable cost to each unit of production and a fixed cost to all production activities combined.

As explained before, variable costs are those that vary with the level of output, like raw materials and labor. The fixed costs do not change.

By allocating fixed costs to all units of output, marginal costing provides a clearer picture of the true cost of each unit of production. This information is useful to make decisions about pricing, production levels, and other factors that affect profitability.

While marginal costing is not the only way to account for production costs, it is a popular method due to its simplicity and usefulness in decision-making.

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