What is cost accounting?
Cost accounting, a sub-field in accounting[1], is a section of managerial accounting that calculates the total and actual cost related to the production of a product or providing a service by capturing all the associated costs – variable as well as fixed costs.
Put differently, cost accounting is primarily about methods and calculations of where a company earns and loses money.
What is the difference between cost accounting and financial accounting?
Simply put, the purpose of financial accounting is to provide financial information about a company’s financial position and performance through financial statements to the company’s stakeholders such as shareholders, creditors, and lenders (banks and other financial institutions).
Contrarily, cost accounting aims to enable the managers of a company to make well-informed business decisions.
Objectives of cost accounting
- Determination of cost
To calculate the cost of sales per unit for each cost object (product or service) is the main objective of cost accounting.
- Cost control
An important objective of cost accounting is to control the costs, keeping the costs of a particular product or service within the limits and standards set by management in the company’s budget. Any deviations from the set standards are to be recorded and reported continuously.
- Cost reduction
Cost accounting allows the management of a company to reduce costs of products, increasing the profitability of a company. However, cost reduction must not jeopardize the quality of a product.
- Basis for determining selling prices
Cost accounting helps to determine the total cost of production, which forms the basis to ascertain the selling price of a product. With the production cost as basis, other external factors such as the demand for the product and the prices of competitive products, are taken into account to calculate the final selling price.
- Guide for prices for tender and quotations
Cost accounting serves as a guide to estimate prices for tenders and quotations.
- Assisting management
The management of a company is assisted in many ways by cost accounting, namely:
- Providing information to prepare a budget.
- Reporting inefficiencies of workers.
- Eliminating waste of material and unnecessary expenses.
- Ensuring optimal use of equipment and effective utilisation of production processes.
- Assisting the management to compare the actual cost with the estimated cost of a product.
- Providing data periodically, i.e., weekly, monthly, or quarterly, regarding the profit or loss of the company, allowing management to estimate future profitability.
- Calculation of closing inventory
Cost accounting is used to determine the value of closing inventory at the end of an accounting period for the preparation of financial statements for the particular period.
Types of costs
There are different types of costs involved in cost accounting:
- Fixed costs
These costs are not directly related to the level of production and do not change when the production of units increases or decreases.
For example, the rent of a building or the lease payment on a piece of equipment that is fixed at a monthly rate remains the same regardless of the number of units of a product manufactured.
- Variable costs
Variable costs, are directly related to the production of an item, changing with the increase or decrease of production units. Labour and raw material costs are examples of this type of cost.
Although, when the total variable cost of a product changes, per-unit cost per unit stays the same, irrespective of a change (increase or decrease) in the number of production units.
- Operating costs
These costs refer to the day-to-day operations of a business and can be either fixed or variable, depending on the nature of a specific situation.
Operating costs can also be a combination of fixed and variable costs, which are called semi-variable costs. For instance, workers receive a fixed salary of R15 000 per month to manufacture a specific number of a certain item per month. As an incentive, an additional amount of R50 is paid to workers for every item manufactured in excess of the required number of units.
The R15 000 per month is a fixed cost, while the additional R50 per unit is considered a variable cost.
- Direct costs
Direct costs are costs that can specifically be associated with the production of a product.
- Indirect costs
Indirect costs cannot be directly related to a certain product, such as the electricity used in a factory.
Types or methods of cost accounting
There are various types or methods of cost accounting.
Standard costing
Standard cost accounting, also known as standard costing or standard costing system, refers to a method where standard costs, rather than actual costs (resource costs) are assigned to the cost of goods sold (COGS) and inventory. Standard costs are also referred to as average costs or expected costs.
This is a very old method of cost accounting, being a popular method used by small and medium-sized enterprises (SMEs) because of its simplicity.
However, the downside of this method is that although standard costs are assigned to the products, a business still has to pay the actual costs for the goods.
The variance, which is the difference between the standard cost and the actual cost, could be significant. If it is determined that the actual costs are higher than expected, the variance is unfavourable. Contrarily, a favourable variance occurs when the actual costs are lower than the standard costs.
Activity-based accounting
Activity-based accounting (ABC) considers all activities that are required to manufacture a product and assigns a value to them, determining fixed and variable costs in proportion to the direct costs associated with production.
ABC is a popular method of cost accounting for various reasons, such as:
- It provides information that enables management to eliminate inefficiencies by adjusting production.
- It is useful in determining which products are unprofitable.
- ABC identifies whether the price of a product is too high in relation to those of competitors in the market and determines whether the company can afford to decrease the product’s price.
Throughput accounting
Throughput accounting aims to augment the efficiency of a business, identifying the factors that prevent a business from attaining its goals.
Put in other words, throughput accounting’s focus is to maximize throughput, i. e. to pass as many items as possible through the production process.
This method of cost accounting focuses on hampering factors such as production bottlenecks and constraints, instead of concentrating on the reducing of expenses.
Cost-Volume-Profit (CVP) Analysis
Cost-volume-profit (CVP) analysis, also known as marginal costing, calculates total fixed and variable costs based on the total quantity of products produced. This information is used to determine a company’s break-even point.
The break-even point refers to the production level at which a business will start to generate a profit. Put differently, the break-even point is the production level where total revenue for a product equals total expense.
The break-even point is calculated as the total fixed costs divided by the contribution margin (sales revenue minus variable costs).
Project accounting
Project accounting is executed during the duration of a specific project. Costs are assessed and management is updated on whether the project is on track. Project accounting reports are required to include all costs, revenues, assets, and liabilities related to the project.
Environmental accounting
Environmental accounting determines the impact cost of a product of a company on the environment. Environmental accounting involves the following costs:
- Costs with regard to waste management.
- Penalties, fines, and related taxes.
- Costs pertaining to the management and handling of contaminated sites.
- Costs involved in prevention technologies.
- Costs to apply technologies to prevent pollution.
- Clean-up costs.
Environmental accounting enables the management of a company to decide whether the production of a product is too expensive when the extra environmental costs are added to the manufacturing costs.
Target costing
Target costing refers to a situation when the management of a company decides in advance what the company is able and prepared to pay for the production of a product, referred to as the target cost. The aim of target costing is to help the company to keep production costs below the target cost.
Life cycle costing
Life cycle costing allows a company to obtain a full picture of all the costs related to the production of an item.
For instance, the related costs can be the financing, maintenance, and disposal of a machine. If applicable, environmental costs can also be part of the related costs.
Advantages of cost accounting
Cost accounting has many advantages. Here are some of them:
- Fixing prices
Fixing prices is one of the main advantages of cost accounting, allowing many businesses to determine the prices of their products based on the production costs of these products.
- Measuring and improving efficiency
Cost accounting provides data that enables a business to measure efficiency regarding to, inter alia, expenses, time, and cost.
- Price reduction
Sometimes tough and difficult economic situations (recession, disasters) may compel a business to reduce the prices of its products even below the total cost of the product.
To help the business to survive these difficult situations, cost accounting plays a major role.
- Identification of unprofitable activities
Overall profits of a company are not a guarantee that all its activities are profitable. Cost accounting enables management to identify profitable and unprofitable activities of the company.
- Stock control
Cost accounting prevents that a business is overstocked or understocked by determining the most ideal and economic re-order level of quantities.
- Evaluates the reasons for losses
Cost accounting plays a major role in determining the cause(s) for losses incurred by a business. This will help the business to address the problem and eliminate the cause, or at least minimise it.
[1] Refer to the article, ‘Accounting Explained for Dummies’, for a general overview of accounting.
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