Cost accounting is necessary for all types of businesses, whether they provide services, manufacture products, or sell merchandise. The purpose of cost accounting is to help managers understand how much running a business costs.
The purpose of cost accounting is to keep track of money spent on labor, maintenance, raw materials, and supplies, among others, and to analyze these costs to find ways to minimize or utilize them.
This guide will offer you an in-depth explanation of what cost accounting represents, the different cost accounting methods, how you can set up the process for your small business accounting, and much more.
What Is Cost Accounting?
In cost accounting, the cost of producing or supplying a product or service is captured, recorded, and analyzed. As a result of this process, your business’s management will be able to make more accurate budgeting decisions, reduce inefficient costs, and eliminate inefficient processes.
Types of Costs
Cost accounting consists of three basic elements:
- The material costs or inventory costs include the direct costs of producing or manufacturing a product. There are three types of inventory: raw materials, work-in-progress, and final products.
- An employee’s labor cost consists of the wages paid to him or her for maintaining, transporting, and producing the finished product. Variable costs include these, as well as material costs, which vary based on the activity’s volume.
- In addition to overhead costs, supplies, utilities, depreciation, advertising, rent, repairs, taxes, travel expenditures, and other operating expenses are also included. Although indirect expenses can’t be traced to a specific cost unit, they are still necessary to carry out a business’s profit-making activities. As these costs don’t change with production volume, they are also considered fixed costs.
The Difference Between Cost Accounting and Financial Accounting
The concept of cost accounting often overlaps with the concept of financial accounting. What are the differences and similarities between these two?
As previously mentioned, cost accounting deals with the costs of production – it looks at how a business’s costs are structured and finds ways to reduce them. Investors and creditors use these accounting reports to get information about sales, expenses, assets, and liabilities.
The main difference between cost accounting and financial accounting is their respective target audiences. The purpose of financial accounting is to provide information to stakeholders outside the business, while the purpose of cost accounting is to provide information to those responsible for making decisions on the inside. As well as tracking and measuring costs, cost accounting uses reports to summarize the main financial activities of a business, such as sales, revenue, equity, liabilities, expenses, etc.
In financial accounting, cost accounting can contribute to the preparation of financial statements. Accounting for costs and expenses makes it easier to generate financial statements based on the information gathered.
Both accounting methods share certain elements, such as material costs, labor costs, and inventory prices.
There is a strong overlap between the concept of cost accounting and the concept of financial accounting. financial statements for your business, then head over to our guide on financial reporting.
Why Is Cost Accounting Important?
Determination of price
Pricing is one of the main objectives of cost accounting. It’s simple: the price you set on the product should cover the cost of production and generate a profit.
A fast food business, for instance, should keep track of the cost of ingredients such as bread, fries, lettuce, tomatoes, ketchup, etc., and price the product based on these direct costs as well as additional labor and overhead.
Cost Control
Cost accounting doesn’t just help you keep track of your expenses – it also allows you to make (any necessary?) changes along the way. If you analyze your costs on a weekly or monthly basis, you can identify areas where you can reduce costs and take the necessary steps to reduce them. As an example, a company may discover that ten hours produce the same results on a particular machine as a twelve-hour shift.
Budgeting
Knowing how your business spends its money will make budgeting for the future much easier. Costs can be tracked and estimated in a way that maximizes profits in your next budget.
Types of Cost Accounting
Cost accounting can be divided into four types:
1. Standard Cost Accounting
In standard costing, a business assigns specific “standard” costs to products rather than the actual cost of direct materials, direct labor, and overhead. Based on efficient use of materials and labor, under standard operating conditions, these standard costs are essentially the budgeted or planned amount for a product.
While standard costs are assigned to these products and services, the business must still pay direct materials and labor costs. To determine whether they have spent the planned amount, they must calculate the difference between the standard cost and the direct cost. This is known as variance analysis.
If the variance analysis determines that your costs are higher than expected, then the variance is unfavorable, and your business has generated less profit than expected. If the costs are less than the standard costs, the variance is favorable, and your business has generated more profit than anticipated.
2. Activity-Based Cost Accounting
A costing system based on activity-based costing (ABC) breaks down overhead and indirect costs based on actual consumption. Usually, this method is used in the manufacturing industry to calculate true production costs.
A high volume of medicine is produced using an automated process that consists primarily of putting chemicals into processing equipment and waiting for the final product to be produced.
In contrast, medicine B is produced at a lower volume due to its manual setup and hands-on effort by pharmaceutical staff. Accordingly, activity-based costing assigns a higher overhead cost to medicine B than to medicine A based on labor costs.
3. Lean Cost Accounting
In lean cost accounting, waste is eliminated, errors are reduced, processes are speed up, and traditional costing methods are replaced with value-based pricing. As a result, lean accounting makes management decisions based on total value stream profits, rather than cost allocation. It not only increases profits and reduces waste, but also promotes teamwork and communication within the company.
4. Marginal Cost Accounting
A marginal costing method, or cost-volume-profit analysis, can help you make short-term decisions. As a result, marginal costing measures the cost difference between every new unit of production.
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