What Is Cost Accounting?

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Cost accounting helps zero in on your expenses and how they apply to each aspect of your business.

  • Cost accounting focuses on the expenses involved with running your business.
  • It is a common form of accounting for manufacturing businesses, as it allows them to break out costs for each product they produce.
  • Cost accounting, when it’s used appropriately, can help businesses identify areas where they can save money.
  • The article is for small business owners looking to learn more about cost accounting and how it can help their business.

A key component of accounting is knowing how much you are spending. If you don’t have a handle on your expenses, you never know whether your business is making money. That’s where cost accounting comes in. Cost accounting is centered specifically on the costs associated with running your business. Before you can dig into cost accounting, it is important to understand what it is exactly, the different types of cost accounting and the benefits of this type of financial tracking.

What is cost accounting?

Cost accounting is a method of accounting that focuses purely on a business’s costs – both fixed and variable. Using the cost accounting method, companies track all of their costs and allocate them to individual processes or units of production, allowing managers to better understand the economics of their business’s activities.

Cost accounting is especially important for businesses that manufacture and sell at scale and/or have diverse product lines, as these companies have many costs associated with manufacturing, packaging, and distributing their goods. For these types of businesses, accounting for costs is critical to accurately calculating profit margins, as well as budgeting, forecasting and identifying efficiencies. [Read related article: What are Accounting Standards?] 

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What is the purpose of cost accounting?

More than other types of accounting, cost accounting gives companies a comprehensive view of their costs. Cost accounting tracks all of a company’s costs associated with its offerings and allocates them to specific products or activities. Whereas in financial accounting, costs appear as just one- or two-line items on a budget, cost accounting lets businesses break expenses down to see exactly what is driving costs. This can provide better insights into what the company can do to cut costs and increase profits.

After all, there are only two ways for companies to make more money: They can either increase sales (which is largely beyond their control), or they can cut costs (which they have greater control over).

What are the benefits of cost accounting?

Not only can you understand the total costs involved to produce your products, but it can be easier to spot instances of overcharging by vendors. Additionally, your company may be able to find efficiencies that allow you to save money.

Some of the benefits of cost accounting include the following:

  • Cost allocation: Managers can allocate costs by product line and per unit of production or hour of labor.
  • Profit drivers: Cost accounting helps business owners gain a deeper understanding of their profit margin and what drives it.
  • Budgeting and forecasting: Calculating costs for individual activities helps senior managers plan for future spending and forecast their finances into the future.
  • Cost savings: Using cost accounting, businesses may be able to identify new efficiencies to help save money.
  • Quicker decisions: Cost accounting can help managers respond quickly to changes in the market, such as when the cost of raw materials increases.

Additionally, cost accounting can also help business owners make sure they capture all of their tax-deductible expenses.

Did You Know?Did you know? Many accounting software programs allow you to identify individual costs and assign them to specific product lines or break them down by unit.

Types of costs

When using cost accounting, it is important to understand the different types of costs.

Cost Examples
Fixed Rent, mortgage payments and insurance
Variable Raw materials, supplies, packaging
Operating Utilities, accounting and legal, marketing
Direct Labor hours for production and distribution

 

While these are the four most common categories for grouping costs, there are other types as well, such as semivariable. In addition, some costs fall into multiple categories, or they may fall into different categories depending on an individual company, the industry it’s in and how it operates.

Fixed costs

Fixed costs don’t change based on a company’s level of production. These costs include items like rent, mortgage payments and salaries for administrative personnel. Fixed costs are significant, because they don’t stop if managers temporarily halt production. Some fixed costs don’t stop even if a business folds.

Variable costs

A company’s variable costs are those that change based on the company’s level of activity. For manufacturing companies, for example, each additional unit of production requires purchasing more raw materials.

Variable costs are significant for a company because they are marginal – each additional unit of production adds more cost to the company. These costs can often be lowered through bulk discounts or other breakpoints.

Operating costs

Operating costs include the expenses involved with running a facility (marketing and utilities are prime examples); it doesn’t include costs that are directly tied to production.

Operating costs can be fixed or variable, but they’re generally costs that companies need to pay to stay in business – even if they aren’t producing anything.

Direct costs

Direct costs are those that a company can tie directly to the production or distribution of a particular product. For example, if you run a manufacturing company, direct costs include the labor hours for manufacturing a product, along with costs for running equipment to manufacture that product.

Direct cost is significant because it is the easiest of the four types to allocate to specific activities or product lines, though it’s not usually the easiest place to find cost savings.

Key TakeawayKey takeaway: When using cost accounting, it is important to understand the different types of costs, including fixed, variable, operating and direct.

Types of cost accounting

Within cost accounting, there are several subtypes. Each of these is used by different types of companies or for various purposes. For example, lean cost accounting is for manufacturing companies implementing other lean practices.

The four main types of cost accounting are:

  • Standard: This is typical cost accounting; costs for each product line are calculated based on historical experience to be used for budgeting and forecasting.
  • Activity: Costs are allocated by individual business activity (each product line).
  • Lean: This is more specialized and designed to provide insights to manufacturing companies implementing other lean practices like lean manufacturing and lean inventory management. It’s more conservative than other types of accounting. For example, you only record the value of inventory over time.
  • Marginal: Marginal cost accounting only considers the variable cost for a specific product. Whereas other types of cost accounting allocate a portion of fixed costs to each product line, in marginal cost accounting, these costs are excluded. It assumes that fixed costs have to be paid whether a business takes on a certain activity or not, so they aren’t allocated to specific activities.

What is the difference between cost accounting and financial accounting?

Cost accounting focuses purely on a business’s costs, while financial accounting combines this information with other items, like revenue, liabilities, and shareholder equity, to provide a comprehensive look at a company’s finances.

Both cost and financial accounting are used to track elements of a business’s finances. This data helps guide company strategy, including informed decision-making. However, while cost accounting focuses on tracking costs and allocating those costs to specific offerings or activities, financial accounting tracks all aspects of a company’s finances. Financial accounting includes cost accounting, as well as other elements – such as income, liabilities, and equity – which it combines to provide comprehensive reports and insights into the company’s financial circumstances and future prospects.

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