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What is 'Cost Accounting'

Cost accounting is an accounting method that aims to capture a company's costs of production by assessing the input costs of each step of production as well as fixed costs, such as depreciation of capital equipment. Cost accounting will first measure and record these costs individually, then compare input results to output or actual results to aid company management in measuring financial performance.

BREAKING DOWN 'Cost Accounting'

While cost accounting is often used within a company to aid in decision making, financial accounting is what the outside investor community typically sees. Financial accounting is a different representation of costs and financial performance that includes a company's assets and liabilities. Cost accounting can be most beneficial as a tool for management in budgeting and in setting up cost control programs, which can improve net margins for the company in the future.

One key difference between cost accounting and financial accounting is that while in financial accounting the cost is classified depending on the type of transaction, cost accounting classifies costs according to information needs of the management. Cost accounting, because it is used as an internal tool by management, does not have to meet any specific standard set by the Generally Accepted Accounting Principles (GAAP) and, as a result, varies in use from company to company or from department to department. 

Development of Cost Accounting

Scholars have argued that cost accounting was first developed during the industrial revolution when the emerging economics of industrial supply and demand forced manufacturers to start tracking whether to decrease the price of their overstocked goods or decrease production.

During the early 19th century when David Ricardo and T. R. Malthus were developing the field of economic theory, writers like Charles Babbage were writing the first books designed to guide businesses on how to manage their internal cost accounting.

By the beginning of the 20th century, cost accounting had become a widely covered topic in the literature of business management.

Types of Cost Accounting

Standard Cost Accounting

This type of cost accounting uses ratios to compare efficient uses of labor and materials to produce goods or services under standard conditions. Assessing these differences is called a variance analysis. Traditional cost accounting essentially allocates cost based on one measure, labor or machine hours. Due to the fact that overhead cost has risen proportionate to labor cost since the genesis of standard cost accounting, allocating overhead cost as an overall cost has ended up producing occasionally misleading insights.

Some of the issues associated with cost accounting is that this type of accounting emphasizes labor efficiency despite the fact that it makes up a comparatively small amount of the costs for modern companies.

Activity Based Costing

The Charter Institute of Management Accountants defines activity based accounting as, "an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs, resources assigned to activities, and activities to cost objects based on consumption estimates. The latter utilize cost drivers to attach activity costs to outputs."

Activity based costing accumulates the overheads from each department and assigns them to specific cost objects like services, customers, or products. The way these costs are assigned to cost objects are first decided in an activity analysis, where appropriate output measures are cost drivers. As a result, activity based costing tends to be much more accurate and helpful when it comes to helping managers understand the cost and profitability of their company's specific services or products. Accountants using activity based costing will pass out a survey to employees who will then account for the amount of time they spend on different tasks. This gives management a better idea of where their time and money is being spent.

Lean Accounting

Lean accounting is an extension of the philosophy of lean manufacturing and production developed by Japanese companies in the 1980s. Most accounting practices for manufacturing work off the assumption that whatever is being produced is done in a large scale. Instead of using standard costing, activity based costing, cost-plus pricing, or other management accounting systems, when using lean accounting those methods are replaced by value-based pricing and lean-focused performance measurements, for example, using a box score to facilitate decision making and create simplified and digestible financial reports.

Marginal Costing

Considered a simplified model of cost accounting, marginal costing (sometimes called cost-volume-profit analysis) is an analysis of the relationship between a product's or service's sales price, the volume of sales, the amount produced, expenses, costs, and profits. That specific relationship is called the contribution margin. The contribution margin is calculated by dividing revenue minus variable cost by revenue. This type of analysis can be used by management to gain insight on potential profits as impacted by changing costs, what types of sales prices to establish, and types of marketing campaigns.

Types of Costs

Fixed Costs are costs that don't vary depending on the amount of work a company is doing. These are usually things like the payment on a building, or a piece of equipment that is depreciating at a fixed monthly rate.

Variable costs are tied to a company's level of production. An example could be a coffee roaster, which after receiving a large order of beans from a far-away locale, has to pay a higher rate for both shipping, packaging, and processing.

Operating costs are costs associated with the day-to-day operations of a business. These costs can be either fixed or variable depending. 

Direct costs are the costs related to producing a product. If a coffee roaster spends 5 hours roasting coffee, the direct costs of the finished product include the labor hours of the roaster, and the cost of the coffee green. The energy cost to heat the roaster would be indirect because they're inexact, hard to trace. 

 

 

 

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