The ability to control costs is a business fundamental. Perhaps nowhere is that more evidentthan in the production of goods and delivery of services, processes with myriad expensesthat if not closely tracked can easily eat into or wipe out a company’s profit margin.
Cost accounting helps protect margins by organizing and tracking all direct and indirectexpenses, providing important insights that can lead to better budgeting, increasedefficiency and, ultimately, higher profit.
What Is Cost Accounting?
Cost accounting analyzes a company’s total production costs for its products orservices. Aform of management accounting, cost accounting examines all variable and fixed expenses andis meant for internal eyes only. Company decision-makers use the results to identify whichproducts and services are most profitable and which ones cost too much to produce relativeto sales.
Cost accounting informs budgeting decisions, product/service pricing and business strategy.
Key Takeaways
- Cost accounting is integral to business decision-making and provides methodologies forascertaining, controlling, and reducing costs to optimize profitability.
- While the benefits of cost accounting include enhanced decision-making and effectiveproduction control, challenges like accurate cost allocation remain hurdles for someorganizations.
- The future of cost accounting is intertwined with technological advancements,necessitating professionals to integrate tools like AI and big data for strategicmanagement.
- Differentiating cost from financial accounting is crucial, yet their interrelationshipforms the backbone of holistic financial management.
Cost Accounting Explained
Cost accounting is the process of tracking, analyzing and summarizing all fixed and variable“input” costs related to the production of a product, acquisition of goods forsale or thedelivery of a service. These include material and labor costs, as well as operating costsassociated with a product or service. Cost accounting helps companies identify areas wherethey may be able to better control their costs, and also informs pricing decisions to ensureprofitability.
Cost accounting figures are used only by a company’s internal management team, socollectionmethods can be customized according to company needs.
Cost Accounting vs Financial Accounting
Cost accounting details the costs associated with producing or acquiring goods for sale orproviding a service. Because it’s not mandatory to perform, cost accounting is notbound tothe same standards required of financial accounting to meet the requirements of externalparties.
This table presents a side-by-side comparison of each form of accounting:
| Cost Accounting | Financial Accounting |
|---|---|
| Organizes and analyzes costs to facilitate costcontrol and efficiency improvements. | Organizes and records a company’s financialtransactions. |
| Reports only to internal management. | Reports the financial position of the company toshareholders, creditors, the government (including tax agencies),investors and external analysts. |
| Can be organized according to the needs ofmanagement and the characteristics of the business. | Must conform to accounting standards such as GAAPand IFRS. |
| Deals with objective, cost-related data requiringmanagerial judgment for allocating expenses. | Aims to present an objective (“true andfair”) viewof the company’s finances. |
What Is the Purpose of Cost Accounting?
Cost accounting helps organizations evaluate the costs associated with manufacturing aproduct or providing a service. While the process itself requires a considerable level ofdetail and time, the strategic insights gained make it a worthwhile endeavor for most anyorganization.
Among the areas where cost accounting can help:
Budgeting: Cost accounting is at the heart of budget planning. By analyzing actual expenses, anorganization can more accurately estimate future fixed and variable costs and allocate themto product lines.
Efficiency: Standard costs are based on the efficient use of labor andmaterials. Cost accounting gives managers a bird’s-eye view of how closely (or not)budgetedcosts match actual costs.
Profit: Uncontrolled variations in expenses can diminish or eliminateprofits even if sales are strong. Cost accounting pinpoints when and where specificproduction expenses begin to outweigh sales, enabling managers to make adjustments.
Elements of Cost Accounting
Cost accounting is based on three principal elements: materials, labor and overhead.
Material
Materials are inputs to production. They are typically broken down into two groups: directand indirect.
Direct materials are materials and parts used in production and reflected ina completed product. Materials can be subdivided into raw materials, such as cotton forclothes or plastic for a phone case; work-in-progress, or products that are not yetcomplete; and finished goods, meaning products that are ready for sale.
Indirect materials are treated as an overhead expense. Examples includesafety equipment and cleaning supplies. Only direct materials are shown on the cost sheet.
Labor
Workers directly involved in production or distribution of goods or delivery of services mustbe paid. Their salaries or wages might include overtime and bonuses; employee benefits arepart of the total cost, too.
As with indirect materials, indirect labor costs are treated as an overhead expense, not alabor expense.
Expenses/overhead
These are costs related to the production or distribution of goods or provision of services,but which cannot be directly attributed to specific goods or services. Typical overheadcosts include:
- Equipment set up, such as for factory machinery.
- Utility bills, such as factory electricity, water and sewerage.
- Facilities costs, including rent/mortgage and property taxes.
- Payroll taxes and pension contributions.
- Depreciation of fixed assets, such as factory machinery and store equipment.
- Interest payments.
Cost Accounting Systems
A cost accounting system helps determine how much the production of a good or service willcost. There are two types of systems: job order costing and process costing.
Job order costing is typically used by businesseswith diversified or customizable products, or by companies that provide services, wherelabor is the dominant expense — for example, a specialist furniture manufacturer or aplumbing or electrical services provider.
In other words, no two jobs are exactly the same. Job order costing estimates and trackscosts for direct materials, labor and overhead costs.
Process costing is often the better choice forfirms that mass-produce standardized products. Instead of estimating the cost of each iteminvolved in the production process, process costing assumes the unit cost of each item isthe same and allocates production costs evenly across the company’s entire output.
Types of Costs
The production of goods and services involves several types of costs. It is important forbusinesses to understand them — and include them in their cost accounting calculations— tobetter control their expenses and improve operational efficiency.
Direct costs are related to the production/acquisition of products ordelivery of services. For a manufacturer, these would include the raw materials and partsthat go into a final product, as well as the labor involved in its production. These arealso known as product costs. For some services-based businesses, such as a law firm, labormay be the only direct cost. Others, such as an auto mechanic, require inventory — carparts, for example — to perform services, so that counts as a direct cost.
Operating costs are indirect costs related to production that cannot be tiedto a specific product or service. Heating and lighting are all examples of indirect costs,as is the labor behind them. Equipment purchases are also indirect costs because, while usedfor production, they don’t go into the final product. That applies to services-basedbusinesses, too. For example, hairdressers must purchase scissors and hairdryers, but unlessclients take them home after a haircut, they are an indirect cost.
Fixed costs don’t change with production and have to be paidregardless ofthe level of production; when production or demand for a product falls, fixed costs causeunit costs to rise, and vice versa.
Variable costs fluctuate with a company’s level of production. Amanufacturer of skiing equipment is likely to see its costs for materials, labor andoverhead rise, and fall in the spring and summer. Some costs have both fixed and variablecomponents. For example, the cost of electricity to run production machinery varies withusage, but the cost of electricity to heat and light the building generally doesn’tunless acompany adds shifts, for example.
Types of Cost Accounting
There are many different types of cost accounting, each with its own focus and approach toanalyzing production expenses. Following is an explanation of each.
Standard costing: Standard costing estimates costs based on the mostefficient use of labor and materials under typical operating conditions. When production iscompleted, actual costs are compared with estimated costs.
The resulting variance highlights the difference between the two and can be key to effectivecost control. For example, if actual costs are persistently higher than standard costs, thenmanagement might consider renegotiating supplier contracts, improving business processes ormaking other changes to bring production costs down. Variances may also indicate thatassumptions made when estimating standard costs need to be revisited.
Activity-based costing (ABC): This form of cost accounting identifies andallocates overhead costs to the activities involved with producing a good or service. ABC costing isparticularly useful when a company has diverse product lines involving different levels ofmaterial or labor.
Take, for example, a ceramics manufacturer that produces two types of patterned plates. Theproduction of one plate is entirely automated; production for the second type involves sometime-consuming manual work, which the company will want reflected in the unit price. Astandard costing approach would allocate production costs evenly across both lines,resulting in an overstated production cost for the first type of plate and an understatedcost for the second type. The ABC approach would allocate a higher proportion of labor coststo the second product line, thus giving a more accurate picture of the cost distribution ofthe two lines.
Related accounting approaches and disciplines
Lean accounting: Lean accounting supports “lean” thinking:streamliningproduction and eliminating waste to maximize productivity. It tries to avoid overproductionby running down inventories and creating just-in-time supplylines. The goal is to meet customer demand, rather than production targets. Leancost accounting focuses on value streams, which are sets of actions that deliver value thatcustomers are willing to pay for. It doesn’t distinguish between direct and indirectcosts —all costs associated with a value stream are regarded as direct costs. Value stream costsinclude labor, materials, production support, machines and equipment, operation support,facilities and maintenance. Costs that don’t fall into the value stream are separatelygrouped as “business sustaining costs.”
Because lean doesn't capture all costs related to production, it isn't as useful for pricingas cost accounting. As a result, many companies use both approaches.
Project accounting: This is a separate discipline that focuses on thefinancial transactions related to managing a project, including project costs, materials,billing and revenue. Costs are typically estimated up front, though they may be updated atintervals based on how actual costs compare. Estimates should include all costs arising fromor associated with the project — materials and labor, of course, but also assetacquisition,post-completion review and clean-up or decommissioning costs.
While project accountants may use cost accounting methods, they are not required to do so.
Target costing: Target costing is a cost accounting technique for companiesthat operate in a very competitive environment where profit margins are thin, such asconstruction or consumer goods, setting a hard limit on the amount production costs can risemay be necessary. Target costing defines the maximum a company is willing to pay forproduction, determined by subtracting the mandated gross margin from the projected productprice. If costs start to rise above the target, thereby eating into a company’sprofits,production is cut back to bring costs down.
Lifecycle costing: Lifecycle costing accounts for all the costs associatedwith an asset over its life span. For example, a machine has an up-front acquisition cost,but it will also have maintenance, repair and, eventually, disposal costs. Costs may alsoarise from its operation, such as to offset environmental impact and ensure safety. Theselifecycle expenses are estimated to determine the total cost of the machine to the companyduring its lifetime. This can help managers estimate the real cost of machine used forproduction.
Cost accounting looks at the cost to produce or deliver goods/service. Life-cycle accountinglooks at the cost to acquire and operate a specific piece of equipment. Understandinglife-cycle costs can help companies decide if or when to purchase a new piece of equipment.
Cost volume profit (CVP): The marginal cost of a product or service is theadditional cost of producing one more unit of that product or service. The marginal cost ofproduction falls as production increases because the contribution of fixed costs decreases.A CVP analysis, also known as break-even analysis, uses the marginal production cost tocalculate the number of units that must be sold to fully cover the cost of production. CVPanalysis is one of many activities performed by cost accountants and breakeven is a keymetric for cost accounting.
CVP can be used to estimate the effect of changes in variable and fixed costs and variationsin the market price on company profits. For example, suppose a company is forced to discounta product heavily because of a market downturn. CVP can help identify whether thediscounting will cause the product to miss its break-even target, and whether reducingproduction and selling down inventory would help bring it toward break even. Managers canthen make an informed decision about whether to continue producing the item at the samevolume, cut production to reduce costs or stop producing it until the market improves.
Formulas for Cost Accounting
Cost accounting includes a variety of concepts and calculations that help a business todetermine how well it’s controlling costs and meeting its profit goals. Integratedaccounting and financial management software can perform the heavy-lifting, freeingmanagement to focus on the business implications instead.
Break-even formula
The break-even point is the point at which a company’s sales exactly cover its totalproduction costs, both fixed and variable. Equating the two determines whether a product isprofitable (or not). The break-even formula is:
Break even (in units) = Total Fixed Costs /Contribution Margin
For example, let’s say a bike manufacturer wants to know how many of its newestmountainbikes it needs to sell to break even. Its total fixed costs are $750,000, variable costs perunit are $500 and each bike sells for $600. To calculate the break-even point — inthiscase, the number of mountain bikes that must be sold — divide $750,000 by $100 ($600 -$500). The result, 7,500, represents how many bikes the company must sell to break even.Multiply 7,500 by $600 (the price per bike) to determine the equivalent break-even point insales. The answer is $4.5 million.
Contribution margin
Contribution margindetermines the incremental profit earned for each unit sold after deducting variable costs.It’s the difference between the price charged per unit and the variable costs toproduceeach unit. In other words, it’s the denominator for the break-even formula.
The formula for contribution is:
Contribution Margin = Sales Revenue –Variable Costs
In the mountain bike example, contribution margin per unit for each new bike is $100 ($600 -$500).
Target net income
Breaking even is good, but making a profit is better. Target net income is the amount abusiness wants to make in profit for a product or service in a given accounting period,after the cost of goods or services (COGS) delivered. The question is how to reach thatgoal. Using the mountain bike example, let’s say the bike manufacturer sets its profitgoalat $2 million. How many bikes does it have to sell?
The formula is:
Unit volume to achieve target net income =(fixed costs + target net income) / (contribution margin per unit)
Let’s plug in the mountain bike numbers: The numerator, 2,750,000 (750,000 + 2,000,000)divided by 100 ($600 - $500) equals 27,500 — the number of bikes that must be sold toreach$2 million. Selling that number of bikes at $600 each would mean $16.5 million in sales—the amount needed in sales to reach $2 million in net income.
Gross margin
Businesses use gross margin to benchmark their production costs against their sales revenue.As such, gross margin is the amount of money a company has left after it deducts COGS fromnet sales. The higher the gross margin, the more a company has earned from a sale afterfactoring for cost. If gross margin is low, a company may decide to raise prices and/or findways to cut production costs.
The formula for gross margin is:
Gross margin = (net sales revenue - COGS) /net sales revenue
Pre-tax dollars needed for purchase
Although business purchases are usually tax-deductible, they are typically paid from incomethat has already been taxed and declared for tax purposes in a subsequent accounting period.To pay for these purchases, therefore, a company must earn enough money to cover the cost ofthe items and the tax it must pay on its income.
The formula to calculate that amount is:
Pre-tax dollars needed for purchase = costof item / (1 - tax rate)
Imagine a company needs to buy four new office computers for a total of $10,000, and thecompany’s tax rate on profits is 20%. The cost, $10,000, is divided by 0.80 (1 -0.20),which comes to $12,500 needed for the purchase.
Price variance
Useful for budgeting, price variance is the difference between the standard, orpredetermined, cost of a product or service and its actual cost. If the actual cost is lessthan the standard cost, this is a favorable variance, indicating greater profitability. Ifactual costs are higher than standard costs, this is an unfavorable variance, indicatingloss.
The formula for price variance is:
Price variance = (actual unit cost -standard unit cost) x number of items purchased
Efficiency variance
Cost accounting analyzes a number of “input” costs — namely, material,labor and overhead —related to the production of a product or service, and there are efficiency varianceformulas for each.
Efficiency variances shed light on operational effectiveness. Many are expressed as costs,but they can also be expressed in quantities like number of hours. They’re all derivedfroma standard variance formula, which is expressed as the actual units of whatever is beingmeasured minus the expected or budgeted units times the budgeted cost — which is oftendollars but might also be hours, for example. For materials, the efficiency variance isreferred to as material yield variance; for labor, it’s labor efficiency variance; andforoverhead it’s overhead efficiency variance. The formulas are:
Material yield variance = (actual unitusage - budgeted unit usage) x budgeted cost per unit
Labor efficiency variance = (actualper-unit labor hours - budgeted per-unit labor hours) x budgeted hourly labor cost
Overhead efficiency variance = (actualper-unit labor hours - budgeted per-unit labor hours) x budgeted overhead rate per unit
Variable overhead variance
Overhead costs are often the costs companies most want to keep under control. Monitoringvariable overhead cost can help, and the formula for doing so is another variation on theclassic efficiency variance formula. Variable overhead variance comprises two components:efficiency and overhead spending.
Unlike the labor efficiency variance, the variable overhead efficiency variance considersindirect costs, such as the salaries of office staff and site security.
The formula is:
Variable overhead efficiency variance =(actual labor hours - budgeted labor hours) x budgeted overhead labor rate
Variable overhead spending variance compares the actual overhead cost of production with thebudgeted or expected cost. The formula is:
Variable overhead spending variance =(actual overhead labor rate - budgeted overhead labor rate) x actual labor hours
Ending inventory
Generally speaking, ending inventory is the value of finished goods that remain for sale atthe end of an accounting period. In production, inventory also includes raw materials, laborand overhead. Ending inventory appears as a current asset on a company’s balance sheet. The basic formula is:
Ending inventory = beginning inventory +net purchases - cost of goods sold
Net purchases account for goods purchased for a product or service less anything returned,reduced in price due to a problem or discounted, perhaps due to a promotion. The formula is:
Net purchases = purchases - returns -allowances - discounts
While the concept of ending inventory is straightforward, how much the goods are determinedto be worth depends on thevaluation method used.
The four main methods are:
First in, first out (FIFO) assumes the oldest inventory sold first. Duringtimes of inflation, this method calculates a higher value for ending inventory, lower costof goods sold and a higher gross profit.
Last in, first out (LIFO) assumes the newest inventory sold first. Duringtimes of inflation, this method can result in lower net income values and a decreased endinginventory value.
Weighted cost average averages the cost of new inventory purchases with thecost of existing inventory. This method is a contender for companies that sell similarlypriced products.
Specific identification tracks the cost of each piece of inventory and theactual price of each item sold. Companies that sell high-cost items, such as cars andjewelry, generally use this method.
Examples of Cost Accounting
Here’s an example of cost accounting for a typical small manufacturing companywe’ll call“Bellmore Gizmos.” The company produces a variety of widgets, but they all haveroughly thesame costs of production. Bellmore Gizmos uses standard cost accounting, which meansoverhead costs are allocated across the entire production.
This is the simplest form of cost accounting. Here is what its basic actual cost card mightlook like:
| Cost category | $000s |
|---|---|
| Direct materials | 600 |
| Direct labor | 1,200 |
| Indirect materials | 100 |
| Overhead: | |
| Sales & marketing | 200 |
| Non-production staff costs | 800 |
| Payroll taxes & pension contributions | 400 |
| Utilities | 200 |
| Premises costs | 600 |
| Depreciation | 150 |
| Interest cost | 50 |
| Total overhead | 2,400 |
| TOTAL COST | 4,300 |
But that’s only part of the picture. Bellmore Gizmos also wants to compare actual coststobudgeted costs, to determine the accuracy (or not) of its estimates. Gaps between the twoare known as variances, and they’re either favorable, meaning profitable, orunfavorable,meaning loss-making.
| Cost category | Budget ($000s) | Actual ($000s) | Variance (%) |
|---|---|---|---|
| Direct materials | 700 | 600 | 14.3% |
| Direct labor | 1,200 | 1,200 | 0% |
| Indirect materials | 50 | 100 | -100% |
| Overhead: | |||
| Sales & marketing | 250 | 200 | 20% |
| Non-production staff costs | 700 | 800 | -14.3% |
| Payroll taxes & pension contributions | 350 | 400 | -14.3% |
| Utilities | 200 | 200 | 0% |
| Premises costs | 600 | 600 | 0% |
| Depreciation | 150 | 150 | 0% |
| Interest cost | 50 | 50 | 0% |
| Total overhead | 2,300 | 2,400 | -4.35% |
| TOTAL COST | 4,250 | 4,300 | -1.18% |
It appears as if Bellmore Gizmos has saved quite a bit on its direct materials, though wedon’t know whether that’s due to better supplier terms or lower production. Thissaving isoffset by higher overhead.
The purpose of cost accounting is to enable managers to budget, identify where efficiencysavings can be made and improve profits. To gain a full picture of how these changes in thecompany’s costs affect its bottom line, we need production and sales data.Here’s that datafor the same period as the cost figures above:
| Product | Unit price ($) | No. produced | No. sold | Sales revenue ($000s) | Inventory ($000s) |
|---|---|---|---|---|---|
| Gizmo A | 5.00 | 300,000 | 250,000 | 1,250 | 250 |
| Gizmo B | 7.50 | 300,000 | 290,000 | 2,175 | 75 |
| Gizmo C | 9.00 | 150,000 | 150,000 | 1,350 | 0 |
| Gizmo D | 13.00 | 100,000 | 80,000 | 1,300 | 260 |
| TOTAL | 850,000 | 770,000 | 6,075 | 585 |
A simple profit formula (Profit = sales - fixed and variable costs) shows Bellmore Gizmos isprofitable. Taking the numbers from these charts shows: Profit = $6,075,000 - $1,900,000(actual variable cost) - $2,400,000 (actual fixed cost), or $1,775,000.
However, because a standard costing approach results in some product lines contributing morethan others, a company might want to do break-even and profit analysis by product line usingcost value profit (CVP) analysis. They might also consider switching to activity-basedcosting (ABC) to match costs to products more accurately.
Cost Accounting Principles to Know
Cost accounting principles dictate how expenses and revenue are recorded. Here are two tounderstand.
Matching principle
In accounting, the “matching principle” requires a company to report expenses inthe sameaccounting period as related revenues for a product or service. This provides a moreaccurate picture of a company’s operations on its income statement. If 500 mountainbikesare sold in April, their cost to manufacturer is recognized in April, too.
Principle of conservatism
Accounting is not always precise, and sometimes accountants need to make decisions about howbest to show financial outcomes. The principle of conservatism per Generally Accepted Accounting Principles(GAAP) says those decisions should present the most cautious, or pessimistic, viewof the company’s finances.
History of Cost Accounting
Modern cost accounting is thought to have started during the Industrial Revolution, whichbegan in Great Britain in the late 1700s and spread to the United States around 1820.Businesses have always needed to track and manage costs, but prior to the advent of massproduction, businesses tended to be small and costs were principally direct variable costs—mostly labor and materials. Then, cost accounting was largely a matter of managing cashflow.
During the Industrial Revolution, much larger and more complex businesses emerged, notably toproduce industrial goods such as steel for railroads. These businesses had fixed costs thatcould not easily be associated with the products they produced — what we now calloverhead.Cost accounting developed as a means of enabling organizations to allocate overhead toproduct production and thus help them make better decisions regarding pricing, investmentsand product development.
In the past few decades, developments in management theory and business practice have led tothe growth of new kinds of cost accounting. These include activity-based accounting, leanaccounting and environmental cost accounting.
Minimize Cost Accounting Efforts With Accounting Software
Cost accounting is often detailed and complex. Automating the process with modern accountingsoftware removes much of the time and expense traditionally involved with manualcost accounting, while providing internal management with the information to informbudgeting decisions, product/service pricing and business strategy.
The most capable accounting software lets business managers set up cost categories and profitcenters as they see fit. Accounting software automatically tracks expenses against budgetand advanced versions flag variances. It can also calculate break-even points, gross marginand other key metrics that help managers identify potential savings, potential areas ofloss, and potential areas of opportunity.
A long way since the Industrial Revolution. A form of management accounting, cost accountingevaluates a company’s total costs to produce its products or services and is meant tobeused by internal stakeholders only. Costs, both variable and fixed, include materials, laborand overhead. Cost accounting helps companies identify areas where they may be better ableto control their costs, as well as set or adjust pricing to maintain profitability.
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Cost Accounting FAQs
What do you mean by cost accounting?
Cost accounting is the process of recording, analyzing and summarizingall fixed and variable costs related to the production of a product or service. Costaccounting helps companies identify areas where they may be better able to control theircosts, as well as set or adjust pricing to maintain profitability. Cost accounting is forinternal use only.
What is cost accounting with example?
Cost accounting is a form of managerial accounting that details the costsassociated with producing a product or service. Because it’s an internal tool and notmandatory, it’s not bound to the accounting standards required of financialaccounting.
Cost accounting determines a product’s break-even point — where its expensesequal sales.Anything above that is profit. For example, if a bike manufacturer calculates its break-evenpoint to occur when it sells 7,500 new mountain bikes, priced at $600 each, then as soon asit sells bike 7,501 it has exceeded break even and made a profit.
What are the types of cost accounting?
There are many types of cost accounting, each with its own focus andapproach to estimating production expenses. One type, standard costing, estimates the costof goods sold and inventory based on the most efficient use of labor and materials undertypical operating conditions. Another type, activity-based accounting (ABC), identifies andallocates costs to the activities involved with producing a good or service. Other typesinclude lean accounting, which focuses on streamlining production and eliminating waste tomaximize productivity, and throughput accounting, which identifies constraints that preventcompanies from reaching their goals and prioritizes what will help reach them.
What are the four types of cost?
Cost accounting is based on a variety of costs. Among them, direct costsare related to the production of products and services, such as raw materials and labor.Indirect, or operating, costs aren’t directly related to production yet are essentialforthe business to run, such as expenses like heating and lighting. Fixed costs, such aspremises costs and depreciation of machinery, don’t vary with production. Variablecostsfluctuate with a company’s level of production.
