Understanding the cash flow of your business – both in terms of incoming cash and expenditures – is crucial if you hope to succeed in any competitive modern market. That’s why you, as a business owner, need to understand cost accounting.
Cost accounting is an effective way to learn how your business is set up and how it uses money. Today, we’ll break down cost accounting, the types of cost accounting you can perform, and when you should practice cost accounting with specific examples.
Cost accounting is managerial accounting that looks at a company’s production costs by considering the variable and fixed costs at each step of the production process.
Cost accounting is not GAAP-compliant, so it can only be used for internal decision-making.
Modern cost accounting is believed to have started during the Industrial Revolution in the late 1700s when steel and metal manufacturers had to start tracking their fixed and variable costs to improve their production process.
It allowed railroad and steel manufacturers to control costs, become more efficient, and make better pricing, investments, and development decisions.
Since the onset of the 20th century, cost accounting has become widely used for better financial management.
Cost accounting systems are used to identify, measure, and record all fixed and variable costs associated with the production process. This information can be used to compare input costs to output results, which can help businesses make better financial decisions and improve their bottom line. Here's a breakdown of all the costs incurred in managing an organization:
Cost accounting and financial accounting are two branches of accounting that track and report financial information about a business. However, they have different purposes and users.
Cost accounting systems are used to track and report the costs of goods or services produced or provided by a business. It is used by internal decision-makers, such as managers, to make decisions about pricing, production, and other aspects of the business. It is not GAAP compliant and cannot be used for external purposes.
Financial accounting is used to record and summarize a business's financial transactions. It is used to prepare financial statements by external stakeholders, such as investors, creditors, and government agencies, to assess the business's financial health.
“Simply put, financial accounting deals with the broader financial picture of a company; cost accounting delves deeper into understanding and managing costs within the organization to enhance internal decision-making.” - Helena Lauchli, Accountant.
The three elements of a cost accounting system are materials, labor, and overhead.
The input for production. It’s broken down into two groups: direct and indirect materials.
Labor costs are another significant element in cost accounting, split into direct and indirect labor costs, depending on the nature of the work involved.
Overhead expenses are the costs incurred in running a business for the production of goods or delivery of services but which cannot be attributed to a specific good or service.
Here are some other examples of overhead expenses:
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Depending on your needs and measurement goals, you might practice one or several cost accounting methods. Some common costing methods include:
In standard costing, predetermined costs are used to track and control the costs of goods and services produced or provided by a business.
The standard costs are based on the optimal use of labor and raw materials to produce the good or service under normal operating conditions.
Even though standard costs are assigned to these goods and services, the company still pays the actual costs. These actual costs are then compared to the standard costs to identify variances. Variances can be caused by several factors, such as changes in the cost of materials or labor or the production process.
“By using established price points, standard costing helps produce realistic spending plans. This helps bring strategic resource allocation in line with operational reality.” - James Angel, Co-CEO & Co-Founder at DYL.com
“Activity-based costing ignores the assumption that all the expenses should go to the product. Instead, it focuses on segregating the expenses to get finer details of information, which can show cause and effect and lead to better decision-making in the business. It, thus, also helps with decision-making as the managers can get more accurate figures for all production costs. Other advantages include a focus on activities and reduced costs.” - Miles Brookes, Director of Tax Strategy – CoinLedger
Activity-Based Costing (ABC) identifies and assigns overhead costs to products or services based on the activities that consume these costs. Activities are tasks or events with specific goals that contribute to the production process, such as operating machinery, assembling parts, or distributing finished goods.
Steps in ABC:
This method offers detailed insights into the cost drivers and can help businesses improve their cost efficiency by eliminating non-value-added activities.
“In some industries, ABC is required by law. For example, in the financial services industry, the SEC requires ABC. This ensures that financial services companies are accurately reporting their costs and that they are complying with all applicable regulations.” - Andrew Lokenauth, Fractional CFO
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Marginal costing, also called cost-volume-profit analysis, determines the impact on the cost of a product when one additional unit is added to production. It is an extremely useful method for deciding pricing, production, and other short-term economic aspects.
Marginal costing enables managers to identify the varying levels of impact that different costs and volumes have on operating profit. Management can also use it to make informed decisions about pricing, product development, and marketing.
Lean accounting is a cost accounting system that is based on the principles of lean manufacturing. Lean manufacturing is a production system that seeks to eliminate waste and inefficiency. Lean accounting follows this same philosophy by focusing on the costs that add value to the product or service and eliminating the costs that do not.
For instance, an accountant can use lean accounting to identify and eliminate wasted time in the production process. Employees can use the saved time to focus on more value-added tasks.
Process costing is typically used by businesses that produce goods in large, continuous quantities, such as chemicals, textiles, or food products. This method assigns costs to each stage of the production process, rather than individual units, and then averages the total costs over the units produced.
Process costing is ideal for businesses with homogenous products, as it helps determine the total cost of production for each stage and ensures accurate tracking of the cost flow through various departments. It’s essential for industries where the final product results from multiple, ongoing processes.
Job costing, on the other hand, is used by businesses that produce products or services based on specific customer orders. Each job or project is unique, with its costs for materials, labor, and overhead.
For instance, in construction or custom furniture manufacturing, each job may require different materials and labor. With job costing, the business tracks the direct and indirect costs associated with each project to ensure accurate pricing and profitability analysis for that specific job.
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Here’s a breakdown of the nine most important cost accounting formulas:
The break-even point is when the total revenue equals the total cost. It is calculated by dividing the fixed cost by the unit cost.
Break-even point = Fixed cost / Unit cost
Example:
If your fixed costs are $10,000 and the unit cost of your product is $50, you would need to sell 200 units to break even.
The contribution margin is the amount of money each unit sold contributes to covering the fixed costs. It is calculated by subtracting the variable cost from the selling price.
Contribution margin = Selling price - Variable cost
Example:
If a product sells for $100 and the variable cost is $40, the contribution margin is $60, meaning each unit contributes $60 toward covering fixed costs.
The target net income is the profit a business wants to make. It is calculated by adding the fixed cost and net target income and dividing it by the contribution margin per unit.
Target net income = (fixed cost + target net income) / (contribution margin per unit)
Example:
If a company has fixed costs of $10,000, a contribution margin of $20 per unit, and a target net income of $5,000, it must sell 750 units to reach that profit.
The gross margin is the amount of money that remains after the cost of goods sold has been deducted from the sales revenue. It is calculated by subtracting the cost of goods sold from the sales revenue.
Gross margin = Sales revenue - Cost of goods sold
Example:
If a company has sales revenue of $50,000 and the cost of goods sold is $30,000, the gross margin is $20,000.
The pre-tax dollars needed for purchase is the amount of money that a business needs to spend to purchase a product or service before taxes are taken into account. It is calculated by dividing the cost of an item by 1 - the tax rate.
Pre-tax dollars needed for purchase = cost of item / (1 - tax rate)
Example:
If an item costs $100 and the tax rate is 10%, the business must spend approximately $111.11 before applying taxes.
The price variance is the difference between the actual price paid for an item and the standard price. It can be either favorable or unfavorable.
Price variance = (actual price - standard price) x number of items purchased
Example:
If the actual price per unit is $25 and the standard price is $20, with 500 units purchased, the price variance is $2,500 (unfavorable).
The efficiency variance is the difference between the actual quantity used and the standard quantity. It can be either favorable or unfavorable.
Efficiency variance = actual quantity - standard quantity
Example:
If the standard quantity for production is 1,000 units but only 900 units were produced, the efficiency variance is 100 units (favorable).
The variable overhead variance is the difference between the actual variable overhead cost and the standard variable overhead cost. It can be either favorable or unfavorable.
Variable overhead variance = (actual labor hours - budgeted labor hours) x budgeted overhead labor rate
Example:
If actual labor hours were 1,500 and the budgeted labor hours were 1,200, with a budgeted overhead rate of $10 per hour, the variable overhead variance would be $3,000 (unfavorable).
The ending inventory is the amount of inventory a business has left at the end of a period. It is calculated by adding the beginning inventory to the purchases and subtracting the sales.
Ending inventory = beginning inventory + purchases - sales
Example:
If the beginning inventory was $5,000, purchases during the period were $2,000, and sales were $3,000, the ending inventory would be $4,000.
Beyond the formulas mentioned above, there are other essential metrics in cost accounting that provide further insights:
Unlike general accounting, cost accounting is an internally focused, organization-specific method used to track and control costs. A cost accounting system can be more flexible than traditional accounting when dividing costs and inventory, but the specific methods and techniques used will vary depending on the organization.
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Cost accounting is a system for identifying, measuring, and reporting the costs of goods and services. It is used by businesses to make informed decisions about pricing, budgeting, and profitability.
Cost accounting enables businesses to determine the following:
With cost accounting, a manager or management team will identify all the variable and fixed costs associated with production processes. In many cases, cost accounting involves measuring and recording costs individually and then comparing them to the output (or profits) to measure financial performance. This enables board directors and business owners to make future solid business decisions.
Cost accounting systems are used to determine whether a potential business venture is really worth an investor’s time and money. They help a manager or business owner to know how they can improve their brand’s efficiency, profitability, and overall operations.
While these costs vary depending on the type of industry and firm, specific cost categories typically included are direct, indirect, variable, fixed, and operating costs.
Since cost-accounting methods are developed for a specific firm, they
“Cost accounting helps organizations gain a deeper understanding of their cost structures, enabling them to identify cost-saving opportunities and reduce wastage. This leads to better cost control and increased profitability.” - Helena Lauchli, Accountant.
Cost accounting and some of its associated techniques can be
“Cost accounting often involves estimates and assumptions (like overhead allocation), which may not always accurately reflect the true costs. This can lead to errors in decision-making if not properly managed.” - Sherman Standberry at MyCPACoach
There are many times when cost accounting could be a wise idea. Say that you run a small business and you are bleeding cash. Despite business booming better than ever and more customers coming to your brand, you can't turn a profit no matter what you try. Performing a cost accounting analysis is what you need.
By running an activity-based cost accounting analysis, you’ll determine exactly what the individual products and services you offer cost your brand in the long run. Through this analysis, for instance, you might discover that one of your products – which isn’t all that popular with your customers – costs your business much more money in terms of what it brings in.
Now that you have this information, you can remove that less-than-popular product and stop offering it. Not only do you save money as you don't have to create that expensive product, but you also boost your overall conversion rate since customers have fewer products.
This is just one hypothetical example of how cost accounting systems are used to maximize your brand and its monetary efficiency. Cost accounting gives you a detailed look at:
This is all precious information, especially if you run a small business as a CEO or manager and must make tough financial decisions yourself.
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Cost accounting is a powerful tool, but it’s not without pitfalls. Here are some common mistakes to avoid:
Implementing cost accounting in your business can be transformative, but it's important to approach it systematically. Here's a step-by-step guide:
Job costing is a method used to track costs associated with specific jobs or projects. Each job is treated as a unique entity, and all costs–materials, labor, and overhead–are tracked separately for that specific job. Job costing is commonly used in industries where products or services are custom-made, such as construction or consulting.
This method provides detailed insights into the profitability of individual projects, enabling businesses to set appropriate pricing and manage resources more efficiently.
Overheads are indirect costs that cannot be traced directly to producing a specific product or service. These costs are necessary to run the business but are not tied directly to any one item. Examples include rent, utilities, and administrative salaries.
Overhead costs are typically divided into two categories:
Overheads are crucial to factor into your cost accounting as they contribute to the overall cost structure of your business.
Period costs are expenses that are not directly tied to the production of goods or services and are expensed in the period in which they are incurred. Unlike product costs, which are associated with the cost of creating inventory, period costs are more aligned with the general operations of the business. Examples include administrative expenses, marketing costs, and rent.
Period costs are recorded on the income statement in the period they are incurred, regardless of when the product they are associated with is sold.
Prime cost refers to the direct costs associated with the production of goods. It includes both direct materials and direct labor but excludes overhead costs. Prime cost provides a clear understanding of the expenses directly involved in manufacturing a product, making it useful for pricing and budgeting decisions.
Prime cost = Direct materials+Direct labor
Example:
If direct material costs for producing a product are $50 and direct labor costs are $30, the prime cost for that product would be $80.
Cost accounting is an invaluable tool for any business looking to manage its expenses effectively, optimize operations, and make informed financial decisions. By understanding the various methods and formulas of cost accounting, businesses can gain insights into their cost structure, track profitability, and identify areas for improvement.
Incorporating modern tools like Fyle, an expense management software, can significantly streamline some of the more complex cost accounting processes.
Fyle’s integration with accounting systems can automate expense tracking, categorize costs accurately, and provide real-time visibility into employee spending. This not only helps reduce the manual effort involved in managing overhead and variable costs but also ensures more accurate and timely data for cost analysis.
Whether you're a small business owner or managing a large enterprise, implementing cost accounting, supported by tools like Fyle, can lead to smarter decision-making, better pricing strategies, and ultimately, a more profitable operation.
