Cost accounting is a kind of management accounting that enables a company’s managers and owners to precisely assess the entire costs involved with its manufacturing process. This enables them to make educated, cost-cutting choices that may essentially “make or break” an organisation financially.
The Fundamentals of Cost Accounting
To fully comprehend the fundamentals of cost accounting, as well as the various ways in which it can be used to quickly and accurately determine a business’s cost-cutting methods and current operational efficiency, you must first have a basic understanding of the various types of costs associated with running a business.
These expenses are often classified based on how their value fluctuates in response to a company’s levels of manufacturing output, and they include:
Costs that are fixed
Costs that change
Costs that are semi-variable
Let’s take a closer look at these expenditures.
Costs that are fixed
Fixed costs are expenses that are “fixed” regardless of the degree of production or consumption involved (as the term implies).
The following are some examples of fixed costs:
Insurance for businesses
Keep in mind that, in practise, fixed expenses do not stay constant, especially when viewed over a lengthy period of time. A more realistic explanation of fixed costs, on the other hand, would infer that they are expenses that are fixed in relation to any production changes that occur in the near term alone. This is due to the fact that a company’s fixed expenses may (and often do) shift dramatically over time.
For example, you may opt to obtain additional business insurance coverage (e.g., general liability insurance), lease a bigger number of corporate cars, or expand to more than one site in the future, all of which would raise your overall fixed expenditures.
Variable costs are those that vary according on your level of output. This is often a linear connection, with an increase in production increasing variable expenses correspondingly.
Variable expenses include the following:
Raw materials and product components
Costs of packaging
Expenses for business phone service
Costs that are semi-variable
Semi-variable costs are those that have both variable and fixed components. These expenses may vary depending on the degree of production involved, but they always include a fixed component that is independent of overall output.
Semi-variable costs are sometimes defined as the expenses that most closely represent the pragmatic realities of day-to-day business, since most company costs are seldom simply classified as either fully fixed or solely variable. In most cases, they will be a mix of the two.
In other circumstances, expenses may begin as fixed but then convert to a more variable structure after a specific amount of production is reached. Telephone bills, for example, will often contain a set basic price that is required every month, as well as extra charges that may be based on the number of calls made, the distance of the calls (national or transnational), and the total length of the conversations.
A direct cost is any expenditure that is directly tied to the entire amount of production of a business’s department or product.
While comparable to variable costs, direct expenses differ in that they may be “traced” directly to a specific product. Variable costs, on the other hand, will vary substantially depending on the overall amount of industrial output. This indicates that, although variable costs may constitute direct expenses, this does not always have to be the case.
For example, a company may manufacture two distinct sorts of items, each of which necessitates the use of distinct materials. While both are dependent on the overall output, the fact that the materials used for each product are solely dependent on a specific type of product means that they are classified as direct costs.
Simply said, they are a direct result of a specific product, rather than a generic expense incurred as a result of the whole output of a business’s manufacturing.
Indirect expenses (also known as administrative costs or indirect overheads) are costs that, unlike direct costs, cannot be immediately connected to the production of any one department or product in a corporation.
This means that, while indirect costs are influenced by a company’s total levels of production and output, unlike fixed costs, they are not “tied down” to any one product or department, and their value does not change proportionally with changes in output in the same way that direct costs’ value does.
A manufacturing business, for example, will need to acquire equipment based on overall levels of output, but this will have little to do with the wants or requirements of a specific product.
Various Cost Accounting Methods
Cost accounting has evolved into two separate forms throughout the years:
System of special order pricing
System for calculating process costs
Both systems are used to enable managers and business owners to collect data directly related to a company’s finances and operating expenditures.
System of Special Order Costs
A company’s output will consist of “custom” goods under a special order cost system of manufacture. These are manufactured separately when a firm receives a client’s request and include items such as:
Maritime vessels (tankers, bulk carriers, container ships, etc.)
Magazines and books
Specialty and unusual things (e.g., custom made shoes, hats, and clothes)
This implies that under a special order cost system, the cost of each special order would be documented separately on a cost sheet or accounting document, and each “job” would have its expenses recorded individually on a cost sheet or accounting document.
This sort of manufacturing is especially widespread in service organisations, such as those focused on law, architecture, and accountancy, since it allows management to simply “monitor” resources effectively and, as a result, determine the actual cost that a company would spend while serving a certain customer.
This may be very beneficial since it allows service-provider organisations to focus more human capital and resources on customers who are “worth it” financially.
In comparison to defending a relatively minor tort or criminal law case, a US law firm will typically invest significantly more resources when representing a nationwide class action, which can result in law firms receiving anywhere between 20% and 30% of the total awarded settlement as a contingency fee.
System of Process Costs
A process cost system, on the other hand, delivers a more consistent and predictable output of identical items (e.g., the ones made by automated machinery in production factories).
This implies that process cost accounting may be employed only when the finished product (or the components that comprise it) is nearly similar and manufactured in huge numbers — for example, a certain kind of computer hardware.
Completed items are then put in stock and withdrawn as soon as fresh orders are received from clients; no unique “jobs” exist that need any sorts of distinguishing adjustments.
Most businesses run their operations using both of the aforementioned approaches (at least to some extent). A manufacturing company may supply a certain item on a regular basis (for example, a car), but it may also offer a relatively small number of alternative component adjustments as a “addition” or restricted offer of that already existing vehicle on occasion.
As a result, although the overall cost of creating such an order would be established using a process cost-based system, calculating the price of each individual element connected with that order would need utilising a work order cost system.
This demonstrates the critical significance of cost accounting in the internal management, organisation, and financial literacy of organisations of all sizes and industries.
Choosing How Much Production Will Cost
Although job order and process cost accounting methods are extremely useful for providing numerical and financial data, they have some limitations when it comes to cost control. While these systems can exactly estimate what a product is now costing a firm, relatively few insights are provided in respect to how much a product “should” cost.
With no comparing numbers, the obvious concern is how company owners and managers will be able to determine how cost-effective their existing productions are and how many (if any) modifications would need to be done immediately.
A standard costing system, which is better classified as a “tool” that businesses can use in either a job order or a process cost system, uses pre-established standard industry costs to develop a measurement that then allows a business’s managers or owners to compare their own actual costs with the previously projected ones.
This might help a company’s internal management determine how much “room” for development it has.
Costing Based on Activity (ABC)
Activity-based costing is very valuable for businesses that wish to identify the real cost of their goods in a comprehensive manner, since it can be used to account for both fixed and indirect expenses connected with each product (e.g., the electric power required, etc.). This is helpful because it allows managers and company owners to more properly match their pricing to the costs of things.
For example, if Vehicle A needs 50 gigajoules to create while Vehicle B only requires 37, a manager or business owner may determine that the firm would benefit considerably by “passing down” the really lower cost of Vehicle B to customers while raising the cost of Vehicle A. (which, in real terms, is more expensive).
For example, if the amount of power used to make Vehicle A is 30% more than the amount required to produce Vehicle B, a company owner may opt to pass this along in the form of a price drop while raising the price of Vehicle A. (since it is more expensive).
Of course, the efficacy of such judgments will be determined by the price elasticity of demand for both items, but this is just one example of how cost accounting may be used to help managers and business owners make educated financial decisions regarding their organisation.
Accounting that is lean
Lean accounting, which gained popularity in the early twenty-first century, strives to make a firm’s financial statements simpler to comprehend and utilise, making them much more accessible to non-financial professionals inside the organisation.
The primary ideas of lean accounting are based on the assumption that information about a company’s activities is essentially simple. Lean accounting helps firm owners to “break down” expenses in a very particular manner by removing any unnecessary material, creating accurate information, and always adhering to generally accepted accounting standards (GAAP).
Lean accounting may assist company owners to obtain a more thorough picture of their organization’s operations’ performance by taking a proactive strategy where they can minimise unnecessary transactions and excessive expenditures on a regular basis.
Why Is Cost Accounting Necessary?
For almost a century, the necessity of cost accounting has been well acknowledged. Having said that, its influence has surely grown in recent years as a consequence of the world’s increasingly interconnected economic environment – even for extremely tiny enterprises.
Differences in production costs between countries — and the resulting comparative advantages — have increased pressure on many Western economies (including the US) to place an even greater emphasis on managing and controlling all internal production costs as much as possible.
Cost accounting can be used to gather useful information that will have a direct impact on a company’s management operations and future expansion plans.
A company’s internal management team may utilise cost accounting to make educated judgments about how its resources should be allocated in the future (increasing profits).
Is Cost Accounting Necessary for My Small Business?
Though few business owners feel the need to include cost accounting efforts into their operations until their company has expanded significantly in size, this is seldom the most efficient or ideal choice.
Because cost accounting systems inherently facilitate managers’ planning of a company’s future growth, business owners will inadvertently discover pivotal financial insights about their business — including their real budgets, standard and actual costs, and break-even analysis — within cost accounting.
As a result, although you may not want or “need” cost accounting when starting out, your organisation will most certainly profit from it anyway.