Cost accounting is the process of recording, classifying, analyzing, allocating, and reporting an organization's costs. It is primarily used within management accounting to provide managers with information for planning, controlling operations, evaluating performance, pricing, and other business decisions. Unlike financial accounting, which is primarily concerned with reporting a business's financial position and results to external parties according to accounting standards, cost accounting is principally concerned with information for internal management.
Modern cost accounting developed during the Industrial Revolution as the increasing scale and complexity of businesses created a need to measure and allocate costs more systematically. Costs may be classified in several ways according to their relationship to products, business functions, production volume, controllability, timing, and managerial decisions. Basic cost elements include materials and labour, as well as expenses and other overheads, while common distinctions include direct and indirect costs and fixed and variable costs.
Cost accounting encompasses a range of methods designed for different managerial purposes. Some approaches are standard cost accounting and variance analysis, throughput accounting, activity-based costing, lean accounting, and marginal costing and cost–volume–profit analysis. These methods differ in how costs are measured and assigned and in the kinds of operational and strategic decisions they are intended to support.
Origins of cost accounting All types of businesses, whether manufacturing, trading or producing services, require cost accounting to track their activities. Cost accounting has long been used to help managers understand the costs of running a business. Modern cost accounting originated during the Industrial Revolution when the complexities of running large scale businesses led to the development of systems for recording and tracking costs to help business owners and managers make decisions. Various techniques used by cost accountants include standard costing and variance analysis, marginal costing and cost volume profit analysis, budgetary control, uniform costing, inter firm comparison, etc. Evaluation of cost accounting is mainly due to the limitations of financial accounting. Moreover, maintenance of cost records has been made compulsory in selected industries as notified by the government from time to time.Bhabatosh Banerjee, Cost accounting: theory and practice
In the early industrial age most of the costs incurred by a business were what modern accountants call "variable costs" because they varied directly with the amount of production. Money was spent on labour, raw materials, the power to run a factory, etc., in direct proportion to production. Managers could simply total the variable costs for a product and use this as a rough guide for decision-making processes.
Some costs tend to remain the same even during idle periods, unlike variable costs, which rise and fall with volume of work (and thus variable costs are higher in busy periods, and fall during idle periods). Over time, these "fixed costs" have become more important to managers. Examples of fixed costs include the depreciation of plant and equipment, and the cost of departments such as maintenance, tooling, production control, purchasing, quality control, storage and handling, plant supervision and engineering.Performance management, Paper f5. Kaplan Publishing UK. Pg 3
In the early nineteenth century, these costs were of little importance to most businesses. However, with the growth of railroads, steel and large scale manufacturing, by the late nineteenth century these costs were often more important than the variable cost of a product, and allocating them to a broad range of products led to bad decision making. Managers must understand fixed costs in order to make decisions about products and pricing.
For example: a company produces railway coaches and has only one product. To make each coach, the company needs to purchase $60 of raw materials and components and pay 6 labourers $40 each. Therefore, the total variable cost for each coach was $300. Knowing that making a coach requires spending $300, managers know they cannot sell below that price without losing money on each coach. Any price above $300 would make a contribution to the fixed costs of the company. If the fixed costs are, say, $1000 per month for rent, insurance and owner's salary, the company could therefore sell 5 coaches per month for a total of $3000 (priced at $600 each), or 10 coaches for a total of $4500 (priced at $450 each), and make a profit of $500 in each case.
Cost accounting vs financial accounting
+Differences between cost and financial accountingCost accountingFinancial accountingComputes costs in a rigorous manner that facilitates cost control and cost reduction.Analyzes transitions in the current accounting period into financial statements (Statement of Cash Flows, Profit or Loss, Balance Sheet, etc.). Reports only to the organization's internal management to aid their decision-making.Reports the results and financial position of the business to the government, creditors, investors, and other external parties.Cost classifications are based on functions, activities, products, processes, and the information needs of the organization in its planning and control.Cost classifications based on the types of transactions.Combines objective and subjective assessment of costs contributing to a standard result.Aims to present a 'true and fair' view of transactions.Information can be presented as accountants see fit.Must adhere to accounting standards such as the IFRS and GAAP.
Cost accounting methods The following are some of the different cost accounting approaches:
Elements of cost accounting
Basic cost elements are: Material Labour Expenses and other overheads
Material (inventory) The materials directly contributed to a product and those easily identifiable in the finished product are called direct materials. For example, paper in books, wood in furniture, plastic in a water tank, and leather in shoes are direct materials. Other, usually lower cost items or supporting material used in the production of in a finished product are called indirect materials. For example, lubricants used to keep machines running, or the chemicals used during the garment manufacturing processes.
Furthermore, these can be categorized into three different types of inventories that must be accounted for in different ways; raw materials, work-in-progress, and finished goods.
Labour Any wages paid to workers or a group of workers which may directly co-relate to any specific activity of production, maintenance, transportation of material, or product, and directly associate in the conversion of raw material into finished goods are called direct labour. Wages paid to trainees or apprentices does not come under the category of direct labour as they have no significant value.
Overheads Overheads include:
Production or works overhead including factory staff Administration overhead including office staff Sales overhead including production and maintenance of catalogues, advertising (development and purchases), exhibitions, sales staff, cost of money Distribution overhead Maintenance and repair including office equipment and factory machinery Supplies Utilities including gas, electric, water, sewer, and municipal assessments Other variable expenses Salaries/payroll including wages, pensions, and paycheck deductions (e.g., National Insurance and PAYE in the UK, FICA in the US) Occupancy (rent, mortgage, property taxes) Depreciation (durable goods including machinery and office equipment) Other fixed expenses
These categories are flexible, sometimes overlapping as different cost accounting principles are applied.
Classification of costs Important classifications of costs include: By nature or traceability: Direct costs and indirect costs. Direct costs are directly attributable/traceable to cost objects, while indirect costs (not being directly attributable) are allocated or apportioned to cost objects. By function: production, administration, selling and distribution, or research and development. By behavior: fixed, variable, or semi-variable. Fixed costs remain unchanged irrespective of changes in the production volume over a given period of time. Variable costs change according to the volume of production. Semi-variable costs are partly fixed and partly variable. By controllability: Controllable costs are those which can be controlled or influenced by conscious management action. Uncontrollable costs cannot be controlled or influenced by conscious management action. By normality: normal costs and abnormal costs. Normal costs arise during routine day-to-day business operations. Abnormal costs arise because of any abnormal activity or event not part of routine business operations, such as accidents or natural disasters. By time: Historical costs and predetermined costs. Historical costs are costs incurred in the past. Predetermined costs are computed in advance on basis of factors affecting cost elements. By decision-making costs: These costs are used for managerial decision making: Marginal costs: The marginal cost is the change in the total cost caused by increasing or decreasing output by one unit. Differential costs: This cost is the difference in total cost resulting from selecting one alternative over another. Opportunity costs: The value of a benefit sacrificed in favour of an alternative course of action. Relevant cost: The relevant cost is a cost which is relevant in various decisions of management. Replacement cost: This cost is the cost at which existing items of material or fixed assets can be replaced at present or at a future date. Shutdown cost: Costs incurred if operations are shut down, and which would not occur if operations are continued. Capacity cost: The cost incurred by a company for providing production, administration and selling and distribution capabilities in order to perform various functions. These costs are normally fixed costs. Sunk cost: A cost already incurred, which cannot be recovered. Other costs
Standard cost accounting
Standard Costing is a technique of Cost Accounting to compare the actual costs with standard costs (that are pre-defined) with the help of Variance Analysis. It is used to understand the variations of product costs in manufacturing. Standard costing allocates fixed costs incurred in an accounting period to the goods produced during that period. This allowed the full cost of products that were not sold in the period they were produced to be recorded as 'inventory' in the Balance sheet to be carried forward to the next accounting period, using a variety of complex accounting methods, which was consistent with the principles of GAAP (Generally Accepted Accounting Principles). It also essentially enabled managers to ignore the fixed costs, and look at the results of each period in relation to the "standard cost" for any given product.
For Example: if the railway coach company normally produced 40 coaches per month, and the fixed costs were still $1000/month, then each coach could be said to incur an Operating Cost/overhead of $25 =($1000 / 40). Adding this to the variable costs of $300 per coach produced a full cost of $325 per coach.
This method tended to slightly distort the resulting unit cost, but in mass-production industries that made one product line, and where the fixed costs were relatively low, the distortion was very minor.
For Example: if the railway coach company made 100 coaches one month, then the unit cost would become $310 per coach ($300 + ($1000 / 100)). If the next month the company made 50 coaches, then the unit cost = $320 per coach ($300 + ($1000 / 50)), a relatively minor difference.