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What is Cost Accounting? Definition, Advantages, and Types

All businesses have to monitor their costs to ensure the most profit for their cost. In this article, we look at what cost accounting is and different types businesses can use, as well as the advantages of this form of accounting.

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Cost accounting is the process of measuring, analyzing, and managing the cost of producing goods and services. Benefits of using cost accounting include providing information on the cost of manufacturing goods for decision-making, helping to improve efficiency and effectiveness of the flow from production to the customer’s hands, and aiding in financial planning and control.

There are several different types of cost accounting, each with its own advantages and disadvantages. The most common types are standard costing, lean accounting, marginal costing, and activity-based costing.

Let’s look at cost accounting in a bit more detail, including its definition, advantages, different types, and how it compares to financial accounting.

Cost Accounting Definition

Cost accounting is part of managerial accounting used to determine the cost of production by collecting and analyzing data from the manufacturing process.

There are various costs associated with production, including direct costs, indirect costs, fixed costs, variable costs, and operating costs. Cost accounting seeks to identify, measure, and manage all of these types of costs.

The goal of cost accounting is to help managers make decisions by providing accurate and timely information about the costs of goods and services. 

Cost Accounting vs Financial Accounting

From the outside, cost accounting and financial accounting may sound like the same thing. In actuality both have very different goals and approaches to accounting.

The goal of cost accounting is to provide managers with a comprehensive picture of production costs, while financial accounting is focused on informing stakeholders of a company’s earnings and expenses while maintaining compliance.

One key difference between cost accounting and financial accounting is that cost accounting doesn’t follow the Generally Accepted Accounting Principles (GAAP). This means that cost accounting can be tailored to the specific needs of a company, such as tracking the detailed costs of production, while financial accounting must adhere to a set of public standards used in preparation of financial statements.

For example, in cost accounting you can use activity-based costing methods, which assign costs to specific activities rather than products or services. This would also not be acceptable in financial accounting because it would not provide accurate information about the overall financial position of the company.

Advantages of Cost Accounting

The strongest advantages of cost accounting are cost control, inventory valuation, and adaptability.

Let’s take a closer look at what each advantage means.

Cost Control

By understanding where money is being spent, managers can make informed decisions about where to cut costs and where to invest in order to improve efficiency.

Cost accounting can help businesses to track cost overruns and identify areas where policy changes could lead to significant cost savings.

When managers understand the cost implications of their decisions, they are better equipped to know where to allocate resources in order to minimize costs.

Inventory Valuation

In order to make sound financial decisions, businesses need to have an accurate picture of the value of their inventory. This is because an inaccurate reading of their inventory value can have rippling effects on their profitability and be the difference between going bankrupt and staying alive.

Inventory valuation can be done on a per-unit basis or on a weighted average basis. Under the per-unit basis, the cost of each unit of inventory is determined separately. Whereas under the weighted average basis, the cost of all units of inventory is combined and divided by the total number of units to determine the average cost per unit.

The weighted average method is generally more accurate, but the per-unit method is simpler and easier to understand.

The objectives of valuing inventory are to determine the gross income and ascertain a company’s financial position. 

Adaptability

Unlike financial accounting, which has a set of rules and regulations that must be complied with, cost accounting can be customized to suit the specific needs of a business.

For example,a business might need to change its product mix in response to a change in customer demand. Cost accounting can be used to track the cost of each component of the product mix and help the business make quick decisions about which products to produce more or less of.

This flexibility makes cost accounting an ideal tool for businesses that operate in rapidly changing environments or that need to make quick decisions.

Adaptability is a key strength of cost accounting and an important reason why it is used by businesses of all sizes. 

Types of Cost Accounting

There are four main types of cost accounting: standard costing, lean accounting, activity-based costing, and marginal costing.

Let’s take a closer look at each one.

Standard Costing

Standard costing uses predetermined costs to value inventory and determine the costs of products or services. It is generally used in manufacturing businesses where production volumes are high and costs are relatively easy to predict.

Under standard costing, each unit of product is assigned a set cost for materials, labor, and overhead. These costs are then used to value inventory and calculate the cost of goods sold.

Standard costing is practical for budgeting and decision-making, as it provides a clear picture of the expected costs of production. The downside to assuming costs this way is that it can lead to unrealistic expectations if actual production costs deviates away from the assumptions.

To manage the difference between actual and standard costs, variances are calculated and applied. There are two types of variance: favorable and unfavorable.

A favorable variance occurs when actual costs are less than standard costs. For example, if the standard cost of an item is $10 and the actual cost comes to $9, the difference of $1 is considered a favorable variance.

An unfavorable variance occurs when actual costs are greater than standard costs. For example, if the standard cost of a widget is $10 and the actual cost is $11, the difference of $1 is considered an unfavorable variance.

Activity-Based Costing

Activity-Based Costing (ABC) is a type of cost accounting that identifies activities within an organization and assigns costs of those activities to products and services. The goal of ABC is to more accurately assign costs to products and services than traditional cost accounting methods.

ABC includes a greater variety of cost drivers, such as worker’s salary, utility costs required to power the operation, the number of customer orders, or the length of time required to complete an activity.

For example, consider a company that manufactures backpacks. The company might use a standard costing method and assign the cost of materials, labor, and overhead to each backpack based on the number of backpacks produced. 

Under an ABC system, the company would instead assign the cost of materials, labor, and overhead to each backpack based on the number of activities required to produce the backpack.

The cost of materials would be assigned based on the number of operations required to assemble the backpack, such as cutting the fabric, sewing, and attaching the zippers. The cost of labor would be assigned based on the number of hours required to complete each operation. 

The overhead cost would be assigned based on the number of machine hours required to complete the backpack. As a result, ABC provides a more accurate picture of the true cost of producing each backpack. 

While the ABC method is more complex and time-consuming to calculate than traditional methods, it can also produce more meaningful information that can help companies form a more appropriate pricing strategy.

Lean Accounting

Lean accounting focuses on eliminating waste and reducing costs throughout the organization, and is based on the principles of lean manufacturing, which emphasizes continuous improvement and the efficient use of resources.

There are five principles of lean accounting: to define value, to map value, create flow, establish pull, and pursue perfection. Lean accounting applies these principles to the financial side of the business, such as budgeting, forecasting, and reporting.

Lean accounting focuses on optimizing activities that add value to the customer, while eliminating or reducing those that do not. Lean accounting also strives to create a “flow” of work, meaning that each step in the process is smoothly connected to the next.

An example of lean accounting in action is where a financial manager uses data to identify areas of waste in a production process. The manager then works with the production team to eliminate the waste and improve the process. As a result, the company saves money and increases profits.

While lean accounting can be beneficial for organizations, it can also be challenging to implement. Companies need to have a strong commitment to continuous improvement and be willing to invest in data collection and analysis. They also need to have the resources and capabilities to put the principles of lean accounting into practice. 

Marginal Costing

Marginal costing (cost-volume-profit analysis) is a type of cost accounting that focuses on the variable costs associated with producing one additional unit of a product. This is most commonly used to optimize production and maximize profits.

Marginal costs are calculated by dividing the changes in production costs by the change in the number of units produced. To illustrate, assume that a company incurs $100 in additional costs when it produces 10 additional units of a product. The marginal cost of producing those 10 units would be $10 ($100/10).

Marginal costing helps in determining when and where to optimize production. For example, if the marginal cost of producing one additional unit is less than the selling price, then it makes sense to produce more units. 

Conclusion

Cost accounting is a critical tool for decision-making in any business, with a variety of methods catered to specific company goals, whether you’re looking to expand your business or keep it lean. 

Although cost accounting can be complex, it is invaluable for understanding the true cost of producing products and services. By using cost accounting internally, businesses can make informed decisions that help them save money and grow.

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