If you’re a business operator, you’re likely wondering, “what is cost accounting?”
Cost accounting is simply creating a system that allows you to fully understand the costs related to your product or service. This also involves understanding how much money it takes in order for you to fulfill customer requests.
Thus, with cost accounting, you can accurately determine the cost of the product you’re selling, which is essential if you want to make a profit.
This post covers the types of cost accounting, how it works, and some of the most frequently asked questions about it.
Types of Cost Accounting
Standard costing involves assigning “standard” costs instead of actual costs to its cost of goods sold (COGS) and inventory. These costs focus on the efficient utilization of materials and labor to produce your goods or services with standard operating conditions in mind. This is basically the budgeted allotment of labor and materials.
While standard costs get assigned to your goods, your operation still has to cover the actual costs.
Variance analysis involves analyzing how the standard cost and actual cost differ. Through this analysis, you’ll determine whether your actual expenses are beyond what you expected. If it is, then the variance is unfavorable. But if you see that the actual costs are less than expected, the variance is favorable.
The cost of input, like the cost of materials and labor, will influence variance favorability. But so does the efficiency or quantity of input utilized, as this is a volume variance.
Activity-based costing is a variation of standard costing. But rather than using a predetermined average cost to assign to your inventory, it assigns costs based on the actual activity you used to produce your items. This includes direct labor, materials, and overhead costs.
This type of costing is based on how you allocate your expenses instead of based on predetermined costs that may or not be accurate.
Activity-based costing is effective for companies that experience fluctuating production rates due to seasonal changes in demand and because the business has different product life cycles. Since these activities are observable as cost drivers, they’re used to measure how to allocate overhead costs.
Most of the time, overhead costs get assigned based on a since generic measure, like machine hours. Thus, activity-based costing is usually more accurate and helpful for analyzing the cost and profitability of a company’s services and products.
Lean accounting focuses on improving financial management practices for companies. This utilizes the philosophy of lean production and manufacturing, which highlights waste minimization and productivity optimization.
For instance, if your operation can lessen the wasted time, your staff can use that saved time on tasks to add value.
Lean accounting replaces traditional costing methods with value-based pricing and lean-focused performance measurements. Any time a financial decision is made, it focuses on how each will impact the operation’s total value stream profitability. These value streams generate profit for the operation, ultimately adding to bottom-line profitability.
Marginal costing, also known as cost-volume-profit analysis, focuses on the incremental costs and profit from a particular action. It’s important for businesses to understand this because it’ll determine if a company can sell a product or service at the desired profit margin.
The basic premise is that costs increase as you produce more units of a product. At the same time, the additional units sold increases the profit that a company can generate.
For instance, if you know what each product costs to produce and sell, you’ll be able to make solid decisions about which product you should sell more of, as well as what products to drop from your inventory. You can also identify how costs and volume impact operating profit.
Management can use this type of analysis to identify potentially profitable new products, as well as sale prices for existing products and the efficacy of marketing campaigns.
Types of Costs
Cost accounting involves several types of costs. Keep these in mind as you’re determining the costs involved in running your operation:
Your fixed costs stay the same, no matter what. Most of the time, these include utilities and rent. But they can include mortgages or lease payments on buildings or a piece of equipment that depreciates at a fixed monthly rate. Keep in mind, if your production levels change for better or worse, your fixed costs should not change.
Variable costs change based on how much you’re selling. For example, this category includes inventory and labor related to production. If you’re manufacturing, your variable costs include materials. This cost goes down based on the unit price of the item.
These costs fall somewhere in between fixed and variable costs and can vary depending on business conditions. Some examples of this include packaging, breakage costs, and postage.
Your operating costs are related to your day-to-day operations. These include office supplies, fixed salaries, and contracts with vendors you use on a regular basis.
Direct costs are related to the production of the product or service. This includes materials, direct labor, and overhead. For example, if you’re producing cannabis fertilizer, your direct costs include the cost of the materials and the hourly wages for people who work on these products.
Your indirect costs are not related to the production of your product. They include facilities, insurance, advertising, shipping and distribution costs, etc. For example, the cannabis fertilizer producer would put the marketing costs in this category because it’s not exact and cannot be connected to individual products.
How Does Cost Accounting Work?
In order to make a profit in business, you need to understand the costs associated with making your product. Then, multiply your total costs by your price per unit.
Once you know your costs and how much you stand to make from every sale, you will have an accurate understanding of whether or not each transaction will be profitable.
A great way to learn the basics of cost accounting is with an actual example. Let’s say you’re producing fertilizer for indoor cannabis growers.
You know your fixed costs are $10,200 per month. Your variable costs include purchasing the materials for each pound of fertilizer you create, which is $3.50 per pound, and your labor costs are $0.32 per hour for each person who works on this project.
Your operating costs are $1,000 per month. Your direct costs are the materials that go into each pound of fertilizer ($3.50), and your overhead costs are the facilities you use to manufacture each pound of fertilizer ($0.55).
You decide to make 1000 pounds of fertilizer per month. The price you charge for each pound is $30 per pound. Because your fixed costs are the same no matter how many pounds of fertilizer you make, your profit per pound is $22.70 ($30 – ($3.50 +$0.55)).
Reflecting on Cost Accounting
While cost accounting has its place in the world, it comes with some drawbacks. These accounting systems can be expensive to develop and implement. But it’s equally important to note that training is time-intensive and can take some trial and error to get right.
If you need assistance with developing and implementing a cost accounting system, feel free to contact us. Our experts are eager to help!