Meaning of Cost Accounting
Cost accounting is a method of managerial accounting which aims to capture the total production cost of a business by measuring the variable costs of each production phase as well as fixed costs, such as a lease expense.
Historians believe that cost accounting was first introduced during the industrial revolution when the new global supply and demand economies forced producers to begin monitoring their fixed and variable costs to automate their manufacturing processes.
Cost accounting allowed rail and steel companies to manage costs and make themselves more competitive. By the early 20th century, cost accounting had become a widely discussed subject in the literature of business management.
A company's internal management department uses cost accounting to define both variable and fixed costs associated with the manufacturing process. It will first individually calculate and report these costs, then compare input costs with production results to assist in assessing financial performance and in making potential business decisions.
Types of Cost Accounting
Job Costing
Job Costing is commonly used in industries such as construction, manufacturing, and custom design. In this method, the costs of materials, labor, and overhead are allocated to each job or order. This allows the business to determine the profitability of each job and make decisions about pricing and resource allocation.
Process Costing
Process costing is used in industries that produce large quantities of identical or similar products, such as chemical processing or food manufacturing. In this method, the costs of materials, labor, and overhead are allocated to each process or stage of production, rather than to individual products. This allows the business to determine the cost per unit of production and make decisions about pricing and resource allocation.
Standard Costing
Standard costing is a method of cost accounting that involves setting standard costs for materials, labor, and overhead and then comparing actual costs to the standards. This allows the business to identify areas of inefficiency and make improvements to reduce costs. Standard costing is commonly used in industries such as manufacturing, where production is highly standardized.
Activity-Based Costing
Activity-Based Costing is used to identify the cost drivers of each activity and allocate costs accordingly. ABC is commonly used in industries where overhead costs are significant and difficult to allocate, such as service industries.
How Cost Accounting Works
There are several key steps involved in cost accounting:
Classify costs: Once costs have been identified, they need to be classified according to their nature and function. For example, costs may be classified as variable or fixed, direct or indirect, or product or period costs.
Assign costs: After costs have been classified, they need to be assigned to the products or services they relate to. This involves allocating costs to specific products based on the resources consumed in their production.
Analyze cost data: Once cost data has been collected and organized, it can be analyzed to identify areas for cost reduction and opportunities for improvement.
Make informed decisions: The final step in cost accounting is to use the cost data to make informed business decisions. This might involve setting prices based on the cost of producing a product, or identifying areas where costs can be reduced to improve profitability.
Importance of Cost Accounting
Cost accounting provides managers with accurate information on the costs associated with different products, services, and operations. This information enables them to identify areas of the business that require improvement and make informed decisions on cost reduction and efficiency measures. Additionally, cost accounting helps in setting prices for products and services that ensure profitability while remaining competitive.
Furthermore, cost accounting is crucial for budgeting and forecasting as it provides accurate data on past costs and trends, helping businesses plan for the future. It also assists in evaluating the performance of different departments and employees by providing data on cost and efficiency metrics.
Cost Accounting Advantages
Helps in determining the cost of production of a product or service accurately.
Helps in determining the selling price of a product or service Provides information for decision-making related to outsourcing, make-or-buy decisions, pricing strategies, etc.
Helps in evaluating the performance of different departments and identifying areas for improvement.
Helps in complying with legal and regulatory requirements related to financial reporting and tax laws.
Cost Accounting Disadvantages
Focus on past data: Cost accounting primarily deals with historical data, which can limit its usefulness in predicting future trends or making strategic decisions.
Limited scope: Cost accounting typically focuses on the costs associated with producing goods and services.
Difference between Cost Accounting and Financial Accounting
Cost accounting is sometimes used to assist decision-making by management within a business, whereas financial accounting is usually used by outside investors or creditors.
Financial accounting reveals the financial status and results of a corporation through financial statements to external outlets, which provide information regarding its sales, expenditures, assets, and liabilities.
Cost accounting can be most useful in budgeting and setting up cost reduction systems as a method for management, which will increase the company's net profits in future.
The key distinction between cost accounting and financial accounting is that while the costs are categorised according to the type of transaction in financial accounting, cost accounting classifies costs according to the management's information needs.
Cost accounting, as it is used by management as an internal method, does not have to follow any common requirements, such as commonly agreed accounting principles (GAAP) and, as a result, differs in use from business to company or department to department.
