Cost accounting is an accounting process that measures all of the costs associated with production, including both fixed and variable costs. The purpose of cost accounting is to assist management in decision-making processes that optimize operations based on efficient cost management. The costs included in cost accounting are discussed in detail below.
Key Takeaways
- Cost accounting is an accounting method that takes into consideration a company's total cost of production by evaluating both fixed and variable costs.
- Managers use cost accounting to help make business decisions based on efficient cost management.
- The types of costs evaluated in cost accounting include variable costs, fixed costs, direct costs, indirect costs, operating costs, opportunity costs, sunk costs, and controllable costs.
- Cost accounting is not generally accepted accounting principles (GAAP) compliant and can only be used for internal decision-making.
Direct Costs
Direct costs arerelated to producing a good or service. A direct cost includesraw materials, labor, and expense or distribution costs associated with producing a product. The cost can easily be traced to a product, department, or project.
For example, Ford Motor Company (F) manufactures cars and trucks.Aplant worker spends eight hours building a car. The direct costs associated with the car are the wages paid to the worker and the cost of the parts used to build the car.
Indirect Costs
Indirect costs, on the other hand, areexpenses unrelated to producing a good or service. An indirect cost cannot be easily traced to a product, department, activity, or project. For example, with Ford, thedirect costs associated with each vehicle includetires andsteel.
However, the electricity used to power the plantis considered an indirect cost because the electricity is used for all the products made in the plant. No one productcan be traced back to the electric bill.
Fixed Costs
Fixed costs donot vary with the number of goods or services a company produces over the short term. For example, suppose a company leases a machine for production for two years. The company has to pay $2,000 per month to cover the cost of the lease, no matter how many products that machine is used to make. The lease payment is considered a fixed cost as it remains unchanged.
Variable Costs
Variable costs fluctuateas the level of production output changes, contrary to a fixed cost. This type of cost varies depending on the number of products a company produces. A variable cost increases as the production volume increases, and it falls as the production volume decreases. Businesses can also decide to forego an activity or production to avoid the associated expenses—called the avoidable costs.
For example, a toy manufacturer must package its toys before shipping products out to stores. This is considered a type of variable cost because, as the manufacturer produces more toys, its packaging costs increase, however, if the toy manufacturer's production level is decreasing, the variable cost associated with the packaging decreases.
Operating Costs
Operating costsareexpenses associated with day-to-day business activitiesbut are not traced back to one product. Operating costs canbe variable or fixed. Examples ofoperating costs, which are more commonly called operating expenses,include rent andutilitiesfor a manufacturing plant.
Operating costs areday-to-day expenses, but are classified separately from indirect costs – i.e., costs tied to actual production. Investors cancalculate a company's operating expense ratio, which shows how efficient a company is in using its costs togeneratesales.
Opportunity Costs
Opportunity costis thebenefits of an alternative given up when one decision is made over another. This cost is, therefore, most relevant for two mutually exclusive events. In investing, it'sthe difference in return between a chosen investment and one that is passed up. For companies, opportunity costsdo notshow up in the financial statementsbut are useful in planningby management.
For example, a company decides to buy a new piece ofmanufacturing equipment rather than lease it. The opportunity cost would be the difference between the cost of thecash outlay for the equipment and the improved productivity versus how much money could have been saved in interest expense had themoneybeen used to pay down debt.
Sunk Costs
Sunk costs arehistorical costs that have already been incurred andwill not make any difference in the currentdecisions by management.Sunk costs are those costs that acompany hascommitted to and are unavoidable orunrecoverable costs.Sunk costs are excluded from future business decisions.
Controllable Costs
Controllable costsareexpenses managers have control over and have the power toincrease or decrease. Controllable costs are considered when the decision of taking on the cost is made by one individual. Common examples of controllable costs are office supplies, advertising expenses, employee bonuses, and charitable donations. Controllable costs are categorized as short-term costs as they can be adjusted quickly.
What Are the Types of Cost Accounting?
The different types of cost accounting include standard costing, activity-based costing, lean accounting, and marginal costing. Standard costing uses standard costs rather than actual costs for cost of goods sold (COGS) and inventory. Activity-based costing takes overhead costs from different departments and pairs them with certain cost objects. Lean accounting replaces traditional costing methods with value-based pricing. Marginal costing evaluates the impact on cost by adding one additional unit into production.
What Is the Main Purpose of Cost Accounting?
The main purpose of cost accounting is to evaluate the costs of a business and based on the data, make better decisions, improve efficiency, determine the best selling price, reduce costs, and determine the profit of each activity involved in the operational process.
What Is the Difference Between Cost Accounting and Financial Accounting?
Cost accounting focuses on a business's costs and uses the data on costs to make better business decisions, with the goal of reducing costs and improving profitability at every stage of the operational process. Financial accounting is focused on reporting the financial results and financial condition of the entire business entity.
The Bottom Line
Cost accounting looks to assess the different costs of a business and how they impact operations, costs, efficiency, and profits. Individually assessing a company's cost structure allows management to improve the way it runs its business and therefore improve the value of the firm.
