What is Cost Accounting?
Cost accounting refers to the process of recording, analyzing, and summarizing costs associated with a production process, and allocating the costs to specific products and services. The costs are first recorded individually, and then input and output costs are matched to determine the financial performance of the company.
The cost information obtained is then shared with the management to help them optimize business processes and plan for the future. Since the management makes decisions relating to the internal operations of the organizations, there is no need to compare the cost information to similar companies within the industry.
Cost Accounting vs. Financial Accounting
One of the key differences between cost accounting and financial accounting is where the information obtained is used. Cost accounting is an internal tool that is used by the management team to make decisions and set up cost control programs that boost the organization’s revenues. Financial accounting, on the other hand, reports the organization’s financial performance to external stakeholders such as government, creditors, investors, and other parties.
The other distinction is in how costs are classified. Financial accounting classifies the costs depending on the type of transaction, whereas cost accounting classifies costs based on the functions, processes, and information needs of the management. Unlike financial accounting, cost accounting is not guided by any rules dictated by the Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). It means that the cost accounting information presented to the management may differ from one company to another.
Types of Cost Accounting
The following are the main types of cost accounting:
1. Activity-based costing
Activity-based cost accounting assigns the cost of each activity performed in an organization to specific products and services according to their consumption. It assigns more indirect costs to direct costs compared to the traditional costing method. The indirect costs in each department are identified and assigned to specific cost objects like customers and products, and the method of allocating the costs is first decided in the activity analysis.
It means that the cost information is more accurate, and it can help managers understand the inputs and outputs of the organization’s products. Companies are motivated to adopt activity-based costing due to the need to improve costing accuracy of its products and services.
2. Marginal costing
Marginal costing, also referred to as cost-volume-profit analysis, is the analysis of the relationship between the production volume, sales, selling prices, costs, expenses, and profits of a product or service. The relationship is referred to as the contribution margin, and it gives insights into the amount of profits that the business can generate.
The contribution margin is obtained by dividing revenues minus variable cost by revenue. Marginal costing provides the management with useful cost information that is used in the decision-making process.
3. Lean accounting
Lean accounting is used in two ways. The first method is the application of lean accounting to a company’s accounting and control process. It can help the management speed up processes, eliminate errors and wastes, and free up the production capacity. The other method is changing the accounting and control processes so that they focus on lean change and improvement of processes.
Lean accounting works without other accounting methods such as activity-based costing and standard costing. Instead, the latter methods are replaced by simple, visual, and lean-focused performance measurements.
4. Standard accounting
The standard type of cost accounting uses ratios to compare the labor and materials used in the production process of a good with the labor and materials that the same good would’ve required to produce under standard conditions.
However, the standard cost accounting methods introduced over a century ago used labor as the only cost measurement since it was the most important cost of producing manufactured goods. Since then, overhead costs have increased in proportion to labor, and it means that allocating overhead cost as the overall cost can mislead the management.
Types of Costs
The following are the main types of cost involved in the production of goods and services:
1. Variable costs
Variable costs are costs that change with changes in the level of production. An example of a variable cost is the cost of raw materials used in the production process. If the level of production increases, the cost of raw materials will increase, whereas a reduction in the level of production will result in a similar decline in the cost of raw materials.
2. Fixed costs
Fixed costs are costs that remain constant even with a decrease or increase in the level of production. An example of a fixed cost is rent for the business premises. The business must pay the agreed rental cost, regardless of whether the business made sales or not.
3. Direct Costs
Direct costs are costs that are directly related to the production of a product and can be directly traced to that product. Direct labor is an example of a direct cost.
4. Indirect Costs
Indirect costs are costs that cannot be easily identified because they are involved in multiple activities, which makes it impossible to allocate the cost to one specific activity. For example, the rental cost incurred by a business may not be directly identified to a specific activity carried out on the premises, since there could be multiple activities taking place within the business premises.
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