Definition and Standards of Cost Accounting | Business Success

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Cost accounting is often used in midsize and large, established businesses to calculate all costs of doing business. It is used to determine if the generated income is substantiated. To begin with, knowing the definition, principles, and jargon is extremely important for understanding what cost accounting is. At that point, you can determine the types of cost accounting and utilize the standards set forth.

Definition: What is Cost Accounting?

Cost accounting is a very valuable tool that is used to evaluate costs in a business. You may utilize cost accounting to figure out the appropriate pricing of a product or determine if your marketing dollars are generating an appropriate amount of income. This allows a business to evaluate its margin while still turning a reasonable profit.

The definition of cost accounting starts by totaling all costs of production, such as variable and fixed costs. Then, using that number, they compare it to the output results.

The perks of cost accounting for business cannot be argued. This helps management obtain a clearer picture of how the resources are being used within the company. It also helps to make month-to-month decisions on budgeting.

Are There Types of Cost Accounting?

Person taking notes and using a calculator at their desk

In short, yes, there are a few different types of cost accounting strategies that businesses use. Determining which style you use will most often come down to preference and business type. Let’s break down the types of cost accounting so you can find which one works for you.

Standard costing

A traditional cost accounting method, standard costing is often used by manufacturers. This branch estimates the expenses of production in order to plan for the following year. Because these costs are estimates, there is often a difference in the standard cost of production and the actual cost.

Depending on the degree of variance between these numbers and in what direction they diverge, you may have a favorable or unfavorable production year based on the analysis.

Let’s say you planned for costs to be $500,000 and anticipate to make $700,000 for the year. Then, at the end of the year, your actual costs were $600,000 and you made $700,000, then that would be an unfavorable outcome. Whereas if your costs stayed at $500,000 and you ended up making $800,000, that would be a favorable outcome.

Advantages of standard costing

This analysis is one of the best types of cost accounting. It is efficient by nature and has a cost control advantage. Generating an analysis can be done in a day, depending on the size of your business, and can be used to make decisions as you go through the year.

If done correctly, it will allow you to make a more accurate budget and stick with it as the months go by.

Disadvantages of standard costing

In some cases, this analysis highlights purely the costs of doing business and doesn’t take into account that sometimes those costs are worth it in the long run to amplify your production.

Activity-Based costing (ABC)

Assigning overhead and indirect costs to products and services is what makes activity-based costing stand apart from the rest. Most other methods only apply direct costs to these types of activities, so this allows a more accurate representation of what things cost to make. This is especially important for pricing products which is why many production companies use it.

With a product in mind, you can calculate its cost by tracking all of the activities required to produce it, then dividing those into cost pools. Then calculate the cost driver rate and determine if the price of the product gives you enough of a margin to make a decent profit.

Advantages of activity-based costing

It will be really easy to make informed decisions about the costs and pricing of products with this type of cost accounting. You will also be able to see just how much facility costs, marketing, and testing go into your products. With all of that information, you can see what steps in the process can be outsourced or reduced to increase your margins.

Disadvantages of activity-based costing

A large amount of data that needs to be tracked and calculated can make it a tedious analysis. Just getting these numbers can lead to confusion. Also, the costs of things change all the time, so calculations can quickly become outdated.

Lean accounting

Lean accounting works hand-in-hand with lean manufacturing which rewards the streamlining of operations and efficiency. It looks at the big picture rather than the benefits of the individual parts.

For example, if your company manufactures 100,000 dials that you use to make a stovetop unit, but only use 50,000 of them, lean accounting would calculate the remaining 50,000 as a loss. The reason for this is that those remaining dials are taking up space, time, and not being sold for profit. This diverges from the typical accounting measure which would calculate those dials as an asset.

Woman using a calculator and reviewing invoices at her desk

Short turnaround times and only making what you will need are things that lean accounting practices benefit from.

Advantages of lean accounting

You will not be making any products that you aren’t going to sell which may help bring down costs. In addition, reducing clutter can help with employee morale, safety, and efficiency. Production time from start to customer may also be shortened, helping your customer service get a little boost as well.

Disadvantages of lean accounting

The time it takes to implement this will be lengthy and the thought process takes time to understand. Reorganizing your process, whether internally or in regards to your suppliers, may also take time to set in line.

Marginal costing

Marginal costing helps manufacturers determine if boosting production and it’s associated costs will benefit the company because of the additional products that come with it. If the marginal costs reduce as you ramp up, then it may be a good idea to do so until you see those margins rise again.

As an example, in food production, purchasing a bulk amount of a specific ingredient may allow you to take advantage of a discount. You will then be able to make more of that food item and subsequently sell more. This would make your price per item less and allow a bigger margin if you sold those items at the same price.

But this tactic doesn’t necessarily work in all cases.

If you purchase a larger amount of eggs for your cake production, but are unable to manufacture more without buying another mixing machine, the cost per finished item will greatly increase.

Advantages of marginal costing

You should know at what point you are making the most out of your production, because you want to be able to take advantage of what you already have. Find that maximum production point and exploit it.

Disadvantages of marginal costing

In order to grow a manufacturing business, you need to be able to increase your margin and/or produce more products. By looking purely at this calculation, you may be discouraged from making large purchases. Buying manufacturing tools and equipment will temporarily shrink your margins. But at some point you will need to make that decision to grow.

How do I Treat Fixed Costs in Cost Accounting?

Fixed costs and variable costs are the two categories of costs when calculating cost accounting. But unlike variable costs, fixed and overhead costs are harder to integrate into your cost accounting analysis. Line items such as rent, utilities, payroll, insurance, training, etc. are indirectly accounting for a large part of your business’s costs and need to be represented in your analyses.

The fixed costs plus the variable costs make up the total expenses for a business.

Some items such as electricity are both fixed and variable, making it difficult to determine. For example, there is a fixed quality to the amount of electricity a company uses, but it can increase if production goes up and vice versa.

Calculating the costs of doing business is one of the most important aspects in ensuring that you make money and grow. So it is important that you include fixed costs into your cost accounting analyses.

Starting a Business in Cost Accounting?

When an individual or group decides to begin a business it is no surprise that they will want to make a profit. No matter if it’s a product or service, cost accounting services are important. What are the costs of manufacturing the products that will be offered? Is there a middleman involved that will need to be paid? What are the other costs associated with running the business? How will all these numbers fit with making the business profitable? This is what business owners want to know. They will also want to know where money can be saved in order to raise profit. This is where you as the accountant performing the cost accounting will be needed.

calculator and change sitting on a table

If you have always loved running numbers and work in the accounting field then starting your own business in this industry is perfect. It is important to remember that trustworthiness, integrity, and honesty are necessary in handling cost accounting for businesses. Having a solid grasp on financial practices and principles is also needed. 

According to Statista, about 4 million people use financial accounting services a year and the numbers are growing. Well over 2 million clerks and accountants generated about $137 million in revenue in the year 2013 and the revenue is growing rapidly. 

The Bureau of Labor Statistics reports that the accounting industry will grow by as much as 12 percent between 2014 and 2024, this exceeds the average growth for all other occupations combined. Point is, when the economy thrives, the accounting industry also thrives. 

Cost Accounting Startup Costs

Startup costs will depend on a few things.

  • How will you deliver your services to the target market?
  • What is your revenue goal?
  • Where will your business be located geographically? 
  • Will you be operating a home office or renting a space? 
  • The cost of operating your office and equipment needed.

Accepting Payments from Customers

When opening your own business you will need to decide how you will be accepting payments from your customers. Making it easy for your customers to pay their invoices allows a smooth process for both you and your clients. It is important to keep in mind that there will be customers that will want to pay for your services both over the phone and with credit cards.

Make sure that you can accommodate your clients and ensure that your payments are PCI compliant and secure. Credit card processing companies will be able to help you navigate these hurdles as you find the capabilities that fit your business.