Business costs are a great way for an entity to track the state of their total assets and liabilities. It is virtually impossible for a business to know how much money is coming in and out if a business has not established a proper accounting system. The costs of a business should be calculated periodically, because it can be used to create a break-even analysis that will help the management identify what are the areas that need to be adjusted.
One management accounting technique that is mostly used for manufacturing and merchandising is cost accounting. This evaluates the total cost of an entity by assessing the variable costs of each step of the production and the fixed costs of running the business. By analyzing the cost structure of a company, managers can better understand how the company products are valued in the market place and how to drive profits.
Given the competitive business climate nowadays, every business needs to have an in-depth knowledge of their costs. This is true for both start-ups and established entities. Without an understanding of operational costs, it is nearly impossible to make the right decisions at the right time.
What is Cost Accounting?
Cost accounting provides management with financial information that is used to make decisions about a company’s costs. It does this by providing direction for budgeting and creating cost control programs. Cost accounting can also be used to improve net margins that can help a business become more profitable in the future.
Because it is used internally, cost accounting does not have to meet any specific standards, like the generally accepted accounting principles (GAAP). This means that there can be variation in how it was used from company to company or even per department.
Some think of cost accounting as the “behind-the-scenes” activity for a business, but in reality, it can be the driving force behind a company’s success. It is important to understand that there are several types of costs incurred during a one-year business cycle, which are defined further in details below.
Types of Costs
Fixed costs are unyielding no matter how much or how little production occurs. These costs, such as a mortgage or lease payment on a building, or depreciation of equipment, remain the same regardless of output. Consequently, an increase or decrease in production would have no effect on these particular costs.
When a company has variable costs, it means that operational expenses will change in accordance with its level of production. In other words, variable costs increase and decrease depending on the number of items produced. These costs include materials, labor, and energy that are directly used in the production of a service or product.
Operating costs refers to expenses that are related to the daily operations of a business. These include rent, utilities and payroll, as well as other costs, such as repairs and maintenance. These costs can be classified as either fixed or variable, depending on the nature of the expense.
Direct costs are those that can be traced back to the production of a specific good. In the case of bread and pastries, for example, direct costs would include the labor required to bake the goods as well as the price of the flour and sugar. Indirect costs, on the other hand, are those that cannot be traced back to a particular good.
Going back to the previous example, indirect costs include the electricity that was used to bake the bread and pastries. Other indirect expenses also include research and development expenses, administrative costs, and marketing expenses.
Standard vs. Activity-Based Costing
The method of allocating “standard” costs is referred to as standard costing. This type is opposed to actual costs, to Cost of Goods Sold (COGS) and inventory. It is calculated based on the efficient use of labor and materials to produce the goods or service under standard operating conditions.
In other words, standard costs are the budgeted amount. Even though standard costs are assigned to the goods, the company is still responsible for paying the actual costs. The process of comparing the standard (efficient) cost to the actual cost incurred is called variance analysis.
When conducting a variance analysis, if it is determined that actual costs are higher than what was initially expected, then the variance is unfavorable. Conversely, if the analysis reveals that actual costs are lower than expected, this is referred to as a favorable variance. There are two factors that can contribute to either a favorable or unfavorable variance. The cost of the input like the labor expense and materials.
Activity-based costing(ABC) is a type of cost accounting that assigns overhead costs from each department to specific cost objects. The ABC system is based on activities, which refer to events, units of work, or tasks with a specific goal. These activities are also considered to be cost drivers, and they are the basis for allocating overhead costs.
Overhead costs are typically assigned using a broad metric, like machine hours. However, activity-based costing (ABC) takes a more tailored approach. An activity analysis is conducted to identify the specific measures that act as cost drivers. This makes ABC much more accurate for managers who are reviewing the cost and profitability of their company’s individual services or products.
Upside and Drawbacks of Cost Accounting
Cost accounting methods are developed for a specific type of business. This actually make it easily customizable to fit the entity’s changing needs. Management can use different criteria to guide their decision-making process when it comes to things like setting prices, distributing resources, and raising capital. This allows management to make more strategic decisions about the company’s direction.
Initial investment in both time and money is often high when developing and implementing a cost accounting system. This is due to the need to train accounting staff and managers, which takes time and effort. Also, complex systems are often more difficult to use, leading to more mistakes being made early on.
Cost accounting is a system to evaluate the total cost of an entity by assessing the variable costs and the fixed costs of running a business. If implemented successfully, it can help in making sure that the entity remains profitable and competitive in the market.