Cost Accounting Importance and Advantages

Illumeo Customer Success's Profile

Knowing how much you're spending is an important part of accounting. You'll never know whether your firm is profitable if you don't keep track of your spending. Cost accounting comes into play in this situation. Cost accounting is a type of accounting that focuses on the expenses of running a firm. Before you go into cost accounting, you must first comprehend what it is, the many forms of cost accounting, and the advantages of this type of financial monitoring.

Cost Accounting Definition?

Cost accounting is the use of accounting and costing concepts, methodologies, and strategies to determine costs and analyze savings or increased expenses incurred in comparison to past experience or industry norms.

Cost accounting is a type of accounting that focuses solely on a company's fixed and variable expenses. Businesses track all of their expenses and allocate them to various processes or units of production using the cost accounting approach, allowing management to assess the economics of their firm's operation.

Cost accounting is especially critical for firms that make and sell in large quantities and/or have a diversified product range, since these enterprises have several costs related to manufacturing, packaging, and distribution. Cost Accounting is crucial for effectively estimating profit margins, budgeting, forecasting, and recognizing efficiencies in various sorts of firms.

Cost Accounting Basics

To help you make better management decisions, here are four things you should know about cost accounting:

  1. Cost Accounting is an Internal Thing

Financial accounting uses statements to communicate a company's financial condition and performance to outside parties, including data on sales, costs, assets, and liabilities. Cost accounting is particularly useful to management in budgeting and developing cost control strategies that increase a company's net margins.

  1. Take All Costs into Consideration

Understanding the various sorts of costs is crucial since it aids in a better understanding of the product or service, which may lead to more competitive pricing. It also helps you to better prepare for your company's future.

They include:

  • Fixed Costs - costs that are constant regardless of production level. E.g., mortgage/lease payment on building or machinery

  • Variable Costs - costs that are proportional to the amount of production. E.g., cost of raw material

  • Direct Costs - costs associated with the production of a product. This may include manufacturing equipment or manpower that is specialized to the product.

  • Indirect Costs - costs involved with a company's day-to-day operations. Depending on the scenario, these expenses may be variable or constant. E.g., administrative, security & personnel costs

  1. Methods of Cost Accounting

Various types of cost accounting are:

  • Standard Cost Accounting

The costs are assigned 'standards' in standard costing. The standard costs are based on the labor and materials used to manufacture the goods and services under normal or standard operating conditions.

  • Activity-Based Costing

Activity-Based Costing assesses each department's overhead expenses before assigning particular cost items such as commodities or services. These tasks are the foundation of the ABC cost accounting system.

  • Marginal Costing

The impact of adding the cost of a product to one extra unit into the manufacturing unit is known as marginal costing, also known as cost volume profit analysis. This sort of costing is beneficial for short-term financial decisions.

  • Lean Accounting

Lean accounting refers to a collection of concepts and methods that provide quantifiable feedback to producers who employ lean production and inventory management approaches. Lean manufacturing may help a company's management speed up processes, reduce inefficiencies, and free up production capacity. It provides you with the financial and non-financial data you'll need to put the lean strategy into action and achieve financial success.

All of these costs aid management in determining the cost effect on the business unit. Management uses this form of study to acquire insight into their ability to generate successful items.

  1. It's Your Choice

Because cost accounting is an internal tool, it is not required to follow any set guidelines, such as Generally Accepted Accounting Principles (GAAP). As a result, its use differs from one organization to the next or from one department to the next. You may customize the system to meet your own requirements.

Importance of Cost Accounting

The importance of cost accounting is highly crucial to an organization's management. The following section clearly discusses the relevance of cost accounting:

Cost Classification

Cost is a general term that has to be categorized before it may be used in other contexts. All such costs must be recorded and classified in cost accounting. The prime cost, direct cost, manufacturing cost, selling cost, and other expenditures are all included in the costs. Classification enables for cost control and determining the profitability of various processes and activities. This aids in the calculation of efficiency.

Cost Control

It is more effective for the company to concentrate on inventory, labor, and several other types of overhead expenditures. For example, they can use the EOQ approach, a costing technique, to achieve optimum efficiency in their inventory management. Similarly, by analyzing labor expenses and machine capacity, a company's efficiency can be increased. Overheads are classified as fixed or variable in cost accounting.

Determination of Price

The major distinction between fixed costs and variable costs is determined in cost accounting. This information is then utilized by the firm or business unit to set product prices based on the product's costs. The management here determines the best pricing for the product or service, one that is neither too high nor too low.

Consider a scenario in which the economy is through a period of depression. To survive the current economic downturn, the businessman cuts the pricing of his items. He can begin by attempting to control variable costs allowing him to set product prices.

Cost Accounting Advantages

Not only will you be able to see the entire expenses of producing your items, but you will also be able to discover occurrences of vendor overcharging. Additionally, your organization may be able to save money by finding efficiency.

Some of the benefits of cost accounting are:

Helpful for Managing Costs

As previously stated, the fundamental goal of incorporating cost accounting into a corporation is to control various forms of expenses. It also assists management in determining the product's and service's cost and selling price.

Helps In Calculating the Total Cost Per Unit

The selling price of the product or service that the company provides must be determined ahead of time. It is necessary to know the manufacturing cost per unit in order to do so. As a result, cost accounting techniques assist the management in determining the total cost of manufacturing per unit.

Displaying Profitable and Non-Profitable Activities

Many activities take place in any enterprise at any one moment, but not all of them are lucrative. As a result, the management must be aware of any actions that are not profitable. Cost accounting aids in the identification of all of these activities.

Fixing The Standards

Everything in the firm must adhere to strict standard. The standards are used by the businesses to develop future projections and budgets. They utilize this as a benchmark to assess the process's or department's actual efficiency.

Standard Costing is an entire discipline of cost accounting that is dedicated only to this method.

Inventory Control

All supplies and storage are subject to an effective system and check. Without examining the physical inventory, an interim profit and loss statement and balance sheet can be created.

Quicker decisions

Managers can use cost accounting to adapt promptly to market changes, such as when the rise in raw material occurs.

Cost Accounting Systems

Manufacturers utilize a cost accounting system to track manufacturing operations in a perpetual inventory system. In other words, it's a manufacturing-specific accounting system that keeps track of inventory as it moves through the various phases of production.

In a typical cost accounting system, raw materials are tracked as they progress through the manufacturing phases and are gradually transformed into finished products in real time. The system promptly records the usage of raw materials by crediting the raw materials account and debiting the items in process accounts as they are placed into production. Because most items go through numerous phases before being labeled as final products, there are frequently several work in process accounts.

There are two basic types of cost accounting systems used by companies in determining product costs.

  1. Job Order Costing

Job order costing is a method of calculating the cost of creating each product. This technique of costing is commonly used when a company creates a number of goods that are distinct from one another and has to assess the cost of performing a single job. The direct labor, direct materials, and manufacturing overhead for that particular project are all included in the job pricing.

Let's say a buyer purchased shoes with their name embroidered on the sides and cotton shoelaces rather than the standard nylon material. Because this is a one-of-a-kind order, a company would utilize task order costing to come up with a one-of-a-kind pricing to charge the consumer for their custom-made shoe.

  1. Process Costing

Process costing is a cost accounting technique used to allocate manufacturing expenditures to mass-produced goods. It may be used, for example, by big manufacturing organizations that mass-produce inventories to assess the entire amount of direct and indirect costs connected with goods that are finished and left in-process at the completion of a certain time period.

Food processing, gasoline and oil processing are among areas where process costing methodologies may be used.

Cost Accounting Formulas

A range of concepts and formulas are used in cost accounting to assist a company assess how successfully it is reducing expenses and reaching profit targets. The hard work may be done by integrated accounting and financial management software, allowing management to focus on the business aspects instead.

The formulae below can be used in cost accounting to determine various sorts of expenses.

  • Prime cost = Direct materials utilized + Direct labor

  • Conversion cost = Direct materials + Factory overhead

  • Factory cost = Direct labor + Direct materials + Factory overhead

  • Total Fixed Costs + Total Variable Costs / Total Units Produced = Cost Per Unit

  • Break-even (in unites) = Total Fixed Costs / Contribution Margin

  • Gross margin = (net sales revenue less cost of goods sold) / net sales revenue

  • Price variance = (actual unit cost - standard unit cost) x No. of items purchased

  • Beginning inventory + net purchases - cost of goods sold = Ending inventory

  • Net purchases = purchases - purchases returns - allowances - discounts

Cost Accounting vs Financial Accounting

Cost accounting focuses only on a company's costs, whereas financial accounting integrates this information with other variables such as income, liabilities, and shareholder equity to create a holistic view of a company's finances.

Cost and financial accounting are both used to track aspects of a company's finances. This information aids in the development of firm strategy, including informed decision-making. Financial accounting, on the other hand, records all elements of a company's finances, whereas cost accounting concentrates on tracking expenses and allocating those costs to certain offers or activities. Financial accounting integrates cost accounting with other factors (income, liabilities, and equity) to give complete analyses and insights into the company's financial conditions and future opportunities.

Conclusion

To gain a better understanding of your organization, consider establishing a cost accounting system. The procedure will assist you in determining the true cost of each element to a client, the cost of future growth, and the prospective revenues of your company. You can better plan budgets, modify pricing, retain inventories at suitable levels, and manage production and running expenses using these measures.

A cost accounting study can help you better grasp the true cost of your items. A realistic picture of your company can help you enhance your profit margins and efficiency.