What are the different types of Cost Accounting? (Overview)

What is Cost Accounting

Cost accounting is a way of managerial accounting which aims to capture the total production cost of a business by measuring the variable costs of each production phase as well as fixed costs, such as a lease expense.

Historians believe that cost accounting was first introduced during the industrial revolution when the new global supply and demand economies forced producers to begin monitoring their fixed and variable costs to automate their manufacturing processes.

Cost accounting allowed rail and steel companies to manage costs and make themselves more competitive. By the early 20th century, cost accounting had become a widely discussed subject in the literature of business management.

Cost accounting developed as an advanced phase of accounting science and is trying to make up the deficiencies of financial accounts. It is essentially a creation of the twentieth century.

Cost accounting accounts for the costs of a product, a service or an operation. It is concerned with actual costs incurred and the estimation of future costs. Cost accounting is a conscious and rational procedure used by accountants for accumulating costs and relating such costs to specific products or departments for effective management action. Cost accounting through its marginal costing technique helps the management in profit planning and through it’s another technique i.e. standard costing facilitates cost control. In short, cost accounting is a management information system which analyses past, present and future data to provide the basis for managerial decision making.

A company’s internal management department uses cost accounting to define both variable and fixed costs associated with the manufacturing process. It will first individually calculate and report these costs, then compare input costs with production results to assist in assessing financial performance and in making potential business decisions.

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Types of Cost Accounting

Cost accounting includes several forms of costs which are listed below:

1. Standard Costing

2. Activity-Based Costing

3. Lean Accounting

4. Standard Costing

5. Marginal Costing

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1. Standard costing

Standard costing assigns “standard” costs, rather than actual costs, to its cost of goods sold (COGS) and inventory. The standard costs are based on an efficient use of labor and materials to produce the good or service under standard operating conditions, and they are essentially the budgeted amount. Even though standard costs are assigned to the goods, the company still has to pay actual costs. Assessing the difference between the standard (efficient) cost and actual cost incurred is called variance analysis.

If the variance analysis determines that actual costs are higher than expected, the variance is unfavorable. If it determines the actual costs are lower than expected, the variance is favorable. Two factors can contribute to a favorable or unfavorable variance. There is the cost of the input, such as the cost of labor and materials. This is considered to be a rate variance. Additionally, there is the efficiency or quantity of the input used. This is considered to be a volume variance. If, for example, XYZ company expected to produce 400 widgets in a period but ended up producing 500 widgets, the cost of materials would be higher due to the total quantity produced.

2. Activity-Based Costing

Activity-based costing (ABC) identifies overhead costs from each department and assigns them to specific cost objects, such as goods or services. The ABC system of cost accounting is based on activities, which is any event, unit of work, or task with a specific goal, such as setting up machines for production, designing products, distributing finished goods, or operating machines. These activities are also considered to be cost drivers, and they are the measures used as the basis for allocating overhead costs.

Traditionally, overhead costs are assigned based on one generic measure, such as machine hours. Under ABC, an activity analysis is performed where appropriate measures are identified as the cost drivers. As a result, ABC tends to be much more accurate and helpful when it comes to managers reviewing the cost and profitability of their company’s specific services or products.

For example, cost accountants using ABC might pass out a survey to production line employees who will then account for the amount of time they spend on different tasks. The costs of these specific activities are only assigned to the goods or services that used the activity. This gives management a better idea of where exactly time and money is being spent.

To illustrate this, assume a company produces both trinkets and widgets. The trinkets are very labor-intensive and require quite a bit of hands-on effort from the production staff. The production of widgets is automated, and it mostly consists of putting the raw material in a machine and waiting many hours for the finished good. It would not make sense to use machine hours to allocate overhead to both items, because the trinkets hardly used any machine hours. Under ABC, the trinkets are assigned more overhead related to labor and the widgets are assigned more overhead related to machine use.

3. Lean Accounting

The main goal of lean accounting is to improve financial management practices within an organization. Lean accounting is an extension of the philosophy of lean manufacturing and production, which has the stated intention of minimizing waste while optimizing productivity. For example, if an accounting department is able to cut down on wasted time, employees can focus that saved time more productively on value-added tasks.

When using lean accounting, traditional costing methods are replaced by value-based pricing and lean-focused performance measurements. Financial decision-making is based on the impact on the company’s total value stream profitability. Value streams are the profit centers of a company, which is any branch or division that directly adds to its bottom-line profitability.

4. Marginal Costing

Marginal costing (sometimes called cost-volume-profit analysis) is the impact on the cost of a product by adding one additional unit into production. It is useful for short-term economic decisions. Marginal costing can help management identify the impact of varying levels of costs and volume on operating profit. This type of analysis can be used by management to gain insight into potentially profitable new products, sales prices to establish for existing products, and the impact of marketing campaigns.

The break-even point, which is the production level where total revenue for a product equals total expense, is calculated as the total fixed costs of a company divided by its contribution margin. The contribution margin, calculated as the sales revenue minus variable costs, can also be calculated on a per-unit basis in order to determine the extent to which a specific product contributes to the overall profit of the company.

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Function of Cost Accounting

The main functions or objects of cost accounting are as follows:

a. Cost ascertainment:The primary objective of cost accounting is to determine the cost of production of every unit, job, operation, process, department or service. The technique of ascertaining cost is known as „Costing‟. In order to determine cost, all the expenses are accumulated, classified and analyzed. It not only determines the cost at completion stage but also determines cost at various stages of production.

b. Cost control:Cost control is one of the important functions of cost accounting. To measure the efficiency of the organization or of the cost centres, the various operations involved in the manufacture of products are to be carefully studied. Budgets and standards for the consumption of materials, use of labour, and for expending the overhead are to be set and compared with actual performances. The variances arising out of the comparison so made tell the tale whether the cost is within control or not.

c. Cost reduction:Cost reduction refers to real or genuine savings through permanent reduction in cost of a product or service without impairing the quality and affecting its purpose for which it was intended to be used. In the competitive market situations, it is utmost important for the organizations to look for activities and search for new technology through research and development activities that can reduce the cost of a product. Cost reduction can be attainable in almost all the areas of business activities. The area covered for cost reduction are like product design, plant layout, production methods, material substitution, reduction in wastages, innovation marketing strategies, purchasing and material control etc.

d. Ascertainment of profitability: It is the object of cost accounting to ascertain the profit making capacity of that activity planned or being carried out and to compare the actual profits made with their profit abilities. Difference is analyzed and efforts are made to earn the maximum profit as per capacity.

e. Determination of selling price:The supply price or the tender price of a product depends upon its total cost plus a margin of profit which the businessman wants to make depending upon the inter-play of factors of demand and supply. Cost accounting provides detailed information about the composition of total cost for the determination of the selling price. It also provides information to decide the extent to which the prices can be reduced to meet the challenge arising out of competition, by differentiating the costs into variable and fixed cost. Similarly, in the event of depression or recession, the cost accountant can guide as to which expenses can be curtailed, to reduce the cost of production and thus to decide the minimum selling price.

f. Providing a basis for business policy and decision-making: The objective of cost accounting is to help the management in the formulation of business policy and in decision-making.

The gross-profit analysis, the cost-volume-profit relationship, the break-even point of sales, and the differential costing method, etc., help the management in profit-planning and in deciding crucial matters like:

(a) Introduction or discontinuance of a product

(b) Utilization of idle plant capacity

(d) Dumping of goods in a foreign market at a cheaper price

(e) Make or buy

(f) Purchase of new plant or continuance with the old plant at the of heavy repairs, etc.

g. Compliance to statutory requirements: The Central Government, under Section 209(1) (d) of the Companies Act, has made it compulsory for 47 industries to maintain cost accounts.

Thus compliance to statutory requirements is also one of the objectives of cost accounting.

Cost Centre– Any unit of cost accounting selected with a view to accumulating all cost under that unit is known as Cost Centre. The unit may be a product, service, division, department, section, a group of plant and machinery, a group of employees of several units. E.g. production department, service department.

Read on: What is cost accounting? Definition, Types and Facts

Distinction between Financial Accounting and Cost Accounting

Though there is much common ground between financial accounting and cost accounting and though in fact cost accounting is an outgrowth of financial accounting yet the emphasis differs.

Firstly financial accounting is more attached with reporting the results of business to persons other than internal management – government, creditors, investors, researchers, etc. Cost accounting is an internal reporting system for an organization’s own management for decision making.

Secondly financial accounting data is historical in nature and its periodicity of reporting is much wider. Cost accounting is more concerned with short-term planning and its reporting period much lesser than financial accounting. It not only deals with historic data but also is futuristic in approach. Thirdly, in financial accounting the major emphasis in cost classification is based on the type of transaction e.g. Salaries, repairs, insurance, stores, etc. But in cost accounting the major emphasis is on functions, activities, products, processes and on internal planning and control and information needs of the organisation.

Utility of Cost Accounting

A properly installed cost accounting system will help the management in the following ways:

1- The analysis of profitability of individual products, services or jobs.

2- The analysis of profitability of different departments or operations.

3- It locates differences between actual results and expected results.

4- It will assist in setting the prices so as to cover costs and generate an acceptable level of profit.

5- Cost accounting data generally serves as a base to which the tools and techniques of management accounting can be applied to make it more purposeful and management oriented.

6- The effect on profits of increase or decrease in output or shutdown of a product line or department can be analyzed by adoption of efficient cost accounting system.

Distinction between Costing and Cost Accounting

Costing is the technique and process of ascertaining costs. It tries to find out the cost of doing something, i.e., the cost of manufacturing an article, rendering a service, or performing a function. Cost accounting is a broader term, in that it tries to determine the costs through a formal system of accounting (unlike costing which can be performed even through informal means). Stated precisely, cost accounting is a formal mechanism by means of which costs of products and services are ascertained and controlled. The institute of cost and management accountants, U.K. defines cost accounting as: the application of accounting and costing principles, methods and techniques in the ascertainment of costs and the analysis of savings and/or excesses as compared with previous experience or with standards. It, thus, includes three things:

1. Cost Ascertainment: finding out the specific and precise total and unit costs of products and services.

2. Cost Presentation: reporting cost data to various levels of management with a view to facilitate decision making.

3. Cost Control: this consists of estimating costs for production and activities for the future, and keeping them within proper limits. Budgets and standards are employed for this purpose.

Cost accounting also aims at cost reduction, i.e., achieving a permanent and real reduction in cost by improving the standards. Cost accountancy is a comprehensive term that implies the `application of costing and cost accounting principles, methods and techniques to the science, art and practice of cost control‟. It seeks to control costs and ascertain the profitability of business operations.

Classification of Cost In the process of cost accounting, costs are arranged and rearranged in various classifications.

The term „classification‟ refers to the process of grouping costs according to their common characteristics. The different bases of cost classification are:

1. by nature or elements (materials, labour and overheads)

2. by time (historical, pre-determined)

3. by traceability to the product (direct, indirect)

4. by association with the product (product, period)

5. by changes in activity or volume (fixed, variable, semi-variable)

6. by function (manufacturing, administrative, selling, research and development, preproduction)

7. by relationship with the accounting period (capital, revenue)

8. by controllability (controllable, non-controllable)

9. By analytical/decision-making purpose (opportunity, sunk, differential, joint, common, imputed, out-of-pocket, marginal, uniform, replacement)

10. by other reasons (conversion, traceable, normal, avoidable, unavoidable, and total).

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