A Simple Explanation of Cost Accounting

Overview

Accounting is a strictly documented recordkeeping of the financial activity of an entity. Accounting data is necessary to monitor and control the activities of the organization. Cost accounting is exactly what it sounds like or how a company decides to measure the costs.

This type of accounting is a set of conscious actions aimed at reflecting the processes of supply, manufacturing, and sale of goods occurring at the enterprise over a certain period of time by means of their quantitative measurement (in physical and value terms), recording, grouping, and analysis.

The main purpose of cost accounting is to oversee production activities and manage the costs of their implementation. Cost accounting generates basic information for the everyday needs of the management. Therefore, management occupies a central place in the cost accounting system of the enterprise.

Elements

Prime costs

Under prime costs, we have direct materials and labor. These can be easily attributed to a specific cost object (product, service, or project), so they are known as direct. The materials are directly used for the making of goods or the labors costs are directly related to the creation of the goods.

If a company develops software, for instance, the cost of wages paid to the programmers is direct. The plastic used to make toys, the flour used to make cakes, glass and steel used to make cars are all examples of direct materials. Glue, thread, and other materials might not be easy to trace to each object, so these are not considered prime costs but fall under indirect costs.

It should be remembered that in most cases direct costs are variable, but this is not always the case. As a rule, variable costs go up in proportion to the volume of products produced, which will be true in relation to the raw materials and other materials used. However, the salary of a supervisor exercising direct control over production is typically a fixed cost.

Overhead

Overhead costs are additional costs that are not directly related to the main production, not included in the labor costs of the main personnel and the cost of raw materials. For the company, such costs are no less important than direct costs, since they allow to ensure the operation of the entire business. In contrast to direct costs that are limited to labor and materials, overhead costs include a wider list of business costs:

  • depreciation of fixed assets, expenses for their maintenance and repair;
  • lease of an office and other non-production premises;
  • salary of the administrative and managerial staff and associated payroll taxes;
  • supplies for the office, cleaning goods and personnel, etc.;
  • communication services, including the internet;
  • property and employee insurance costs;
  • travel expenses;
  • safety measures, security services, etc.;
  • staff recruitment as well as training and retraining of employees;
  • advertising and consulting services.

There is no specific list of overhead costs, so each company draws up its own list of such costs. Cost accounting helps to properly allocate overhead items to various products, processes, or even customers.

A Simple Explanation of Cost Accounting

Importance

To remain viable and grow, businesses should be able to understand the cost and then manage it effectively. A business needs to have a system to account for all its costs because it should be able to measure its costs both for financial reporting purposes and also to understand what it costs it to run the business.

Although most business owners and managers understand this, without cost accounting they will not have the proper tools to achieve this. Thus, besides investing money into advertising, research, and new equipment, the management should invest in good cost accounting to be able to evaluate whether all these costs are rational and help the business succeed.

Management is able to set standards and compare the actual costs with the standards thanks to cost accounting. This includes comparing the actual costs to the past data or standards, then evaluating the causes of these variances. It might make sense to look at each cost category separately, but that might not always be helpful.

For instance, the direct materials cost might have risen because you have paid too much for the items or you used too much to produce the same amount of the final product. However, what if the company found a supplier who sold materials for less, but it turned out that the quality of these materials was not as good. Thus, it might seem that the production department needs to improve its work because it used too much material, but it was actually the purchasing department that messed up and needs to pick suppliers more carefully. Accordingly, it is important to look at the total variances and dig deeper sometimes. This is where detailed cost accounting will come in very helpful.

Cost vs Financial Accounting

Financial accounting and cost accounting have completely different goals. Financial accounting tells the business owners and outside users (investors, credit companies, regulators, etc.) of the data the profit and loss of a particular business as well as its financial position. Cost accounting, on the other hand, provides information to management for proper planning, operations, control, and decision making.

While financial accounting can provide you information on the net profit or loss of a business as a whole, cost accounting discloses the profit or loss of each product, job, or service. Moreover, cost reports can be prepared for the management as often as desired, while financial reports are typically prepared at the end of the year or at least less frequently. It is also worth noting that cost accounting is done only because a business sees it as necessary for its success and only a few businesses are required to maintain cost accounting. Financial accounting, however, is the basis for reporting to the government and payment of the taxes, so it is mandatory for every business.

Finally, cost information is also used for the evaluation of performance purposes. So, as was mentioned earlier, cost accounting is based on a comparison of actual transactions and estimated costs. When it comes to financial accounting, all the numbers have to be strictly actual, verifiable facts and figures because it is formal recordkeeping of business finances.

A Simple Explanation of Cost Accounting

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