What Is Cost Accounting?

In order to fully understand the basics of cost accounting, as well as the several ways in which it can be used to quickly and accurately determine a business’s cost-cutting methods and current operations efficiency, you will need to possess a fundamental understanding of the types of costs that are associated with running a business.

These costs are usually categorized on the basis of how their value changes in relation to the levels of production output of a company and include:

• Fixed costs
• Variable costs
• Semi-variable costs
• Direct Costs
• Indirect Costs

Let’s examine these costs further.

Fixed Costs

Fixed costs are costs that (as the name suggests) remain “fixed” regardless of the level of output or usage involved. 

Examples of fixed costs include:

• Rent
• Wages
• Business insurance

Keep in mind that in pragmatic terms, fixed costs do not actually remain constant — particularly when examined over a long-term period. Contrarily, a more accurate description of fixed costs would conclude that they are costs that are fixed in respect to any output changes that occur in the short term only. This is because, in the long term, a business’s fixed costs can (and generally do) change significantly. 

For example, you may decide to purchase increased business insurance coverage in the future (e.g., general liability insurance), lease a larger amount of company vehicles, or expand to more than one location — all of which will increase your total fixed costs. 

Variable Costs

Variable costs are costs that change depending on your level of output. This can commonly be a linear relationship, whereby an increase in the level of output increases the variable costs proportionally.

Examples of variable costs include: 

• Raw materials and product components
• Packaging costs
• Royalties
• Direct labour
• Business phone service expenses

Semi-Variable Costs

Semi-variable costs are costs that include a variety of variable and fixed components. These costs may change depending on the level of output involved, but they always retain a fixed element that is entirely irrespective of the total output. 

Semi-variable costs are often described as the costs which most accurately reflect the pragmatic reality of day-to-day business, as most business costs incurred will seldom be easily categorized as either solely fixed or solely variable. Usually, in fact, they will be a combination of both.

In some cases, costs may start out as being fixed but will then transition into more of a variable structure after a certain level of output has been surpassed. Telephone bills, for example, will commonly entail a fixed standard fee which is due to be paid every month but will then include additional charges which could depend on: the number of calls made, the distance of the calls (national or transnational), and the total time of the calls.

Direct Costs

A direct cost is any cost that is directly related to the total level of output of a particular department or product within a business. 

While these are similar to variable costs, they vary in the sense that direct costs can be “traced” directly to a specified product. In contrast, variable costs will change greatly depending on the level of production output holistically. This means that even though variable costs can be direct costs, this does not necessarily have to be the case vice versa.

For example, a firm may produce two different types of products, both of which require different materials. While both of these will be dependent on the general output produced, the fact that the materials used for each product will be dependent on a specific type of product exclusively will mean that they are classified as direct costs. 

Simply put, they are a direct consequence of a specified product, not a general cost incurred due to the overall output of a business’s production.

Indirect Costs

Indirect costs (also known as administrative costs or indirect overheads) are costs which — contrary to direct costs — cannot directly be linked with the output of any particular department or product in a business. 

This means that even though indirect costs are impacted by the total levels of production and output within a company, (unlike fixed costs) they are not “tied down” to any one product or department, and their value does not change proportionally with changes in output in the same way that the value of direct costs does.

For example, a manufacturing factory will need to purchase machinery based on their total levels of production, but this will not in any way be associated with a particular product’s needs or requirements.

Over the years, two distinct types of cost accounting have been developed:

• Special order cost system
• Process cost system

Both systems are used to allow managers and business owners to gather data that directly relates to the finances and operational costs of a business.

Special Order Cost System

In a special order cost system of production, a business’s output will consist of “custom” items. These are individually made after a company receives an order from a client and include products such as:

• Aircrafts
• Maritime ships (tankers, bulk carriers, container ships, etc.)
• Books and magazines
• Niche and novelty items (e.g., custom made shoes, hats, and clothes)

This means that under a special order cost system, a separate record would be provided for the cost of each special order, and each “job” would have its costs recorded individually on a cost sheet or accounting document.

This type of manufacturing is also commonly seen in firms that provide services — including those that focus on law, architecture, and accounting, as this can allow management to easily “track” resources efficiently and consequently identify the precise cost that a company will incur when servicing a specific client. 

This can be really useful, as it can enable service-providing businesses to tailor more human capital and resources on the clients that are “worth it” from a monetary standpoint. 

For example, a US law firm will commonly invest significantly more resources while representing a nationwide class action — which can see law firms receive anywhere between 20% and 30% of the total awarded settlement as a contingency fee, in comparison to when defending a relatively small tort or criminal law case.

Process Cost System

On the other hand, a process cost system produces a more consistent and predictable output of identical products (e.g., the ones made by automated machinery in production factories). 

This means that process cost accounting can only really be used where the final product in question (or the components that encompass it) are practically identical and are produced in very large quantities — for example, a specific type of computer hardware. 

A business’s completed products are then placed in stock and removed as soon as new orders are received by customers; no separate “jobs” exist which require any types of distinct changes.

Combination of Systems?

Most companies utilize both of the aforementioned systems for their operations (at least to some extent). A manufacturing business may offer a particular item on a regular basis (e.g., a vehicle), but it may also occasionally offer a relatively small number of alternate component changes as an “addition” or limited offer of that already existing vehicle.

Consequently, the holistic cost of making such an order would be determined using a process cost-based system, but determining the costs of each unique piece associated with that order would require relying on a job order cost system. 

This illustrates the pivotal role of cost accounting in the internal management, organization, and financial literacy of businesses — regardless of the industry or size in question.

Determining How Much Production Should Cost

Standard Costing

Even though job order and process cost accounting methods are extremely useful in providing numerical and financial data, they are somewhat limited when considering cost control. While these systems can make it possible to precisely determine what a product is actually costing a business at the moment, very few insights are given in relation to how much a product “should” be costing. 

With no comparative figures, the obvious question is how exactly business owners and managers would be able to identify how cost-efficient their productions currently are and how many (if any) changes would need to be implemented imminently. 

A standard costing system — which is better categorized not as an independent third option but as a “tool” that businesses can use in either a job order or a process cost system — uses pre-established standard industry costs to develop a measurement that then allows a business’s managers or business owners to compare their own actual costs with the previously projected ones. 

This can allow the internal management of a business to identify how much “room” they have for improvement. 

Activity-Based Costing (ABC)

Activity-based costing is very useful for companies that want to determine the true cost of their products in an all-encompassing way, as it can be used to take into account the fixed and indirect costs that are associated with each product (e.g., the electric power required, etc.). This is useful because it can allow managers and business owners to tailor their prices proportionately to the costs of products more accurately. 

For example, if Vehicle A requires 50 gigajoules to produce, while Vehicle B requires only 37, a manager or business owner may decide that the company would profit significantly by “passing down” the real lower cost of Vehicle B to consumers while increasing the cost of Vehicle A (which, in real terms, is more expensive). 

For example, if the amount of electricity needed to produce Vehicle A is 30% higher than the amount needed for the production of Vehicle B, a business owner may choose to pass this down in the form of a price decrease, while increasing the price of Vehicle A (since it is more expensive).

Of course, the effectiveness of such decisions will depend on the price elasticity of demand of both products, but this is just one example of how cost accounting can be used to allow managers and business owners alike to make informed financial decisions about their company. 

Lean Accounting

Lean accounting — which started to become popular in the early 21st century — aims to ensure that a business’s financial statements become easier to understand and use, making them significantly more accessible to non-financial experts within a company.

The main principles of lean accounting stem from the belief that the information of a business’s operations is inherently non-complex. By reducing all irrelevant material, generating accurate information, and always complying with generally accepted accounting principles (GAAP), lean accounting enables company owners to “break down” costs in a very specific way.

Lean accounting can allow business owners to attain a more comprehensive understanding of their business’s operations’ performance by adopting a proactive approach where they can eliminate inefficient transactions and extra costs on a regular basis.

The importance of cost accounting has been widely recognised for nearly a century. That being said, its impact has undoubtedly been further enhanced in recent years as a result of the world’s increasingly integrated economic climate — even for very small businesses.

Differences in production costs between countries — and the comparative advantages that follow — have meant that many Western economies (including the US) are under increased pressure to place an even bigger emphasis on managing and controlling all internal production costs as much as possible.

Cost accounting can be used to ascertain valuable information that will be directly impactful towards a business’s management operations and future expansion plans. 

The internal management team of a business can use cost accounting to make informed decisions that relate to how a company’s resources can be best allocated in the future (increasing profits).

Though few business owners see the need to implement any cost accounting initiatives into their operations until they have grown substantially in size, this is seldom the most efficient or desirable option.

Cost accounting systems inherently facilitate managers’ planning of a company’s future growth, and this means that, within cost accounting, business owners will inadvertently discover pivotal financial insights about their business — including their real budgets, standard and actual costs, and break-even analysis. 

Therefore, even though you may not necessarily require or “need” cost accounting when starting out, your business will likely benefit from it regardless.