Cost Accounting: Meaning, Types & Examples

What is Cost Accounting

Cost accounting is a form of managerial accounting that analyses how much money is being used in production. It analyses the different kinds of costs that a business incurs for ways to make production as cost-efficient as possible.

The objective of cost accounting is to provide management with information that can be used for decision-making, cost control, and performance evaluation.

Cost Accounting vs Financial Accounting

To further understand what cost accounting is, we must first differentiate it from the kind of accounting that we are familiar with: financial accounting. 

Types of Costs in Cost Accounting

Cost accountants and analysts take into account different kinds of costs in their calculations. 

Fixed Costs

Fixed costs are those which remain constant month after month. These costs remain the same, regardless of whether the company produces more or less of a product or service. Some examples of fixed costs include rent, salaries, property taxes, insurance, and depreciation of fixed assets.

For example, suppose a company has a fixed rent of Rs 50,000 per month for its office space. In this case, the rent expense remains constant, even if the company increases or decreases its production or sales volume. Similarly, if a company pays a fixed salary of Rs 60,000 per year to an employee, the salary expense will remain constant, regardless of the level of production or sales volume.

Variable Costs

These costs change according to the activity level of the business. If the business sells more in a certain period, these costs are likely to also change. Variable costs are typically associated with the production of a product or service, such as raw materials, labor, and utilities.

For example, if a company produces 100 units of a product, the cost of raw materials required to produce those units will be higher than if the company produces 50 units. Similarly, if a company increases its production volume, it will need to hire more labor, which will increase the labor cost.

Direct Costs

Direct costs are those which can be attributed directly to the production of a good or service. Examples of direct costs include direct materials, direct labor, and other direct expenses directly related to the production of a specific product or service.

Direct materials are raw materials that are used in the production process, such as the cost of wood for a furniture manufacturer. Direct labor is the cost of the labor required to produce a specific product or service, such as the salary of a factory worker who assembles furniture.

Direct costs are also used to calculate the cost of goods sold (COGS), which is a critical metric for many businesses to determine their gross profit margins.

Operating Costs

Somewhat similar to direct costs, operating costs are all those relating to the daily operations of the business. While direct costs are those only related to the production of goods and services, operating costs are those relating to how the business functions on a daily basis. This could include salaries paid to employees and labor costs.

Direct costs are directly related to the production of a specific product or service. Instead, operating costs are more general and apply to the overall operations of the business. For example, rent is an operating cost that applies to the business as a whole, while direct materials are a direct cost that applies only to the production of a specific product.

Types of Cost Accounting

Since cost accounting doesn’t follow any format or procedure, it has different types depending on the requirements of internal management. 

Standard Costing

In this form of cost accounting, accountants calculate the difference between the “standard cost” of producing goods vs the “actual cost” of producing goods. 

The assumption here is that there is an ideal cost to producing goods – that is as cost-effective as possible. Accountants and analysts do a variance analysis to determine the difference between this ideal cost and the actual cost that was incurred. 

If the actual costs were more than the ideal or standard cost, the variance analysis is unfavorable. On the other hand, if the actual costs were less than the standard costs, the variance analysis is favorable. 

Activity-Based Costing

Activity-Based Costing, commonly called ABC, assigns a certain amount of money to each activity that the business undertakes. A thorough analysis of the kind of activity and the resources it requires is undertaken, and costs are appropriately allocated. 

For example, a bakery might allocate more money towards the overhead costs of machinery like ovens and mixers, while a construction business might allocate more money towards labor and manpower. 

ABC gives cost accountants a good idea of how much money is being spent and on what. 

Cost-Volume-Profit Analysis

Marginal costing, also called cost-volume-profit analysis is used to understand how a decision will change the way cost affects profit.

In this kind of cost accounting, the analyst or accountant calculates the breakeven point – which is the point at which expenses equal revenue. For example, if a bakery earns Rs 70,000 as revenue in a certain month, breakeven is achieved when its expenses are also Rs 70,000 for that month. 

Businesses use this analysis to understand how much sales are needed to break into profit. 

Objectives of Cost Accounting

The primary objective of cost accounting is to determine the most efficient cost of production or services. By collecting, analysing and recording costs within a company, cost accountants help make informed decisions about pricing, profitability and cost control.

Controlling costs is a very important way to improve bottom-line numbers and optimize resource utilization. Cost accounting identifies areas of excessive expenditure and helps with measures to reduce or eliminate them.

Another objective of cost accounting is to facilitate planning and budgeting. Cost accountants can estimate and forecast the costs for a period of time based on past trends and projected activities. In this way, the management can set targets, allocate resources and monitor performance against these planned costs.

By comparing actual costs with standard costs or budgets, cost accounting enables performance analysis and identifies areas of improvement.

Improving Business Costs

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