Guide

What is cost accounting?

Learn about cost accounting, how it differs from financial accounting, and its pros and cons for your business.

A person looking at a computer with a bar graph and money.

Cost accounting, also known as managerial accounting, is about more than numbers and ledgers – it’s the cornerstone of financial decision-making. It helps businesses manage the financial dynamics of their operations by analyzing and recording expenses to uncover the direct costs of their products and services.

In the end, cost accounting gives you clarity about operating costs to help you make better decisions, and steer your business towards improved profitability.

Defining cost accounting

Cost accounting is part of a company’s overall business strategy. Because it’s for internal purposes only, cost accounting doesn’t need to follow Generally Accepted Accounting Principles (GAAP).

Using cost accounting, businesses allocate expenses to different activities and areas, and determine whether each one is a fixed cost or a variable cost. When you look at the total cost of the production and sale of goods and services, you can determine the break-even point – the point at which you start generating a profit.

Cost accounting clarifies your operating costs

Why add cost accounting, another layer of bookkeeping, to your already busy financial management? Because it helps managers analyze all the business’s operating costs and address inefficiencies, ultimately boosting profits. Specifically, it enables them to:

  • determine the cost of goods sold
  • track and control the costs of production for specific products and services
  • align pricing, budgeting and quoting with the business's financial position

Pros and cons of cost accounting

Businesses can see many benefits when implementing a cost accounting system.

Pros

Cost accounting helps managers make better business decisions. It helps them spot unnecessary costs and reduce production-process inefficiencies, improving the business's bottom line.

It does this by clarifying the direct materials expense and indirect costs of each product or service, making it easier for a business to develop a budget and forecast revenues and expenses.

And since cost accounting isn’t bound by a specific standard, businesses can perform it according to their needs.

Cons

However, cost accounting also has downsides.

  • It requires expertise in analyzing and interpreting financial data, which can be challenging for small businesses.
  • It also relies on prior-period data, which may not reflect the company’s current situation.
  • Cost accounting can increase the administrative burden, as it’s time consuming to gather and scrutinize data.

The differences between cost accounting and financial accounting

Cost accounting and financial accounting are both valuable to a business but they have distinct differences.

  • Financial accounting has an external focus – it represents the financial position of the business to external stakeholders – while a business uses cost accounting internally to guide its decisions. Financial accounting is used mainly to generate financial statements (such as balance sheets and income statements) that summarize the business’s performance to help attract investments or funding from lenders.
  • Cost accounting is internal financial reporting for the management team to help with budgeting, financial planning and cost control. It focuses on classifying, allocating and analyzing costs to assess the business’s financial performance.

Types of cost accounting

There isn’t a one-size-fits-all approach to cost accounting. Here are the most common types:

  • Standard costing: Standard cost accounting uses estimated costs based on the best use of materials or labor. It compares estimated costs to actual costs and analyzes differences to find ways to improve, like renegotiating with suppliers or finding a cheaper supplier.
  • Activity-based costing (ABC): This looks at all costs for a specific product or service. It assigns each expense to different cost objects (activities, people or projects), which helps to measure overhead costs. ABC is popular because it enables businesses to find unprofitable items and inefficiencies.
  • Marginal costing: Also known as cost-volume-profit analysis, marginal costing is often used in manufacturing. It shows the cost of making one more item on the product line, so a business knows how much they need to spend to create additional products.
  • Process costing: Process costing is used mainly in manufacturing to find the production cost for each unit of a product. It keeps track of the expenses at each production step and divides the total cost by the number of items made. Process costing relies on weighted average cost and FIFO (first-in, first-out) costing.

An accountant or bookkeeper can help you decide which kind of cost accounting is right for your business. You can find one in our advisor directory.

Disclaimer

Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.

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