Cost accounting is the cornerstone of financial decision-making. It’s about more than numbers and ledgers. Cost accounting helps companies understand and manage the financial dynamics of their business operations. It involves analyzing and recording expenses to uncover the direct cost of your products and services.
In the end, it gives you clarity about operating costs to make decisions, and steers your business toward improved profitability.
Defining cost accounting
Cost accounting, also known as managerial accounting, is part of a company’s overall business strategy. Cost accounting is an internal tool businesses use to make better-informed decisions; it isn’t for external stakeholders. 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.
The purpose of cost accounting
Why add another layer of bookkeeping to your already busy business financial management? It comes down to allowing managers to analyze all the business’s operating costs and address possible inefficiencies, ultimately boosting profits.
With cost accounting, managers can track and control the costs of production for specific products or services. It helps to determine the cost of goods sold and to align pricing, budgeting, and quoting with the business's financial position.
Advantages and disadvantages of cost accounting
Businesses can see many benefits when implementing a cost accounting system. However, it also has downsides.
- Assists management in business decisions, potentially leading to increased profits and reduction of a company’s costs.
- Provides a clear picture of 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.
- Since it’s not bound by a specific standard, it allows businesses to customize how they do it based on their unique needs.
- Helps management spot unnecessary costs, reduce production process inefficiencies, and improve the business's bottom line.
- Requires expertise in analyzing and interpreting financial data, which can be challenging for small businesses that lack a dedicated cost accountant.
- Relies on prior period data, which may not reflect the company’s current situation and hinder decision-making.
- Can be time-consuming to gather and scrutinize data, leading to increased administrative burden.
Types of costs
Every small business has different types of costs. Knowing the fundamentals and how each can impact a company’s bottom line is essential for small business financial management. Some costs are fixed, and others are variable.
Fixed costs don’t change. It doesn’t matter how much work is being done, the number of sales you have, or how much your client list grows, fixed costs stay the same. Examples of fixed costs are mortgage or rent payments, insurance premiums, and property taxes. utilities.
Variable costs are those that can change depending on the quantity of work, number of sales, amount of production, or total orders placed. Examples of variable costs include inventory purchases, raw materials, temporary contractors, commissions, and transaction fees.
Understanding the difference between fixed and variable expenses can help you assess your cost structure for better financial control overall.
The differences between cost accounting and financial accounting
Cost accounting and financial accounting are valuable to a business. Both involve analyzing and recording financial information, but they have distinct differences.
- Financial accounting primarily focuses on generating financial statements, such as balance sheets and income statements. It provides an overview of a business’s financial 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.
The main difference is that financial accounting represents the financial position of the business to external stakeholders, while cost accounting is used in-house to guide the business.
Types of cost accounting
There isn’t a one-size-fits-all approach to cost accounting. Several methods are available to help businesses analyze and manage costs effectively. Here are common cost accounting types:
- Standard costing: Standard cost accounting uses estimated costs based on the best use of materials or labor. It compares the estimated costs to the actual costs, and analyzes differences to find ways to improve, like renegotiating with suppliers or finding a cheaper supplier.
- Activity-based costing (ABC): Activity-based costing looks at all costs for making a specific product or service. It uses cost allocation to assign each expense to different cost objects (activities, people, or projects), which helps to measure overhead costs. ABC is popular because it allows businesses to find unprofitable items and inefficiencies.
- Marginal costing: Marginal costing, also known as cost-volume-profit analysis, is often used in manufacturing. It shows the cost of making one more item on the product line, so a business knows how much more they need to spend to create additional products.
- Process costing: Process costing is used primarily 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.
Different types of cost accounting methods help businesses gain valuable insight into costs, identify areas for improvement, and make decisions to improve financial performance.
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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