What are the 4 types of cost accounting, and which one is right for you?

A key aspect of accounting is understanding how much your business is spending. Otherwise, it will be hard to determine whether your company is earning a profit. 

This is where cost accounting, which centers around the costs of running a business, enters the equation. Service providers, manufacturers and retailers are among the many business types that use cost accounting to keep a handle on costs.

Cost accounting, defined

Cost accounting is a method by which companies evaluate and analyze their operational expenditures. It requires systematically documenting a company’s fixed costs and variable costs, such as labor, maintenance, raw materials and supplies.

The aim of cost accounting is to help businesses understand how to manage the costs of products and services to maintain profitability. That means cost accounting may influence budget decisions, service and product prices, and business strategies.

Cost accounting does not comply with Generally Accepted Accounting Principles and is used only for internal business purposes. Because it doesn’t have to follow established standards, cost accounting can be adapted to meet the needs of a given business. 

The components of cost accounting

1. Cost control

Through cost accounting, businesses can better understand the cost price and sale price of a product or service. They can use that information to develop techniques to control costs and maximize profitability.

2. Bookkeeping

Defined as the process of recording a company’s financial transactions into organized accounts on a daily basis, bookkeeping is an integral part of cost accounting.

3. Cost planning

Cost accounting helps determine how much it really costs to make a product or service. A company can set prices by adding a profit margin to actual cost.

4. Cost comparison

Cost accounting entails the comparison of different products, activities, methods or areas for production or distribution.

5. Cost evaluation

Cost accounting requires identifying which factors have the most significant impact on costs.

6. Cost finding

Finding costs involve estimating or measuring various cost components, such as individual goods, divisions or other organizational units. Cost accounting data helps companies determine the actual cost of those components.

7. Inventory management

Cost accounting facilitates more efficient inventory management by tracking how much of an item was purchased and where the profits went.

8. Evaluating efficiency

Cost accounting helps businesses reduce costs and improve cost efficiency without reducing the level of production

Cost accounting versus financial accounting

Financial accounting refers to a field of accounting focused on the summary, analysis and reporting of a business’s financial transactions. It entails preparing financial statements used to communicate the business’s financial performance to investors and the public.

On the other hand, cost accounting is a type of management accounting, which centers around creating in-depth reports and projections for the business internally.

The table below breaks down four primary differences between cost accounting and financial accounting.

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Why cost accounting is important for businesses

The main benefits for businesses that use cost accounting include: 

• Keeping costs in check – Cost accounting helps companies predict the cost and selling price of a product or service, which informs business policies. With cost value as a guide, management can devise ways to control costs to boost profit.

• Figuring out the total cost per unit – Cost accounting helps businesses determine the total cost of every unit of a product or service to set the right price.

• Identifying profitable, unprofitable activities – Cost accounting shows management which initiatives should be discontinued, and which should be fostered.

• Cost comparison over time – Data from cost sheets created over multiple periods helps management compare costs for the same good or service over time.

• Budgeting – It is much easier to create a business budget when you know exactly how the money in your company is being spent.

Types of cost accounting

There are four primary forms of cost accounting. Each one has its own emphasis and method for assessing costs.

1. Standard cost accounting

Benefit: Preferred by many businesses for its simplicity and ease of use.

Assigns specific “standard” costs to direct materials, direct labor and overhead rather than assigning actual costs. These standard costs are predicated on the efficient use of labor and materials operating under standard conditions, so they become the de facto budgeted sum for a product.

Businesses that use standard cost accounting perform variance analyses to calculate the difference between assigned standard costs and actual direct costs of material and labor spent. 

If actual costs exceed standard costs, the business generated less profit than anticipated. If actual costs are less than standard costs, the business generated more profit than expected.

2. Activity-based cost accounting

Benefit: Helps businesses identify which activities raise production costs.

In keeping with the principle that products consume activities, activity-based cost accounting aims to calculate the cost of products in a way that accounts for indirect costs. To that end, activity-based cost accounting assigns indirect costs — aka overhead costs — to each activity in the production process.

At most modern manufacturing companies, overhead costs tend to use a much larger proportion of total production costs. 

Activity-based cost accounting gives such businesses a better understanding of the production activities required for each activity and the associated costs. This in turn can lead to improved efficiency and lower costs.

3. Lean accounting

Benefit: Helps businesses determine what creates the most value for customers.

Focuses on optimizing productivity through better financial management practices, such as streamlining production and eliminating waste. Lean accounting aims to prevent overproduction by reducing inventory and instead establishing a just-in-time supply chain. 

With lean accounting, traditional costing methods are replaced by value streams, which are groups of actions that give customers something they are willing to pay for. 

Financial decisions are based on their impact to the business’s total value stream profitability. 

4. Marginal cost accounting

Benefit: Helps businesses identify the most efficient level of production for a manufacturing process.

Calculates how much more it will cost to make a product if an extra unit is manufactured. The marginal cost is derived by dividing the change in production costs by the change in quantity.

If the marginal cost to produce one more unit exceeds the per-unit price, your profitability is negatively impacted, and if the marginal cost is lower than the per-unit price, you stand to profit. 

Marginal cost accounting helps determine the most efficient level of production for a manufacturing process. But it generally only considers variable costs, meaning it ignores the effect of fixed costs.

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