.avif)
What is cost accounting? (Examples, definitions, formulas)
Learn the most common cost accounting methods and why cost accounting is an important decision-making tool.
.png)
1 minute
October 11, 2024
SMBs need to forecast costs and compare budgeted costs to actual spending. Cost accounting includes a number of methods to analyze costs, reduce spending, and to increase profits.
This post gives an overview of cost accounting methods, the assumptions used, and provides examples. You’ll learn some of the best practices for applying cost accounting concepts that may help you make better business decisions.
Key highlights:
Eliminate late receipt submissions and streamline transaction reconciliation with Rho.
Businesses can use cost accounting to plan the costs required to create a product or deliver a service. Managers may apply cost accounting methods to analyze differences between budgeted and actual costs. The goal is to identify all costs and improve cost control.
Financial accounting includes these components:
Financial accounting uses actual data and cost accounting reports use budgeted information to project costs for planning purposes. Cost accounting data is internal company information.
Management accounting (or managerial accounting) is another type of accounting that generally does not have to conform to a set of accounting standards. Stakeholders create reports for internal company use only, and data is generated for business management decisions.
For example, a business may have the option to sell a product as is, or add more value to the product and attempt to sell it at a higher price.
Managers should compare the additional costs to process further to the additional revenue generated from the higher sale price. If the added revenue is more than the additional cost, the company will spend more on production and sell at a higher price.
Management accounting may consider non-financial factors such as customer preferences and overall economic conditions. This accounting method may be applied to a single product, or to an entire product line.
The matching principle matches revenue earned with expenses incurred to produce revenue. The accrual method of accounting is used to comply with the matching principle.
The cash basis of accounting posts revenue when cash is received and expenses when cash is paid. The cash basis ignores the accounting period (month or year) and posts revenue and expenses based solely on cash movements.
To illustrate, assume that a coffee shop owes $8,000 in payroll to employees for work during the last week of December 2024. Payroll is not processed until January 5th of 2025, and the coffee shop has a December 31, 2024 year-end. Here are the accounting transactions using accrual accounting and cash-basis accounting.
On December 31st, the coffee shop posted $8,000 to payroll expenses and $8,000 to accrued payroll, a liability account. When employees are paid on January 5th, accrued payroll is reduced by $8,000 and cash decreases by $8,000.
Accrual accounting posts the payroll expense in December so that the payroll expense is matched with revenue in late December.
No entry is posted on December 31st. When employees are paid on January 5th, the coffee shop posts $8,000 payroll expense and cash decreases by $8,000.
Cash-basis accounting posts the payroll expense in January when cash is paid. This method does not match revenue with expenses.
Many accounting transactions involve judgment. When in doubt, the principle of conservatism states that accountants should post a transaction that generates lower net income.
For example, Generally Accepted Accounting Principles (GAAP) provide guidelines to determine when revenue is recognized. Generally speaking, revenue is recorded when the buyer receives the goods or when the seller finishes delivering a service.
Ridgeline Lumber supplies lumber to homebuilders and remodelers and the company posts revenue when the buyer receives a lumber order. Midwest Builders received $15,000 in lumber on June 15th, but the company is in financial trouble and may not pay the invoice.
The principle of conservatism states that revenue for the Midwest Builders invoice should not be recognized until the payment is received. This decision reduces net income until the invoice is paid.
Cost accounting is used to identify every cost a business incurs, and to assign every cost to a product or service sold to a customer. Here are some specific cost accounting benefits that improve financial performance:
Managers can determine if a particular cost adds value to a product or service or isn’t needed.
Assume that a furniture company is analyzing the cost of producing metal handles for kitchen cabinets. Management determines that a third-party contractor can make the metal handles for a lower cost. The company outsources the production of metal handles to reduce costs.
Cost accounting is a tool to allocate costs to different products and services.
The furniture company produces 15 different products in the same manufacturing plant. Management needs to allocate the utility costs to heat and cool the factory to each product.
Using a cost accounting system, the company decides to allocate utility costs based on the percentage of total sales. If kitchen cabinets represent 25% of total sales, the cabinets are allocated 25% of the utility costs.
Cost accounting is used to determine the total cost to produce a specific product. The management team can add a profit to the total cost to price each product.
The furniture company produces a dining room table at a total cost of $640. If management wants a 20% profit margin, the sale price is $800 ($640 total cost plus $160 profit). The profit margin is ($160 profit / $800 sale price), or 20%.
Sunrise Appliances manufactures many products, including the Premium Refrigerator. Here are the costs to produce a refrigerator:
Business owners account for both direct costs and indirect (overhead) costs. Direct costs can be traced to a product or service. Indirect cost cannot be traced to a product or service. Instead, indirect costs are allocated, typically based on an activity level (labor hours, machine hours, etc.)
Material costs for refrigerators include steel, other metals, plastic, and electrical components.
Labor costs include hours worked to produce a product, including hours to operate machinery or equipment.
As explained below, material and labor costs may be direct or indirect.
Overhead costs include utility bills, repair and maintenance costs for fixed assets, and depreciation expenses. The cost for accountants, attorneys, and other workers not directly involved with production is an overhead cost.
These costs are allocated, based on an activity level or some other metric. An example above allocated utility costs based on the percentage of total sales. Repair and maintenance costs for machinery may be allocated based on the number of machine hours used during the year.
There is a relationship between cost and the amount of use an asset can handle.
Sunrise Appliances, for example, spends $3,000 on repair and maintenance each year for a machine that cuts metal for production. The operations manager knows that the machine can operate for 1,500 hours a month without breaking down.
If Sunrise does not spend dollars to repair and maintain the machine, or if the machine is operated for more than 1,500 hours a month, a breakdown will occur. Managers should plan costs taking into account each asset’s relevant range.
Operating costs are incurred for day-to-day business operations. The cost of goods sold and selling, general, and administrative (SG&A) costs are operating costs.
Non-operating costs include interest expense on loans and other costs not related to normal operations.
Fixed costs do not change with the level of sales or production. Factory leases and corporate loans are fixed costs.
Businesses generally should not allocate fixed costs on a per-unit basis. This approach may create a risk that the company will allocate more than the total fixed costs.
Assume that a factory pays $60,000 for a security guard and the production forecast is 5,000 units annually. The operations manager allocates the security guard cost as ($60,000 cost / 5,000 budgeted units), or $12 per unit.
If the business produces 5,300 units, the security guard cost allocation is ($12 per unit X 5,300 units), or $63,600. Fixed costs total $60,000 and the cost allocation is incorrect. Fixed costs should be analyzed based on total dollars, not on a per-unit basis.
Variable costs change with sales and production levels. Direct material and direct labor costs are common variable costs.
Inventoriable costs including the cost to purchase, store, and manage inventory. Sunrise Appliances purchases electrical equipment that operates ice makers in each refrigerator. The equipment can break easily, and Sunrise pays for specialized handling during shipping.
Non-inventoriable costs are not related to inventory. SG&A expenses and interest expenses are non-inventoriable costs.
Production costs are incurred to produce a product or deliver a service. All material and labor costs are normally classified as production costs.
Standard costs are budget assumptions about cost per unit and level of production or usage. A variance is the difference between actual and budgeted costs, and financial management includes analyzing variances to understand costs.
In standard cost accounting, standard price is used for material variances, and standard rate is used for labor variances.
Standard costing is used for other types of cost accounting, including marginal costing. Marginal costing is the change in production costs incurred by producing one more unit of product.
Sunrise creates a separate cost analysis for the Premium Refrigerator stainless steel refrigerator doors. Here are standard costs and actual costs to produce a door:
A price variance is a difference between budgeted and actual price for a product or service. Here is the formula:
Sunrise has a price variance for both material and labor costs:
A favorable cost variance means that actual costs are less than budgeted, which is why the number is negative. If actual costs are higher than budgeted, the variance is unfavorable, or a positive number.
The material price variance is favorable because the actual price is less than budgeted ($2.50 vs. $3.00). The labor rate variance is unfavorable because the actual rate is more than budgeted ($28 vs. $25).
A price variance means that the business pays more or less than planned. An efficiency variance occurs when the business uses more or less of an input than planned.
An efficiency variance is a difference between budgeted and actual quantity used for items purchased at a specific price. The formula is:
Sunrise has different cost efficiency variance for both material and labor costs:
Overhead costs may be fixed or variable, and managers frequently analyze overhead using these two categories.
As your business grows, total overhead increases, and you can benefit from examining the costs in detail. Managers often find inefficiencies in overhead costs because the cost are more difficult to assign to products and services.
Cost objects can be a product line, department, or a customer. Costs are assigned to cost objects. To properly account for a company’s costs, managers need a rationale that justifies why a specific cost is assigned to a cost object.
Fixed overhead costs do not change with fluctuations in sales or production.
To explain, assume that a company posts $10,000 of annual depreciation expense on a piece of machinery. Management expects to operate the machine for 1,600 hours during the year.
The budgeted allocation rate: ($10,000 annual depreciation / 1,600 machine hours) = $6.25 per hour. If a customer order requires 5 hours of machine time, the business allocates ($6.25 X 5), or $31.25 of fixed overhead.
If the actual depreciation expense or machine hours operated varies from the budget, the difference creates a variance.
Variable overhead costs change as activity levels change.
For this example, consider a car manufacturer that makes multiple parts. Management decides to allocate factory utility costs based on the total number of machine hours for the entire factory. Here is the cost allocation;
Unlike depreciation expense in the cost structure explained above, utility costs change with production levels. If more parts are produced, utility costs are higher. If the actual utility costs or machine hours operated vary from the budget, the difference creates a variance.
Activity-based costing (ABC) uses activity levels to allocate indirect costs to a product or service. Common activity levels include units sold, labor hours worked, or machine hours used. ABC is used in several examples above.
Target costing starts with an estimate of the price a customer will pay for the product or service. The target profit is subtracted from the price to determine the target cost. Management’s goal is to keep total costs at or below the target cost amount.
Sunrise Appliances performs research on customer preferences and its competitors and calculates the target cost:
Management must analyze direct material, direct labor, and overhead costs to “fit” all costs into the $1,100 target cost balance.
Lifecycle costing identifies all of the costs that a product will incur over the product’s lifecycle. Lifecycle costing can also be applied to services. Here are some of the cost components:
If a business does not consider costs over the entire lifecycle, profits will decline in later years as unplanned costs are paid.
Job order costing is used when each customer order has a unique set of costs. A home remodeler or a custom furniture builder should use job order costing. The business creates a job estimate for direct materials, direct labor, and overhead costs for each customer project.
Process costing assumes that every unit produced is identical. A business that only manufactures a specific type of pencil should use product costing. Each unit moves through the same production process, and the total cost is computed by adding the costs in each step of production.
Variable costing treats fixed manufacturing costs differently than absorption costing. To explain, assume that a manufacturer pays $70,000 in salary and benefits to an operations manager who supervises factory production.
Variable costing expenses the fixed manufacturing costs as they are incurred. Variable costing assumes that fixed manufacturing costs are too difficult to trace to a product. As a result, the principle of conservatism dictates that the costs should be expensed as they are paid.
Absorption costing adds fixed manufacturing costs to inventory and the costs are not expensed until inventory is sold. When inventory is sold, the cost of goods sold is increased. Absorption costing views fixed manufacturing costs as inventoriable costs.
The method you choose impacts company financial results:
The pre-tax dollars needed for a purchase formula is the cost of the item divided by (1 - tax rate percentage).
Assume that a business needs to purchase a $30,000 machine and the tax rate is 25%. Here is the calculation:
Most businesses use one of the three inventory valuation methods listed below. To explain, assume that a retailer purchases men’s blue blazers on three dates in June. The retailer does not have any beginning inventory of blazers on June 1st:
The total cost of inventory ($60,220) is the same, regardless of the inventory valuation method used. The differences are in the timing of the costs. To illustrate, assume that the retailer sells 260 blazers on June 29th.
FIFO assumes that the oldest units are sold first. Using FIFO, 100 units are sold at $170, 150 at $182, and 10 at $199. The oldest units are also the least expensive, so FIFO generates a lower cost of goods sold on June 29th.
LIFO assumes that the newest units are sold first. Using LIFO, 80 units are sold at $199, 150 units at $182, and 30 units at $170. The newer units are also more expensive, so LIFO generates a higher cost of goods sold on June 29th.
The weighted average method calculates the per unit cost as ($60,220 total cost / 330 total units), or $182.48. The per unit cost is multiplied by 260 units sold to compute the inventory value on June 29th.
Once all 330 units are sold, all three methods report $60,220 as the total cost.
These accounting methods use cost accounting and additional strategies to manage production.
Lean accounting refers to increasing productivity by eliminating waste and shortening the time required to produce a product or service.
One component of lean accounting is just-in-time (JIT) manufacturing, which attempts to reduce the time and effort required in the supply chain. JIT strives to minimize the raw materials on hand so that materials are used in the production process as soon as they are received.
Project accounting includes job order costing, billing, and revenue recognition issues for project work. A home remodeler uses job order costing because each customer project has different requirements and costs.
Assume that a remodeler is paid a portion of the total project’s cost based on completion goals. For example, the customer pays 20% of the project’s cost when the foundation for the room addition is complete. Another 20% is paid when electrical and plumbing work is completed.
The partial billing payments allow the remodeler to pay for labor and material costs as the project moves forward.
Cost-volume-profit (CVP) analyzes costs, sales levels, and profit in a single formula. Managers can change the variables in the CVP formula and assess the impact on business results.
The break-even point formula is used to determine if the business can generate enough sales to cover all costs. The formula is:
Note the following:
To illustrate, assume that Sunrise Appliances sells a Budget Refrigerator at a sale price of $700. Variable cost per unit is $380, and fixed costs total $250,000. Here is the break-even point for the Budget Refrigerator:
$0 Profit = $700 sale price (X) - $380 variable cost (X) - $250,000 fixed costs
$0 Profit = $320X - $250,000
$250,000 = $320X
X= 781 units (with rounding)
Sunrise must sell 781 Budget Refrigerators to break even.
Contribution margin is defined as sales less variable costs and contribution margin can be calculated per unit or in total dollars. The contribution margin per unit for Budget Refrigerators is $700 sale price - $380 variable cost = $320 per unit.
Contribution margin is also used to compute the break-even point in units. As explained above, the break-even point in units is ($250,000 fixed cost / $320 contribution margin per unit), or 781 with rounding.
The contribution margin in dollars must pay for all fixed costs to reach the break-even point.
Target net income is the profit goal you use in the break-even formula. Assume that Sunrise Appliances decides to set a $60,000 target net income for Budget Refrigerators. The only variable that changes in the break-even formula is profit:
$60,000 Profit = $700 sale price (X) - $380 variable cost (X) - $250,000 fixed costs
$60,000 Profit = $320X - $250,000
$310,000 = $320X
X= 989 units (with rounding)
Sunrise Appliances must sell 989 units to generate a $60,000 profit on Budget Refrigerators.
Gross margin is sales less the cost of goods sold. Cost of goods sold includes the direct costs incurred to produce a product or service. Note that gross margin differs from contribution margin discussed above.
Businesses use cost accounting to plan the costs required to create a product or deliver a service. Managers apply cost accounting methods to analyze differences between budgeted and actual costs.
Most traditional accounting methods use actual data and cost accounting reports use budgeted information to project costs for planning purposes. Cost accounting generates internal company information and does not need to conform to regulatory requirements.
Financial accounting, for example, uses a bookkeeping system to post journal entries for actual accounting transactions. Auditing the financial statements is based on actual accounting data, not budgeted amounts.
Cost accounting includes direct materials, direct labor, and overhead costs. Managers plan for each of these costs, and compare budgeted costs to actual expenses.
Assume that a business manufactures baseball gloves. The company should determine the direct materials required, including leather, plastic and other materials. Producing the gloves requires direct labor costs, and overhead should be applied to the cost of each glove.
Cost accounting helps managers to identify unnecessary costs that can be reduced. When managers can accurately determine the total cost of a product, the business can price the product to achieve a specific profit margin.
Cost accounting is time consuming, and requires a manager to generate budgeted costs, monitor actual spending, and perform variance analysis to explain variances.
Cost accounting is an effective tool to identify wasteful spending and to determine a product’s total cost. Cost accounting requires timely and accurate accounting data, so that managers can monitor spending and analyze cost variances.
Manage all of your spending and cash using Rho’s automated platform. Rho is a business banking platform that offers the tools companies need to manage their cash and grow their businesses.
Backed by 24/7 customer support, in partnership with banks, Rho offers business checking accounts and enterprise-grade spend management: accounts payable, corporate cards, and expense management – with no monthly fees.
Book a demo today!
Ken Boyd is a guest contributor. The views expressed are his and do not necessarily reflect the views of Rho.
Any third-party links are provided for informational purposes only. The third-party sites and content are not endorsed or controlled by Rho.
Rho is a fintech company, not a bank. Checking and card services provided by Webster Bank, N.A., member FDIC; savings account services provided by American Deposit Management, LLC, and its partner banks.
Investment management and advisory services provided by RBB Treasury LLC dba Rho Prime Treasury, an SEC-registered investment adviser. RBB Treasury LLC facilitates investments in securities: investments are not deposits and are not FDIC Insured. Investments are not bank guaranteed, and may lose value. Investment products involve risk and past performance does not guarantee future results. Registration with the SEC does not imply a certain level of skill or training. Treasury services provided through Interactive Brokers LLC.
Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.