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2020-01-27 16:01:01Accounting & TaxesEnglishThis article explains what is cost accounting, elements of cost accounting, types of costs, methods of cost accounting and techniques of... Basics: What is Cost Accounting?

Accounting Basics: What is Cost Accounting?

7 min read

There are various stakeholders to the business that require timely, reliable and accurate financial information for various purposes. For instance, external stakeholders like creditors are keen to know the ability of the business entity to pay off its debts.

Likewise, the internal stakeholders like the management needs financial information for formulating plans, policies and taking key decisions for smooth running of the business.

Thus, different branches or types of accounting provide different economic information useful to both internal and external stakeholders. Where financial accounting reveals profit or loss of a business during a particular accounting period, cost accounting provides per unit costs and profit or loss on various products or services provided by the business.

Thus, financial accounting reports financial information that is used by both internal and external users. However, cost accounting provides cost data to the management, that is the internal users, for formulating plans, policies and effective decision making.

In this article you will learn what is cost accounting, elements of cost accounting, types of costs, methods of cost accounting and techniques of cost accounting.

What is Cost Accounting?

Cost accounting is the type of managerial accounting that involves classifying, analysing and interpreting cost. This type of accounting is undertaken so as to determine the cost of products or activities accurately.

Further, it also involves the process of (i) recording, controlling, reporting costs and verifying the correctness of cost information and (ii) checking if the cost rules and principles have been applied appropriately.

Thus, cost accounting helps in determining the underlying reasons for increase in profits or losses. In other words, it helps in identifying the unprofitable product lines or services that can either be:

  • done away with or
  • towards which necessary steps can be taken by the management to adjust the product or service mix.

Additionally, by comparing costs over different periods, inter-company costs or standard versus actual costs, management can determine the gaps in performance and take corrective measures to improve performance.

Cost Accounting Elements

There are three elements of costs. These include:

  • Material
  • Labour
  • Other Expenses

Each of the elements can further be subdivided into Direct and Indirect costs.

Direct costs are the ones that can be easily attributed to the units of output so produced. For instance direct material for a bat manufacturing company would be raw material such as wood. Likewise, direct labour would be the wages paid to workers involved in manufacturing bats. And direct expenses would include the amount paid for hiring an equipment for manufacturing bats.

Indirect costs, on the other hand, are the costs that are not conveniently or directly attributed to a product or service. In other words, these are the costs incurred on material, labour and expenses that are incidental to the production of goods or services. For instance, factory or office rent, utilities, office expenses, accounting and legal expenses, etc.

Let’s take these up individually to understand the various elements of costs.

Types of Costs

  • Material Costs

The items or inputs that are used to manufacture products account for material costs. These costs can further be divided into Direct Material and Indirect Material costs.

  • Labour Costs

Labour costs are the wages paid to the workers or labour employed. These are further subdivided into direct labour and indirect labour.

  • Expense Costs

These include both direct expenses – that can be easily traced to the product or service produced and indirect expenses – that cannot be easily or directly identified with a product of service.

Various types of costs can be categorized as follows:

  • Fixed Cost

These are the costs that remain unchanged or unaffected by the changes in the amount of goods or services produced or sold over a short period of time.

These are the expenses incurred by a business entity irrespective of any specific goods, services being produced or particular business activities being undertaken. Examples of fixed costs include rent, insurance, salaries, etc.

  • Variable Cost

Variable costs are the costs that change with the change in the level of output or business activities.

In other words, variable costs increase with the increase in the level of output and decrease with the decrease in the level of output.

Although the per unit variable cost is constant, however, the total variable costs change directly with the change in the volume of output. Examples of variable costs include direct material, direct labour etc.

  • Sunk Cost

These are the costs that have already been incurred by a business and cannot be recovered or reversed by any actions taken in the future.

Since these costs have already been incurred, they are referred to as past costs that are not considered in future decision making process.

Thus, the management takes into consideration only those costs that are appropriate for future business decision making.

  • Opportunity Cost

Opportunity cost is nothing but the benefits or profit that you lose over choosing an alternative course of action.

For instance, by investing money in plant and machinery a business owner has to give up on the gains he could have made if the same amount was invested in say shares or other financial securities.

Opportunity cost of losing the next best alternative helps the management in better decision making.

Cost Accounting Techniques

There are various techniques used by the management in order to control costs and undertake effective decision making. These are as follows:

  • Historical Costing

As the name suggests, this is a costing technique that relates to ascertaining costs that have already been incurred by a business entity.

As per this technique, costs are determined only after the production of goods or occurrence of business activities takes place.

In other words, it is the original cost at which assets are acquired by a business entity. Historical costs allow the users of the financial statements to draw comparisons between financial statements of two or more periods.

  • Marginal Costing

Marginal costing is a costing technique where costs are categorized as fixed and variable cost. Furthermore, the cost of producing additional outputs is calculated and the impact of changes in volume or type of such additional output on profit is analysed.

  • Standard Costing

Standard costing involves setting standard costs and comparing them with the actual cost.

Furthermore, the deviations of actual costs from the standard or predetermined costs are measured and analysed. This involves finding the underlying causes, their impact and taking the necessary action for maximum efficiency in production.

  • Activity Based Costing

In activity based costing, the business entity determines the cost of producing products by assigning a cost to each activity that contributes to the production of a good or service.

Thus, activity based costing takes both direct costs and overhead expenses that are incurred to produce each good or service.

  • Direct Costing

It is a costing technique in which costs that are directly incurred for goods, services or processes are charged to them.

The indirect costs, however, are written off against the profits only in the accounting period in which they occur.

  • Uniform Costing

In this costing technique, uniform or standardized cost accounting methods and principles are implemented by a large number of firms. This enables comparability between the accounting data of various firms so as to measure their performance.

  • Absorption Costing

Absorption costing involves charging the total cost, that is both fixed and variable cost, to the products, processes and operations.

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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