Cost Accounting – Types, Example, Advantages, and More

What is Cost Accounting?

Cost Accounting is referred to as a branch of managerial accounting, which mainly aims to encapsulate all costs within a company, by assessing variable costs along with each step of production. It is considered to be a metric that helps companies to make informed decisions that are backed by reliable quantitative measures.

Cost Accounting is different from financial accounting in the sense that financial accounting is used in order to communicate the performance of the company to external stakeholders.

On the contrary, cost accounting mainly considered as an internal metric that helps the company to make important decisions. Therefore, cost accounting is primarily an internal metric that is used to evaluate cost centers, and how they can be managed in order to help the company aim for better efficiency within the organization.

In order to do that, cost accounting inculcates all inputs that are associated with production. This implies that it used both, variable costs as well as fixed costs in order to determine the best strategy for the company. Within the realm of cost accounting, there are several different measures that are utilized by businesses. Various types of Cost Accounting include standard costing, activity-based costing, lean accounting, as well as marginal costing.

Types of Cost Accounting

As mentioned earlier, cost accounting in itself has a number of types. The description for all these types of cost accounting is given below:

1) Standard Costing

Standard Costing involves companies having benchmarks or standards that they believe are going to result in a higher efficiency rate. Therefore, as opposed to actual costs, standard costs are used as the basis of the cost of goods sold and inventory.

Regardless of the fact that the actual costs are still incurred, which have to be borne by the company, yet standard costing helps the company to analyze the reason behind variances. These variances can subsequently be traced down in order to get a better idea regarding what needs to be done in order to minimize the impact of standard costing.

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2) Activity-Based Costing

Activity Based Costing is used to identify overhead costs from all the relevant departments within the production setup. In this regard, it is imperative to consider the fact that these activities are used because they are considered to be predominant cost centers for the company.

Therefore, associating relevant costs to these variables considerably helps companies to make decisions regarding the application of these overhead costs. Overhead costs are mostly assigned on generic measures, like machine hours, or labor hours. Based on this, the company is able to make decisions regarding adjustments that need to be made in the cost centers in order to catapult better optimization across their operations.

3) Lean Accounting

Lean Accounting mainly lies in the realms of ensuring that financial management practices are considerably improved within an organization. It is considered to be an extension of lean manufacturing and production.

It mainly requires companies to identify cost centers and value centers, so that they can make decisions based on the actual activities of the business that generate the most profits.

4) Marginal Costing

Also referred to as Cost-Volume-Profit Analysis, marginal costing aims to capture the impact on the overall costing if production is increased by a single unit. It helps management in the identification of varying levels of costs and volumes on the overall operating profit of the company.

Therefore, the company can then make informed decisions based on new product additions, as well as changes in prices and the subsequent impact on the overall volume.

Example of Cost Accounting

Cost Accounting is widely used across almost all organizations today. Here is a few examples of the most commonly used metrics of cost accounting:

Advantages of Cost Accounting

Cost Accounting tends to be highly popular across all organization types, regardless of the industry they are operating in. The main reason as to why cost accounting is highly preferred amongst managerial accounting is summarized in the points mentioned below:

  • Improvement of Efficiency: The greatest advantage of cost accounting is the fact that it helps the company to understand their internal cost structure, and how it can be managed in order to make the system more efficient. For example, Activity Based Costing helps to identify major cost centers, as well as major activities funded by these costs.
  • Distinction between profitable and unprofitable activities: Cost accounting helps in determining which activities are considered profitable. This implies that using cost accounting a company to distinguish the profitable activities from the non-profitable ones. This can help them discontinue operations in cases where they think it is not profitable.
  • Price and Volume Related Decisions: Setting prices arbitrarily is not always a best course of action. In this regard, it is important to note the fact that cost accounting helps companies to set their pricing, with a proper understanding regarding their profitability, and impact on the price change on their overall profits.
  • Control over Materials: Variance Analysis tends to be one of the most important integral insights for the company. Cost accounting helps the company to draw budgets, to make sure that they are able to get have a better material (and labor) utilization rate. This can help them to formulate internal controls. Budgeting and monitoring is going to help them to figure out what exactly were the reasons behind the variation, and how can they avoid this from happening in the future.
  • Cost Accounting helps companies to apply budgeting and forecasting. This helps them to prepare for the future, and hence, get a competitive edge over other players in the market.
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Limitations of Cost Accounting

Given the fact that cost accounting is considered to be one of the most integral decision making tool-kit for organizations, yet it can be seen that there are several other factors that need to be considered as considerations towards limitations of cost accounting. These limitations are given below:

  • Firstly, it can be seen that cost accounting is quite expensive. This means that companies might not always have the resources to hire an accountant to execute management accounting in a proper manner. Therefore, for smaller companies with limited budgets, implementing a cost accounting system might not be entirely feasible.
  • Cost Accounting is not required for compliance, therefore, it is often redundant. Since cost accounting is not entirely compulsory by law, it is important to note the fact that it might only lead to increased costs for the company. This is because the reality might often be different from the outcomes put forth by cost accounting. Therefore, cost accounting is normally an addition, which might not always add value to the company.
  • Cost accounting is often complex and is not always applicable. Cost Accounting is often considered to be highly complex, because of which it cannot always be applied. For example, standard costing might change from year to year hence, standardized rates might not always hold. In the case of any variance, it might lead to excessive pressure on the workforce which might eventually lead to demotivated workers.
  • The fact that cost accounting mostly relies on past data tends to be problematic from the perspective of the company. This tends to be problematic because it cannot be used by companies that do not have a past data record, or for companies that are newly established. Also, a lot of companies tend to see significant volatility when it comes to pricing and costing. Therefore, cost accounting might not be well suited across all industry types.
  • Cost Accounting does not consider external factors. The main focus of cost accounting is to derive internal efficiency using internal company metrics. It does not incorporate any external factors that impact the profitability of the business. Therefore, this cannot be solely relied upon by businesses.
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