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Cost Accounting Fundamentals

• First Online: 19 November 2021

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• Teddy Steven Cotter 6  

Part of the book series: Topics in Safety, Risk, Reliability and Quality ((TSRQ,volume 39))

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Whereas managerial accounting tracks financial performance relative to strategic plans and budgets, cost accounting estimates costs, allocates overhead costs, and develops standard product costs. This chapter will provide an overview of cost accounting fundamentals. First, the chapter will define the different types of costs and cost purposes. Next, cash flow diagram conventions and uses are discussed in terms of breakeven, profit, and loss. Finally, the fundamentals of cost accounting for materials and components, labor, and overhead allocation are presented.

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Department of Engineering Management & Systems Engineering, Old Dominion University, Norfolk, VA, USA

Teddy Steven Cotter

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Cotter, T.S. (2022). Cost Accounting Fundamentals. In: Engineering Managerial Economic Decision and Risk Analysis. Topics in Safety, Risk, Reliability and Quality, vol 39. Springer, Cham. https://doi.org/10.1007/978-3-030-87767-5_3

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Published : 19 November 2021

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What Is Cost Accounting?

Understanding cost accounting.

• Cost vs. Financial Accounting
• Cost Accounting FAQs

The Bottom Line

• Corporate Finance

Cost Accounting: Definition and Types With Examples

Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Her expertise is in personal finance and investing, and real estate.

• Accounting Explained With Brief History and Modern Job Requirements
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• Current and Noncurrent Assets
• Accounting Theory
• Accounting Principles
• Accounting Standard
• Accounting Convention
• Accounting Policies
• Principles-Based vs. Rules-Based Accounting
• Accounting Method
• Accrual Accounting
• Cash Accounting
• Accrual Accounting vs. Cash Basis Accounting
• Financial Accounting Standards Board (FASB)
• Generally Accepted Accounting Principles (GAAP)
• International Financial Reporting Standards (IFRS)
• IFRS vs. GAAP
• US Accounting vs. International Accounting
• Understanding the Cash Flow Statement
• Breaking Down The Balance Sheet
• Understanding the Income Statement
• Financial Accounting
• Financial Accounting and Decision-Making
• Financial vs. Managerial Accounting
• Cost Accounting CURRENT ARTICLE
• Certified Public Accountant (CPA)
• Chartered Accountant (CA)
• Accountant vs. Financial Planner
• Tax Accounting
• Forensic Accounting
• Chart of Accounts (COA)
• Double Entry
• Closing Entry
• Introduction to Accounting Information Systems
• Inventory Accounting
• Last In, First Out (LIFO)
• First In, First Out (FIFO)
• Average Cost Method

Cost accounting is a form of managerial accounting that aims to capture a company's total cost of production by assessing all of its variable and fixed costs.

Cost accounting is not compliant with generally accepted accounting principles (GAAP); this accounting method is only used by businesses for internal purposes.

Key Takeaways

• Cost accounting is a form of managerial accounting that aims to capture a company's total cost of production by assessing both its variable and fixed costs.
• There are different types of cost accounting, including standard costing, activity-based costing (ABC), lean accounting, and marginal costing.
• Cost accounting is not compliant with generally accepted accounting principles (GAAP); therefore, it is only used internally to help companies make fully informed business decisions.
• Unlike financial accounting, which provides information to external financial statement users, cost accounting is not shared externally, so its methods can be tailored to meet the particular needs of a company.

Investopedia / Theresa Chiechi

Cost accounting is used by a company's internal management team to identify all variable and fixed costs associated with its production processes. Once all input costs are measured and recorded individually, a company can compare all of these costs to its output results. This is one way for a company to measure its financial performance and make future business decisions.

Types of Costs

Cost accounting attempts to capture all of a company's costs, both variable and fixed. While the exact costs used in cost accounting vary from industry to industry—and business to business—these cost categories will typically be included: direct costs, indirect costs, variable costs, fixed costs, and operating costs.

• Fixed costs are costs that don't vary depending on the level of production. These are usually things like the mortgage or lease payment on a building (or a piece of equipment) that's depreciated at a fixed monthly rate. An increase or decrease in production levels would cause no change in these costs.
• Variable costs are costs tied to a company's level of production. For example, a floral shop ramping up its floral arrangement inventory for Valentine's Day will incur higher costs when it purchases an increased number of flowers from a local nursery.
• Operating costs are costs associated with the day-to-day operations of a business. These costs can be either fixed or variable, depending on the unique situation of the business.
• Direct costs are costs related to producing a specific product. If a coffee roaster spends five hours roasting coffee, the direct cost of the finished product includes the labor hours of the roaster and the cost of the coffee beans.
• Indirect costs are costs that cannot be directly linked to a product. In the previous coffee roaster example, the energy cost to heat the coffee roaster is an indirect cost because it is inexact and difficult to trace to any individual products.

Cost Accounting vs. Financial Accounting

Financial accounting presents a company's financial position and performance to outside investors and creditors through financial statements , which include information about its revenues , expenses , assets , and liabilities .

While financial accounting presents information for external sources to review, cost accounting is often used by management within a company to aid in decision-making. Cost accounting can be beneficial as a tool to help management with budgeting. It can also be used to set up cost-control programs, with the goal of improving net margins for the company in the future.

Another key difference between cost accounting and financial accounting is that, while in financial accounting the cost is classified depending on the type of transaction, cost accounting classifies costs according to the information needs of the management. 

Cost accounting, because it is used as an internal tool by management, does not have to meet the standards set forth by  generally accepted accounting principles (GAAP) and, as a result, varies in use from company to company.

Cost accounting methods are typically not used to determine tax liabilities.

Types of Cost Accounting

Standard costing.

Standard costing assigns "standard" costs—rather than actual costs—to its cost of goods sold (COGS) and inventory. These standard costs are based on the most efficient use of labor and materials to produce the good or service under standard operating conditions; these standard costs are basically the budgeted amount. (Even though standard costs are assigned to the goods, the company still has to pay actual costs.)

Assessing the difference between the standard—most efficient—cost and the actual cost incurred is called variance analysis. If the variance analysis determines that actual costs are higher than expected, the variance is unfavorable. If it determines the actual costs are lower than expected, the variance is favorable.

Two factors can contribute to a favorable or unfavorable variance: the cost of the input and the efficiency (or quantity) of the input. The cost of the input is the cost of labor and materials. This is considered to be a rate variance.

The efficiency or quantity of the input used is considered a volume variance. For example, if XYZ company expected to produce 400 widgets in a period but ended up producing 500 widgets, the cost of materials would be higher due to the total quantity (volume) produced.

Activity-Based Costing (ABC)

Activity-based costing (ABC) identifies overhead costs from each department and assigns them to specific cost objects, such as goods or services. ABC cost accounting is based on activities, which refer to any event, unit of work, or task with a specific goal—such as setting up machines for production, designing products, distributing finished goods, or operating machines. These activities are also considered to be cost drivers , and they are the measures used as the basis for allocating overhead costs .

Traditionally, overhead costs are assigned based on one generic measure, such as machine hours. Under ABC, an activity analysis is performed where appropriate measures are identified as the true cost drivers. As a result, ABC cost accounting tends to be much more accurate and helpful when reviewing the cost and profitability of a company's specific services or products.

For example, suppose there is a company that produces both trinkets and widgets. The trinkets are very labor-intensive and require quite a bit of hands-on effort from the production staff. The production of widgets is automated; it mostly consists of putting raw material in a machine and waiting many hours for the finished goods. It would not make sense to use machine hours to allocate overhead to both items because the trinkets hardly use any machine hours. Under ABC, the trinkets are assigned more overhead costs related to labor and the widgets are assigned more overhead costs related to machine use.

Lean Accounting

The goal of lean accounting is to improve financial management practices within an organization. Lean accounting is related to lean manufacturing and production, which has the stated goal of minimizing waste while optimizing productivity. For example, if an accounting department is able to cut down on wasted time, employees can focus that saved time more productively on value-added tasks.

When using lean accounting, traditional costing methods are replaced by value-based pricing  and lean-focused performance measurements. Financial decision-making is based on the impact on the company's total value stream profitability. Value streams are the profit centers of a company; a profit center is any branch or division that directly adds to a company's bottom-line profitability.

Marginal Costing

Marginal costing (sometimes called cost-volume-profit analysis ) examines the impact on the cost of a product by adding one additional unit into production. It is useful for short-term economic decisions. Marginal costing can help management identify the impact of varying levels of costs and volume on operating profit. This type of analysis can be used by management to gain insight into potentially profitable new products, sales prices to establish for existing products, and the impact of marketing campaigns.

The  break-even point —which is the production level where total revenue for a product equals total expense —is determined by calculating the total fixed costs of a company and dividing that by its contribution margin. The contribution margin , calculated as sales revenue minus variable costs, can also be calculated on a per-unit basis in order to determine the extent to which a specific product contributes to the overall profit of the company.

History of Cost Accounting

Scholars believe that cost accounting was first developed during the Industrial Revolution; the emerging economics of industrial supply and demand forced manufacturers to start tracking their fixed and variable expenses to optimize their production processes.

How Does Cost Accounting Differ From Traditional Accounting Methods?

In contrast to general accounting or financial accounting, cost accounting is an internally focused, firm-specific method used to implement  cost controls . Cost accounting can be much more flexible and specific, particularly when it comes to the subdivision of costs and inventory valuation. Cost-accounting methods and techniques will vary from firm to firm and can become quite complex.

Why Is Cost Accounting Used?

Cost accounting is helpful because it can identify where a company is spending its money, how much it earns, and where money is being lost. Cost accounting aims to report, analyze, and improve internal cost controls and efficiency. Even though companies cannot use cost-accounting figures in their financial statements (or for tax purposes), they are important for internal controls.

Which Types of Costs Go Into Cost Accounting?

These will vary from industry to industry and firm to firm. However, certain cost categories will typically be included (some of which may overlap), such as direct costs, indirect costs, variable costs, fixed costs, and operating costs.

What Are Some Advantages of Cost Accounting?

Since cost-accounting methods are developed by—and tailored to—a specific firm, they are highly customizable and adaptable. Cost accounting is useful because it can be adapted, tinkered with, and implemented according to the changing needs of a business. Unlike the  Financial Accounting Standards Board (FASB) -driven financial accounting, cost accounting need only concern itself with insider eyes and internal purposes. Management can analyze information based on criteria that it specifically values; that information can then be used to guide how prices are set, resources are distributed, capital is raised, and risks are assumed.

What Are Some Drawbacks of Cost Accounting?

Cost-accounting systems, and the techniques that are used with them, can have a high start-up cost to develop and implement. Training accounting staff and managers in new accounting systems takes time and effort, and mistakes may be made early on. Higher-skilled  accountants  and  auditors  are likely to charge more for their services when evaluating a cost-accounting system.

Cost accounting is one method a company can use to estimate how well the business is running. Cost accounting looks to assess the different costs of a business and how they impact operations, costs, efficiency, and profits. Individually assessing a company's cost structure allows management to improve the way it runs its business and, therefore, improve the value of the firm. Since it is not GAAP-compliant, cost accounting cannot be used for a company's audited financial statements released to the public. Figures from cost accounting are meant to be internal metrics only.

Fleischman, Richard K., and Thomas N. Tyson. "The Economic History Review: Cost Accounting During the Industrial Revolution: The Present State of Historical Knowledge." Economic History Review , vol. 46, no. 3, 1993, pp. 503-517.

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