Importance of Cost Accounting and its Application

The companies always look for lastingness and presence in the business market, as the business market is defined by intense competition and a permanent increase in the no of companies, companies had to build a strong system of costs equivalent with the nature of the company’s function and provide accurate information of product prices that enable them to get control over the cost elements and then leave out avoidable costs and reduce the costs of products as much as possible while achieving the desires of the consumer to improve product sales and then profits maximization, finally, continuity and increase competitiveness in the business market, and to accomplish this intimidating equation, it is just companies must 1^st  apply modern cost systems such as ABC (activity-based costing), as well as follow new methods of reducing costs such as the continuous target costing, improvement method,  and total quality management, etc. However, with the verity of activities and the huge size of companies, the application of such modern systems for cost accounting has become hard and can only be obtained with the help of cost accounting software that achieves the company’s objectives by connecting all departments and providing all the accurate data of the company’s cost elements in a way that guarantees companies control the cost elements and then have control over them, in this article we will cover how this can be achieved. We will also discuss the importance, types, functions and applications of cost accounting.

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Highlights

• Cost accounting focuses on the expenditures involved with running your business.
• It is a usual form of accounting for manufacturing businesses, as it allows them to break out costs for every product they manufacture.
• Cost accounting, when it’s used suitably, can help businesses recognise areas where they can save money.

A key component of accounting is to understand how much you are spending. If you don’t have a control on your expenses, you will never understand whether your business is making money. This is  where cost accounting comes in to play. Cost accounting focuses specifically on the costs associated with running your business. Before you can understand cost accounting in detail, it is important to understand what does it exactly mean, the different types of cost accounting and the advantages of this type of financial tracking.

Cost Accounting: Meaning

Cost accounting is a form of accounting that concentrates strictly on a business’s costs – both fixed and variable. Using the cost accounting method, companies identify all of their costs and allocate them to various processes or units of production, allowing managers to clearly understand the economics of their business’s activities.

Cost accounting is particularly important for businesses that manufacture and sell at scale and/or have various product lines, as these companies have plenty of costs associated with manufacturing, packaging, and distributing their goods. For these types of businesses, accounting for costs is essential to accurately calculating profit margins, along with forecasting, budgeting and identifying efficiencies.

Cost Accounting: Purpose

Compared to other types of accounting, cost accounting provides companies a comprehensive view of their costs. Cost accounting tracks all of a company’s costs linked with its offerings and allocates them to specific products or activities. On the other hand in financial accounting, costs appear as just one or two line items on a budget, cost accounting allows businesses bring down the expenses to see exactly what is driving costs. This can give better insights into what the company can do to reduce costs and amplify profits.

In general, there are only two method by which companies can make more money: They can either increase sales (which is largely out of their control), or they can reduce costs (which they have better control over).

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Cost Accounting: Benefits

Not only can you understand the total costs involved to manufacture your products, but it can be easier to spot instances of overcharging by sellers. In addition to that your company may be able to determine efficiencies that allow you to save money.

Some of the benefits of cost accounting are listed below:

Cost allocation: Managers can assign costs by product line and per unit of production or an hour of labor.

Profit drivers: Cost accounting helps business owners get a deeper understanding of their profit margin and what controls it.

Budgeting and forecasting: Calculating costs for single activities helps senior managers plan for future expenditures and forecast their monetary resource into the future.

Cost savings: With the help of cost accounting, businesses may be able to recognise new efficiencies to help save money.

Quicker decisions: Cost accounting can help managers respond rapidly to changes in the market, such as when the cost of raw materials ramps up.

In addition to these, cost accounting can also help business owners to ensure that they capture all of their tax-deductible expenses.

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Types of costs

When using cost accounting, it is essential to learn about the different types of costs.

Cost	Examples
Fixed Cost	Mortgage payments, rent and insurance
Variable Cost	Supplies, raw materials,  packaging
Operating Cost	Accounting and legal, utilities, marketing
Direct Cost	Labour hours for production and distribution

While these are the 4 most common categories for grouping costs, there are different types as well, such as semi variable. In addition, some costs fall into many categories, or they may fall into different categories based on an individual company, the industry it’s in and how it functions.

Fixed costs

Fixed costs don’t vary based on a company’s level of production. These costs include items such as mortgage payments, rent and salaries for administrative personnel. Fixed costs are important, as they don’t stop if managers temporarily stop production. Some fixed costs don not halt even if a business folds.

Variable costs

A company’s variable costs are those that vary depending upon the company’s level of activity. For manufacturing companies, for eg, each additional unit of production needs purchasing more raw materials.

Variable costs are important for a company because they are marginal – every additional unit of production adds extra cost to the company. These costs can often be reduced through bulk discounts or other breakpoints.

Operating costs

Operating costs consists of the expenses involved with running a facility (marketing and utilities are prime eg); it doesn’t consider costs that are directly associated with production.

Operating costs may be fixed or variable, but they are usually the costs that companies require to pay to stay in business – even if they aren’t producing anything.

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Direct costs

Direct costs include those costs that a company can tie directly to the production or distribution of a specific product. For eg, if you run a manufacturing company, direct costs include the costs for running equipment to manufacture that product along with labor hours for manufacturing a product.

Direct cost is important as it is the easiest of the four types to allocate to a particular activities or product lines, though it’s not usually the easiest place to find cost savings.

Types of cost accounting

Within cost accounting, there are different sub-types. Each of these is used by different types of companies for various functions. For eg, lean cost accounting is for manufacturing companies utilizing other lean practices.

The 4 major types of cost accounting are:

Standard: This is regular cost accounting; costs for each product line are calculated depending upon historical experience to be used for forecasting and budgeting.

Activity: Costs are assigned by individual business activity (each product line).

Lean: This is more specialized and fashioned to give insights to manufacturing companies implementing other lean practices such as lean manufacturing and lean inventory management. It is more conservative compared to other types of accounting. For example, you only document the value of inventory over time.

Marginal: Marginal cost accounting only considers the varying cost for a specific product. Whereas other types of cost accounting assign a portion of fixed costs to each product line, in marginal cost accounting, these costs are not included. It assumes that fixed costs have to be remunerated whether a business takes on a certain activity or not, so they are not allocated to particular activities.

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Difference Between Cost Accounting and Financial Accounting:       

Cost accounting focuses strictly on a business’s costs, while financial accounting combines this information with other costs, like liabilities, revenue and shareholder equity, to give a extensive look at a company’s finances.

Both cost and financial accounting are needed to keep track of the elements of a business’s finances. This data helps escort company strategy, including informed decision making. However, while cost accounting aims at tracking costs and allocating those costs to special offerings or activities, financial accounting keeps track of all aspects of a company’s finances. Financial accounting consists of cost accounting along with other elements like income, liabilities, and equity – which it combines to give detailed reports and insights into the company’s financial circumstances and future prospects.

The Importance of Cost Accounting

• Cost accounting is important for all functions(of a companies) and it is not as is prevalent that cost accounting is constricted in importance for manufacturing companies only, cost accounting has an important role in finding and controlling the services cost, and that the success elements of any commercial activity is the use of cost accounting systems and therefore the significance of cost accounting is as follows:
• Cost control by aggregating and recording all the cost elements of the company.
• Cost classification via cost accounting methods, which allows us to differentiate between all types of costs.
• Pricing of products in cost accounting plays an important role in limiting the pricing of products, as it provides cost reports, it is also possible to make use of newer methods of pricing of products such as the target costing method, via which the price of products can be calculated and the target profit margin can be added before starting production.
• Contributing to amplify the company’s profits and increasing its competitiveness, had it not been for the cost accounting, the companies would not have been able to learn about the costs of products and control it, and thus the ability to reduce costs to the lowest possible value and increase profits to the maximum possible profit.
• Generating the budgeting, via the methods of cost accounting, the company can create budgeting, and so that such budgeting can be created, the actual activity costs of the company must be calculated for previous years so that the company can predict what the future cost will be and can also via budgeting of tightening control and control of cost elements by comparing actual costs with standard costs and detecting deviations, then analyzing these variances and working to resolve these shortcomings of costs.
• Assisting the department in taking decisions by providing the necessary cost reports, whether it is for the production elements or activities (cost centers) to help the department in excluding the avoidable costs, and supporting the important cost centers that achieve the consumer’s desires and improve the product’s ability to compete in the market.
• Cost accounting has a set of objectives or rules that are seeking to accomplish in companies so that companies achieve their desired objectives.

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The Objectives of Cost Accounting

The objectives of cost accounting are completely in accordant with the company’s objectives, as they both look forward to cost reduction and increasing the profitability and competitiveness of the company, perhaps the most important objectives of Cost Accounting are the following:

• Accurately deciding product costs, through what cost accounting does of recording, collecting and classifying costs.
• Controlling of over cost elements.
• Assisting the department in taking decisions via appropriate cost reporting.
• Planning for the future via cost accounting that provides the budgeting.
• Pricing products and finding the target costing and then profits maximization.
• Amplifying the profitability and competitiveness of companies.

Given in the next section are some of the most important applications of cost accounting for some activities.

Cost Accounting Applications

There is no activity without its ability to apply cost accounting to it because all activities can be applied to cost accounting

We will discuss some of the activities to which cost accounting is applied in this section:

1. Hotel cost accounting

Cost accounting in hotels is performed to record all the hotel costs, assort and analyze them to provide reports to the department for observation and decision-making purposes, in the hotel system; it follows the homogeneous system of accounts, each hotel department has its revenues and expenses and hence every unit of the hotel can be considered as cost centers and cost accounting procedures in hotels is based on designing a chart of cost centers, which includes:

i) Revenue cost centers that generate revenue

It represents the hotel divisions that generate revenue for the hotel and are its activity base such as

a) Rooms Division

b) Food Department

c) Beverage Department

d) SPA& Fitness Division

e) Laundry Department

d) Front Office Department

ii) Service cost centers that do not generate revenue

a) Finance Department

b) Human Resources Department

c) Procurement Department

The role of cost accounting in hotels

Segregating  the hotel into cost centers where the costs is calculated, whether they are variable costs or fixed costs, direct costs or indirect costs, and each cost center is assigned by its proportion of the costs, hence the role of cost accounting appears in calculating the ratios of fixed costs from activities that do not make revenue for the hotel to the total costs to work on reducing it to the maximum possible extent that does not impact the operational capacity of the hotel, in addition to the role of cost accounting in determining revenue from activity to know how much each department (cost center) make revenue and how much is spent on it of the expense and in the end it is possible to generate Cost Center reports for each specific department separately and also for the hotel in general. Through these reports the hotel managers can leave out activities that do not generate revenue or address the shortcomings and analyze the causes of their problems as well as extend activities that generate revenue for the hotel.

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2. Manufacturing Cost Accounting

The manufacturing activity is determined by that which is based on the process costing system; for example a manufacturing plant (packaged cheese), there are certain phases for the production of a single package of the product. Hence, its possible to calculate how much it costs from direct materials, direct labor and manufacturing overhead cost, and therefore it is easy to predict the costs of each work order in advance, even if approximately, and creating production budgets and comparing these planned costs with the actual costs, and cost accounting calculates the cost elements for each work order through:

a. Direct Materials Cost

It includes all the materials used in the production process, whether raw materials, semi-finished materials, or packing and packaging materials, etc. cost accountant keeps an eye on their prices by following the policy of perpetual inventory through controlling the inventory, which allows him to determine direct material costs.

b. Direct Labor Cost

It means all direct labor costs incurred production as wages for machine operators like sorting, picking, packaging,  production line workers etc.

c. Manufacturing Overhead Cost

The cost accountant determines all overhead costs and additional services and assign them to the products in proportion to the consumption of each product of them and that is by creating cost centers for all production departments and allocating each department with the necessary overhead costs.

The role of cost accounting in manufacturing 

Cost accounting has an important role in the manufacturing activity, as it determines the product costs accurately, which assists the company in setting product pricing policies, it also has a major role in tightening control over cost elements of direct material costs, direct labor cost and manufacturing overhead cost via controlling materials costs and the company can know the ratio of fixed costs to total costs in a way that assists the department to reduce the fixed costs to the minimum possible value, which does not affect the company’s activity. Cost accounting plays an important role in the treatment of the cost variances through the provided budgeting, so each work order, it must be included in the budgeting to compare the actual costs with the standard costs and knowledge of variances and analyzing them and then treatment of these variances.

3. The importance of cost accounting software

Cost accounting software has an important role in applying the policies and procedures of modern systems of cost accounting and calculating costs as accurately as possible, via

a) Connecting between the departments in the cost accounting software of the manufacturing companies assists in classifying, recording and appropriate allocation of all the costs to each cost center instantly which leaves no provision for the field for neglecting any cost.

b) Linking between the purchasing department and finance department of manufacturing companies allows the cost accountant to determine and control material costs as accurately as possible and measure the prices of materials in a way that increases the ease of pricing products.

c) Linking between the production department and the human resources department facilitates the determination of wages and then the cost of the product.

d) Creating a chart of cost centers and link it to the chart of accounts, that achieves modern systems of cost accounting.

e) Reports provided by cost accounting software facilitate the works of cost control and for creating budgeting and for detecting variances as quickly and accurately as possible, thus finding their causes and treating them.

f) Cost accounting software facilitates the decision-making by getting rid of avoidable costs.

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Cost Accounting: Quiz

1. Financial audit looks forward at the verification of a

a) cost accounting

b) financial accounting

c) management accounting

d) none of these

Ans: (b) financial accounting

2. Volume variance is segregated into capacity variance, calender variance and

a) casual variance

b) performance variance

c) efficiency variance

d) normal variance

Ans: (c)efficiency variance

3. Management by exception exercise controls over

a) favourable items

b) unfavourable items

c) management

d) subordinate

Ans: (b) unfavourable items

4. ____ costing cannot be used in small concerns.

a) Unit

b) Service

c) Process

d) Standard

Ans: (d) Standard

5. _____ is the technique of exercising control over unfavourable items.

a) MBO

b) MBT

c) MBE

d) ZBB

Ans: (c) MBE

6. Standard cost of labour – Actual cost of labour is equal to __________.

a) Total labour cost variance

b) Labour cost ratio

c) Variance ratio

d) Either (2) or (3)

Ans: (a) Total labour cost variance

7. _______ costing is a standardisation of the costing practices and principles in the same industry.

a) Standard

b) Uniform

c) Process

d) Marginal service

Ans: (b) Uniform

8. The success of ______ costing is dependent on mutual trust and co-operation among the units.

a) standard

b) uniform

c) process

d) service

Ans: (b) uniform

9. Uniform costing facilitates _____ comparison of cost of production.

a) inter-firm

b) inter-unit

c) intra-firm

d) intra-unit

Ans: (b) inter-unit

10. Cost audit assists the

a) manager

b) customer

c) shareholder

d) financial auditor

Ans: (d) financial auditor

 

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