What is Cost Accounting

Cost accounting is a branch of accounting that focuses on

- recording,
- analyzing, and
- controlling the costs
associated with producing goods or delivering services. Its primary purpose is to help organizations
- manage and reduce costs,
- make strategic decisions, and
- improve efficiency.

Here are some core aspects of cost accounting:

1. Cost Collection & Classification:

o Cost collection is the process of gathering, recording, and categorizing all costs
associated with business operations to accurately assess, allocate, and manage
expenses. It is a foundational step in cost accounting, allowing organizations to
understand where their money is spent, improve cost efficiency, and make informed
financial decisions.

2. Cost Control and Reduction:

o Cost Control: Cost control is the process of monitoring and regulating the expenditure
within predefined budgetary limits to keep it aligned with the budgeted figures. The
primary goal is to maintain expenses at acceptable levels without compromising the
quality of products or services

o Cost reduction: Cost reduction is the process of permanently lowering costs by finding
and implementing more efficient methods, technologies, or practices. Unlike cost
control, cost reduction focuses on lowering the base cost structure over the long term.

3. Costing Methods:

o There are various costing methods used to calculate the cost of products or services, like

a. Job costing
b. Process costing
c. Activity-based costing (ABC)
d. Variable Costing
e. Absorption Costing
f. Standard Costing
g. Historical Costing
h. Uniform Costing
 4. Cost-Volume-Profit (CVP) Analysis:

o This analysis helps businesses understand the relationship between costs, sales volume,
and profits. It’s essential for pricing strategies, break-even analysis, and understanding
the impact of changes in costs or prices on profits.

5. Decision-Making Support:

o Cost accounting provides information to support decisions, such as whether to produce

or outsource, accept special orders, or discontinue a product line. Relevant costing and
margin analysis help determine the financial impact of these choices.

6. Budgeting and Variance Analysis:

o Cost accounting aids in budgeting by setting standards cost and analysing variances
between expected and actual costs, allowing businesses to identify inefficiencies.

Conclusion:

Overall, cost accounting is a vital tool for businesses aiming to:

- Control costs,
- Maximize profitability, and
- Make informed financial decisions.

Cost Accounting Systems

There are eight different types of cost accounting systems:

1. Historical Costing

The Historical Costing System is a traditional cost accounting method that records assets,
expenses, and liabilities at their original purchase price, regardless of any subsequent changes in
market value. Industries using Historical Costing: Textile, Food Processing, Beverages, Chemicals,
Pharmaceuticals, etc.

2. Absorption Costing

The Absorption Costing System, also known as full costing, is an accounting method where all
costs of production are absorbed by the units produced. This means that both fixed and variable
costs are included in the cost of each product. Industries using Absorption Costing: Aerospace,
Automative, Ship Building, Chemicals, etc.

3. Direct Costing (Marginal Costing)

The Direct Costing System, also known as variable costing or marginal costing, is an accounting
method where only variable production costs (direct costs) are included in the cost of goods
manufactured. Industries using Direct Costing: Manufacturing, Oil & Gas, Construction,
Automobile, etc.
4. Standard Costing
The Standard Costing System is a cost accounting method where standard costs are established
for products, materials, labor, and overhead. These standard costs are based on expected costs
under normal operating conditions, serving as benchmarks for performance evaluation and cost
control. In this system, the actual costs incurred are compared to these standards, and any
variances are analyzed to assess efficiency and identify areas for improvement. Industries using
Standard Costing: Manufacturing, Oil & Gas, Construction, Automobile, etc.

5. Uniform Costing

Uniform Costing System refers to a standardized method of costing applied across different
companies or divisions within the same industry, ensuring that all firms adopt the same
principles and practices for calculating costs. Industries using Uniform Costing: Automobile,
Electricity, Steel Industry, etc.

6. Activity Based Costing (ABC)

ABC method is used to get a more accurate understanding of the costs associated with making
products or providing services. Instead of just adding up all expenses and spreading them evenly
across products, ABC focuses on specific activities that drive costs in the production process. By
tracing costs back to these activities, a business can better understand what each product or
service truly costs. Industries using ABC: Manufacturing, healthcare, and service sectors, etc.

7. Process Costing
Process costing is a method used to calculate the cost of making products that are mass-
produced and go through multiple stages or steps. Imagine a factory that makes thousands of
identical items, like bottles of soda or rolls of paper. Since each product is the same, the
company doesn’t need to track the cost of each individual item separately. Instead, it calculates
the total cost of production for each stage (or "process") and then divides that cost by the
number of units produced to get the average cost per item. Industries using Process Costing:
Chemical Industry, Food & Beverages, Textile, Cement, etc.

8. Job Costing
Job costing is a way to calculate the cost of making products or providing services that are
unique or customized. Instead of averaging costs over identical items like in process costing, job
costing tracks all costs for each individual job or project separately. This method is perfect for
businesses that work on custom orders or projects where each one is different, such as building
a house, creating a custom piece of furniture, or designing a unique software solution.
Industries using Job Costing: Construction, consulting, etc.
Cost Vs Expense
Cost refers to the total expenditure incurred to produce or acquire something, which can be part of the
production process or related to creating an asset.

Expense refers to the portion of the cost that is used up or consumed in the current period and is
deducted from revenue to determine profit.

Classification of Cost
Cost classification refers to the process of categorizing costs based on their characteristics, behavior,
function, or relation to production.

Understanding how to classify costs helps businesses with budgeting, financial reporting, and decision-
making. Here are the main ways costs are classified:

1. Based on Behavior

a) Fixed Costs:

 Definition: Costs that do not change with the level of production or sales. They remain
constant over a range of activity.

 Examples: Rent, insurance premiums, salaried employees, depreciation on machinery.

b) Variable Costs:

 Definition: Costs that vary directly with the level of production or sales. The more you
produce or sell, the higher these costs.

 Examples: Raw materials, direct labor (wages for hourly workers), packaging supplies.

c) Semi-Variable (Mixed) Costs:

 Definition: Costs that have both fixed and variable components. They remain fixed up to
a certain level of activity but increase with production beyond that level.

 Examples: Utility bills (e.g., a fixed base rate + additional charges based on usage),
maintenance costs (fixed for regular checks but additional for repair work).

2. Based on Function

a) Production Costs (Manufacturing Costs):

 Definition: Costs incurred in the production of goods or services.

 Examples: Direct materials, direct labour, factory overhead (e.g., factory rent, machinery
maintenance).
 b) Non-Production Costs (Non-Manufacturing Costs):

 Definition: Costs that are not directly involved in the production of goods or services.

 Examples: Administrative expenses (e.g., office salaries, office rent), selling and
distribution costs (e.g., marketing, transportation).

c) Direct Costs:

 Definition: Costs that can be traced directly to a specific product, service, or

department.

 Examples: Direct labor, direct materials (e.g., the wood used to make furniture).

d) Indirect Costs:

 Definition: Costs that cannot be traced directly to a specific product or service. They are
usually allocated across various products or services.

 Examples: Factory rent, utilities, administrative salaries.

3. Based on Nature

a) Materials Costs:

 Definition: The cost of raw materials and components used in production.

 Examples: Steel, wood, fabric, components for electronic devices.

b) Labor Costs:

 Definition: The cost of labor employed in production or service delivery.

 Examples: Wages, salaries, bonuses, and benefits for workers directly involved in
production or services.

c) Overhead Costs:

 Definition: Indirect costs associated with the production process. These are not directly
tied to the creation of a specific product but are necessary for operations.

 Examples: Factory rent, utilities, equipment depreciation, office supplies.

4. Based on Controllability

a) Controllable Costs:

 Definition: Costs that can be influenced or controlled by a manager or department

within a specific period.

 Examples: Direct materials, direct labour, and operating expenses that can be adjusted
with better management.
 b) Uncontrollable Costs:

 Definition: Costs that cannot be easily changed or influenced by a manager, often due to
external factors or long-term contracts.

 Examples: Rent agreements, long-term insurance premiums, fixed government taxes.

5. Based on Time

a) Historical Costs:

 Definition: Costs that have already been incurred in the past.

 Examples: Costs recorded on previous financial statements, such as the purchase price
of equipment.

b) Predetermined Costs (Budgeted Cost):

 Definition: Estimated costs set in advance, often based on historical data and expected
future conditions.

 Examples: Budgeted cost for next year’s production based on past performance and
projected sales.

6. Based on Decision-Making

a) Relevant Costs:

 Definition: Costs that will be affected by a particular decision and should be considered
when making that decision.

 Examples: Incremental costs for a special order, additional material costs when
launching a new product.

b) Irrelevant Costs:

 Definition: Costs that will not be affected by a decision and should not be considered.

 Examples: Sunk costs (costs that have already been incurred and cannot be recovered),
past research and development costs.

7. Other
a) Opportunity Costs:
 Definition: Opportunity cost refers to the value of the next best alternative that you give
up when making a decision. In simple terms, it's the cost of choosing one option over
another.
 Examples: Investing in One Stock Instead of Another, Buying a New Phone Instead of
Paying Off Debt, Spending Time Watching TV Instead of Learning a New Skill, Choosing a
Job with a High Salary Over Job Satisfaction, etc.
b) Sunk Cost
 Definition: A sunk cost is a cost that has already been incurred and cannot be recovered,
regardless of what decision is made in the future. Once a cost is spent, it’s considered
"sunk," meaning it should not influence future decisions.
 Examples: Research & Development expense, Equipment purchase cost, Marketing
Campaign, Training cost, etc

c) Imputed Cost
 Definition: An imputed cost is a cost that is not actually paid out in cash but is still
considered for decision-making purposes. It's a theoretical or notional cost that
represents the opportunity cost of using resources in one way rather than another. In
simple terms, it's a cost that you should account for, but don't have to physically spend.
 Examples: Company’s car for delivery, Owner capital, Using owned premises for
business, etc