Cost accounting is the specialized discipline of managerial accounting focused on timing and attributing costs accurately. Although the concept of cost accounting is simple, the actual practice is challenging, whether the business is manufacturing, construction, distribution, or even professional services. Cost accounting theory is vast, its merits highly debated by professionals, implementing cost accounting is resource-intense, and, let’s face it, costing is not sexy. Despite its drawbacks, the critical information provided to management through good cost accounting far outweighs its burden. Conversely, bad cost accounting (or no cost accounting) frequently leads to financial distress and business failure.
Does your business need better cost accounting? Signs of bad cost accounting include:
- Volatile gross margins month-to-month
- Profit on your income statement, but shrinking cash
- Consistent losses and no understanding of the root of the problem
- An inventory process that is burdensome to maintain and prone to error
What is the purpose of cost accounting?
Cost accounting, like any form of financial accounting, is an information system to empower management decision making. By assigning accurate cost to each of your products or services, you can:
- Direct your sales team to sell profitable products and services
- Plan efficiency improvements that maximize impact
- Identify unfavorable variance and improve operations
- Direct research and development efforts toward profitable markets
- Perform financial analysis to gain market insight
- Have predictable inventory levels and minimize both shrinkage (loss) and excess (overstock)
Without good costing, you are left guessing based on instinct. Businesses under $2M in revenue can get by with instincts only, but your instincts tend to miss important details in larger businesses. That’s where good financial accounting can help.
Good costing is also good control. A relatively minor variance over the course of months can grow into a stunning wallop by year end, and solid cost accounting can identify both the variance and its cause before it becomes a nasty surprise.
What are the two types of costs?
Variable costs increase with each additional unit sold. Fixed costs remain (relatively) constant with each unit sold. Consider an iPhone factory as an example: a variable cost would be computer chips; whereas a fixed cost would be facility rent.
Most small businesses calculate gross margins on variable costs only, but a cost accountant would apply both fixed and variable costs to your margins. This allocation is critical to effective planning – if our example factory can’t make enough iPhones to cover their rent, then no amount of sales will ever bring them to profitability.
Cost accountants sometimes create confusion. For example, that factory may have a month with lower sales (but the same facility rent) driving their margins down. A naïve manager may see this drop in margins, decide costs are too high, and begin prematurely laying off staff or downsizing the facility. This is a classic costing “death spiral,” and illustrates the importance of having a cost accountant or CFO to interpret your financial and consult on business decisions.
What are the different types of cost accounting?
Choosing the right type of cost accounting creates simplicity and insight; choosing the wrong type of cost accounting creates burden and confusion. As a cost accountant, I could write an entire article on each type of cost accounting, but here’s a high-level summary:
Standard Cost Accounting
Standard costing is popular with manufacturers and distributors. By assigning each SKU a standard “cost,” this system allows managers to analyze variances of actual vs. standard, informing management decision making.
Activity Based Costing (ABC)
ABC assigns costs based on activity – for example, a machine shop might group activities around metal forming, machining, and finishing as separate categories. The result is usually an average hourly rate or cost per unit processed – useful insight when quoting and selling new products.
Project accounting groups costs based on discrete projects, primarily in construction and professional services. Project accounting empowers good cost management and financial analysis; plus, the added benefit of being intuitive to non-accountants.
Target costing broadens the accounting view to a life-cycle cost rather than a narrow manufacturing cost. This is important for innovation organizations or businesses with high research and development expenses. Target costing occurs outside of financial statements and is not as useful in small business, where uncertainty makes setting cost targets impractical.
There are dozens of other costing-management philosophies that focus on resource planning and management, such as throughput accounting, resource consumption accounting, and environmental accounting.
Do you have good cost accounting?
Not sure if your cost accounting system is reliable? At CFOshare, we have cost accountants who will consult with you for free. Book an appointment today.