Master Cost Accounting: Its Functions, Formulas, and Limitations

Running a business without knowing where the money is going is a complete nightmare, which can lead to financial disruption. That’s when Cost Accounting can work its magic. It is a system that helps you track every dollar, ensuring your business runs smoothly and efficiently. 

This system can also help streamline operations and build strategies for scaling the business. In this blog, we will discuss the meaning of cost accounting, its functions, limitations, and much more. 

Let’s get into it!

What is Cost Accounting?

Cost accounting is a pillar of accounting that demonstrates and focuses on calculating, recording, and analyzing the cost associated with making and producing goods and services for the business. It also supports corporate accounting. 

Without the track of cash outflow, the business can not solidify its foundation to keep going in the future. Cost accounting is the shield that explains which part of the business needs to be cut to function seamlessly while maintaining the quality of the service. The objectives of cost accounting are to look over internal decision-making and build crisis management strategies and a foolproof business plan. 

Let’s talk more about the objectives and goals of cost accounting in detail in the next section. 

Objectives of Cost Accounting

Unlike financial accounting which handles external reporting, this serves to prevent businesses from failing in the future because of a lack of funds. Here are its primary objectives: 

• Cost Management – Recognizing and minimizing unnecessary expenses to enhance cost efficiency.
• Cost Analysis – Evaluating the true cost of manufacturing to establish suitable selling prices.
• Budgeting and Forecasting – Creating financial strategies based on expense predictions.
• Profit Optimization – increasing earnings by recognizing opportunities for cost reduction.
• Decision-Making – Aiding management in strategic business choices, including pricing and resource distribution.
• Performance Assessment – Evaluating the effectiveness of various departments and procedures.

These are the objectives of this pillar of accounting that’s important for every business, whether it’s big or small. 

Types of Costs in Cost Accounting 

Businesses have various costs that are crucial to know and are covered in this accounting. Here are the types of cost accounting costs you must know about:

• Fixed Costs: Costs in the production area that can not be cut or compromised on. (eg, rent, electricity, salary)

• Variable Costs: Costs that fluctuate and vary with every production. (eg, labor cost, raw material, offline or online events)

• Direct Costs: Expenses that are directly linked to the production and are important. (eg, manufacturing cost, raw material, labor)

• Indirect Costs: Expenses not directly linked to the cycle of production but are necessary. (eg, administrative costs, marketing costs, utilities)

• Opportunity Costs: Money put aside after the discussion for the marketing or creation opportunity. 

• Sunk Costs:  Money that can’t be recovered and won’t influence future production. 

Whenever you make a cost accounting book, these are certain costs that you need to include to manage the cash outflow effectively. 

Moving ahead, let’s discuss the various methods of cost accounting in the next section. 

Formulas of Cost Accounting 

Various formulas of cost accounting are used to determine the expenses by calculating the production, pricing, and profitability. One needs to know all the formulas to be ready to use them in need of critical decision-making. Let’s take a look over all of them here: 

If you want to calculate the total of fixed and variable costs, here’s how to calculate:

Total Cost=Fixed Cost+Variable Cost

If you are looking to break down the production cost per unit, here’s what to use:

Cost per Unit= Total Cost/Number of Units Produced

This metric signifies the direct cost that comes to the production.

Prime Cost=Direct Materials Cost+Direct Labor Cost

This is the cost involved in turning the raw materials into finished goods. 

Conversion Cost=Direct Labor Cost+Manufacturing Overhead

This is a type of profit that is calculated before deducting the operational cost of the business. 

Gross Profit = Revenue- Cost of Goods Sold (COGS)

This is a metric that determines the direct cost associated with producing goods that have been sold by the business. 

COGS=COGM+Opening Finished Goods Inventory−Closing Finished Goods Inventory

This is the number that the business calculates, which tells the number of units that must be sold to cover the entire production cost. 

BEP (in units)= Fixed Costs/Selling Price per Unit−Variable Cost per Unit

This determines the total cost involved in producing the goods in that cycle. 

COGM=Direct Materials Used+Direct Labor+Manufacturing Charges+Opening Work-in-Progress Inventory−Closing Work-in-Progress Inventory

This determines all the indirect expenses involved during the cycle of production. 

Overhead Absorption Rate = Total Overhead Costs/Total Machine Hours or Total Labor Hours

This is the main formula that determines the profitability and financial status of the business.

Profit Margin = (Net Profit/ Revenue) X 100

Using the formulas listed above, you can do cost accounting easily. Note that the function of these formulas varies depending on the method of cost accounting. Let’s learn more about this in the next section. 

Types of Cost Accounting Methods 

Businesses in different sectors vary from each other in terms of operation, production, and profitability, thus, each of them uses a different accounting method to calculate and analyze the finances. Here are the types and functions of cost accounting:

Job Costing 

This method is for companies that customize their product or services. Here, the costs are generally associated with jobs. Job costing works for construction, consulting, or specialized manufacturing to calculate the overhead, labor, and material costs. 

Process Costing 

This method is best for businesses producing goods in bulk, such as food or chemical manufacturing. It helps to calculate the entire production cycle rather than a single unit. The best examples are FMCG companies. 

Activity-Based Costing 

This method works for businesses having diverse production. ABC helps to streamline the process by calculating the complex overhead costs. The best application of ABC is found in the IT industry, healthcare, and manufacturing. 

Standard Costing

This is the method where the predetermined cost of the production is set and is later compared to actual expenses. Standard costing is used by companies for budgeting and performance evaluation. 

Marginal Costing 

Marginal costing relies solely on variable costs and does not consider any fixed costs in the business. This works best for making price strategies and evaluating profitability. 

Absorption Costing 

Absorption cost includes both fixed costs and variable costs to check the compliance of the product with Generally Accepted Accounting Principles (GAAP). This is done to overview the expenses while taking notes from external reports. 

Target Costing 

Target costing is a strategy in which companies establish a preferred cost for a product by considering market prices and consumer expectations. They use reverse-engineering to attain this cost by refining design, materials, and manufacturing methods. This works best for electronics and automotive production.

Life-Cycle Costing 

This is a long-term approach that offers complete ownership of the production units. Life-cycle costing is used commonly and works in sectors of aerospace and renewable energy. 

Each of the above given methods serves different purposes and benefits the companies to boost their profitability, streamline cost structure, and improve business operation. 

Importance of Cost Accounting 

Every company or business has the scope of cost accounting and should utilize it to the fullest. Here are the reasons why cost accounting is so important:

• Improves Cost Effectiveness: You can track all unnecessary expenses, ensuring to fully enhance the use of the available resource.
• Better Decision-Making: Managers can evaluable the position and take decisions about pricing, budgeting, and expense management.
• More Profitability: This helps in implementing cost-saving measures, which leads to improved profits.
• Helps in Financial Planning: Precise expense information helps in measuring achievable budgets and financial objectives.
• Facilitates Competitive Pricing: Companies can establish competitive rates while maintaining profitability by using the metrics of cost accounting.

Cost Accounting vs Financial Accounting: What’s the Difference?

As cost accounting is a part of bookkeeping, it is often overlooked because of the misconception that it is financial accounting. However, both of these are two separate areas and deal with numbers serving different purposes for the business. Let’s understand the difference here: 

Aspect	Cost Accounting	Financial Accounting
Purpose	Works in internal team decision-making.	Works for the external reposting to the company stakeholders.
Focus	Cost analysis in production and expenditure control.	Look over overall financial status.
Reporting Period	Whenever needed.	Quarterly or annually.
Users	Managers and team members.	Board members, investors, and regulators.
Regulations	Not constrained by government rules.	Follows legal and accounting laws.

What are the Applications of Cost Accounting?

Cost accounting applies to all types of industries and sectors in regulating and managing finance. Here are some sectors using this accounting and the reasons why:

• Production Companies: To calculate manufacturing expenses and establish pricing approaches.
• Healthcare: For managing budgets and controlling expenses in hospitals and medical institutions.
• Retail: To assess profit margins and control inventory expenses.
• IT and Software Engineering: For budgeting and resource distribution in projects.
• Service Sector: To establish pricing for services and evaluate profitability.

These are the sectors that are greatly leveraging the benefits of cost accounting. Moving ahead, let’s understand the limitations of this financial concept. 

Challenges of Cost Accounting

Even though cost accounting has great benefits, it comes with a whole set of difficulties, especially for small businesses and new business owners. However, knowing these challenges can help navigate through the situation easily. Let’s discuss them here:

• Complexity – Handling intricate cost information can be labor-intensive and demands knowledge.
• Cost Allocation Concerns – Accurately distributing indirect costs can prove challenging.
• Data Precision – Mistakes in expense documentation can result in deceptive financial choices.
• Constant Market Fluctuations – Continuously altering prices requires regular revisions in cost accounting documentation.

So what’s the solution? First, you must acquire skills and gain thorough knowledge of cost accounting terms and concepts. Secondly, you must invest in a software program to automate the process, which reduces the risk of errors and time in manual labor. 

How to Start Using Cost Accounting in Your Business?

Once you implement cost accounting in your business, you will have a significant shift toward better financial planning and strategizing. However, this should be done correctly. So here’s the breakdown to get you started: 

• First, know what sector your business is in and all the costs needed to keep up the production. 
• Evaluate your company’s size, financial status, and goals to choose the right cost accounting method to follow. 
• Invest in decent accounting software to track the sales and maintain direct and indirect costs. 
• Review the reports regularly to adjust your pricing strategy and improve operational efficiency. 

Conclusion

This was all about what cost accounting is, functions of cost accounting, all the metrics, and limitations. As we have explained everything in this blog, we hope this will help you to understand the concept and implement cost accounting correctly in your business. Share the info with your friends and family to make them aware too!

Frequently Asked Questions