What Is Cost Accounting?

Category: Business

In the management of a company's finances, the relationship between spending expenses and profitability is weighed against its success or failure. Cost accounting is the branch of managerial accounting that systematically assists managers in the internal balancing of spending and profits, as well as assessing operational costs and budget analyses.

History

  • Cost accounting is as old as managing businesses. It was developed as an accounting procedure in the 1890s, yet business owners have always dealt with the accounting techniques of operating a successful business. Cost accounting assisted business owners in understanding the relation between expenses and profits, and it taught owners how to bring more profitability into their business practices.

    Cost accounting further evolved to its current practices during the industrial revolution. Large industries had to develop accounting practices to manage their large production expenses and profits. Cost accounting helped companies with their recording and tracking systems: Managers and owners could examine costs vs. profits to make vital operational decisions.

    Cost accounting, at this stage, was relegated to the amount of spending as it related to production. Most of cost accounting related to the variable costs of a business, where production had high and low periods in relation to the costs of materials, manpower and energy. These variable costs were the most important elements in the cost management of businesses during the industrial revolution. There were also other costs related to production that would not change, and these were referred to as fixed costs. The relevance of fixed costs would not be fully acknowledged until the field of cost accounting evolved to more modern practices in later years.

Considerations

  • Keeping records of historical costs allows managers to take the amount of an item's overhead and build that into its standard cost, as a more efficient and less fluctuating technique of managing a company's production inventory.

    Standard cost accounting allows managers to examine and analyze the variance between a product's actual cost to make and its standard cost, given that factors like materials, labor and amount may vary from one production period to another. Managers can see why and how their product line increased or decreased in revenue value, based on the costs associated with it. Managers rely on the ability to actively and efficiently examine how well their company's production is operating and yielding profits.

Types

  • Cost accounting has two branches: Activity-Based Costing (ABC) and Cost-Volume-Profit Analysis (CVP). In activity-based costing, productions are given the assessed costs based on the amount of work they require. Accountants evaluate where and how employees spend their time, and they use this data to determine the best, most efficient areas in which to allot cost funds. Companies use this information to develop a more cost-efficient business, by directing monies toward those areas within the business that are not operating as efficiently as they could.

Features

  • Another branch of cost accounting is Cost-Volume-Profit Analysis (CVP). This is a direct way of determining that a company's earnings are directly related to its costs. When the costs are equal to the amount earned, there is no profit or loss for the company.

    In Cost-Volume-Profit Analysis, cost is only affected by a change in the production's associated activity. This is an observation of the linear pattern of costs as it relates to a company's revenues. Cost-Volume-Profit Analysis is a simplified approach to managing a business's cost behaviors.

Shortcomings

  • Standard cost accounting gradually decreased in relevance as employment standards changed to hourly wages, instead of wages per item produced.

    Fixed costs have increased and variable costs have decreased with the advent of more standardized and modernized approaches to businesses. Salaries alone--as they changed over to hourly or salaried wages--are an example of a fixed cost.

    Modern equipment, which performs many operations that were once carried out by human labor, has also contributed to this shift away from standard cost-accounting procedures. Equipment alone, which is another fixed cost, is now a major expense in the management of a company's total cost.

    Standard cost accounting is weak in explaining shifts in profits associated with an increase or decrease in inventory. It doesn't clearly explain why, in some cases, inventory increases can increase profits and inventory decreases can decrease profits.

An Alternative Method

  • Throughput accounting is an alternative to cost accounting that addresses some of its shortcomings. Throughput accounting seeks a way to increase the throughput of production based on the limits of the company. It does not assess a company's expenses based on production and services. Rather, it maximizes the profitability of a company by identifying that company's limit and optimizing its ability to generate more throughputs.

    Throughput accounting also helps companies to see their functionality as it relates to production and operations. Companies can analyze whether or not a certain production line will be cost-effective. This method of accounting provides insight and information about whether a certain production project will cause a company to lose money, even before production begins. It provides the effectiveness for today's businesses that cost accounting did yesterday.


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