Cost Accounting

1. What is cost accounting?

Cost is an expense incurred by a particular unit. In another way, the cost is what the business
sacrifices in order to produce one unit of product. Accounting is the art and science of recording,
classifying, summarizing, and analyzing inputs to make a sense of the information related to
financial, management, or cost.
Cost accounting is a form of managerial accounting that aims to capture a company's total cost of
production by assessing the variable costs of each step of production as well as fixed costs, such
as a lease expense.
Cost accounting is defined as "a systematic set of procedures for recording and reporting measurements
of the cost of manufacturing goods and performing services in the aggregate and in detail. It includes
methods for recognizing, classifying, allocating, aggregating and reporting such costs and comparing them
with standard costs."

 The Chartered Institute of Management Accountants in England (CIMA) has defined Cost
Accounting as, ‘the process of accounting for cost from the point at which expenditure is incurred
or committed to establishment of its ultimate relationship with cost centers and cost units. It is a
formal mechanism by means of which costs of products or services are ascertained and controlled.

It is concerned with accumulation, classification, analysis and interpretation of cost data for
three major purposes:
(a) ascertainment of cost,
(b) operational planning and control, and
(c) decision-making.

2. Purpose of Cost Accounting

There are basically three purposes of cost accounting –

 Cost control: The first function of cost accounting is to control the cost within the
budgetary constraints management has set for a particular product or service. This is
important since management allocates limited resources to particular projects or production
processes.
 Cost computation: This is the main function of cost accounting and this is the source of
all other functions of cost accounting. In the section below, we will see how we can
calculate the cost of sales per unit for a particular product.
 Cost reduction: Cost computation helps the company reduce costs on projects and
processes. Reduction in costs means more profits since the margin will naturally increase.
Types of Costs:

 Fixed costs are costs that don't vary depending on the level of production. These are
usually things like the mortgage or lease payment on a building or a piece of equipment
that is depreciated at a fixed monthly rate. An increase or decrease in production levels
would cause no change in these costs.
 Variable costs are costs tied to a company's level of production. For example, a floral shop
ramping up their floral arrangement inventory for Valentine's Day will incur higher costs
when it purchases an increased number of flowers from the local nursery or garden center.
 Operating costs are costs associated with the day-to-day operations of a business. These
costs can be either fixed or variable depending on the unique situation.
 Direct costs are costs specifically related to producing a product. If a coffee roaster spends
five hours roasting coffee, the direct costs of the finished product include the labor hours
of the roaster and the cost of the coffee beans.
 Indirect costs are costs that cannot be directly linked to a product. In the coffee roaster
example, the energy cost to heat the roaster would be indirect because it is inexact and
difficult to trace to individual products.
 Historical costs are costs whereby materials and labor may be allocated based on past
experience. Historical costs are costs incurred in the past. Predetermined costs are
computed in advance on basis of factors affecting cost elements. In modern cost account
of recording historical costs was taken further, by allocating the company's fixed costs over
a given period of time to the items produced during that period, and recording the result as
the total cost of production.

For example: if the railway coach company normally produced 40 coaches per month, and the
fixed costs were still $1000/month, then each coach could be said to incur an Operating
Cost/overhead of $25 =($1000 / 40). Adding this to the variable costs of $300 per coach
produced a full cost of $325 per coach.

This method tended to slightly distort the resulting unit cost, but in mass-production industries that
made one product line, and where the fixed costs were relatively low, the distortion was very
minor.

For example: if the railway coach company made 100 coaches one month, then the unit cost would
become $310 per coach ($300 + ($1000 / 100)). If the next month the company made 50 coaches,
then the unit cost = $320 per coach ($300 + ($1000 / 50)), a relatively minor difference.

Activity-Based Costing
Activity-based costing (ABC) identifies overhead costs from each department and assigns them to
specific cost objects, such as goods or services. The ABC system of cost accounting is based on
activities, which is any event, unit of work, or task with a specific goal, such as setting up machines
for production, designing products, distributing finished goods, or operating machines. These
activities are also considered to be cost drivers, and they are the measures used as the basis for
allocating overhead costs.
The Break Even Point:
The break-even point, which is the production level where total revenue for a product equals total
expense, is calculated as the total fixed costs of a company divided by its contribution margin. The
contribution margin, calculated as the sales revenue minus variable costs, can also be calculated
on a per unit basis in order to determine the extent to which a specific product contributes to the
overall profit of the company.