What is Cost Accounting?
Cost accounting aims at capturing a company’s costs of production by assessing the input costs of each step of production as well as fixed costs, such as depreciation of capital equipment. Cost accounting will measure, record costs and aid company’s management in measuring financial performance. An entrepreneur is obliged to understand the basics of cost accounting and estimate the cost of products or services and decide on the selling prices and profitable sales targets.
What is the Purpose of Cost Accounting?
- Profit determination: it is an important indicator for commercial success. It is calculated as revenues minus expenses. The net profit determination depends on the accuracy of the cost accounting applied.
- Cost estimation: the key purpose of the cost accounting is to estimate with accuracy the cost per output products or services. This step is essential to decide on the selling prices and profitable volume targets.
- Asset valuation: the value of an asset is calculated as the current value of its future cash flows. Thus cash flow calculations will require a cost accounting to determine the associated expenses and its projection.
- Internal control: the management accounting should provide factual and accurate data on cost accounting that can be used by the management to plan, control and make important decisions.
Why Should an Entrepreneur learn Cost Accounting?
An entrepreneur is encouraged to understand the basics of cost accounting and how to plan for profitability. The outcomes of cost accounting are estimating the cost of products or services and deciding on the selling prices and sales targets. If an entrepreneur has gained the knowledge to understand the cost accounting, he of she will be able to better plan and manage business issues and succeed. like any early stage businesses, the focus is usually on launching the business and sell to customers. Therefore, applying an accurate cost accounting system will help an entrepreneur to estimate the cost of products and profitably plan for sales and marketing aspects.
What are the Characteristics of Useful Cost Accounting?
- Relevance: it must be relevant to the purpose for which it is provided.
- Timeliness: if it is received too late to be acted on, information has no value.
- Comparability: cost accounting information is frequently used to make comparisons such as, between two entities’ performance over time or of the performance of different entities within the same time.
- Objectivity: users of cost accounting information need to be confident that it is as free from subjective elements as possible.
- Reliability: the cost accounting information should be accurate for its purpose.
- Completeness: the cost accounting information should consider essential issues related to subject in discussion.
What are the Types of Cost Accounting?
- Standard Cost Accounting: standard cost accounting essentially allocates indirect cost (i.e. marketing and administration costs) to production cost based on one allocation basis, as on direct labor or machine hours spent to produce an order. It is used at calculating the production cost for the specific and continuous orders.
- Activity Based Costing: it is an approach used to calculate the production cost through planning activities and resources to produce an order, estimating resource consumption and calculating the cost of final outputs. Activity based costing tends to be much more accurate and helpful when it comes to helping managers understand the cost and profitability of their company’s specific services or products.
- Lean Accounting: Lean accounting is an extension of the philosophy of lean manufacturing developed by Japanese companies, mainly Toyota manufacturing, in the 1980s. It is influenced by the customer value of the final product or service. According to this approach, the cost of production will be calculated using the standard or activity based approach and then the cost is adjusted with a certain margin against the value perceived by the target customers.
- Marginal Costing: it is based on the analysis of the relationship between the selling price, the volume of sales, the quantity produced, the costs (fixed and variables) and profits. That specific relationship is called the contribution margin. The contribution margin is calculated by dividing the gross profit or loss on the revenues. This type of analysis can be used by management to gain insight on potential profits as impacted by quantity sold, changing costs, applied selling prices and conducted marketing campaigns.
What is the challenge in allocating overheads to costing?
Due to the fact that overhead cost has risen proportionate to direct cost since the genesis of standard cost accounting, allocating overhead cost as an overall cost has ended up producing occasionally misleading insights. This is considered the key reason for using the activity-based instead of the traditional cost accounting. The activity-based approach is a straight-forward approach to estimated the variable or direct costs for production cost, but it is a bit challenging to allocated overheads (indirect cost) to final production cost. Standard cost accounting applies proportional direct labor hours or machine hours as a basis to allocate the proportional overheads to final production cost. However, the activity based approach deals with direct and indirect cost as consumed resources to produce an order and cost is calculated based on consumed resources regardless of the type of cost as being direct or indirect.
What is the Importance of Cost Estimation?
It is not possible for cost accounting to provide useful information in support of decision making and planning/control without a considerable element of estimation being present. Such estimates maybe based on past experience and or any future progress on subjects related to cost accounting inputs and the processes. Hence cost accounting is frequently used by the management for future purposes such as planning, control and decision making reasons; therefore, estimation is an integral part of any cost accounting system. Estimation assumptions can be checked and adjusted based on actual results.
What are the Types of Cost?
- Fixed costs: they are costs that don’t vary depending on the production levels. These are such as, marketing, administration and depreciation costs.
- Variable costs: they are tied to a company’s level of production. An example could be raw material and labor costs.
- Operating costs: they are costs associated with the day-to-day or core operations of a business. These costs can be either fixed or variable.
- Direct costs: they are the costs related to producing a product. They are unambiguous and quantifiable attributed to a single target cost objective (i.e. a product). Direct costs are such as, raw material and direct labor costs.
- Indirect costs: They are cost not related directly to producing a product. Indirect costs are such as, marketing and administration costs.
What is the Breakeven Point?
The central of the cost/volume/profit analysis is the concept of the breakeven. The breakeven point is the level of sales when the revenue is equal to total cost and net profit is zero. The break even volume can be calculated as: total fixed cost divided on the contribution margin or can be calculated as total costs divided by the selling price. Breakeven analysis is based on the fact that a business must sell more than the breakeven volume to achieve profit. Therefore, business strategy should be articulated to achieved this point as minimum in order the business to be successful. It is basically when higher sale (volume) is achieved, simply the more profit will be made. This is due to the fact that the contribution amount will be sufficient to cover the fixed cost incurred and to contribute into a net profit. Economy of scale will enable reduction of overhead per unit solid to the minimum level.
Written by: Munther Al Dawood
Enterprise Development Services