Cost Accounting: Objectives, Methods, Techniques, and Software

Cost accounting is an effective way to control, ascertain, and reduce a company’s cost of production. Furthermore, it fixes the selling price and increases the profitability of a company. 

It is a branch of accounting that assists financial accounting in inventory valuation, budgeting, and cost determination, & supports corporate accounting in the planning process and leadership tasks.

Thus, in today’s article, we will discuss what cost accounting is, its objectives, features, scope, users, methods, techniques, software, types of cost, and a comparison between its advantages and disadvantages.

What is Cost Accounting?

“Cost” in “cost accounting” conveys the expenditure incurred on or attributable to a specific thing or activity.

Cost accounting is a specialized branch of accounting that involves the accumulation, classification, allocation, and recording of costs. It involves the study of concepts, tools, and techniques that help in ascertaining and analyzing the production cost of a company.

Key Takeaways

• Cost accounting deals with the cost of production and calculating the per-unit cost of a product or service.
• It provides information to internal stakeholders, explaining the cost structure of the company to managers and executives.
• With the help of cost accounting, companies track their spending, returns, and losses.
• It’s managerial accounting that analyzes the cost of labor, materials, and overhead for internal decision-making.

In simple words, it is a practice concerned with controlling costs through recording, examining, and summarizing a company’s spending on any process, service, or product.

Objectives of Cost Accounting

A business opts for cost accounting practices to attain the following objectives.

1. Cost Ascertainment: Determining the cost of production is the primary objective of cost accounting. It is concerned with accumulating various production phase expenditures, such as labor, material, and production overhead.
2. Cost Control: Controlling the cost of production is another effective goal of cost accounting. It includes comparing the actual cost with the budgeted cost of production to determine whether the cost is under control or not. If not, managers eliminate the inefficiencies through strategic planning.
3. Cost Reduction: Cost accounting assists companies in choosing a cost-effective way to reduce the unit cost of a good without compromising the quality.
4. Budgeting and Forecasting: The information from cost accounting is used to prepare effective budgets for different departments and forecast the future cost of production.
5. Decision-Making: Cost accounting assists management in the decision-making process by disclosing insight and useful production cost details. This includes break-even points for sales, pricing, improving the quality of the product, etc.
6. Selling-Price Determination: Fixing higher or lower selling prices for the produced goods can adversely affect the profitability of the business. Cost accounting enables the management to calculate the per-unit cost of production. It provides the complete cost structure of producing each good to determine a rational selling price.
7. Evaluating Performance Analysis: Cost accounting helps in evaluating the low-performing areas of the production phase by analyzing the fixed and variable costs.
8. Legal Compliance: Accounting for the cost of production is mandatory for manufacturing companies. Companies with total turnover above a specific income need to submit their cost accounts for filing taxes with the government.
9. Inventory Valuation: Cost accounting values the most important asset, the inventory of the business, through methods like weighted average cost, LIFO, and FIFO.

Features of Cost Accounting

The following are the key features of cost accounting that make it useful for businesses.

• Recording and analyzing: Cost accounting involves systematically recording and analyzing costs associated with a company’s operation, products, and services.
• Production-cycle oriented: The accounting of the cost of production is production-cycle oriented, which means the frequency of reporting depends on the production cycle of a business.
• Both art and science: Cost accounting is both an art and a science, as it adheres to methodologies while also utilizing skill to solve business issues with cost data.
• Determines efficiency: The methods of cost accounting are effective in determining the unit’s or process’s efficiency. It reveals the waste of time and resources.
• Identifies cost: Cost accounting identifies the different types of costs that become components of the total cost. These components include material, labor, and overhead.
• Price setting: Cost accounting determines the unit cost of the product and services.
• Assist in management: The data and information of cost accounting are utilized by management to make strategies, plans, and decisions.
• Classifies and allocates costs: Cost accounting classifies and allocates the cost into different categories, such as fixed, variable, direct, indirect, operating, marginal, etc.

Importance of Cost Accounting

Different businesses utilize cost accounting for various purposes. This includes survival, quick decision-making for small businesses, and measuring profitability and forecasting for large businesses:

For Small Scale Businesses

The following are the importance of cost accounting for small-scale businesses:

• Survival and growth: Cost accounting helps small businesses determine the right sale price of their goods and services to survive in the competitive market. 
• Managing cash flow: Cash is crucial for operating a small business. Cost accounting leverages the cash flow management of small businesses, improving their liquidity. 
• Quick decision-making: Due to frequent fluctuations in the competitive market of small-scale businesses, quick decision-making is crucial. Cost accounting provides the required data and insights to make the right decision. 
• Improves transparency: Cost accounting enhances the transparency of small-scale businesses by providing cost analysis statements that include fund allocation, resource utilization, and areas of inefficiencies.

For Large Scale Business

The following are the importance of cost accounting for large-scale businesses:

• Budgeting: Due to producing large quantities of goods, creating a budget is important for large-scale businesses. The data and information from cost accounting are used to prepare adequate budgets. 
• Forecasting: Although forecasting is important for all scales of businesses, it is mostly used by large-scale businesses. Cost accounting provides accurate past data on costs that help businesses plan their future. 
• Profitability Analysis: Generally, large-scale businesses produce multiple goods and services. Cost accounting allocates the cost to different products, which allows these businesses to evaluate the profitability of each product line.

Scope of Cost Accounting

The scope of cost accounting is concerned with the activities and functions of managing a company’s cost of production. The following are its functions:

• Cost determination: It ascertains the overall cost of each unit of production that includes the cost of material used, workers employed, and expenses incurred (direct and indirect) using historical or standard data for calculation.
• Cost report: The information and data extracted from cost accounting are used to prepare cost reports that are utilized for making plans, strategies, and decisions for the future.
• Cost audit: This allows the verification of the cost sheets and ensures that all the accounting principles are correctly implemented.
• Cost analysis: Cost accounting analyses and finds the factors creating variances in the actual and estimated standard cost of production that significantly improve cost management and strategic decisions.
• Cost computation: This involves calculating the production cost of each unit or in bulk.
• Budget formulation: Cost accountants analyze historical data and the market environment to create budgets and forecast the future. It mainly includes developing realistic projections of future costs and revenue.

Types of Cost

There are several costs included in the production process of goods and services. Therefore, understanding the types of costs is crucial for treating them correctly during computation.

• Direct cost: Also known as the product cost, these are the costs that are directly tied to the production of goods. For example, raw materials, wages, etc. 
• Indirect cost: These costs are not directly linked to the production process, but are essential for the processing of the business. For example, administrative expenses, security costs, utilities, etc.
• Fixed cost: These are the costs that remain fixed every month and don’t fluctuate with the volume of production. For example, rent, insurance, salaries, interest expenses, etc.
• Variable cost: These costs vary with the change in the quantity of production. For example, raw materials, packaging, packaging, etc.

Elements of Cost Accounting

The cost accounting is based on the three elements, they are mentioned as follows:

Material

The input for production is called Material. It is further categorized into two types:

• Direct Material: These materials can be easily traced and identified with the unit of finished goods. Mostly, these materials are the necessary raw materials required for production. For example, wood in a baseball bat.
• Indirect Material: These materials can’t be located in the finished unit of the produced good, but are part of the production process. Being used in small quantities, they don’t affect the production cost significantly. For example, disposable tools like gloves.

Labor

The workers involved in the production of goods are called labor. Similar to material, labor is also categorized into two types:

• Direct Labor: The cost of direct labor includes salaries, wages, overtime, and bonuses paid to the workers who were directly involved in the production process.
• Indirect Labor: These are the costs of labor that are not directly involved in the production process. This cost is generally classified as an expense or overhead.

Overhead

Overhead are the expenses incurred by the business in the production process that are not directly attributed to specific goods. Depending on the nature of the expense, overheads are classified into the following types:

• Fixed: These are the expenses that remain the same every month and don’t change with changes in the volume of production. For example, rent, depreciation, salaries, etc.
• Variable: These are the expenses that fluctuate with the change in the activity level of the business. The higher the volume of production, the higher the variable overhead. For example, raw materials for production, wages, advertising, etc.
• Semi-variable: These are the combination of fixed and variable expenses, where the cost may or may not increase with an increase in the volume of production. For example, repair and maintenance, vehicle expenses, telephone bills, electricity costs, etc.

Users of Cost Accounting

Unlike financial accounting, cost accounting has both internal as well as external users. The following are the lists of internal and external users of cost accounting.

Internal 

Internal users are the parties within the business that use the accounting information. 

• Managers are the most important internal users of cost accounting. They use the data and information for selling price determination, evaluating performance, controlling costs, and decision-making.
• Auditors use the cost accounting data to assess the business performance by verifying if the business performed well as per the cost planning.
• Employees use cost accounting information and data of an organization to identify the necessary work efficiency of employees to complete tasks. Furthermore, it also helps them understand the different bonus plans.

External 

External users are users of accounting data and information outside the business entity.

• Shareholders use the cost accounting information to make an investment decision in a company. This includes information about the cost share, market expansion, etc.
• Creditors utilize the cost information to identify the credit-paying ability of the business. It helps them decide whether to provide goods on credit or not.
• Regulatory authorities check the cost accounting data of an organization to ensure that they comply with the principles, regulations, etc.

Methods of Costing

Costing is the process of evaluating the total cost of production. The following are the different methods to determine this cost:

Here are some of the most commonly used methods of costing:

1. Job costing: a costing method used when production is not highly repetitive and consists of jobs. This method suits businesses that provide customized and unique products or services to their customers. For example, a company producing filmmaking props, customized t-shirts, 
2. Contract Costing: Also known as Terminal costing, this method is primarily used to track and determine the cost of each contract in construction and engineering projects, such as building highways, ships, dams, etc. It includes a precise accounting of the direct and indirect costs of each contract.
3. Cost-Plus Costing: A part of contract costing, cost-plus costing includes contracts where, along with cost, an agreed sum to cover overhead and profit is paid to the contractor. It is mostly seen in cases where the government is the contractee.
4. Batch Costing: This method is mostly used in companies where the goods are produced in different predetermined lots called batches. Here, each batch consists of a specific number of produced goods that helps in determining the cost of each batch. This method is mostly used by pharmaceutical and packaged food companies. 
5. Process Costing: Known as the most used costing method in manufacturing industries, process costing is employed in businesses where a product passes through different processing stages, each distinct and well-defined. To find the cost of a given unit, manufacturers assign costs to each process and then divide the total cost by the number of units produced. This method is mostly used in companies producing chemicals, soap, paint, etc.
6. Operating Costing: The best-suited costing method for the service sector, operating costing, is employed where the expenses are incurred for providing services. The provided services must be uniform to ascertain the cost. Common businesses where this method is used are bus companies, electricity service-providing companies, railways, etc.
7. Unit/Output/Single Costing: It is a method where the cost of producing per unit is ascertained and the amount of each element constituting such a cost is determined. It is mostly used in companies where the products can be expressed in identical quantitative units and production is continuous. For example, paper mills, brick-making, and cement manufacturing companies.
8. Departmental Costing: This costing method is effective for companies where manufacturing is divided into different departments. It is concerned with separately determining the cost of output for each department.

Cost Accounting Formulas

The following are the commonly used formulas for cost accounting: 

Prime cost = direct material cost + direct labor cost.

Conversion cost = direct labor cost + manufacturing overhead costs.

Total manufacturing cost = direct materials + direct labor + manufacturing overhead.

Cost of goods manufactured (COGM) = beginning WIP inventory + total manufacturing costs – ending WIP inventory.

Cost of goods sold (COGS) = beginning Inventory + purchases during the period − ending Inventory.

Techniques of Costing

Costing techniques are used in companies to control costs and make some important managerial decisions. There are several types of costing techniques,  each providing a different view.

Also known as variable costing, this technique determines the increase in the cost of producing one more unit of production while the fixed costs of the period are completely written off against the contribution. The variable cost mainly includes the cost of direct labor, direct materials, and sales commission. 

This technique is useful in manufacturing industries where the volume of production keeps changing.

To calculate the marginal cost, you have to do the following:

• Identify the change in the quantity of production.
• Calculate the change in the cost of production by subtracting the previous cost from the new cost of production after changes.
• The final step is to divide the additional cost of production by the change in the quantity of production.

Marginal cost = Change in cost / Change in quantity

Furthermore, marginal costing is the simplest costing technique that aids in determining the profitability of producing extra units.

This technique is used for controlling the cost of production by comparing the estimated (standard cost) and actual cost of producing goods. In this technique, manufacturers anticipate the upcoming expenses of production based on historical data, such as labor, materials, and overhead.

The standard costing technique is used because determining a company’s actual cost in advance is impossible.

The following are the steps to calculate the standard cost.

• Calculate the estimated cost of direct labor by multiplying hourly rates by the hours worked.
• Determine the standard market price of raw materials. 
• Evaluate the manufacturing overhead by adding the fixed and variable expenses of production.
• By combining all the costs mentioned earlier, you will get the standard cost of production.

Standard cost = Direct labor + Direct material + overheads

Standard costing suits companies with mass production of repetitive and common goods and services, such as cement, bricks, etc.

Also known as full costing, this technique charges all variable costs and fixed costs to the cost center or cost unit. The term “absorb” shows that it considers all the costs into product cost.

Absorption cost = (Direct labor costs + Direct material costs + Variable manufacturing overhead + Fixed manufacturing overhead) / Number of units produced

Absorption costing provides a more accurate picture of profitability than variable costing, particularly if all of its products are not sold during the same accounting period as their manufacture. 

Activity-based costing is a technique that identifies activities in an organization and assigns the cost of each activity to all goods and services according to their actual consumption. 

This technique is best suited for manufacturing companies with multiple product lines that involve different levels of material, labor, and high overhead costs.

The following are the steps to develop an activity-based costing system in an organization:

• The first step is to identify the major activities in an organization.
• Then focus on value-adding activities and eliminate the non-value-adding ones.
• Select the activity cost drivers, as these provide the true cost of business activity by including the indirect expenses.
• After identifying and selecting the activity cost drivers, it is time to assign them to cost objects. Manufacturers ensure that the cost objects are salable to the customers.

Activity Based Cost = Total cost pool / Cost driver

Activity-based costing considers all cost activities instead of depending on just one variable.

In this costing technique, all the direct costs are charged to operations, processes, or products, and all the indirect costs are written off against the profits. 

Direct costing is mostly used for short-term decision-making and internal reporting, like pricing, product mix decisions, make-or-buy decisions, etc. Remember, direct costs don’t consider fixed costs like depreciation, rent, etc.

To calculate the direct cost, you need to add the direct cost of labor, materials, and direct expenses.

Direct cost = Direct material + Direct labor + Direct expenses

Under direct costing, only variable manufacturing costs are included in the product cost. 

Uniform costing is the only method that takes the help of both methods and techniques of cost accounting. In this costing technique, several companies employ standardized principles and the same methods of cost accounting. By the same methods, we mean the same depreciation method, same absorbing method, same stock valuation method, etc.

This method helps to compare the performance of different companies within the same industry, resulting in the establishment of realistic pricing policies and many more.

Education, electricity, and construction are the most common industries that use the uniform costing technique.

Under this technique of costing, all expenditures are recorded after incurring them. In simple words, the cost of producing a unit of goods and the total cost of production are determined after they have occurred.

Companies that use the historical costing technique record the assets at their purchasing cost and don’t maintain the cost as per the market value. Therefore, this technique is called the post-mortem of the cost of production.

Furthermore, this technique is inefficient in measuring cost centers and controlling costs.

Cost Accounting: Advantages vs Limitations

The experience of utilizing cost accounting varies depending on the size and nature of a firm. Understanding the advantages and limitations of cost accounting can help businesses decide whether to go for it or not.

Advantages	Limitations
1. Controls the cost: The cost accounting system primarily focuses on controlling the cost of production of goods and services. It helps the managers foresee the pricing of the goods and services, which helps them plan strategies to control the costs.	1. Expensive: Cost accounting is expensive, as the business has to hire experts to implement and maintain the practices.
2. Tracks profit: Overall profit doesn’t always mean that all the company’s activities are profitable. Cost accounting helps companies track their profit-making activities and take measures to eliminate losses.	2. Not universally applicable: Due to the lack of a standardized format and system, cost accounting can’t be applied to all industries. Each industry has to make changes before its usage.
3. Improves efficiency: Cost accounting provides data that allows companies to measure their efficiency and improve it significantly, with costing techniques like standard costing.	3. Complexity: The whole process is known for its complexity. Even experts can sometimes face challenges while estimating the costs.
4. Budgeting: The cost accounting system allows the management to forecast and make a budget for a company after analyzing trends and past costs.	4. Lack of uniformity: Due to the lack of a standardized format and system, comprehending the cost accounting information is challenging. Different cost accountants may conclude different results from the same information.
5. Fix prices: Costing in cost accounting differentiates the fixed and variable costs of production, making the pricing fixed in different scenarios. Without cost accounting, profit-making and precise pricing are difficult.	5. Less accurate: Determining the standard cost or estimated cost of producing goods is based on historical data, which can’t always be accurate.
6. Reduces cost: In tough situations like depression, cost accounting helps managers make tough decisions, such as pricing the goods lower than their cost.
7. Evaluate performance: Cost accounting helps businesses compare their budgeted costs with standard costs to evaluate their business performance and improve the concerning areas.

To effectively benefit from cost accounting, a firm needs to review and update the system regularly. 

Choosing The Right Cost Accounting Software

Cost accounting software aids businesses in analyzing expenses, allocating costs accurately, and enhancing budgeting. By integrating this software, businesses save time, sync financial data, provide detailed insight, promote data accuracy, etc. 

Therefore, we will guide you in choosing a suitable cost accounting software.

Factors for Selecting The Right Cost Accounting Software

The following are factors to consider before opting for cost accounting software. 

• User Friendliness: Software with a complex user interface can make the whole cost accounting process inefficient and increase the training cost. Thus, choose software that provides easy-to-navigate features, clear documentation, and training resources to foster a smooth adoption process.
• Integration: An ideal cost accounting software should be able to integrate various other systems, like EPR tools, payroll, CRM, e-commerce platforms, project management tools, etc., to reduce manual data entry and provide a unified view of operations.
• Needs: Before deciding on cost accounting software, understand why you need accounting software. There are chances of buying software that doesn’t provide the features you want, such as cost through any specific method. 
• Security: Security is a major factor when choosing cost accounting software, as it stores the crucial cost data of your business. Make sure to select trustworthy and completely secured software to avoid unauthorized access to sensitive data.
• Compatibility: Before choosing a cost accounting software, ensure that it is compatible with your business, as small businesses might need easy-to-use software while big organizations may require software to solve complex costing methods.
• Customer Support: 24×7 customer support plays a crucial role in software, as you frequently need customer support to get used to cost accounting software. Search for software that provides email, phone, and chat support.
• Price: The prices of accounting software vary depending on the provided features and fee options. Therefore, decide on a budget for investing in decent and required software.

The following are some of the most commonly used cost-accounting software programs on the market:

• Zoho Books
• NetSuite
• QuickBooks 
• FreshBooks
• Xero
• Wave Accounting
• Sage Accounting 

Remember to do research before buying any accounting software to avoid spending money on unwanted software.

Bottom Line

Cost accounting is the process and procedure for determining the cost of producing goods and services. It provides areas where the companies have the scope to control costs. Its data and information are used by various lifebloods of a business, such as employees, managers, and auditors. 

Remember that it is not GAAP (Generally Accepted Accounting Principles) compliant, which means it can’t be used to audit the financial statements of a company.