When you look at a profit and loss statement, you see a summation of revenues and expenses resulting in the net earnings for that accounting period.
This bird's-eye view of your incomes and costs is valuable for understanding whether the business is profitable. However, it doesn’t answer why or how the business is profitable.
In addition to the traditional accounting processes incorporated in the accounting cycle, businesses use cost accounting to understand better what’s driving performance. This additional view gives valuable insights on how business units are performing, where revenue is generated, and where costs need to be cut.
What is cost accounting?
Cost accounting is a key part of financial management that involves tracking, analyzing, and reporting a company's expenses to understand the actual cost of producing goods or services. Used mainly by internal teams, it helps businesses improve efficiency, control spending, and make smarter, data-driven decisions.
Typically, this involves dividing costs across products, services, departments, or projects. By doing so, the business understands the true costs of individual parts of the business, assisting with budgeting, pricing strategy, and asset management.
Unlike traditional financial accounting, cost accounting does not follow the Generally Accepted Accounting Principles (GAAP). This means cost accounting can only be used internally and should not be used in the production of financial documents used for any external use, like tax filing or applying for credit.
Key aspects of cost accounting
Cost accounting takes on different shapes and forms based on the business’s practices. However, there are five key components shared in each approach.
Internal focus
Cost accounting is only for internal use, which allows for a higher level of customization. The reports can be created for optimal value, tailored to the needs of the business and its management team.
Cost control and reduction
A crucial component of cost accounting is understanding where money is being spent on a granular level. Breaking down expenses into buckets highlights where the business is potentially overspending and requires adjustment.
Cost accounting reporting is a balanced combo of a bird’s eye view and detailed breakdown: you get more detail than a basic P&L, but you’re not overrun with detail.
Pricing decisions
Accurate cost information is paramount for setting prices for goods or services. Beyond the direct costs that go into fulfilling a sale, cost accounting adds in a proportion of indirect costs and overhead costs for the full picture. This additional layer of detail helps businesses set prices that ensure profitability.
Performance evaluation
Cost accounting allows businesses to evaluate the performance of a department, product, project, or business unit by comparing its true costs against its budget or forecast. You’ll know exactly where the business is going over budget, and decide whether there needs to be an adjustment to spending habits or resource allocation.
Resource allocation
Having the historical reporting of cost accounting gives you an idea of how your costs are changing across business units. This insight helps create more accurate budgets, identify areas of investment, and optimize operations.
Cost accounting vs financial accounting
Cost accounting and financial accounting serve different purposes, and it’s crucial to understand the difference.
Financial accounting refers to the universal standards of financial reporting that are used for external purposes, such as for investors, creditors, and regulatory bodies. These documents must follow set guidelines (like GAAP) to ensure consistency.
The strict requirements of financial accounting pass on to its timing, as businesses are required to create financial accounting reports on a quarterly or annual basis for tax purposes.
Cost accounting is not as strict as it is only used for internal management. The reports are highly customizable and are maintained on a schedule that the business chooses. This allows for greater flexibility in how the reports are created, structured, and maintained.
Who uses cost accounting?
Cost accounting is used across industries and by businesses of all sizes.
Manufacturing businesses would use cost accounting to track the cost of production and understand the profitability across products. Service providers would similarly want to understand their cost of delivery for setting prices.
The many different iterations of cost accounting are ultimately for understanding the expenses incurred by a business on a deeper level. If you’re looking to understand your operational efficiency, control costs, and maximize profitability, try using cost accounting to guide your decision-making process.
Benefits of cost accounting
Businesses take on the extra lift of cost accounting in order to generate value from these benefits.
Enhanced decision-making
Detailed insights into cost structures and operational efficiency help businesses understand where their money is going and how effectively it’s being used. This helps management leverage data in its decision-making rather than using its judgment or subjective information.
Improved budgeting and planning
The historical data of cost accounting gives insight into how costs have changed and trended over time. When it comes time to create a budget or forecast performance, they’ll have a clearer picture of what their costs may be.
Better understanding of profitability and pricing
By breaking up costs by different goods or services, you understand the profitability of each business unit. You may realize that a certain product or project isn’t sustaining its costs, implying that it’s time to re-evaluate your pricing model.
Common cost accounting methods
How cost accounting looks in your business will depend on how your business is structured and operates. These are six of the most common cost accounting methods to consider as a stepping off point.
Standard costing
Standard costing starts with setting predetermined cost estimates (“standards”) for the materials, labor, and overhead for a set business unit. The business then regularly compares the actual costs in a reporting period against the standards to identify potential overspend.
The standard costing method is useful for businesses that have consistent, predictable costs that can be used as benchmarks, such as manufacturing businesses or service companies.
Activity-based costing
The activity-based costing method involves allocating costs based on the specific activities they pertain to. These activities could be product lines, service offerings, or projects.
Actual costs for each activity are easily bucketed, with overhead costs divided based on a flat amount or use level.
Activity-based costing is useful for businesses that want to understand the true costs of providing a good or service. This option helps you understand the profitability and costs of each activity, a crucial detail for pricing decisions.
Marginal costing
Marginal costing is centered on the variable costs of a good or service. More specifically, it identifies what the cost of producing one additional unit of good or service is.
The method doesn’t include fixed costs as part of the production process (these costs are called “period costs”). As period costs, they must be covered by the contribution margin of the good or service.
Marginal costing is primarily used in short-term decision-making and break-even analysis. With the revenue amount and the marginal cost of an additional unit, you can find how many units need to be sold to cover all fixed costs.
Job costing
Job costing is primarily used for businesses that operate on a project-by-project basis, like construction companies or contractors.
Direct costs like materials and labor are assigned to a specific project, allowing the business to identify exactly how much money has been spent fulfilling its end of the deal. It then knows exactly how much profit was made from the project.
Tracking job costs is extremely useful for pricing projects going forward. When approached with a project of a similar scope, prior projects can be used to estimate costs and set a price that protects profits.
Process costing
Process costing is primarily used by manufacturers to determine the cost of each step in the production process, rather than each individual item.
For example, a clothing manufacturer may look at the costs of designing patterns, cutting fabric, and sewing the clothes. To determine the per unit cost, they total the costs and divide it by the total quantity produced.
By breaking out production costs into individual steps, businesses can identify which parts of the process are most costly and in need of cost-cutting.
Lean accounting
Lean accounting is unique among cost accounting methods as it’s focused on value generation. It involves looking at both all financial costs and the cost of time and providing a measure of value for each.
If the cost is not generating sufficient value, it’s deemed inefficient, and the business must explore an alternative.
As an example, an accounting team could be spending too much time processing invoices rather than working on high-value work like budgeting and forecasting. If it’s found to be inefficient, they would explore alternatives to free up that time.
The lean accounting methodology is highly complex as it involves looking beyond simple financial costs and requires assigning values. However, if done correctly, it trims any waste in the business and bolsters operational efficiency.
Types of costs in cost accounting
Throughout the cost accounting process, you’ll divide costs based on certain definitions. These are the main terms you’ll encounter throughout:
- Fixed costs: Costs that do not change with activity level, such as rent or salaries.
- Variable costs: Costs that change proportionally to activity level, such as direct labor or cost of goods sold.
- Semi-variable costs: Costs that have a fixed component, but also increase with usage, such as utilities or pay-per-minute phone plans.
- Direct costs: Costs that are solely used in a single activity or business unit, such as direct labor or sales commissions.
- Indirect costs: Costs that are used across activities or business units, such as administrative salaries or insurance.
- Product costs: Costs that are uniquely used in providing a single product, such as raw materials or packaging.
- Period costs: Costs that are not associated with production, such as software or marketing.
You may have recognized that there is crossover throughout these categories (for example, product costs may be considered direct costs). These categories are not exclusive, and the ones you use ultimately depend on what cost accounting method you’re using.
Cost accounting formulas
Several formulas are used in the cost accounting process. These are a few you may want to make use of.
Total cost formula
The total cost formula is a simple summary of all production costs incurred by the business in the reporting period. To find this value, simply input your values in the formula below:
Cost per unit formula
Taking it one step further than the total cost formula is the cost per unit formula. This is the approximate cost of producing one unit or providing the service once.
Contribution margin formula
Contribution margin is the amount of money pocketed on sales revenue after all variable costs are considered. Calculate contribution margin with this formula:
Similar to the cost per unit formula, you can divide this value by the number of units sold to get the contribution margin per unit.
Break-even point formula
The break-even point is the number of units a business needs to sell to cover its fixed costs and be profitable. The break-even point formula is:
Keep your costs controlled with financial automation
Cost accounting helps you understand your expenses, but to control them, you need an expense management solution.
With BILL, you can control budgets and manage spend at scale with automation and real-time reporting. Our virtual cards come with auto-enforced limits, transaction limits restrictions, and cost controls to keep spending in check without constant monitoring.
Reporting is updated in real-time, so you can keep a pulse on every dollar spent. No extra work, no constant reconciliations, just the value you need, when you need it.
Reach out for a demo to learn more about how BILL can automate your expense management and keep more money in your business.
