:max_bytes(150000):strip_icc():format(jpeg)/cost-accounting-0dae1cc4dd244312acc871e8895f6402.jpg)
What Is the Cost Accounting Method?
The cost accounting method, which assesses a company’s production costs, comes in a few broad styles and cost allocation practices. However, cost accounting comes with advantages and disadvantages over other types of accounting methods.
Key Takeaways
- The cost accounting method is an internally focused, firm-specific system used to estimate cost control, inventory, and profitability.
- It can be much more flexible and specific when compared to general accounting methods.
- The complexity of cost accounting, however, means that it can be costly in a number of ways.
Understanding Cost Accounting
Cost accounting was originally developed in manufacturing firms, but financial and retail institutions have adopted it over time.
Contrasted with general accounting or financial accounting, the cost accounting method is an internally focused, firm-specific system used to estimate cost control, inventory, and profitability. Cost accounting can be much more flexible and specific, particularly when it comes to the subdivision of costs and inventory valuation. Unfortunately, this complexity-increasing auditing risk tends to be more expensive and its effectiveness is limited to the talent and accuracy of a firm’s practitioners.
The main difference between cost accounting and financial accounting is the intended audience and level of detail. Cost accounting provides in-depth, detailed information primarily for internal use by management to aid in decision-making. Financial accounting is designed to provide a high-level view of a company’s financial health. Let’s now take a look at reasons why cost accounting may or may not be the better of the two, depending on a given situation.
Advantages of Cost Accounting
Easier to Adapt/Change
Managers appreciate cost accounting because it can be adapted, tinkered with, and implemented according to the changing needs of the business. Unlike the Financial Accounting Standards Board (FASB)-driven financial accounting, cost accounting need only concern itself with internal eyes and internal purposes.
Fast Fact
Activity-Based Costing (ABC) is a more refined method of cost allocation that assigns costs based on the activities that consume resources. Though it may cost a lot to implement, a company can get access to tremendous insights and information.
Easier to Monitor and Control Costs
Labor costs are easier to monitor and control through cost accounting. Depending on the nature of the business, wage expenses can be taken from orders, jobs, contracts, or departments and sub-departments. This means management can pick and choose how it determines efficiency and productivity. This is very important when estimating the marginal productivity of individual employees.
Can View Data in Different Ways
Cost accounting can be thought of as a sort of three-dimensional puzzle. Accounts, calculations, and reports can be manipulated and viewed from different angles. Management can analyze information based on criteria that it values, which guides how prices are set, resources are distributed, capital is raised, and risks are assumed. It’s a crucial element in management discussion and analysis.
Enhances Decision-Making
Cost accounting supports decision-making by providing the financial data needed to evaluate different options. Whether deciding on production methods, investment opportunities, or cost-cutting measures, businesses can rely on cost accounting to weigh the financial implications and provide back-up to the choices that can be made.
Useful for Comparing Different Options
Cost accounting can also be used to help make capital investment decisions by analyzing potential returns on investment. By examining the costs associated with purchasing new equipment, expanding facilities, or launching new products, businesses can assess the financial feasibility of investments. Whereas financial accounting might require each of these potential projects to conform to one set of analytical rules, cost accounting allows each of these options to be analyzed specific to its own details, meaning decision-makers can potentially compare their options more effectively.
Disadvantages of Cost Accounting
May Require Capital Investment
Implementing cost accounting systems can come with significant initial setup costs. For small businesses, the need for specialized software, training, and staff may make it difficult to justify the investment. The ongoing maintenance and updates to the system can also be costly.
May Complicate Decision-Making Analysis
Cost accounting can add complexity to a business’s financial reporting system. The detailed tracking of direct and indirect costs, along with the need for multiple allocation methods, may require sophisticated software, additional personnel, and more time. This complexity can sometimes overwhelm smaller businesses or organizations without the necessary resources to implement and manage it effectively.
Tip
Cost accounting is useful not only for reporting actuals but for making future plans. By analyzing past cost behavior, businesses can predict future costs and set more realistic budgets or forecasts.
May Require Additional Steps to Verify Accuracy
Even if the rigidity of financial accounting creates some inherent disadvantages, it does remove the uncertainty and misapplication of accounting guidelines of cost accounting. Uncertainty equals risk, which always comes at a cost. This means additional—and often more vigorous—reconciliation to verify accuracy.
May Have Overreliance on Highly-Skilled Talent
Higher-skilled accountants and auditors are likely to charge more for their services. Employees have to receive extra training and must sufficiently cooperate with data input. Non-cooperation can render ineffective an otherwise beautifully constructed system.
May Overemphasize Short-Term Decisions
Cost accounting might encourage a business to prioritize cost-cutting measures that are not sustainable in the long run. For example, efforts to reduce labor costs or use cheaper materials could compromise the quality of products or services, leading to customer dissatisfaction or reputational damage. Short-term cost reductions, therefore, might be the suggested option when looking at cost accounting reports though this may not actually be what’s best for the company long-term.
What Is Cost Accounting?
Cost accounting is a branch of accounting that focuses on tracking, analyzing, and controlling the costs associated with the production of goods or services. It helps businesses understand the costs incurred in manufacturing and operating, breaking down expenses into fixed, variable, and semi-variable costs.
What Are the Main Types of Costs in Cost Accounting?
In cost accounting, costs are typically classified into three main types: fixed costs, variable costs, and semi-variable (or mixed) costs. Fixed costs remain constant regardless of production levels, such as rent or salaries. Variable costs fluctuate with production output, like raw materials and labor. Semi-variable costs are a combination, having both fixed and variable components, such as utilities or maintenance.
How Is Cost Accounting Different from Financial Accounting?
While cost accounting focuses on internal decision-making, financial accounting is concerned with creating standardized reports for external stakeholders. Cost accounting provides detailed insights into the cost structure of a business to help with pricing, budgeting, and cost control. Financial accounting prepares overall financial statements that provide an overview of a company’s financial health for investors, creditors, and regulators.
Why Is Cost Accounting Important?
Cost accounting is important because it helps businesses track and manage their expenses. By understanding where and how money is being spent, companies can make informed decisions that improve profitability, reduce waste, and optimize where they decide to put their resources.
The Bottom Line
The repeated trade-off in any accounting method is accuracy versus expediency. Cost accounting reflects this more dramatically than other accounting methods because of its pliability. Every business needs to find its own balance between the ability to analyze data and the requirements to wrangle it.
