A Primer On Cost Accounting
By: Wouter Van Heeswijk
Tags: Accounting, Cost Accounting, Business, Costing, Finance

Although the word ‘accounting’ does not directly stir excitement within most people, having a proper insight into finances is essential to make intelligent business decisions. This primer cuts to the essence within a few minutes.

Unlike financial accounting (which is concerned with external reporting and heavily regulated), cost accounting is simply a means to present a comprehensive cost picture to improve decision-making.

In short, being able to accurately allocate costs to products allows to:

Set appropriate sales prices

Identify opportunities for efficiency gains

Create better production schedules

More accurately determine inventory value

There are many different perspectives on costs. The following classifications are the most important:

Fixed and variable costs

Fixed: Independent of production levels. Think permanent staff, rent, insurance. Variable: Dependent of production levels. Think materials, energy, flexible labor.

Direct and indirect costs

Direct: Costs incurred by production process. Think materials, labor hours, equipment, energy. Indirect: Not directly linked to production. Think insurance, marketing, administration.

The main challenge of cost accounting is to assign indirect costs to individual products. Direct costs are often easy enough to trace. The challenge is to assign indirect costs.

Also here, there are gradations of difficulty. Probably you will not assign the costs of machine repair to the exact product where it broke down, but it is reasonable to divide these repair costs over production. These are so-called cause-and-effect allocations.

Other costs, like laptops for the administration department, are so far away from the production process that allocation is really up to the decision maker. These are dubbed arbitrary allocations.

The challenge of cost accounting is in assigning indirect costs. Sometimes there are clear relations between indirect costs and production, at other times allocation is essentially arbitrary. [image by author]

There are many techniques to assign costs. An outline of the most common ones follow below.

Direct costing

In direct costing, only variable production costs are taken into account. The rationale is that fixed costs cannot be immediately influenced, whereas variable costs directly link to production levels. Smaller companies often use direct costing, as including fixed costs would lead to unfeasibly high sales prices.

Intuition

Only variable costs (depending on production level) are allocated

All fixed costs are ignored, as they cannot be influenced on short notice

Pros

Focus on production-level dependent costs that can directly be influenced

Intuition on extra income generated by additional units sold

Useful for decisions without fixed costs, such as outsourcing

Cons

Cost picture incomplete by ignoring fixed costs

Considerably underestimates true production costs

Absorption costing

Photo by Terry Vlisidis on Unsplash

Whereas direct costing only concerns itself with variable costs, absorption costing takes into consideration both fixed and variable costs. It restricts itself to manufacturing costs though; no marketing of administration involved. Compared to direct costing, it allocates a larger cost proportion to products, yielding higher costs per product.

Intuition

Divide both variable and fixed production costs over units produced

Ignore overhead not directly tied to production

Pros

More complete cost picture than direct costing, including fixed production costs

Compliant with external accounting principles (i.e., GAAP), so only a single record for cost accounting and financial accounting

Cons

Does not include non-manufacturing overhead (e.g., marketing, R&D, administration)

For small production volumes, can yield unreasonably high costs per product

Marginal costing

Marginal costing is concerned with the costs that extra production entails. Given any production level, you can determine how much extra costs producing Δ more units bring (often Δ=1). Marginal costing is often used to the determine the optimal production level: if marginal costs equal the marginal revenue, maximum profit is attained.

Intuition

Compute additional costs for producing extra units

Can be determined for various production levels

Pros

Map costs for various production levels

In combination with marginal revenue, marginal costing helps to determine the optimal (profit-maximizing) production level

Cons

Does not provide direct insights into average production costs

Slightly harder to interpret than some other methods

Standard costing

Cost allocation is hard, but does not always lead to actionable insights. Some costs are simply to small to bother, or the production process might simply not change that much over time. Rather than measuring costs, it is also possible to estimate them. Standard costing is concerned with these estimates, also allowing to predict costs before they are incurred. Often, certain markup percentages are applied to products to allocate certain cost types. For instance, a 2% marketing budget may be added to each product.

Intuition

Determine cost estimates for certain types of costs

Add standard overhead percentages to product costs

Pros

Easy to implement and apply

Allows to estimate future costs, rather than measuring in hindsight

Monitor discrepancies between estimates and observations

Cons

Can wildly oversimplify true costs per product

Not suitable for fast-paced environments where cost rates change rapidly

Cost estimates may drive inappropriate managerial actions

Target costing

Photo by Oliver Buchmann on Unsplash

Target costing is a bit of an odd duck, as it in fact does not consider costs at all. It is a market-driven approach, starting with the sales price (e.g., based on competition), attaches a desired profit margin, and as such provides the maximum costs that products should incur. It is more of a normative technique than an allocation tool, but often proves indispensable. Especially when frequently developing new product, target costing is useful as a viability check.

Intuition

Set (maximum) product costs based on desired profit margin

Work back from realistic market price to required cost structure

Pros

Suitable for environments with frequent new products or product updates

Market-driven approach to costing, checking whether product is feasible

Cons

No consideration for actual costs incurred

Does not provide an evidence-based cost view

Activity-based costing

Photo by David Rodrigo on Unsplash

Activity-based costing (ABC) is often seen as the Holy Grail of cost accounting. The idea sounds appealing: all costs (including activities such as R&D and marketing) are tied to activities that in turn link to products, yielding the most complete and accurate cost picture. This approach typically yields the highest costs per product, as well as the most accurate one. It is also the most difficult and time-consuming technique though.

Intuition

Assign costs to activities, then proportionally assign those activities to individual products.

Allocate the full costs incurred by the company to products, including general overhead.

Pros

If done correctly, ABC provides a close approximation of ‘true’ costs per unit

Explicitly includes non-manufacturing overhead (e.g., R&D, marketing), which may be a substantial part of total costs.

Accurate allocation of opaque activities to products.

Cons

Assigning some indirect costs with reasonable accuracy can be either very hard or arbitrary.

Tracking and allocating all corporate costs is time-consuming.

Highest cost allocation per product, may be unattractive for certain purposes.

3 Minutes! Activity Based Costing Managerial Accounting Example (ABC Super Simplified) by MBAbullshitDotCom

Hybrid costing

As mentioned, cost accounting is just for internal use and not bound by regulations. As such, several methods may be combined. Large differences in marketing campaigns may warrant Activity-Based Costing, yet for the staples and paperclips Standard Costing likely suffices.

The future — A data science perspective

All cost allocation techniques in this article have been around for many, many years. Still, the current rise of data science opens up some exciting new opportunities.

With everything nowadays being tracked, stored and automated, the opportunities to allocate costs are unprecedented. High-frequency sensor data and real-time production data hide vast insights; attaching this information to production costs allows for accurate cost allocations.

In the years to come, expect to see considerably more detailed and accurate cost portrayals.