It’s hard to overstate the importance of cost accounting, particularly in today’s economy where effective cash management is paramount. In a sentence, cost accounting involves recording the costs that your company sustains when producing goods or providing services in order to streamline expenses and inform future decisions.
Through cost accounting, you gain essential insight into where your business is spending money, how much it earns, and where money can potentially be saved. This makes cost accounting a critical activity if you’re seeking to understand how profitable your business is and how efficiently it’s performing.
Of course, an activity that provides that kind of value isn’t a cakewalk. But that doesn’t make it rocket science either. With the right level of foundational knowledge, initiating cost accounting activities in your business is an achievable goal. And by reading this article, you’re taking your first step toward it.
What we’ll cover:
- The basics of cost accounting
- Primary business costs
- Cost accounting vs. financial accounting
- Practical applications
- Implementing cost accounting in your business
- How accounts payable software supports cost accounting
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The basics of cost accounting
A cost accountant is an organization’s financial detective, helping their business understand exactly where money is going. To do this requires evaluating every single expense that goes into making a product or providing a service, which includes direct costs like materials and labor and indirect costs (or overheads) such as employee wages. These costs are consolidated, tracked, and analyzed to provide business leaders with insights that enable them to make decisions about pricing, budgeting, and resource management.
Primary business costs
We just gave a couple of examples about the types of costs you need to factor into cost accounting (materials and employee wages). Let’s detail the primary examples that apply to every business.
- Fixed costs: These are the costs that remain fixed regardless of your company’s level of production or business activity, and they remain constant in the short term. Common examples include rent, insurance, and salaries of permanent staff.
- Variable costs: The flipside of fixed costs. They vary in direct proportion to changes in production of activity levels. These include raw materials, direct labor hours, and production supplies.
- Operating costs: The ongoing expenses incurred by your business to maintain its daily operations. They can either be fixed or variable, but do not include direct costs related to producing goods or services.
- Direct costs: These are the materials used to make a product. If you were running a bakery and you decide to sell cookies, the cost of flour, butter, and sugar are direct costs as they can be directly attributed to the production of the cookies.
- Indirect costs: Conversely, these can’t be directly attributed to a product. In the cookie example, the rent for your bakery would be an indirect cost. It’s necessary to produce the cookie, but it can't be easily traced to the individual item you sell.
Simple, right? Granted there’s a few to consider, but accountants have a remarkable ability to name things literally so that they’re easy to remember.
Cost accounting vs. financial accounting
With a basic understanding of cost accounting and the terminology involved, you may now be wondering what the difference is between cost accounting and financial accounting.
After all, both involve evaluating financial data to provide insights to stakeholders. Both contribute to the preparation of financial statements. And both support budgeting and planning processes.
Despite these similarities, it’s important to note that the two activities have distinct focuses and objectives. Financial accounting is intended to provide an accurate overview of an organization’s financial performance and position for external stakeholders (such as investors) to inform their decisions about investing in the company. Whereas cost accounting is internally focused, enabling organizations to meticulously manage their organizational spend and make smart decisions on it.
The key differentiation: Cost accounting serves internal stakeholders and financial accounting serves external stakeholders. Now, let’s explore how cost accounting can be applied within your organization.
Practical applications of cost accounting
As a critical accounting activity, you’ll be unsurprised to learn that cost accounting has a plethora of practical applications. But we won’t list all of them here. However, it's important to understand the following three examples to gauge how this activity can help your organization.
Pricing decisions
In today’s economy, your pricing must be regularly evaluated for you to remain competitive. With rising interest rates increasing the cost of money, you’ll want to make sure that you’re pricing products and services competitively to ensure you maintain customer interest, while achieving your desired profitability.
Through analyzing cost components such as materials, labor, and overhead, your business can determine optimal price points, evaluate profitability, and assess break-even thresholds. Cost accounting also helps you to understand the impact of discounts, promotions, or product mix variations on overall profitability.
Inventory valuation
Cost accounting guides the three following inventory valuation methods. Whichever method you choose to use, cost accounting ensures their accuracy and keeps your financial statements credible and your business compliant.
- FIFO (First-In, First-Out): This method assumes that the first items purchased or produced are the first sold. FIFO often reflects current market costs more accurately and is commonly used when inventory costs are rising.
- LIFO (Last-In, First-Out): LIFO assumes that the most recent items purchased are the first sold. In periods of rising costs, LIFO can result in lower reported income for tax purposes but may not accurately reflect market costs.
- Weighted Average: This calculates the average cost per unit based on the total cost of goods available for sale, divided by the total number of units.
Performance evaluation
Through cost accounting, your business can break down financial performance. You can compartmentalize costs into direct materials, labor, and overhead to identify cost drivers and areas of expenditure. This helps you to establish cost control measures and allocate resources efficiently.
Moreover, you can glean profit margins. By comparing revenues with different cost components, you can calculate gross profit margins and net profit margins. This reveals whether products, projects, or departments contribute positively to overall profitability.
You can also look ahead to make strategic decisions. Cost accounting aids in developing strategic plans by forecasting costs, budgeting, and assessing the financial impact of different strategies.
Implementing cost accounting in your business
With these benefits in mind, you’re likely wondering how to implement cost accounting in your business. Here’s a step-by-step guide to get you started. There are 9 stages to consider, but each is simple to follow.
- Set goals: Define why you want to use cost accounting. Is it for pricing decisions, cost control, or performance evaluation? This will guide your implementation.
- Categorize costs: Break down your costs into categories like materials, labor, and overhead. This organizes your expenses for analysis.
- Choose allocation methods: Decide how you’ll allocate indirect costs to specific products or activities. Common methods include activity-based costing or percentage allocation
- Gather data: Collect data on expenses, production quantities, and activity levels. Use invoices, time sheets, and other records to inform cost information.
- Calculate costs: Apply your chosen allocation methods to distribute indirect costs. Add direct costs (materials and labor) to get the total cost for your product or service.
- Inventory valuation: Decide on an inventory valuation method and apply this method to value your inventory accurately.
- Evaluate data: Review your cost data to identify cost drivers, variations, and improvement opportunities. Compare costs with revenues to assess profitability.
- Optimize decisions: Use your cost data to improve decisions, such as determining optimal pricing and allocating resources.
- Communicate results: Cost reports should be prepared to demonstrate the impact of cost accounting and ensure continued progress.
There’s a lot that goes into cost accounting, so simplicity is key. Establishing a clear framework to start is the goal, and this can be expanded on as employees and teams become familiar with the process.
How accounts payable software supports cost accounting
Of course, there are tools available to guarantee a simplified approach to cost accounting. What you’ll have realized is the sheer volume of information that must be considered to effectively manage the process, spanning every area of your business. Here’s how you can control that data deluge.
With accounts payable (AP) software, you can centralize your financial data, which makes it far simpler to access and analyze cost-related information. You don’t need to spend time trawling through your tech stack and you can depend on a single platform to provide you with the information you need.
AP software captures all expenses related to AP processes. You can capture data on invoices, bills, and other financial transactions and categorize costs accurately, whether that’s by departments, projects, or cost centers. You can also allocate indirect costs to specific projects or departments to ensure proper cost distribution.
All of this data is displayed via customizable reporting dashboards that allow you to deeply understand the financial health of your organization. You can use these to quickly generate cost reports, analyze organizational spending patterns, and assess the financial impact of different decisions.
Put simply, AP software is transformational when it comes to cost accounting. It ensures total accuracy of financial data, meaning you can spend your time understanding what the data says about your business, rather than checking it’s correct. It also provides the capabilities you require to compartmentalize costs and make comparisons, which accelerates the cost accounting process.
Ready to implement cost accounting to boost your business? Schedule a demo of Quadient AP today to see how our technology can support you.
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