Cost Methods In Accounting

When you plan to consider an accounting system, it is essential to thoroughly understand the meaning of costs and the methods of cost assignment. Under reasonable circumstances, the relevance of cost determination is very significant in business areas that deal with a lot in the calculation of investment and net profit. Cost refers to any cost incurred when you operate your organization or other related activities. In addition, it includes opportunity costs on alternative projects/activities that could have been carried out instead. We will help ace your cost methods in accounting assignments and exams.

Cost Methods In Accounting
Cost Methods In Accounting

What Is Cost Accounting?

Cost accounting is the branch of accounting that deals with the determination and evaluation of costs. It involves classifying, analyzing and determining large data scales concerning cost and their allocation to different areas. In addition, it focuses on compiling reports which financial and management professionals will use in making informed decisions about management accounting, like economic value analysis (EVA) and short-term financial planning activities.

Cost Accounting vs. Finance Accounting

Generally, finance accounting assists in providing information for investors who make decisions based on this information, while cost accountants give valuable data to top decision-making executives within a company, such as the CEO or CFO. Therefore, it can be concluded that finance accounting provides data required for external reporting. In contrast, cost accounting offers internal profitability measures and data needed in control and planning decisions.

Differences between direct and indirect approach

There are different types of methods used in calculating costs; these include direct and indirect costing.

There are two main approaches used by accountants when assigning costs: direct costing and indirect costing.

Direct Costing

Under direct costing, costs are assigned to products and services based on the actual cost incurred in producing them. This method allows for the calculation of product profitability which is a measurement of performance because it can tell you what amount is received from each unit sold.

If there is variation in costs involved in the production, this will affect the final selling price obtained. The main limitation with this approach is that it does not consider fixed overheads and therefore gives an incomplete view of profit contribution from different departments.

Indirect Costing

Under indirect costing, overhead expenditures are allocated using predetermined proportions or percentages as a basis rather than actual amounts. Thus, giving overhead costs does not reflect the actual price per unit.

Indirect costing includes several different methods such as overhead Absorption, burden rate and standard costing.

There are different ways to use indirect costing methods, including Absorption, burden rate,  and standard costing. Absorption costing accounts for all overhead expenses to calculate net operating income. It allocates overheads based on units produced rather than specific products. Therefore it considers the allocation of both variable and fixed costs.

The burden rate method considers the use of equipment, materials and other resources to calculate costs associated with a given project or production line. Under this method, direct labor is charged based on an agreed-upon hourly rate multiplied by actual hours worked plus indirect costs. Average costing assumes that rule-of-thumb methods are used for each product. This method considers the allocation of overhead costs based on previous years’ results.

Importance Of Cost Accounting

  1. Financial Decision Making

The most crucial purpose of cost accounting is financial decision-making. Some of which include:  Forecasting cash inflows and outflows; Allocation of capital to various business units for further investment; Determining whether a product or service should be discontinued; Making pricing decisions for products/services to maintain profits; Forecasting prices for new products/services launched by competitors; Determining the profitability of existing products/services and finally selecting an appropriate pricing strategy.

  1. Management Control Systems

Another purpose of cost accounting is management control systems. These include:  Determining how efficient workers are (productivity); Obtaining data required for variance analysis; Determination of variances in costs and revenues by comparing actual with expected results; Assisting in the calculation of various cost performance indices such as labor efficiency, material utilization, overhead application rate, etc.; Planning, design and implementation of new projects.

  1. Performance Evaluation/Financial Analysis

Cost accounting can be used to evaluate operating results. The primary purpose of this evaluation is to determine whether the business unit has been performing well or not through analyzing profit margins, losses or gains from certain products/services. It gives a clear picture of where the company is heading and whether current strategies are working because it helps identify the leading cause behind differences in targets.

  1. Limitations Of Cost Accounting

Cost accounting is limited due to several factors:  Difficulty in assigning costs that are comparable between departments; Costs set using allocation method do not take into account fixed overheads; Costs assigned using Absorption or burden rate methods do not reflect actual cost per unit; When comparing companies operating on different bases (for example cash basis vs. accrual basis); Differences in timing for recording transactions may make results unpredictable; Allocation of overhead expenses will increase the possibility of manipulation.

Mistakes to Avoid During Cost Accounting

Cost accounting is an essential tool for any business to create a competitive advantage over its competitors. It helps to improve existing processes, procedures and functions within the organization.   However, organizations often commit mistakes such as:

Failure to use cost accounting information in decision-making;

  • Not fully understanding cost accounting concepts because of lack of knowledge or experience;
  • Budgeting incorrect costs for products/services then leads to possible losses of revenue. ;
  • Not perceiving costs incurred during the production process (such as goods waiting to be sold).

Cost Accounting Key Terms

Absorption cost method – Under this cost accounting method, all production-related expenses are allocated regularly to products manufactured during that period.  This method is used mainly for internal purposes such as determining costing margins or variances from standards.

Allocation base – The different bases used when apportioning overhead costs include direct labor hours (DLH), natural labor rate (DLR), machine rates, and machine efficiency.    These bases can also be used to allocate other cost types, such as indirect expenses.

Apportionment – This is the process of dividing shared costs among departments. For example, labor cost apportionment is essential to determine the number of employees required by operations and calculate payroll costs allocated to each department for human resource management purposes. The labor cost apportionment formula considers total staff hours worked by all departments during a specific period.  It is not necessary that this base must correspond with the allocation base.

The absorption costing method estimates production-related expenses and allocates them over units produced during a specific period (period cost). It assumes that firms charge indirect production expenses as part of the cost of goods produced, which is considered a full measure.  This method is mainly used for internal purposes such as computing performance ratios and calculating product costs. Example:   Direct labor hours (DLH) allocation base is used when allocating production-related expenses from department A to units produced in department B.

A burden rate is a standard rate representing the combined costs associated with indirect activities, divided by an activity’s total output or sales volume over time.    It does not consider the costs of specific departments as it uses an average cost assigned to each unit produced or sold during each period. Burden rates are commonly used for product costing and pricing purposes as they help determine the total cost of a product when sold.

Direct Labour Hour – The sum of immediate labor time worked by employees in all departments during a given period.  It is also calculated based on an allocation base that can be any combination of direct labor, machine hours or machine rate.

Direct conversion costs represent expenses associated with goods produced, such as direct materials, direct labor, and plant management administration costs. When calculating product costs under the Absorption costing method, these are usually allocated to units produced instead of charged to the expense account directly associated with the cost object.

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Cost Methods In Accounting
Cost Methods In Accounting