|All content presented here and elsewhere is solely intended for informational purposes only. The reader is required to seek professional counsel before beginning any legal or financial endeavor.|
The purpose of cost accounting is to find out which product or service costs the least to make and therefore which product gives you the largest amount of profit and those that do not. The 8 different types of costs are most relevant when it comes to manufacturing businesses and businesses involved in the distribution of physical products.
8 Types of Cost in Cost Accounting
#1 – Direct Cost
Direct costs are among the most common. They are the direct cost associated with the production of a product. Direct costs would include labor or materials. They may also include distribution costs and other expenses, depending on the method of accounting. The most obvious example of a direct cost would be a car manufacturing company. The direct costs would be the total cost of the individual parts themselves.
#2 – Fixed Cost
The most obvious example of a fixed cost would be a lease. If you need to pay $3,000 a month for the next 2 years for a property, then this is a fixed cost. The defining characteristic of a fixed cost is that it does not change. A fixed interest rate repayment on a loan is also a fixed cost (provided it is not tied to a variable interest rate). Regardless of how well or poorly the business is doing, a fixed cost will always remain a fixed cost. Fixed costs are easier to calculate as they tend to be more tangible.
#3 – Variable Cost
In direct contrast to a fixed cost, a variable cost can change depending on business performance. The more products you produce, the more you will pay for packaging and distribution. But remember that a variable cost is not a direct cost. Even if you pay more for components and if you pay more for hours worked, this still goes under direct costs in most instances.
#4 – Operating Cost
These are sometimes referred to as operating expenses. These can be either fixed or variable. Operating costs are costs that are associated with daily business activity but are distinct from indirect costs. Rent and utilities are typical examples of operating costs. They are essential for business operations but are not involved in the manufacturing process directly or indirectly.
#5 – Opportunity Cost
This is usually only relevant when deciding between more than one potential business opportunity. The opportunity cost is the cost associated when you go with one investment, and potentially lose out on other investments. What has to be understood is that there is always a potentially superior investment, and you need to shoot for ‘good’ as opposed to perfect. If you are deciding to rent vs buy a new piece of equipment, then you could compute the opportunity cost with all of the variables.
#6 – Sunk Cost
Sunk costs are costs that will not be recovered by the business. They cannot be recovered regardless of what happens. They are excluded from future business decisions. If you have invested money in a business that has gone bankrupt, it is a sunk cost already (even though you may recuperate some of the revenue through the court system).
#7 – Controllable Cost
Controllable costs are ones where a manager (or board) decides what will happen at a particular cost. Bonuses, charitable donations, advertising, office supplies, employee events, are all examples of controllable costs. But their value is not so easy to calculate. While they are a cost, you cannot simply reduce them down to zero and expect to run a successful business.
The 4 Major Types of Cost Accounting Methods
Of all the major accounting costs listed below, Standard Cost Accounting is the one most widely used by small and medium-sized business models. However, it is activity-based costing that is deemed to be the most accurate and the one that is heavily used by Corporate outfits. It outlines in greater detail the profit/cost of products and services so management can make better decisions.
- Activity-Based Costing – This type of cost accounting is an approach to the costing and monitoring of activities that involves tracing resource consumption and costing final outputs, resources assigned to activities, and activities to cost objects based on consumption estimates. It involves accumulating the overheads from each department and assigning them to specific cost objects, such as products, services, and customers.
- Standard Cost Accounting – This type of cost accounting uses different types of ratios to compare how efficiently labor and materials are being used (or can be used) to produce goods and services in standard conditions. One of the issues associated with standard cost accounting is that it emphasizes labor efficiency even though labor costs make up a small percentage of costs in modern companies.
- Job Costing – This involves the detailed accumulation of production costs attributable to specific units or groups of units. For example, the construction of a custom-designed piece of furniture would be accounted for with a job costing system. The costs of all labor worked on that specific item of furniture would be recorded on a timesheet and then compiled on a cost sheet for that job. In a similar vein, any wood or other parts used in the construction of the furniture would be charged to the production job linked to that piece of furniture. This information may then be used to bill the customer for work performed and materials used or to track the extent of the company’s profits on the production job associated with that specific item of furniture.
- Process Costing – This involves the accumulation of costs for lengthy production runs involving products that are indistinguishable from each other. For example, the production of 100,000 gallons of gasoline would require that all oil used in the process, as well as all labor in the refinery facility, be accumulated into a cost account, and then divided by the number of units produced to arrive at the cost per unit. Costs are likely to be accumulated at the department level, and no lower within the organization.
Key Formulas/Terms in Cost Accounting
If you are interested in cost accounting, then you need to understand the following key terms. There are hundreds (even thousands) of key terms and definitions that could be mentioned within the realm of business. However, the following definitions are relevant in terms of cost accounting.
- Breakeven Formula – This the point at which a business breaks even taking into consideration the price of the goods/services rendered. It is the minimum amount of goods/services that need to be produced before the business is not operating at a loss for its materials and labor (not inclusive of debt, but potentially inclusive of interest on debt to be paid at each interval). However, the method you use to calculate your break-even formula will depend on your style of business. If you are not manufacturing physical products, there are different ways to go about it.
- Target Net Income – In the context of cost accounting, target net income is your projected target income or goal that you expect to achieve. So it is not a concrete existing figure, but what you would like to make based on the current projections. Remember that net income and net profit mean the same thing in accounting, though they can sound different.
- Gross Margin – The gross margin of a given enterprise is its gross sales taken from the cost of goods sold. It denotes the operational efficiency of a business, in the sense of how much gross profit it makes after production costs. But it is not net profit. A business can have an excellent gross profit and horrible net profit. So the gross margin is more useful to internal management than external investors. Gross margin is sometimes referred to as gross profit margin.
- Price Variance – This is very useful when deciding how many products you need to order. It is the tidal variance between the standard cost and the retail cost. To calculate it, you just multiply the difference between the standard and retail cost by the total units sold. The price variance is an extremely useful metric in cost accounting when companies are doing their budget.
- Efficiency Variance – This is another definition that is especially important when it comes to cost accounting and manufacturing. It is the difference between the projected estimate for the completion of a process and the required inputs. For instance, the production of a product might be estimated to require 20 hours of labor and take 25 hours. This is a negative efficiency variance. Most often, a slightly negative efficiency variance is to be expected.
Software to Help With Cost Accounting
While many software packages are specific to particular industries, popular programs include SAP and Oracle. Familiarity with these packages will strengthen a cost accountant’s ability to perform and analyze data at foundation levels. Cost Accountants should stay abreast of new developments in accounting technology and trends, to ensure efficiency and effectiveness.
There are many types of software that have been specifically designed to assist with this area. This is suited to specialized companies. For generic businesses without such niche requirements, the more general accounting software is more appropriate. Some of the best accounting platforms include: