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Understanding the Basics of Cost Accounting

By Edited Nov 13, 2013 0 0

To most people, all accounting is the same. Unfortunately, this is not really true. There are many different types of accounting. A few examples are: tax accounting, general ledger or cost accounting. Most people can identify tax accounting and general ledger accounting is the summarization of all information for management with the preparation of summary level financial statements.

• What, then, is cost accounting?

The primary purpose of cost accounting is to provide the details of the direct costs versus the indirect costs required to produce a given product. By separating these costs, it is possible to provide information to manage the activities and costs of an organization in an effort to increase profits.

• Production Costs (Cost Of Goods Sold)

Simply stated, production costs (Cost Of Goods Sold) are all costs required to produce a finished product. That includes the total value of labor, materials and related overheads required to complete production. In cost accounting, these expenses are further categorized to enable a company to track costs from start to finish in cost elements that are clearly defined and easily monitored. A cost accounting system includes both direct and indirect costs outlined as follows:

• Direct Costs

Direct Material – The raw materials required to assemble a product such as metals, plastics and electronic components are considered direct material.

Direct Labor – The human effort required to produce a product is considered direct labor. To provide further analysis, the labor can be subdivided into categories. Examples of this would be: assembly, test and inspection labor. Direct labor costs are accumulated at the actual salary cost for each individual in each of the labor categories.

• Indirect Costs

The additional costs required to produce a product such as material storage, equipment and support personnel are considered indirect costs and are collected into overhead cost groups. An overhead rate is established for each overhead group and is calculated by dividing the total overhead expenses for a year by the total direct costs for a year

Material Overhead – Material overhead costs include all activities, costs and personnel related to the purchase, storage and movement of materials during the production process. Examples of material overhead costs are: purchasing salaries, stockroom salaries, employee benefits, equipment, utilities and supplies.

The material overhead rate is established by dividing the total material overhead expenses for a year by the total direct material costs for a year and is expressed in percentage form.

Labor Overhead – Labor overhead costs include all activities, costs and personnel related to the labor effort associated with producing a product. Examples of labor overhead costs are supervision, employee benefits, equipment, utilities and supplies.

The labor overhead rate is established by dividing the total labor overhead expenses for a year by the total direct labor costs for a year and is expressed in percentage form.

• General and Administrative (G&A) Costs

The total cost of the business, however, must also include additional general and administrative (G&A) expenses not directly related to the production of a good or service. Examples of these costs are: human resources, finance, marketing and executive management. The G&A expense rate is established by dividing the total G&A by the total COGS and is expressed in percentage form.

• The Purpose of Cost Accounting

The purpose of separating and collecting the costs of a business in different categories is so management can analyze the costs over a period of time and compare trends from one period to another. Regardless of the fluctuation in the actual numbers from year to year, expressing expenses as a percentage of cost provides a more relative comparison. In addition, the ability to drill down through cost accounting information is a powerful tool that allows management to pin point where problems exist and gives them the opportunity to make changes to increase profit.

This is quite different from the summary level profit and loss statement prepared in general ledger accounting. An illustration of a cost accounting statement versus a profit and loss statement is provided below:


The cost accounting statement gives much greater visibility into the details of the cost elements. However, the added power of cost accounting is not realized until cost elements are compared from one period to another. The costs elements are expressed in percentages of total cost to make relevant comparisons and to pin point potential problems.

See the comparison of a business for Year 1 and Year 2 in the illustration below:


To some, this only looks like a lot of numbers on a piece of paper. But, to a trained cost accountant, it is a quick road map to help management analyze the business and zero in on areas for improvement.

The illustration above has been numbered in red for better explanation. Examining at each of the numbered items in order reveals what's really going on in this business.

1 & 2 – Net income actually increased from $36.3 million to $52.9 million which is cause for celebration. However, the net income percentage (net income divided by sales) reveals that somehow the company did not perform as well as it did the year before. The net income percentage actually went down from 36% to 28%. Further analysis reveals why.

3 – The direct labor percentage increased from 3.6% to 4.5% in production. Looking further into the details, it was discovered that the new employees hired to sustain rapid growth were not trained properly. This caused additional hours to be expended in assembly, test and inspection.

4 – The cost of supervision and employee benefits were also up from the prior year. Further analysis revealed that additional supervisors were employed to try to sort out the production issues.

5 – The total labor overhead increased as a result of the production problems.

6 & 7 – Although the G&A (General and Administration) expense was down as a percentage of cost it did not offset the decrease in sales percentage to cost in the second year.

8 – The sales percentages reveal that the sales increases did not keep pace with the cost increases.

Overall, the company made much more money than the prior year. However, improvements in training production personnel could reduce costs and bring even more money to the bottom line.

This is a simple cost accounting analysis. More in depth information can be obtained by drilling even further down through the details – right down to the nut, bolt, screw and washer if necessary.

In reviewing the information above, it is easier to understand the basics of cost accounting. By separating costs in meaningful categories, it is possible to provide information to analyze the business and have the opportunity to make improvements to increase profits.

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If you are looking for more information on business management, you might be interested in some of the other articles I've written:

How to Create an Effective Performance Appraisal System, Qualities of an Effective Leader, Understanding the Concept of Opportunity Cost, Basics of How to Counsel an Employee for Improper Behavior, Understanding the Importance of Organizational Behavior, Understanding the Use of Financial Ratios in Management of Working Capital



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