Cost accounting is the process through which the expenses of a company are identified and measured, the term expense being understood not only as an outflow of money but also as consumption of goods, depreciation of assets and results.
The objective of cost accounting is to provide information on the costs of a company, of a certain product or service, of a certain area or department, of a particular customer, etc., to make a better financial analysis of these.
We can account for costs, for example:
Unlike general accounting, cost accounting is for internal use only and, therefore, is not necessary, so there is no standard cost method or system used for all companies equally, but rather each company can adopt the method or system that it deems best, taking into account their needs or objectives.
Nowadays where the prices of products and services are constantly changing, it is necessary to always keep in mind the costs of the products and services offered.
How to Count the Costs of a Company?
Let’s see below the general steps that must be followed to account for the costs of a company or business:
1# Total Costs or Partial Costs
The first step in the accounting of the costs of a company is to determine what expenses we will consider as costs. To account for the costs of a company there are two methods: the Total Costs method and the Partial Costs method.
In this method, all expenses related to the product or service are considered as costs, as well as administrative and sales expenses, and all other expenses (financial expenses, taxes, etc.) are called expenses. This method is usually used to find the point of equilibrium.
In this method, all expenses related to:
- The acquisition of merchandise: in the case of a marketing company (a company dedicated to the purchase and sale of products).
- Product manufacturing: in the case of an industrial company (a company dedicated to the production or manufacture of products).
- The provision of the service: in the case of a service company.
And all other expenses (administrative expenses, sales expenses, financial expenses, taxes, etc.) are called expenses. This method is usually the most convenient and easy to use.
In general, costs are investments related to the product or service; while the expenses are disbursements related to the administration or management of the company.
2# Variable and Fixed Costs or Direct and Indirect Costs
Once we have decided what disbursements we will take as costs, for a better analysis we proceed to classify them in Variable Costs and Fixed Costs or, in any case, in Direct Costs and Indirect Costs.
Variable Costs and Fixed Costs
In this case, we classify the costs according to their behavior with the fluctuations of the activity:
- Variable Costs: these costs vary according to changes in activity levels, it is the number of units sold (in the case of a trading company), the volume of production (in the case of an industrial company), or the number of services performed (in the case of a service company). Examples of variable costs are raw materials, fuels, spare parts, packaging, hourly wages, etc.
- Fixed Costs: these are costs that are not affected by variations in activity levels. Examples of fixed costs are rents, maintenance of machines and equipment, depreciation, insurance, fixed fees, and salaries, etc.
Something important to take into account is that when production increases, the Variable Costs increase, but not the Fixed Costs or the Unit Variable Cost.
For example, if we produce 10 products with a Variable Cost of 400 and a Fixed Cost of 1600, the Total Costs, the Unit Cost, the Unit Variable Cost, and the Unit Fixed Cost would be as follows:
- Total Costs: 400 + 1600 = 2000
- Unit Cost: 2000/10 = 200
- Unit Variable Cost: 400/10 = 40
- Fixed unit cost: 1600/10 = 160
And if our production increases by 10 products, the production would be 20, the Variable Costs 800, the Fixed Costs 1600, and the Total Costs, the Unit Cost, the Unit Variable Cost, and the Unit Fixed Cost would be as follows:
- Total Costs: 800 + 1600 = 2400
- Unit Cost: 2400/20 = 120
- Unit Variable Cost: 800/20 = 40
- Fixed unit cost: 1600/20 = 80
Variable costs are called “Varial ” as their value varies (increases or decreases) when sales or production do so; while fixed costs are called “fixed” since their value does not vary when sales or production do.
Direct Costs and Indirect Costs
In this case, we classify the costs according to the identification for the purpose of the cost.
- Direct Costs: these costs are directly involved in the production of the product or service, or are part of it. In order to identify them, we see what are the costs that can be distributed among the products; for example, the raw material (since it is known how much raw material is used for each product), electricity (when it is known how much electricity is used for a given product), etc.
- Indirect Costs: these costs indirectly occur in the manufacture of the product or the provision of the service. To identify them, we see what are the costs that cannot be distributed among the products; For example, electricity.
3# Determine Expenses
Once we have decided which disbursements we will consider as costs (Total Costs or Partial Costs method), and we have classified them into Variable Costs and Fixed Costs, or in Direct Costs and Indirect Costs, we proceed to identify the Expenses ( which would be all disbursements that we have not considered as costs).
The expenses are classified into:
Operating expenses, in turn, are classified as:
- Administrative Expenses: these are disbursements that are related to management activities; for example, labor costs (salaries, bonuses, insurance) of the managers, administrators and auxiliary of the company, rents, materials and office supplies, insurance, depreciation (of administrative buildings, office equipment, machines, furniture), taxes, electricity, water, etc.
- Sales Expenses: are disbursements that are related to the marketing activities of the products; for example, labor expenses (salaries, bonuses, commissions) of the sales manager and the sellers or the bill collectors, advertising, sales tax, packaging, transport, storage, etc.
Note: when we use the Total Costs Method, Operating Expenses are considered as costs.
Financial Expenses are disbursements related to the financing of the company’s operations (interest).
Other expenses include disbursements such as losses, bad debts, unforeseen expenses, etc.
4# Identification and Analysis
Finally, once we have determined which elements we will consider as costs, we have classified them, and we have determined the expenses, we proceed to identify each element with its respective cost, and then, we proceed to analyze them according to the need or objective that count the costs.
Here are some examples of how to count and analyze costs in a marketing company, an industrial company, and a service company.
Remember that cost accounting does not have a standard method or system that is used for all companies equally, but that a company can adopt the cost method or system that it deems most convenient according to its needs or objectives.
i- Costs in a Marketing Company
When it is a marketing company (company dedicated to the purchase and sale of products), the usual thing is to call costs only to Acquisition Costs ; that is to say, to the costs conformed by the value of the merchandise that is bought, as well as to the disbursements related to said purchase, such as freight, insurance, import duties, etc.
Here is an example of how to account for the costs of a marketing company:
Suppose we start operations with an initial inventory of 30 televisions at a cost of US $ 100 each, then buy 10 televisions at the US $ 100 each, and then sell 5 televisions at the US $ 300 each. If we have operating expenses of US $ 400 (administrative expenses: the US $ 100 and sales expenses: the US $ 300), what would be our net profit?
The Income Statement would be:
|Sales (300 x 5)||1500|
|(-) Cost of Sales (100 x 5)||500|
|(-) Administrative expenses||100|
|(-) Selling expenses||300|
When the merchandise that is acquired has different sales values; for example, that the televisions of the initial inventory are of US $ 100, but the 10 that were bought are of US $ 120, in this case, it is not possible to find the exact Cost of Sales, since the Unitary Cost of a television varies. In this case, what we have to do is find a weighted average.
If we find the weighted average:
- 30 televisions x 100 = 3000
- 10 televisions x 120 = 1200
- Total cost = 4200
- Average Unit Cost: 4200/40 = US $ 105
The new Income Statement would be:
|Sales (300 x 5)||1500|
|(-) Cost of Sales (105 x 5)||525|
|(-) Administrative expenses||100|
|(-) Selling expenses||300|
ii- Costs in an Industrial Company
When it is an industrial company (a company dedicated to the production or manufacture of products), the usual thing is to call costs only to Production Costs; that is, the costs that occur within the production process.
These production costs are made up of the following elements:
- Costs for the purchase of Raw Materials or Direct Materials
- Costs for the acquisition of goods that will be transformed into finished products or that will be part of it; for example, inputs, parts, labels, etc.
Direct Labor Costs
Costs made up of salaries and benefits of workers who work directly in the production of the product.
Indirect Manufacturing Expenses
Costs of the necessary elements for the manufacture of the product, but that intervene indirectly in the elaboration of the same.
Indirect Manufacturing Expenses, in turn, are made up of:
- Indirect Materials: made up of auxiliary materials, factory supplies, fuels, spare parts, lubricants, cleaning supplies, etc.
- Indirect Workforce: made up of the salaries and salaries of professional, technical, specialized or auxiliary personnel in charge of complementary tasks not directly linked to the production process, such is the case of the plant manager, supervisors, cleaning staff, maintenance, security, etc.
- Other Indirect Expenses: conformed by insurance against risks, depreciation, rents, electricity, water, telephone, maintenance services, subsidies, etc.
Here is an example of how to account for costs in an industrial company:
Suppose we are asked to manufacture 40 tables. What would be the net profit and the price of each table if we expect to obtain a 20% profit?
The data we have are:
- The raw material (wood) has a cost of US $ 800 for the 40 units.
- The salary for the operators who will carry out the cutting, brushing, arming and painting work is US $ 380 in total.
- Glue, nails, varnish, etc., with a total value of US $ 140 will be used.
- It is estimated that depreciation, energy, and others have a value of US $ 80.
- Administrative and sales expenses amount to US $ 180.
1- First of all, we find the Production Cost:
|Indirect Manufacturing Expenses|
|(-) Indirect Materials||140|
|(-) Other Indirect Expenses||80|
2- Once we have found the Production Cost, we proceed to find the Unit Cost:
Unit Cost: 1400/40 = US $ 35
3- Then we proceed to find the price at which we should sell each table to earn a gross profit of 20% of the Production Cost:
The sale price of each table would be: 1680/40 = US $ 42
4- To find the net profit, we make our projected Income Statement:
|(-) Cost of Sales (40 x 35)||1400|
|(-) Operating expenses||180|
iii – Costs in a Service Company
When it comes to a service company, it is usual to call costs only related costs are the provision of the service.
These costs are made up of the following elements:
Miscellaneous Supply Costs
Costs formed by the purchases made by the company to provide the service.
Labor costs for the service
Costs made up of the salaries of the workers who provide the service.
Costs made up of elements that indirectly intervene in the provision of the service, such as depreciation, electricity, water, telephone, rents, maintenance, repairs, etc.
Here is an example of how to estimate costs in a service company:
Suppose that in our car repair shop, we are asked to repair a car that has a crash on the right side, in addition to a headlight breakage. The costs are:
- Faro: US $ 50
- Putty: US $ 5
- Welding: US $ 15
- Labor: US $ 25
How much should we charge for the service in order to earn 30%?
|Total costs (70 + 25)||95|
Cost accounting is the process through which the disbursements of a company are identified and measured, the term disbursement being understood not only as an outflow of money but also as consumption of goods, depreciation of assets and results.
Unlike the general accounting that a company is obliged to keep (for example, to be able to declare and pay its taxes), cost accounting is not mandatory but is carried out only for internal reasons when the company’s managers consider it necessary.
That is also why unlike general accounting that is governed by globally accepted accounting standards, to keep cost accounting there is no standard method or system that is used for all companies equally, but that the company can adopt the method or system that you consider best considering your needs or objectives.