Cost Accounting: Concepts, Importance, and classification

Cost accounting relates to cost information for internal use by management and greatly assists management in formulating operating objectives and schedules, comparing actual versus expected performance, and reporting.

Senior managers, management, and the administrative department are constantly faced with different situations that directly affect the operation of the company, the information they obtain about the costs and expenses incurred by the organization to carry out its activity, and that governs its behavior. , are of vital importance for decision-making in a fast and efficient way, this currently makes cost accounting highly relevant to the needs of information users.

Table of Contents

What is the cost
Cost Accounting Definition
- Cost accounting objectives
Fundamentals of information in cost accounting

What is the cost

Cost is defined as the value sacrificed to acquire goods or services by reducing assets or incurring liabilities at the time the benefits are realized.

Cost Accounting Definition

In a general sense, cost accounting is the technique used to collect, record, and report information related to costs and, based on said information, decide optimally and adequately related to planning and control thereof. Said in another similar way, cost accounting is an information system used by the company to determine, record, control, analyze, and interpret all the information related to the costs of production, distribution, administration, and financing of the entity. Cost accounting has a managerial approach since it provides basic information to company managers with a view to proper planning and control of the same, as well as for the costing of their products and services. Therefore, this accounting helps managers to make better decisions within the company.

Cost accounting objectives

Provide the information to determine the cost of sales and be able to calculate the profit or loss for the period.
Determine the cost of inventories, with a view to the presentation of the balance sheet and the study of the financial situation of the company.
Provide information to exercise adequate administrative control and facilitate correct decision-making.
Facilitate the development and implementation of the business strategy.

(Berrío Guzmán, Deysi and Castrillón Cifuentes, Jaime. Costs to manage manufacturing, commercial and service organizations, 2nd Edition. Ediciones Uninorte, 2008, p.3)

Fundamentals of information in cost accounting

The information required by the company can be found in the set of daily operations, clearly expressed in cost accounting, from which the evaluation of administrative and managerial management emerges, becoming a fundamental tool for the consolidation of the entities. To provide understandable, useful, and comparable information, it must be based on past revenues and costs needed for product costing, as well as projected revenues and costs for decision-making.

The data needed by users can be found in a “Pool” of cost information and can be classified into different categories according to:

The cost elements of a product.
The relationship with production.
The relationship with the volume.
The ability to associate them.
The department where they were incurred.
The activities carried out.
The period in which costs are to be charged to revenue.
The relationship with planning, control, and decision-making.

The most important and relevant aspects that support the information in cost accounting are presented below.

1. Cost elements of a product:

The cost elements of a product or its components are direct materials, direct labor, and indirect manufacturing costs, this classification provides the necessary information for measuring income and setting the price of the product.

Materials :

They are the main resources used in production; These are transformed into finished goods with the help of labor and manufacturing overhead costs.

Direct: They are all those that can be identified in the manufacture of a finished product, are easily associated with it, and represent the main cost of materials in the production of a product.
Indirect: They are those that are involved in the development of a product but have relative importance compared to the direct ones.

Manpower :

It is the physical or mental effort used to make a product.

Direct: It is the one directly involved in the manufacture of a finished product that can be easily associated with it and that has a great cost in the elaboration.
Indirect: It does not have a significant cost at the time of production of the product.

Indirect manufacturing costs (IMC):

They are all those costs that accumulate from indirect materials and labor plus all the costs incurred in production but that at the time of obtaining the cost of the finished product are not easily identifiable directly with it.

2. Relationship with production

This is closely related to the cost elements of a product and the main objectives of planning and control. The two categories, based on their relationship to production are:

Prime Costs: These are all direct materials and direct labor from production.

Prime costs= MP + DL

Conversion costs: They are those related to the transformation of direct materials into finished products, that is, direct labor and indirect manufacturing costs.

Conversion costs = DL + IMC

Production costs – Cost accounting – Photo: bisgovuk

3. Relationship with volume

The costs vary according to the changes in the volume of production, this is part of almost all aspects of the cost of a product, these are classified as:

Variable costs: These are those in which the total cost changes in direct proportion to changes in volume, while the unit cost remains constant.
Fixed costs: These are those in which the total fixed cost remains constant while the unit fixed cost varies with production.
Mixed costs: These have the characteristic of being fixed and variable, there are two types:
Semi-variable: The fixed part of the semi-variable cost represents a minimum charge, being the variable part the one that acquires a greater weight within the cost of the product.
Staggered: The part of the staggered costs changes at different levels of production since these are acquired entirely by volume.

Comment: From the relationship between the cost and the volume of production it can be said that:

Variable costs change in proportion to volume.
Variable costs per unit remain constant when volume changes.
Total fixed costs remain constant when the volume is changed.
Fixed costs per unit increase when volume decreases and vice versa.

Information about the various types of costs and their behavior patterns is vital for managers’ decision-making.

4. Ability to associate costs

A cost can be considered direct or indirect depending on the ability of management to associate it specifically to orders or departments, they are classified as:

Direct costs: These are those that management can associate with specific items or areas. Materials and direct labor are the clearest examples.
Indirect costs: They are those common to many items and therefore are not directly associable to any item or area. Indirect costs are usually charged to items or areas based on allocation techniques.

5. Department where costs were incurred

A department is the main functional division of a company. Departmental costing helps management control overhead costs and measure revenue. The following types of departments are found in manufacturing companies:

Production departments: These directly contribute to the production of an item and include the departments where the conversion or manufacturing processes take place. Includes manual and mechanical operations performed directly on the product.
Service departments: They are those that are not directly related to the production of an article. Their role is to provide services to other departments. The costs of these departments are usually assigned to the production departments.

6. Activities carried out:

The costs classified by function are accumulated according to the activity carried out. Depending on the activity, the costs are divided into:

Manufacturing costs: These are related to the production of an item. Manufacturing costs are the sum of direct materials, direct labor, and manufacturing overhead.
Marketing costs: Are incurred in the promotion and sale of a product or service.
Administrative costs: They are incurred in the direction, control, and operation of a company and include the payment of salaries to management and staff.
Financial costs: These are related to obtaining funds for the operation of the company. They include the cost of interest that the company must pay on the loans, as well as the cost of extending credit to customers.

7. Period in which costs are charged to income

In this case, some costs are first recorded as assets (Capex) and then deducted (Charged as an expense) as they expire. Other costs are initially recorded as expenses (Operating expenses).

Categorizing costs concerning benefit periods helps management measure revenue, prepare financial statements, and associate expenses with revenue in the appropriate period. It is divided into product and period costs :

Product costs: They are those that are directly and indirectly identified with the product. These costs do not provide any benefit until the product is sold and therefore would be incurred until the completion of the product. When products are sold, their total costs are recorded as an expense called the cost of goods sold.
Period costs: These are not directly or indirectly related to the product. Costs for the period are written off immediately since no relationship between cost and revenue can be determined.