Cost Accounting For Dummies
Cost accounting is a valuable tool you use to reduce and eliminate costs in a business. You also use cost accounting to determine a price for your product or service that will allow you to earn a reasonable profit. Familiarize yourself with the most important formulas, terms, and principles you need to know to apply cost accounting. You'll also want to get the scoop on text-taking strategies for cost accounting students.
Must Know Formulas for Cost Accounting
To reduce and eliminate costs in a business, you need to know the formulas that are most often used in cost accounting. When you understand and use these foundational formulas, you’ll be able to analyze a product’s price and increase profits.
Profit ($0) = sales – variable costs – fixed costs
Target Net Income
Target net income = sales – variable costs – fixed costs
Gross margin = sale price – cost of sales (material and labor)
Contribution margin = sales – variable costs
Pre-Tax Dollars Needed for Purchase
Pre-tax dollars needed for purchase = cost of item ÷ (1 - tax rate)
Price variance = (actual price - budgeted price) × (actual units sold)
Efficiency variance = (Actual quantity – budgeted quantity) × (standard price or rate)
Variable Overhead Variance
Variable overhead variance = spending variance + efficiency variance
Ending inventory = beginning inventory + purchases – cost of sales
Important Terms and Principles Cost Accountants Should Know
Many accountants will tell you that cost accounting is the most difficult accounting subject to learn. That's because cost accounting has many terms that are not used in other areas of accounting (financial accounting and management accounting, to name a few). If you're looking for an overview of the most important terms and principles for this subject, you've found it! These concepts provide a foundation for learning cost accounting.
Reviewing accounting basics
Accountants use many principles to guide their decision-making process, such as the matching principle and the principle of conservatism.
Matching principle: This principle states that your company’s revenue should be matched with the expenses that relate to that revenue. If you sell lamps in May, you create revenue for that month. The May revenue should be matched with the expenses you incurred for the lamps sold in May. So, the cost of the lamp is matched with the sales proceeds for the lamp’s sale.
Principle of conservatism: Accountants often need to make judgments. Conservatism means that the decision should generate the least attractive financial result. If there’s a decision about revenue, the conservative choice is to delay recognizing revenue in the financial statements. Expenses should be posted to the financial statements sooner rather than later. These choices generate financial statements that are less optimistic, which is why the approach is called conservative.
There are four basic types of cost that accountants need to keep in mind — direct, indirect, fixed, and variable costs. They are defined as follows:
Direct costs: Direct costs can be directly traced to the product. Material and labor costs are good examples.
Indirect costs: These can’t be directly traced to the product; instead, these costs are allocated, based on some level of activity. For example, overhead costs are considered indirect costs.
Fixed costs: Fixed costs don’t vary with the level of production. A good example is a lease on a building.
Variable costs: Unlike fixed costs, variable costs change with the level of production. For example, material used in production is a variable cost.
Every cost can be defined with two of these four costs. For example, the cost to repair machinery is an indirect variable cost. You decide if the cost is direct or indirect, and if the cost is fixed or variable.
Checking out cost accounting basics
Just like in any discipline, you use specific cost accounting terms and ideas to communicate meaning and understand procedures. Understanding basic concepts in crucial, so to start using cost accounting analysis, you should be familiar with these terms:
Contribution margin: This term is defined as sales minus variable cost. When you subtract your fixed costs from contribution margin, the amount left over is your profit.
Breakeven point formula: The breakeven point is the level of sales where your profit is zero. The breakeven formula is sales minus variable cost minus fixed cost. You multiply your sales per unit by units sold. You also multiply the variable cost per unit by the same units sold. The sales level that makes the formula equal to zero is the breakeven point.
Relevant range: Relevant range is a term that relates to machinery, equipment, or vehicles in your business. Think of relevant range as the maximum level of use for the item you operate in your business. Say you use a sewing machine. As long as you operate the machine at or below the relevant range, it should operate normally. The machine’s cost should come in at the level you expect. If you operate above the relevant range, the machine won’t operate as you expect. You need to invest in a second machine to operate above the relevant range.
Digging deeper into cost accounting analysis
As you further your study, you use more complex cost analysis tools. From job costing to variances, the more involved the job, the more involved your cost accounting tools become. Here are some important tools you’ll use:
Job costing: This method of costing assumes that every customer job is different. Plumbers and carpenters are good examples of businesses that use cost accounting. Because every job is different, each customer job is assigned material, labor, and overhead costs.
Process costing: Companies use process costing when partially completed units are moved from one production area to another. Process costing assumes that the products you produce are similar or even identical.
Activity-based costing (ABC): ABC costing can be used for both job costing and process costing analysis. You use ABC costing to assign costs to your product more specifically. ABC costing analyzes the activities that cause you to incur costs; you then connect the cost to the activity.
Variance: A variance is a difference between your planned or budgeted cost and your actual results. A favorable variance occurs when your actual costs are less than your budgeted or planned cost. An unfavorable variance is when actual costs are higher than planned.
Inventoriable costs: These are costs that are directly related to the product. Production costs are inventoriable costs for a manufacturer. If you are a retailer, your cost to purchase inventory is also an inventoriable. Other costs you incur for goods are included, such as shipping and storage costs.
Avoiding Pitfalls on Cost Accounting Exams
Cost accounting is a great tool to improve the profitability in any business. It’s a critical subject that accounting students need to learn to be successful in their careers. However, some cost accounting concepts are easily misunderstood and therefore difficult to address correctly on exams. These test-taking strategies will help you succeed on a cost accounting exam by clarifying what is truly being asked in each question.
Read the last sentence first. Cost accounting questions often provide lots of data, but not all of that information is needed to answer the question. Test item writers refer to that data as distractors. If you start at the top and read down, you read a lot of unneeded data. Read the last sentence first. That strategy gets you to what the question is truly asking. Then you can read the rest of the question — and pull out only the data you need to answer the question.
Absorption costing vs. variable costing: The only difference between these two costing methods is how they address fixed manufacturing costs. A typical question on this topic lists variable manufacturing costs, or fixed selling and administrative costs. Don’t be fooled! Absorption and variable costing treat these other costs in the same way, so ignore them.
Favorable vs. unfavorable variances: Of course, the word favorable means better or preferred. However, in cost accounting, favorable has a different meaning, depending on whether you’re talking about a cost or revenue. Less actual costs than budgeted is a favorable variance. However, more actual revenue than planned is a favorable variance. In both cases, your actual profit is more than planned. Unfavorable variances are the reverse: More actual costs and less actual revenue is unfavorable.
Production costs: Many cost accounting questions relate to production of a physical product (rather than a service). Make sure you’re clear on whether the question is asking about units of a product, or an amount of material needed per unit. For example, one bicycle (one unit) requires two wheels. Be clear on which item (units or wheels) you’re using when you calculate costs.
Total fixed costs vs. fixed costs per unit: Some cost accounting questions provide you with a fixed cost per unit. If you determine that you need fixed costs to answer the question, pause for a minute. Try to find total fixed costs in the question and use that number. Fixed costs per unit should be avoided. That’s because, at some point, you sell enough to cover your costs. As a result, the additional units you produce don’t have any fixed costs attached to them. Fixed cost per unit is misleading.
Process costing: Process costing questions often address how costs move from one production department to another. Keep in mind that, almost always, material costs are put into production before labor costs. If you’re making leather baseball gloves, you need material (leather) in production before you can do anything to it (cut, sew, treat the leather, and so on). If you keep that in mind, computing material and labor costs may be easier.