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Important Terms and Principles Cost Accountants Should Know

Part of the Cost Accounting For Dummies Cheat Sheet

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.

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