What is cost accounting?
Cost accounting is a branch of managerial accounting used inside businesses to identify, measure, record, and analyze the costs of producing goods or delivering services. It breaks costs into components so managers can control expenses, set prices, evaluate product profitability, and improve operations. Unlike financial accounting, cost accounting is an internal tool and is not constrained by external reporting standards such as Generally Accepted Accounting Principles (GAAP).
Brief historical context
Cost accounting gained importance during the Industrial Revolution, when growing factories and more complex production processes required better systems for tracking manufacturing costs. Later developments include activity-based costing (ABC) to improve overhead allocation and lean accounting, which emerged from Toyota’s lean manufacturing ideas to focus measurement on value streams and waste reduction.
Key cost categories (definitions and examples)
– Fixed cost: A cost that does not vary with production volume (e.g., monthly rent). Example: rent of $10,000 per month is the same whether you make 100 or 1,000 units.
– Variable cost: A cost that changes in direct proportion to output (e.g., raw materials). Example: $5 of material per unit → 100 units cost $500.
– Operating costs: Costs required to run the business day-to-day; can be fixed or variable (examples: utilities, maintenance, wages).
– Nonoperating costs: Costs unrelated to core operations (examples: interest expense, gains or losses on asset sales).
– Direct cost: A cost that can be traced directly to a product or service (examples: materials, direct labor). Example: a chair requiring $50 wood + $30 fabric + $40 direct labor → direct cost = $120.
– Indirect cost (overhead): Costs that benefit multiple products or the organization as a whole and cannot be assigned to one item without allocation (examples: factory heating, supervisory salaries).
– Sunk cost: A past expense that cannot be recovered and should not affect future decisions.
Basic formulas
– Total cost = Fixed costs + (Variable cost per unit × Quantity)
– Unit cost = Total cost / Quantity
– Fixed cost per unit = Fixed costs / Quantity
Worked numeric example (fixed + variable)
Assume:
– Monthly fixed cost (rent, insurance, salaried admin): $10,000
– Variable cost per unit (materials + direct labor): $5.00
At 100 units:
– Total cost = 10,000 + (5 × 100) = 10,000 + 500 = $10,500
– Unit cost = 10,500 / 100 = $105.00
At 1,000 units:
– Total cost = 10,000 + (5 × 1,000) = 10,000 + 5,000 = $15,000
– Unit cost = 15,000 / 1,000 = $15.00
This shows how fixed cost per unit falls as volume rises (economies of scale).
Common cost-accounting methods (what they do and when to use them)
– Standard costing: Management sets predefined (standard) costs for materials, labor, and overhead. Actual costs are compared with standards to compute variances for investigation and control. Useful in stable, repetitive manufacturing. Example: if standard flour per loaf = $0.50 but actual = $0.60, investigate price increases, waste, or inefficiency.
– Activity-based costing (ABC): Allocates overhead to specific activities (e.g., setup, inspection) and then to products based on their use of those activities. Better for firms with varied products or where overhead is a large portion of cost.
– Lean accounting: Aligns cost measurement with lean manufacturing principles by tracking value streams and exposing waste rather than spreading costs across all products.
– Marginal costing (contribution approach): Focuses on variable costs and contribution margin (selling price − variable cost). Often used for short-term pricing and decision making.
Practical tips
– Exclude sunk costs from decisions about the future.
– Choose overhead allocation bases that reflect how resources are consumed (machine hours, labor hours, number of setups).
– Use standard costing to highlight variances quickly; use ABC when overhead is significant and diverse.
– Regularly review and update standard costs and allocation bases as processes change.
Checklist — setting up a simple cost-accounting system
1. Identify cost objects (products, services, departments).
2. Classify costs as fixed, variable, direct, or indirect.
3. Choose cost drivers/allocation bases for indirect costs.
4. Select one or more costing methods (standard, ABC, marginal) that fit your operations.
5. Set standards and budgeting targets where appropriate.
6. Collect actual cost data and record by cost object.
7. Compute variances (actual vs. standard) and investigate material differences.
8. Report findings to management with actionable recommendations.
9. Review and update assumptions regularly.
A short example of direct cost aggregation
Product: Wooden chair
– Wood: $50
– Fabric: $30
– Direct labor: $40
Total direct cost per chair = $120
Add allocated overhead per chair (e.g., $30) → full product cost = $150
Bottom line
Cost accounting helps managers understand where money is spent, how costs behave with production changes, and which products or processes are profitable. It’s a flexible, internal tool—choose methods and allocation rules that reflect your operations and update them as the business evolves.
Selected reputable sources
– Investopedia — Cost Accounting: https://www.investopedia.com/terms/c/cost-accounting.asp
– Institute of Management Accountants (IMA): https://www.imanet.org/
– U.S. Small Business Administration (SBA) — Manage finances: https://www.sba.gov/business-guide/manage-your-business/manage-finances
– Financial Accounting Standards Board (FASB): https://www.fasb.org/
Educational disclaimer
Educational disclaimer
This content is educational only. It explains cost-accounting concepts and methods for learning and planning. It is not individualized financial, tax, or investment advice. For decisions affecting your business or taxes, consult a qualified accountant or advisor.
Quick checklist — how to implement basic cost accounting
1. Define objectives: pricing, profitability by product, inventory valuation, or cost control.
2. Choose a costing method: job costing (custom batches), process costing (continuous output), or activity-based costing (ABC; by activities).
3. Identify direct costs (traceable to a product) and indirect costs (overhead).
4. Select allocation bases for overhead (machine hours, labor hours, floor space, activity drivers).
5. Estimate totals for the period (total overhead, total allocation base).
6. Compute rates, allocate overhead to products, and add direct costs.
7. Review monthly and update estimates each period.
Key formulas (with definitions)
– Total product cost = Direct materials + Direct labor + Allocated overhead.
– Overhead allocation rate = Estimated total overhead / Estimated total allocation base.
– Allocation base: measure used to spread overhead (e.g., machine-hours).
– Activity rate (ABC) = Cost of activity pool / Total quantity of activity driver.
Worked numeric examples
Example A — simple overhead rate (extends the chair example)
Assumptions:
– Direct material (wood) = $50
– Direct material (fabric) = $30
– Direct labor = $40
– Estimated factory overhead for period = $60,000
– Estimated total machine-hours for period = 3,000 machine-hours
– This chair uses 1.5 machine-hours
Step 1 — compute overhead rate:
Overhead rate = $60,000 / 3,000 mh = $20 per machine-hour
Step 2 — allocate overhead to one chair:
Allocated overhead = 1.5 mh × $20/mh = $30
Step 3 — total cost per chair:
Total cost = $50 + $30 + $40 + $30 = $150
Notes: If estimates change (over/underapplied overhead), adjust in the period-end cost of goods sold or via closing adjustments per your accounting policy.
Example B — activity-based costing (ABC) for two activities
Assumptions:
– Direct costs per chair: materials $80, labor $40 → direct total = $120
– Two overhead cost pools: Assembly and Finishing
– Assembly pool cost = $40,000; driver = assembly hours; total assembly hours = 4,000
– Finishing pool cost = $20,000; driver = finishing setups; total setups = 1,000
– One chair uses 0.5 assembly hours and 0.2 of a finishing setup (fractional to show driver usage)
Step 1 — activity rates:
Assembly rate = $40,000 / 4,000 hrs = $10 per assembly hour
Finishing rate = $20,000 / 1,000 setups = $20 per setup
Step 2 — allocate to one chair:
Assembly allocation = 0.5 hr × $10 = $5
Finishing allocation = 0.2 setup × $20 = $4
Total allocated overhead = $9
Step 3 — total cost per chair:
Total cost = direct $120 + overhead $9 = $129
Comparison: ABC can change product costs relative to a simple single-rate approach if products consume activities disproportionally.
Common pitfalls and best practices
– Pitfall: Using an inappropriate allocation base (e.g., labor hours when overhead mainly driven by machine usage). Result: misleading product costs.
– Pitfall: Not updating estimates often enough; seasonal businesses may need monthly updates.
– Best practice: Start simple (single-rate) and move to ABC when products or processes are diverse and overhead is significant.
– Best practice: Keep documentation of assumptions and review variances (actual vs. applied overhead) each period.
– Best practice: Use cost-accounting results for internal decisions — do not automatically use them as financial
reporting without reconciliation to GAAP/IFRS. Management accounting (internal) can use flexible, detailed allocations for decision support; external financial statements must follow the applicable accounting standards and consistent inventory valuation rules.
Reconciling cost accounting to financial statements
– Predetermined overhead rate (often used for applied overhead)
– Formula: Predetermined overhead rate = Estimated total manufacturing overhead / Estimated total amount of allocation base
– Applied overhead = Predetermined overhead rate × Actual amount of allocation base
– Example: Estimated overhead $200,000; estimated machine-hours 40,000 → rate = $200,000 / 40,000 = $5. If a job uses 300 machine-hours, applied overhead = 300 × $5 = $1,500.
– At period end, compare total applied overhead to actual overhead. The difference is an overhead variance that must be closed to cost of goods sold (COGS) or prorated to inventory and COGS under external-reporting rules.
– Inventory valuation for external reporting normally includes direct materials, direct labor, and a systematic share of manufacturing overhead. Specific rules depend on GAAP (FASB) or IFRS (IAS 2).
Common cost-accounting methods (brief definitions)
– Job costing: Tracks costs by individual order or job. Useful when products are distinct (custom work).
– Process costing: Pools costs by department/process and averages over homogeneous units. Useful for continuous production (chemicals, food).
– Activity-based costing (ABC): Allocates overhead using multiple activity pools and drivers. Useful when overhead is diverse and products consume activities unevenly.
– Standard costing: Uses predetermined standard costs for materials, labor, and overhead; variances (actual vs. standard) are analyzed each period.
– Direct (variable) costing: Treats only variable manufacturing costs as product costs; fixed overhead is expensed. Often used for internal decision-making, not for external inventory valuation under GAAP.
Step-by-step: implementing a simple
system. Below is a compact, practical continuation of “Step-by-step: implementing a simple” cost-accounting process for a small manufacturer. It focuses on concrete steps, formulas, numeric examples, a checklist, common pitfalls, and brief notes on reporting and review.
Step-by-step: implementing a simple cost-accounting system
1) Define objectives and scope
– Decide what you want to measure (unit cost, job profitability, gross margin by product).
– Choose the reporting frequency (monthly is common for small firms).
– Identify which costs you must capture: manufacturing costs vs. nonmanufacturing (selling, admin).
2) Choose a costing method (practical choice for small firms)
– Job costing: when products are made to order.
– Process costing: when many identical units are produced.
– Activity-based costing (ABC): when overhead is large and diverse and you need more precise allocations.
For a simple start, pick one primary method and expand later.
3) Identify cost categories and pools
– Direct materials (DM): traceable inputs.
– Direct labor (DL): wages of workers directly making the product.
– Manufacturing overhead (MOH): indirect costs (utilities, indirect labor, depreciation).
Group MOH into meaningful pools if using multiple allocation bases (e.g., machine-related, setup-related).
4) Select allocation bases (drivers)
– Typical drivers: direct labor hours, machine hours, number of setups, number of units.
– Choose drivers that reflect how costs are incurred (e.g., machine-intensive plant → machine hours).
5) Estimate activity levels and rates for planning
– Estimate annual (or period) totals for MOH and the chosen allocation base.
– Compute the predetermined overhead rate:
Predetermined overhead rate = Estimated MOH / Estimated activity base
Example:
Estimated MOH = $20,000
Estimated machine hours = 4,000
Overhead rate = $20,000 / 4,000 = $5 per machine hour
6) Record actual costs during the period
– Capture invoices for materials, timecards for labor, utility bills, etc.
– Use a simple chart of accounts to separate DM, DL, MOH, and nonmanufacturing costs.
– For job costing, maintain job sheets recording materials and labor per job.
7) Apply overhead to production
– Apply MOH to jobs/units using the predetermined rate:
Applied MOH = Overhead rate × Actual activity used by the job
Example:
Job uses 3 machine hours → Applied MOH = $5 × 3 = $15
8) Compute total and unit cost
– Total manufacturing cost = Direct materials + Direct labor + Applied MOH
– Unit cost = Total manufacturing cost / Units produced
Numeric example (period basis):
Direct materials = $50,000
Direct labor = $30,000
Applied MOH = $20,000
Units produced = 10,000
Total manufacturing cost = $100,000
Unit cost = $100,000 / 10,000 = $10.00 per unit
9) Perform variance analysis (if using standards)
– Common variances:
– Materials price variance = (Actual price − Standard price) × Actual qty
– Materials usage (quantity) variance = (Actual qty − Standard qty allowed) × Standard price
– Labor rate variance = (Actual rate − Standard rate) × Actual hours
– Labor efficiency variance = (Actual hours − Standard hours allowed) × Standard rate
Example — material price variance:
Standard price = $2.00/unit; Actual price = $2.10/unit; Actual qty = 20,000
Price variance = ($2.10 − $2.00) × 20,000 = $0.10 × 20,000 = $2,000 unfavorable
10) Create simple management reports
– Unit cost by product or job.
– Gross margin by product line.
– Variance summary (if applicable).
– Overhead spending vs. budget and applied vs. actual MOH.
11) Review and refine
– Compare applied MOH to actual MOH: the difference is underapplied (applied actual).
– Adjust rates periodically (at least annually) or when capacity changes materially.
– Use variance drivers to investigate root causes (price shocks, inefficiencies, measurement errors).
Worked small ABC example (two activity pools)
– Suppose MOH is $30,000 split into:
Pool A — Machine maintenance = $18,000; driver = machine hours
Pool B — Setups = $12,000; driver = number of setups
– Estimated machine hours = 6,000; estimated setups = 300
– Rates:
Maintenance rate = $18,000 / 6,000 = $3.00 per machine hour
Setup rate = $12,000 / 300 = $40 per setup
– Job X uses 10 machine hours and 2 setups:
Allocated MOH = (10 × $3.00) + (2 × $40) = $30 + $80 = $110
Implementation checklist (practical)
– Define objectives and required outputs.
– Select costing method and drivers.
– Build or adapt chart of accounts and job sheets.
– Estimate activity levels and compute rates.
– Set up simple templates (spreadsheets or basic accounting software).
– Train staff on data capture (timecards, material requisitions).
– Reconcile applied MOH to actual MOH monthly.
– Document procedures and review annually.
Common pitfalls and how to avoid them
– Mixing product and period costs: classify selling/admin separately from manufacturing.
– Using too few drivers: can distort cost allocation; start simple, add complexity only when needed.
– Ignoring capacity: allocating fixed overhead over actual run rate can hide underutilization.
– Not updating standards or estimates: review when operations change.
– Poor data capture: job costing is only as good as the time/material records
Advanced topics and formulas — quick reference
– Activity-Based Costing (ABC). Allocates overhead based on multiple cost drivers (activities) rather than a single base (like machine hours). Use when overhead is large and products consume activities differently.
– Steps: identify activities → assign costs to activity pools → choose drivers → compute cost per driver unit → apply to products by driver usage.
– Worked example: three activity pools — Setup ($120,000), Inspections ($60,000), Material handling ($20,000). Drivers are setups (6,000), inspections (12,000), moves (2,000). Rates: Setup = 120,000/6,000 = $20 per setup; Inspection = 60,000/12,000 = $5 per inspection; Handling = 20,000/2,000 = $10 per move. A product requiring 10 setups, 15 inspections, and 3 moves is allocated: 10×20 + 15×5 + 3×10 = $200 + $75 + $30 = $305 in overhead.
– Overhead application rate. Also called predetermined manufacturing overhead (MOH) rate.
– Formula: Predetermined MOH rate = Estimated total MOH cost / Estimated total driver (e.g., machine hours).
– Example: Estimated MOH $500,000; estimated machine hours 50,000 → rate = $10 per machine-hour. A job using 120 machine-hours gets 120×10 = $1,200 applied MOH.
– Standard costing and variance analysis. Standard costing uses pre-set (standard) prices and quantities for materials and labor; variances measure performance.
– Material price variance = (Actual price – Standard price) × Actual quantity purchased.
– Material usage (quantity) variance = (Actual quantity used – Standard quantity allowed) × Standard price.
– Labor rate variance = (Actual hourly rate – Standard hourly rate) × Actual hours.
– Labor efficiency variance = (Actual hours – Standard hours allowed) × Standard rate.
– Quick numeric example: Standard material cost = $2.00/kg; standard usage = 5 kg/unit. For 100 units: standard qty = 500 kg. Actual: purchased 520 kg at $2.10/kg. Material price variance = (2.10−2.00)×520 = $52 unfavorable. Usage variance = (520−500)×2.00 = $40 unfavorable.
– Absorption vs variable (direct) costing. Absorption (full) costing assigns fixed manufacturing overhead to inventory; variable costing treats fixed MOH as a period expense. The choice affects reported profit and inventory valuation.
– Break-even and contribution margin. Contribution margin per unit = Selling price − Variable cost per unit. Break-even units = Total fixed costs / Contribution margin per unit. Useful for short-term decisions.
Implementation checklist for a small manufacturing firm
1. Select costing method: job, process, standard, ABC — pick the simplest that meets management needs.
2. Map processes and identify cost pools (direct materials, direct labor, machine setup, inspections).
3. Choose activity drivers that best explain resource use (hours, setups, inspections, weight).
4. Build data capture tools: timecards, material requisitions, job travelers, barcode scans.
5. Create templates or configure ERP/ERP-lite: chart of accounts
, cost center codes, job numbers, standard-cost tables, and reporting templates (monthly product P&L, inventory schedule, and variance reports). Ensure naming conventions are consistent so exported data matches accounting periods.
6. Set and document overhead allocation rules. Decide whether to allocate manufacturing overhead (MOH) by direct labor hours, machine hours, percentage of direct labor, or activity-based drivers. Document the denominator (e.g., expected annual machine hours) and the formula for the predetermined overhead rate:
Predetermined overhead rate = Budgeted MOH / Budgeted driver activity
Record the rationale and review frequency (quarterly or when volumes change >15%).
7. Pilot and validate with sample jobs. Run 2–4 representative jobs or production runs through the system. Compare:
– Job-level costs vs. manual calculations
– Inventory valuations vs. prior-periods
– Variances (actual vs. applied MOH)
Correct mapping errors, mis-routed GL (general ledger) accounts, or wrong driver assignments before full rollout.
8. Train users and lock controls. Train production supervisors, purchasing, payroll, and accounting staff on:
– How to record time/materials
– Job numbering and job travelers
– When to use standard vs. actual quantities
Implement basic controls: dual-sign approvals for materials issued, timecard review, and periodic spot checks.
9. Monthly close and variance review checklist. At month-end:
– Post all direct materials and direct labor to jobs.
– Apply MOH using the predetermined rate; record applied MOH and actual MOH.
– Reconcile applied MOH to actual; post MOH variance (favorable/unfavorable).
– Produce inventory valuation, cost of goods sold (COGS), and a product P&L.
– Investigate variances > materiality threshold (e.g., 5% or $X).
10. Continuous improvement and governance. Schedule quarterly reviews to:
– Recalculate overhead rates if underlying drivers shift
– Reassess activity drivers (for ABC — activity-based costing)
– Update standards and re-train staff
Establish a simple governance document describing who may change costing rules and how changes are approved.
Worked examples (practical checks)
A. Job-costing example (single job)
– Direct materials = $1,200
– Direct labor = $800
– Machine hours used = 40
– Predetermined MOH rate = $50 per machine hour
Applied MOH = 40 × $50 = $2,000
Total job cost = $1,200 + $800 + $2,000 = $4,000
If units produced for job = 100 → Unit cost = $4,000 / 100 = $40 per unit
Use this to check system output: if the ERP shows different totals, trace each GL posting.
B. Absorption vs. variable costing demonstration (inventory effect)
Assumptions:
– Production = 1,000 units
– Sales = 800 units
– Selling price = $15 per unit
– Variable cost per unit (materials + labor + variable MOH) = $8
– Fixed MOH (period cost if variable costing) = $6,000
Absorption costing:
– Fixed MOH per unit = $6,000 / 1,000 = $6
– Unit product cost = $8 + $6 = $14
– COGS (sold 800) = 800 × $14 = $11,200
– Gross profit = Sales 800×$15 − COGS = $12,000 − $11,200 = $800
Variable costing:
– COGS (variable portion only) = 800 × $8 = $6,