You can’t run a successful business without understanding the numbers. That’s where cost accounting comes in. It’s the financial Sherlock Holmes that investigates every penny you spend in the production process.

Cost accounting digs deep into your business’s inner workings, tracking every expense from start to finish. It’s all about giving you the inside scoop on where your money’s really going. That way, you can make smarter decisions and give your revenue a boost.

Learn about the key concepts of cost accounting and how to start applying them to your own finances.

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What Is Cost Accounting?

Cost accounting looks at all the expenses that go into producing your business’s offerings. This includes both fixed costs (like rent) and variable costs (like materials). The goal is to identify all the factors that go into your production process—which includes both products and services. Then, you record and measure these factors over time. This helps you make informed financial decisions.

Unlike financial accounting, cost accounting isn’t meant for third parties like banks or investors. You won’t find cost accounting reports in annual statements or other filings. Instead, it’s part of managerial accounting. This means it’s a tool for managers or owners-operators to use behind the scenes.

Cost Accounting Versus Financial Accounting

Though they both deal with crunching numbers, cost accounting and financial accounting have distinct roles. Let’s take a look:

• Purpose. Cost accounting is strictly for internal use. It helps you control expenses and boost efficiency. Financial accounting is for people outside the company. It shows investors, lenders, and regulators how efficiently a business manages its resources.
• Rules. Cost accounting is flexible. You have the freedom to tailor your methods to what works best for your business. Financial accounting has to follow strict standards like Generally Accepted Accounting Principles (GAAP). This is to protect investors and lenders. When companies have to follow standardized rules, it’s harder for them to cook the books or mislead investors.
• Focus. Cost accounting zooms in on production costs to get a detailed look into expenses. It tracks everything that goes into making a product or providing a service. Financial accounting takes a step back. It looks at the big picture of a company’s performance.

Types of Costs

To really get a handle on cost accounting, you have to understand different types of costs. Let’s break them down:

• Fixed Costs. First up are the predictable regulars of your expenses. They don’t change no matter how much you produce. Rent, insurance, and loan payments are all fixed costs. Whether you make one widget or a million, these costs stay the same.
• Variable Costs. Unlike fixed costs, variable costs go up and down with your business activities. Raw materials and direct labor are good examples. The more you produce, the more of these costs you’ll have. But the same applies to any services that fluctuate in usage, like utilities.
• Operating Costs. These are your day-to-day expenses for running the business. They can include both fixed and variable costs. Think rent, administrative salaries, and office supplies. Some operating costs, like electricity, might have both a fixed component (the basic connection fee) and a variable component (based on how much you use). These are called semi-variable or mixed costs.
• Direct Costs. Direct costs are expenses you can easily trace to a specific product. If you’re making chairs, the wood and labor are direct costs. 
• Indirect Costs. These are a little trickier to pin down. They’re necessary for production but not directly tied to making a particular product. Rent, marketing, and quality control are all indirect costs. They support production but aren’t as clearly tied to what you do or sell.

You can further break down these costs into the three main elements of cost accounting:

• Materials. This includes both direct (like wood for chairs) and indirect (like wood glue) materials. Direct materials are usually variable costs, while indirect materials can be fixed or semi-variable.
• Labor. This includes direct (like bakers) and indirect (like their supervisors) labor. Direct labor is typically a variable cost, while indirect labor is often a fixed cost.
• Overhead. These are all the indirect costs of running your business, like rent and utilities. These are usually fixed or semi-variable costs.

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Cost Accounting Systems

What exact costs should you track, and how should you organize the data? Cost accounting systems show you the way. There are two main types: job order costing and process costing. Here’s a quick guide:

• Job Order Costing. This system is perfect for businesses that make custom or varied products. It tracks costs for each specific job or project. Think of a graphic designer who creates unique logos. With job order costing, they can see exactly how much each unique project costs.
• Process Costing. On the flip side, process costing is ideal for companies that mass-produce identical or very similar items. This system averages costs across all units produced. It’s commonly used in industries like food processing or chemical manufacturing.

Choosing the right system for you depends on your business model. If you’re making unique items or providing custom services, job order costing is probably your best bet. But if you’re cranking out identical products in large quantities, process costing will likely serve you better.

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4 Cost Accounting Methods

Once you’ve chosen an accounting system, it’s time to decide how you’ll analyze and control costs. Here are four popular approaches:

1. Standard Costing

With standard costing, you use historical data and other factors to estimate what your costs will be under “standard” conditions. In other words, you start by looking at the costs you expect to pay under typical circumstances.

Next, you compare these standard costs to what you actually spend. The difference is called variance, which can be favorable (actual costs are lower than expected) or unfavorable (actual costs are higher). This helps you understand how efficient your production process is and where it might need improvement.

2. Activity-Based Costing

Activity-based costing takes a closer look at your overhead costs. Instead of lumping them together, it ties them to the specific activities involved in production. This includes things like operating a machine or closing a customer support ticket.

Activity-based costing gives you a more accurate picture of what’s really driving your costs. It shows you which activities involved in production are using up the most resources. Then, you can find ways to make them more efficient.

3. Marginal Costing

Marginal costing focuses on how much it costs to produce one additional unit of your product or service. It’s helpful for short-term decisions about pricing or production levels.

4. Lean Accounting

Lean accounting is all about cutting the extras. It focuses on eliminating waste in your production process. The goal is to streamline operations and provide more value for your customers.

Lean accounting often goes hand-in-hand with lean manufacturing principles. It’s about doing more with less and constantly looking for ways to improve efficiency.

5 Formulas for Cost Accounting

Cost accountants use several key formulas to analyze data and make decisions. Here are five of the most useful:

1. Contribution Margin

This formula calculates how much each unit helps cover fixed costs and profit.

Contribution Margin = Selling Price per Unit – Variable Cost per Unit

2. Break-Even Point

This finds the sales volume where total revenue completely covers total costs.

Break-Even (in units) = Total Fixed Costs / Contribution Margin per Unit

3. Gross Margin

This measures product profitability after accounting for direct production costs.

Gross Margin = (Net Sales Revenue – Cost of Goods Sold) / Net Sales Revenue

4. Price Variance

This shows the difference between the expected and actual costs of materials or labor.

Price Variance = (Actual Unit Cost – Standard Unit Cost) x Quantity Purchased

5. Efficiency Variance

This measures how efficiently you’re using your resources compared to expectations. You can apply it to any of the main elements of cost accounting, like labor or materials.

Efficiency Variance = (Actual Quantity Used – Standard Quantity) x Standard Price

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4 Tips for Getting Started With Cost Accounting

Here are some practical tips to help you start cost accounting:

• Track Every Penny. Don’t let small expenses slip through the cracks. Record all costs, no matter how minor they seem. This gives you a more complete picture of your finances.
• Know Your Costs Inside and Out. Learn to distinguish between the different types of costs. This leads to more accurate cost allocation and smarter budgeting decisions.
• Keep Your Financial House in Order. Well-organized records make reporting and analysis a breeze. They also help you spot trends and variances more easily.
• Embrace Technology. Start with basic accounting software to automate cost tracking. This simplifies your processes and reduces the risk of manual errors. As your needs grow, you can always upgrade to more sophisticated tools.

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Invoice Simple’s Business Expense Tracker Does It All

Applying cost accounting principles starts with careful expense tracking. And Invoice Simple makes it easy.

Invoice Simple’s business expense and receipt tracker lets you scan any receipt and capture key info automatically. All expense data is ready to export into a summary report whenever you need it.