What it means
Financial accounting reports the results of the business as a whole to outsiders. Cost accounting works inside, answering questions the financial statements cannot: what does this product cost to make, is this customer profitable, which department is over budget, should we make or buy this component, what price covers our costs.
It began in manufacturing, where the cost of a unit is a composite of materials, labour and overhead assembled from many records, and it now applies to services, projects, healthcare and public bodies. The basic operations are classification and assignment.
Costs are classified by behaviour (fixed, variable, semi-variable, step), by traceability (direct, traceable to a cost object; indirect, requiring allocation), by function (production, selling, administration) and by controllability. Direct costs are traced to the cost object, whether a product, job, service, customer or department, while indirect costs (overheads) are pooled and assigned by an allocation base such as labour hours, machine hours, floor space, headcount or, in activity-based costing, the activities that drive them.
The choice of base determines the cost assigned and therefore the apparent profitability of everything measured, which is why cost accounting is as much judgement as arithmetic. The methods suit different environments: job costing for bespoke or batch production (construction, printing, professional services) and process costing for continuous production (chemicals, food, oil), which averages costs over units and uses equivalent units for partly finished work.
Standard costing sets a predetermined cost for each product from engineered material quantities, labour times and overhead rates, records actual costs, and analyses the variances (price, usage, rate, efficiency, spending, volume) to show where and why costs departed from plan. Activity-based costing responds to the growth of overhead by assigning it through cost drivers (number of set-ups, orders, inspections, deliveries) rather than volume, revealing that low-volume, complex products consume far more overhead than volume-based allocation shows.
Absorption and marginal costing differ on fixed production overhead. Absorption costing includes it in product cost (required for external inventory valuation), so profit varies with production volume as well as sales, whereas marginal costing treats it as a period cost and values inventory at variable cost, so profit varies with sales alone and contribution analysis is direct.
Businesses commonly keep absorption figures for reporting and marginal figures for decisions, reconciling the two. Cost accounting's outputs feed everything: product costs for pricing and mix decisions, cost of goods sold and inventory for the financial statements, budgets and standards for control, customer and channel profitability, make-or-buy analyses and capacity decisions.
Its failures are equally consequential, because an allocation that misstates product costs leads to wrong prices and wrong product decisions, and businesses have exited profitable products and kept loss-making ones on the strength of costings that were arithmetically correct and economically wrong.
In practice
Real-world examples
Example 1
A hospital uses cost accounting to determine the cost of a hip replacement at $14,200, including theatre time, implant, ward days and overheads, against a reimbursement of $13,800.
Example 2
A law firm's job costing shows that fixed-fee conveyancing work earns $40 an hour against $180 for litigation, prompting a review of the fixed fee.
Example 3
A brewery's process costing values 400,000 litres of beer in tanks at month end at $1.85 a litre, materials complete and conversion 55% complete.
Think of it
Cost accounting is like figuring out exactly how much it costs to bake a single cookie, including ingredients, your time, and oven electricity.
Formula
Calculation
Total Product Cost (absorption) = Direct materials + Direct labour + Variable production overhead + Fixed production overhead absorbed
Overhead Absorption Rate = Budgeted overhead / Budgeted activity (labour hours, machine hours, units)
Product Cost (marginal) = Direct materials + Direct labour + Variable overhead
Activity-based cost = Sum over activities of (Cost driver rate x Driver units consumed by the product)
Standard cost variance = (Standard cost of actual output) minus Actual cost, analysed into price and quantity elements
Worked example. A manufacturer makes two products, a standard valve (high volume) and a custom valve (low volume), and costs them three ways.
Data: standard valve, 50,000 units a year; custom valve, 5,000 units. Direct materials: standard $12 each, custom $30 each. Direct labour: standard 0.5 hours at $24 ($12), custom 1.5 hours at $24 ($36). Total labour hours: 25,000 + 7,500 = 32,500. Production overhead $1,300,000 a year, comprising: machine running $400,000; set-ups $300,000 (standard runs 50 set-ups a year, custom 250); quality inspection $250,000 (standard 500 inspections, custom 1,500); material handling $200,000 (standard 1,000 movements, custom 1,000); factory occupancy $150,000.
Method 1, traditional absorption by labour hours: rate = $1,300,000 / 32,500 = $40 per hour.
- Standard: $12 + $12 + 0.5 x $40 = $44
- Custom: $30 + $36 + 1.5 x $40 = $126
Method 2, activity-based costing:
- Machine running $400,000 by machine hours (standard 0.3 hours, custom 0.6: 15,000 + 3,000 = 18,000 hours): $22.22 per hour; standard $6.67, custom $13.33
- Set-ups $300,000 / 300 = $1,000 each; standard 50 x $1,000 / 50,000 units = $1.00 per unit; custom 250 x $1,000 / 5,000 = $50.00 per unit
- Inspection $250,000 / 2,000 = $125 each; standard 500 x $125 / 50,000 = $1.25; custom 1,500 x $125 / 5,000 = $37.50
- Handling $200,000 / 2,000 = $100 each; standard $2.00; custom $20.00
- Occupancy $150,000 by labour hours: $4.62 per hour; standard $2.31, custom $6.92
- Standard total overhead = $13.23; cost = $12 + $12 + $13.23 = $37.23
- Custom total overhead = $127.75; cost = $30 + $36 + $127.75 = $193.75
Method 3, marginal costing (variable overhead only: machine running and half of handling, $500,000, assigned by machine hours at $27.78):
- Standard: $12 + $12 + $8.33 = $32.33 contribution basis
- Custom: $30 + $36 + $16.67 = $82.67
Consequences: the company prices at cost plus 30%. Under traditional absorption: standard $57, custom $164. Under ABC: standard $48, custom $252. The company has been overpricing its standard valve (losing volume to competitors who price at $50) and underpricing its custom valve by nearly $90, winning custom orders it loses money on.
The old prices can be checked against the ABC costs. Standard valves earned $57 - $37.23 = $19.77 each, or $988,500 on 50,000 units. Custom valves lost $164 - $193.75 = -$29.75 each, or -$148,750 on 5,000 units. The company's total profit on these two products is $988,500 - $148,750 = $839,750, so the standard valve was subsidising a custom range that looked profitable only under the labour-hour method. ABC-based pricing moves the custom price to about $252 and the standard price to about $48, so each product is priced on what it actually costs.
Standard costing check: the standard cost card for the standard valve, after ABC, is $37.23. In a month, actual cost per unit is $39.10 on 4,200 units. Variance $7,854 adverse, analysed: material price $0.60 per unit adverse (supplier increase, $2,520), labour efficiency $0.80 favourable (new fixture, $3,360), overhead spending $2.07 adverse (unplanned maintenance, $8,694). The report directs the purchasing manager to the supplier and the maintenance manager to the machine.Case study
Seen in the real world
This is a fictional, illustrative scenario. A manufacturer of electrical enclosures had used the same costing system for twenty years: overhead allocated by direct labour hours at a rate updated annually. Its product range had grown from 40 to 900 items, the labour content had fallen with automation from 40% of cost to 12%, and overhead had grown to 55%. The costing system, allocating more than $4 of overhead for every $1 of labour, told management that the high-volume standard enclosures made little margin and that the small-batch specials, which used little labour, were the profitable lines. The sales strategy followed: push specials, discount standards.
Profit fell every year. A new controller rebuilt the costing on activity-based principles and found that the specials consumed 70% of the set-up, engineering, scheduling and inspection costs while producing 20% of revenue, and that their true margin was negative on 60% of the items; the standard enclosures were the company's profit. The company cut the range to 350 items, repriced the specials by 40% to 80% (losing half of them, unlamented), and invested in the automation of the standard lines. Margin rose from 4% to 11% in two years. The controller's presentation to the board was titled "We were right about the costs and wrong about where they came from."
Watch out
Common mistakes
- Allocating overhead on a volume base (labour hours, units) in an operation where overhead is driven by complexity, which overcosts simple high-volume products and undercosts complex low-volume ones.
- Making decisions on absorption costs that include fixed overhead which will not change with the decision; marginal costs and contribution are the basis for volume, pricing and make-or-buy choices.
- Leaving the costing system unchanged as the business changes, so that allocation bases set decades ago misdescribe today's cost structure.
Questions
People also ask
What is the difference between cost accounting and financial accounting?
Financial accounting reports the whole business to outsiders under external standards. Cost accounting measures the cost of products, services, activities and units internally, for pricing, control and decisions, under methods the business chooses.
Which costing method should a business use?
It depends on the operation: job costing for bespoke work, process costing for continuous production, standard costing for control, activity-based costing where overhead is large and driven by complexity, marginal costing for decisions. Most businesses combine several.
Why does the overhead allocation base matter so much?
Because it determines how the largest and least traceable costs are assigned to products, and therefore which products appear profitable. A wrong base produces wrong prices and wrong product decisions with arithmetic that looks correct.