Cost accounting facts for kids

Cost accounting helps businesses understand how much it costs to make products or offer services. It's like a special detective for money, looking closely at all the expenses involved. This helps managers make smart choices about how to run the business, save money, and plan for the future.

While cost accounting information can also be used for official financial reports, its main job is to help managers inside a company make good decisions.

Why Cost Accounting Started

Every type of business, whether it makes things, sells things, or offers services, needs to track its costs. Cost accounting has been around for a long time to help business leaders understand their expenses.

Modern cost accounting really grew during the Industrial Revolution. Factories became very big and complex. Business owners needed better ways to track all the money spent to make products. This helped them decide how to price things and how to make their operations more efficient.

In the early days of factories, most costs were "variable costs". This means they changed directly with how much was produced. For example, the more products made, the more money was spent on materials and worker wages. Managers could easily add up these costs for each product.

Over time, "fixed costs" became more important. These costs stay mostly the same, no matter how much is produced. Examples include rent for a factory, insurance, or the cost of machines. In the 1800s, these fixed costs grew a lot with big industries like railroads and steel. Managers needed to understand these fixed costs to make good decisions about what to produce and how to set prices.

For example, imagine a company that makes railway coaches.

• Each coach needs $60 in materials and $240 for six workers ($40 each). So, the "variable cost" for one coach is $300.
• The company's "fixed costs" (like rent and owner's salary) are $1000 per month.
• If they sell coaches for $600 each, they make $300 profit on each coach ($600 - $300). This $300 helps cover the fixed costs.
• If they sell 5 coaches, they make $1500 from sales ($300 x 5). After paying the $1000 fixed costs, they have $500 profit.
• If they sell 10 coaches for $450 each, they make $1500 from sales ($150 x 10). After paying the $1000 fixed costs, they still have $500 profit.

Understanding these costs helps the company plan.

Cost Accounting vs. Financial Accounting

Cost accounting and financial accounting are both about money, but they have different goals.

Ways to Do Cost Accounting

There are different ways businesses can track and understand their costs:

• Activity-based costing (ABC)
• Cost–volume–profit analysis
• Environmental accounting
• Joint cost
• Process costing
• Project accounting
• Resource consumption accounting
• Standard cost accounting
• Target costing
• Throughput accounting
• Life-cycle costing

Parts of Cost Accounting

The basic parts of any cost are:

1. Materials
2. Labour (work done by people)
3. Expenses and other overheads (other costs)

Materials

Direct materials are the main parts of a product that you can easily see. For example, the wood in a chair or the paper in a book. Indirect materials are smaller, supporting items that are also used but are harder to track for each product, like the thread in a shirt.

Materials are also tracked as different types of "inventory":

• Raw materials (like wood before it's made into a chair)
• Work-in-progress (chairs being built)
• Finished goods (chairs ready to sell)

Labour

Direct labour is the pay given to workers who directly help make a product. This includes people who build, maintain machines, or move materials to turn raw stuff into finished goods. Pay for trainees usually isn't direct labour because they don't add much value yet.

Overheads

Overheads are all the other costs that are not direct materials or direct labour. They include:

• Costs related to making products, like factory staff salaries.
• Office costs, like administration staff.
• Selling costs, like advertising, sales staff, and making catalogs.
• Costs for delivering products.
• Maintenance and repair for office and factory equipment.
• Supplies.
• Utilities like gas, electricity, and water.
• Other changing expenses.
• Salaries and payroll costs (wages, pensions).
• Rent or mortgage for buildings.
• Depreciation (the way the value of equipment goes down over time).
• Other fixed expenses.

These categories can sometimes overlap, depending on how a company wants to track its costs.

How Costs Are Grouped

Costs can be grouped in many ways:

• By nature:

* Direct costs are clearly linked to a specific product or service. * Indirect costs (or overheads) are not directly linked and are shared among many products.

• By function: Costs can be for production, administration, selling, distribution, or research.
• By how they behave:

* Fixed costs stay the same no matter how much is produced (like rent). * Variable costs change with the amount produced (like raw materials). * Semi-variable costs are partly fixed and partly variable.

• By control:

* Controllable costs can be changed by managers. * Uncontrollable costs cannot be changed by managers.

• By normal activity:

* Normal costs happen during regular business. * Abnormal costs happen because of unusual events like accidents.

• By time:

* Historical costs are costs from the past. * Predetermined costs are planned costs for the future.

• For decision-making: These costs help managers make choices:

* Marginal costs: The extra cost to make one more unit of a product. * Differential costs: The difference in cost between two choices. * Opportunity costs: The value of what you give up when you choose one option over another. * Relevant cost: Costs that matter for a specific decision. * Replacement cost: How much it would cost to replace something now. * Shutdown cost: Costs that happen if a business stops operating. * Capacity cost: Costs to have the ability to produce, sell, and manage. These are usually fixed. * Sunk cost: Money already spent that cannot be gotten back.

Standard Cost Accounting

Standard cost accounting compares the actual costs of making something with what the costs *should* have been (called "standard costs"). This helps businesses see why costs were different from what they planned.

For example, if the railway coach company usually makes 40 coaches a month, and fixed costs are $1000, then each coach could be said to have an extra cost of $25 ($1000 / 40). Adding this to the $300 variable cost, the "full cost" would be $325 per coach.

This method helps managers understand if they are spending too much or too little on materials or labour. A big part of this is "variance analysis," which breaks down the differences between planned and actual costs. This helps managers figure out *why* things were different and what they can do to fix it.

Throughput Accounting

As businesses grew more complex and made many different products, people started to question if traditional cost accounting was always the best for making decisions. They realized that "every production process has a limiting factor," like a bottleneck.

Throughput accounting focuses on making the most money from sales, especially when there's a bottleneck. It aims to get the most "throughput dollars" from each limited resource.

"Throughput" means the money you get from sales minus the cost of the materials used to make those sales.

Activity-Based Costing (ABC)

Activity-based costing (ABC) is a way to assign costs to products based on the specific "activities" needed to make them. An activity could be "talking with a customer about an invoice."

Companies use ABC to get a more accurate idea of the true costs and profits of their products or services. Traditional methods might just guess indirect costs as a percentage of direct costs. ABC tries to turn many indirect costs into direct costs by linking them to specific activities.

With ABC, accountants figure out how much time employees spend on different activities. Then, they can see the total cost for each activity by adding up the salaries spent on it.

This information helps managers decide where to improve their operations. For example, if a company finds that a lot of money is spent on "researching customer order details," they know they need to fix their order process. While ABC can be very detailed, it can also be time-consuming and complex.

Lean Accounting

Lean accounting helps businesses that use "lean manufacturing" (which focuses on reducing waste). It changes how accounting, control, and measurement are done to support this lean way of thinking.

Lean accounting has two main goals: 1. Make accounting processes lean: This means removing waste, speeding up processes, and making them easier to understand. 2. Change accounting itself: This is the more important goal. It means changing how costs are tracked and reported so they help the business improve and understand customer value.

Lean accounting moves away from old methods like standard costing. Instead, it uses:

• Measurements focused on lean goals.
• Simple ways to track costs for different product lines.
• Easy-to-read financial reports that everyone can understand.
• Simpler ways to control transactions by reducing the need for complex systems.
• Focus on creating value for customers.
• Simpler financial planning instead of traditional budgets.
• Pricing based on value.
• A clear understanding of how lean changes affect money.

As a company becomes more "lean," lean accounting helps create a "lean management system." This system helps with planning, reporting, and motivating changes to help the company grow.

Marginal Costing

Marginal costing looks at how sales, production, costs, and profits are related. This helps managers make important decisions, like setting prices or choosing which products to sell.

Contribution Margin The "contribution margin" is the money left over from sales after paying for the variable costs. This money helps cover the fixed costs and then contributes to profit.

Here's an example:

Contribution Margin Ratio The "contribution margin ratio" shows the contribution margin as a percentage of sales. It tells you how much of each dollar of sales is available to cover fixed costs and make a profit.

For example, if the contribution margin is $400,000 and sales are $1,000,000, the ratio is 40% ($400,000 / $1,000,000).

This ratio helps managers see how much profit they might make if sales increase or decrease. If sales go up by $80,000 and the ratio is 40%, then the profit will increase by $32,000 ($80,000 x 40%).

Here's how the income statement would look with the extra sales:

Variable costs are 60% of sales (100% - 40% contribution margin ratio). So, $1,080,000 x 60% = $648,000. The total contribution margin is $1,080,000 x 40% = $432,000.

See also

In Spanish: Contabilidad de costos para niños

• Accountancy
• Cost overrun
• Fixed asset turnover
• Management accounting
• IT cost transparency
• Kaizen costing
• Profit model