Cost accounting aims to improve an organization's profitability by analyzing its costs of operations. It's a major part of financial reporting but also plays a role in managerial accounting where it is used to inform planning and quality improvement.
Traditional Cost Accounting
Traditional cost accounting combines overhead/indirect and direct (materials and labor) costs and allocates those expenses to each product. It assumes a consistent ratio between overhead and production costs; in other words, the more products created, the more overhead. In organizations where this is definitely a valid assumption, or in ones where overhead is a small proportion of total costs, this kind of cost accounting has the distinct virtue of simplicity, but given the complex nature of most of today's organizations, it is not a full enough picture.
Activity-based costing, which became popular in the 1980s as a result of the quality movement and increasing business complexity, is the form of cost accounting that examines costs by type of activity rather than by end product. This allows for closer analysis of the individual systems within an organization and more effective discovery of cost inefficiencies. It's particularly valuable in organizations where indirect costs are considerably higher than direct costs.
The five steps to activity-based costing are:
- Identify all organization activities.
- Assign a cost to each activity.
- Determine the components of each cost (for example, costs for materials are based on the amount purchased, costs for research and development staff are based on the hours spent).
- Collect data for each activity (how much did the organization spend on that activity).
- Determine product costs.
To determine cost-per-unit, it divides each product or service into unit-level activities (production of one unit), cost per batch, product-sustaining activities (what's necessary to keep producing), and facility-sustaining activities (keeping the necessary physical plant in operation).
Total Cost Analysis and Life Cycle Cost Analysis
Both total cost analysis and life cycle cost analysis examine the cost of a business process, such as research and development, or of a physical asset, such as equipment. These are often part of activity-based costing, although they can stand alone in making budgeting decisions.
Life cycle cost analysis is predominantly used for product development, determining the total cost of creating a product (or service). It begins with the cost of planning and development through the end of its lifespan and eventual disposal. Total cost analysis is usually used for purchasing decisions, usually equipment, and includes every direct and indirect aspect of acquiring, operating, and eventual disposal.
Variance analysis is a form of cost accounting that determines the difference between actual costs and either standard costs, meaning how much comparable organizations spend on the same processes, or projected costs. The level of variance between actual costs and standard costs measures an organization's efficiency. In other words, it measures how much they get out of a dollar compared to the norm.
Full Cost Accounting
Full cost accounting is a term often used for calculating the environmental or social costs associated with an activity or business, such as pollution, job loss, or habitat destruction. These calculations often appear in business social responsibility reports.
Return on Investment
Calculating return on investment (ROI) is the ultimate goal of cost accounting, as it determines the ultimate value of an organization's investment in an activity, whether creating a product or expanding operations.
The standard ROI calculation is benefit divided by cost. More extensive analysis includes opportunity costs, such as how else could the money have been invested, and return on total assets (ROA), which measures the profit divided by the organization's assets.