Cost accounting basics: methods and examples

Cost accounting: the short answer

Cost accounting is the process of recording, classifying and assigning costs to products, services, jobs, departments or activities so a business knows what each one really costs. It matters because prices, product decisions, inventory values and margins all depend on it: a company that cannot cost its products accurately can grow sales and still lose money on every order.

Financial accounting reports what the business spent in total, by nature: materials, salaries, rent, depreciation. Cost accounting reorganises the same spending by purpose, answering what a unit, a job or a customer costs. Under IFRS the two meet in inventory: IAS 2 requires inventory to include the costs of conversion, so the overhead a cost accountant absorbs into each unit ends up on the balance sheet until the goods are sold.

How costs are classified

Every costing method starts from the same classifications. A single cost can sit in several at once: a machine operator's wage is a direct, variable cost in a factory that pays by output, but a fixed cost in one that pays a monthly salary regardless of volume. Either way it is a product cost, whereas the sales manager's salary is a period cost.

• Direct costs: traced economically to one cost object, such as raw material in a product or hours booked to a job.
• Indirect costs (overheads): shared by many cost objects, such as factory rent, supervision, maintenance and power.
• Prime cost: direct materials plus direct labour plus direct expenses.
• Conversion cost: direct labour plus production overhead, the cost of turning materials into product.
• Variable costs: change in total with activity, such as materials and piece-rate labour.
• Fixed costs: unchanged in total within a relevant range, such as rent and salaried staff.
• Product costs: included in inventory under IAS 2 until the goods are sold.
• Period costs: expensed as incurred, such as selling, distribution and general administration.

Job costing versus process costing

Job costing is used when each order is distinct: a print run, a custom machine, a consulting engagement, a building repair. Each job gets its own cost card that collects the materials issued to it, the hours booked to it and a share of overhead. Contract costing is job costing for long projects, and batch costing treats a batch of identical units as one job.

Process costing is used when identical units flow continuously through the same steps: beverages, chemicals, cement, food. Costs are collected by process for a period and averaged over the output. The complication is work in progress at the period end, which is handled with equivalent units: a unit that is half converted counts as half a unit of conversion.

Example. A process starts 10,000 units. 8,000 are completed and 2,000 remain in progress, with all materials added at the start and conversion 50% complete. Materials cost EUR 60,000 and conversion costs EUR 45,000.

• Materials equivalent units: 8,000 + 2,000 = 10,000; cost per unit = 60,000 / 10,000 = EUR 6.00.
• Conversion equivalent units: 8,000 + (2,000 x 50%) = 9,000; cost per unit = 45,000 / 9,000 = EUR 5.00.
• Completed output: 8,000 x (6.00 + 5.00) = EUR 88,000, transferred to finished goods.
• Closing work in progress: (2,000 x 6.00) + (1,000 x 5.00) = 12,000 + 5,000 = EUR 17,000.
• Check: 88,000 + 17,000 = 105,000 = 60,000 + 45,000.

Overhead absorption: a worked job costing example

Overheads cannot be traced to a job, so they are absorbed using a predetermined rate: budgeted overhead divided by budgeted activity, measured in the driver that best explains the overhead, commonly machine hours in automated plants and labour hours in labour-intensive ones. The rate is set before the year so jobs can be costed and priced as they happen.

Example. Budgeted production overhead is EUR 480,000 and budgeted activity is 24,000 machine hours, so the absorption rate is EUR 20 per machine hour. Job 104 uses EUR 3,200 of materials, 60 labour hours at EUR 25 and 40 machine hours. If the job is quoted at EUR 7,000, gross profit is EUR 1,500, a margin of about 21.4% on the selling price.

• Direct materials: 3,200.
• Direct labour: 60 hours x 25 = 1,500.
• Prime cost: 4,700.
• Production overhead absorbed: 40 machine hours x 20 = 800.
• Total production cost of Job 104: 5,500.

Under- and over-absorbed overhead

Because the rate is based on budgets, the overhead absorbed into jobs rarely equals the overhead actually incurred. At the period end the difference is cleared to profit or loss. Continuing the example, actual overhead for the year is EUR 500,000 and actual activity is 25,500 machine hours. Absorbed overhead is 25,500 x 20 = EUR 510,000, which is EUR 10,000 more than incurred, so overhead is over-absorbed and profit is improved: Dr Production overhead control 10,000 / Cr Cost of sales 10,000. If actual overhead had exceeded the absorbed amount, the under-absorption would be an extra charge to cost of sales.

IAS 2 sets a limit on how much fixed overhead can sit in inventory. Fixed production overheads are allocated on the basis of the normal capacity of the facilities. In a period of low production the amount per unit is not increased, and the unallocated overhead is expensed as incurred; in a period of abnormally high production the amount per unit is reduced so inventory is not measured above cost. Abnormal waste, storage (unless needed in production), administrative overhead and selling costs are excluded from inventory altogether.

Absorption costing versus marginal costing

Absorption costing includes fixed production overhead in the cost of each unit; it is required for external reporting under IAS 2. Marginal (variable) costing treats fixed production overhead as a period cost and values inventory at variable cost only. Marginal costing is used internally because it shows contribution: selling price minus variable cost, the amount each unit adds towards fixed costs and profit.

Example. A product sells for EUR 50 with variable cost of EUR 30, so contribution is EUR 20 per unit. Fixed costs of EUR 120,000 are covered at 120,000 / 20 = 6,000 units, the break-even point. Now suppose fixed production overhead is EUR 100,000, the company produces 10,000 units and sells 9,000. Absorption costing carries EUR 10 of fixed overhead in each unit, so the 1,000 units in closing inventory hold EUR 10,000 of fixed overhead. Absorption profit is therefore EUR 10,000 higher than marginal profit in that period. When the inventory is sold later, the difference reverses.

That timing effect is why managers should be wary of a profit rise that comes from building inventory. Under absorption costing, producing more than you sell defers fixed costs to the balance sheet; the cash has still been spent.

Standard costing and the basic variances

A standard cost is a predetermined cost per unit for materials, labour and overhead. Actual results are compared with the standard allowed for the actual output, and the differences are variances, analysed by cause. IAS 2 permits standard costs to be used for measuring inventory only if the results approximate actual cost, and standards must be reviewed regularly. Our guide on budgeting and variance analysis covers sales and flexible budget variances; here the focus is production cost variances.

Example. The standard for one unit is 2 kg of material at EUR 5 per kg and 0.5 labour hours at EUR 20 per hour. In the month 1,000 units are made using 2,100 kg bought for EUR 10,080 (EUR 4.80 per kg) and 480 labour hours paid EUR 10,080 (EUR 21 per hour). The standard cost of the output is EUR 10,000 for materials and EUR 10,000 for labour.

In a standard costing ledger, inventory is carried at standard and each variance has its own account. The material price variance, for example, is posted as Dr Raw materials at standard 10,500 / Cr Payables 10,080 / Cr Material price variance 420. Variance accounts are cleared to cost of sales at the period end unless they are large enough to require part of them to be carried in inventory.

• Material price variance: (5.00 - 4.80) x 2,100 kg = 420 favourable.
• Material usage variance: (2,000 kg standard - 2,100 kg actual) x 5.00 = 500 adverse.
• Total material variance: 10,000 - 10,080 = 80 adverse (420 F - 500 A).
• Labour rate variance: (20 - 21) x 480 hours = 480 adverse.
• Labour efficiency variance: (500 hours standard - 480 actual) x 20 = 400 favourable.
• Total labour variance: 10,000 - 10,080 = 80 adverse (480 A - 400 F).

Activity-based costing

Traditional absorption spreads overhead with one volume driver, which overcosts high-volume, simple products and undercosts low-volume, complex ones. Activity-based costing (ABC) groups overheads into activity cost pools, such as machine set-ups, purchasing or quality inspection, and assigns each pool using the driver that causes it.

Example. Set-up costs are EUR 60,000 for 120 set-ups, or EUR 500 per set-up. Product A is a specialist item made in short runs: 100 set-ups for 5,000 units, so set-up cost is EUR 50,000, or EUR 10.00 per unit. Product B is a standard item: 20 set-ups for 20,000 units, EUR 10,000 in total, or EUR 0.50 per unit. A machine-hour rate would have spread the EUR 60,000 mostly to Product B because it uses more hours, hiding the fact that Product A causes most of the set-up cost. ABC is more expensive to run, so most businesses apply it only to the overheads that are both large and uneven in how products consume them.

Common mistakes in cost accounting

The errors below distort both pricing decisions and the inventory figure in the financial statements, so they matter to auditors as much as to managers.

• Absorbing selling, distribution or head-office administration costs into inventory, which IAS 2 does not allow.
• Leaving under-absorbed overhead from a low-production period in inventory instead of expensing it.
• Using an absorption rate set years ago that no longer reflects capacity or cost levels.
• Pricing on full absorption cost in a short-term decision where only relevant, incremental costs matter.
• Keeping standards unchanged so long that inventory at standard no longer approximates actual cost.
• Treating a favourable price variance as good news without checking whether cheaper material caused an adverse usage variance.
• Counting a profit increase from inventory build-up as operating improvement.

Cost tracking in Skyline Nexus ERP

Skyline Nexus ERP records cost information as dimensions rather than extra accounts. Each journal line can carry a cost centre and a project, and each journal carries the branch it belongs to. Cost centres are built as a tree under Fiscal Authority, an account can be flagged Requires Cost Center so nothing posts to it untagged, and the Cost Center Analysis report shows revenue and expenses by cost centre or department. Budgets can be set per cost centre, and Budget vs Actual shows budget, actual spent, variance and utilisation.

On the product side, cost of goods sold follows the business's stock accounting method, where FIFO is the IFRS-compatible choice, and product categories can carry their own GL Sales and GL COGS accounts so revenue and cost of sales split by product line. Project GL integration maps work in progress and material consumption accounts, and project material issues post to the ledger when Auto-post Material Issues to GL is switched on. Standard cost variances and activity-based rates are then worked out from the cost centre and project data Skyline Nexus records, for example by exporting the general ledger transactions to Excel.