Blogs on Accounting, Finance & Economics

Cost Accounting refers to the approaches and activities adopted by managers to use the company’s resources to increase the value given to customers and to achieve organizational goals. Cost Accounting, if used and analyzed correctly, will help to take important business decisions.     Here are some cost accounting terms that you should know!     Cost Object Cost object is the product or service with respect to which the cost needs to be computed. For example, if a car manufacturer wants to assess costs, the cars that they manufacture would be their cost object. Similarly, the cost object for a bank would be its customer accounts. Costs are classified on the basis of the cost object.       Direct and Indirect Costs Costs are classified under two categories as given below:     Direct Costs These are costs that can be directly traced or caused by a product, service, project, organizational unit, or activity. For example, the cost of a steering wheel is a direct cost in the manufacturing of a car. Similarly, the cost of effort undertaken by a worker in making the doors of the car also amounts to direct cost. Below are some examples of direct costs: Cost of cement used in the construction of a building Cost of tires used in building a car Cost of a project management consultant in the construction of a bridge     Indirect Costs These are costs that cannot be directly traced to a single product, service, project, organizational unit, or activity. These costs are allocated rather than being traced to individual products or services as there is no cost-effective way of tracing them directly. For example, the rent of a plant used to manufacture cars of multiple varieties cannot be directly traced to every car model. Hence, the rent is an indirect cost. If the plant were to manufacture only one car model, then the rent would become a direct cost. Similarly, the cost of supervisors for various products of the company is also an indirect cost and needs to be allocated in some proportion instead of being directly traced to the products. Below are some examples of indirect costs: Salary of staff in corporate headquarters Cost of adhesive used in creating various products of the company. This is especially because it may not be cost-effective to try and relate this cost directly to each product. It would be much better to allocate this cost on a certain basis (an estimation) Cost of power in a plant making many different products       Variable and Fixed Costs When a company changes the number of products and/or services it provides, its total costs would also change. However, some costs change in relation to quantity or volume whereas others do not. On this basis, these are the following categories of costs:     Variable Costs Costs that change proportionately with volume are called variable costs. So, if the company sells 10% more products, its variable costs would also go up by 10%. For example, the cost of car tires is variable and so is the cost of the steering wheel. We saw earlier that both these costs are also Direct costs. Hence, a certain cost can be Direct and at the same time, Variable. Below are some other examples of variable costs. Cost of paint required for a house Cost of labor for manufacturing a truck Cost of wood in constructing a house     Non-variable/Fixed Costs These are exactly the opposite of variable costs. They do not vary with the quantity or volume of the product manufactured or the service provided. This means that this cost is independent of the volume. For example, the rent of office premises is a fixed cost as it does not change with the change in business volume. Below are some examples of fixed costs: Cost of assembly line for a car model Cost of supervisors Cost of rent paid by a bank branch office   However, it may be noted that fixed costs are generally fixed within a certain relevant range. For example, if the business grows so much that a new office will have to be bought to accommodate the new machinery and personnel, then the rent cost changes. Hence, it is said to be fixed only over a certain volume of business called the relevant range. The diagram and table below show how fixed costs behave over the relevant range.       Semi-variable Costs Many costs are a combination of both the above costs. The total amount in such costs will then change with volume, but not proportionately. It is always best to try and separate this into two components – fixed cost and variable cost, and deal with them separately. For example, telephone bills usually contain a fixed charge for having a connection and a variable charge based on actual usage. In this case, it is easy to separate the two costs. Similarly, the cost of driving a car includes many other cost components, like the cost of gasoline, oil, tires, and maintenance, all of which are variable. But there are also costs of insurance and registration that are fixed. Hence, the total cost in both the above cases is semi-variable and can be easily separated into its fixed and variable components.     The two distinctions of costs – Direct and Indirect and Variable and Fixed are on separate dimensions. Hence, every cost would be a combination of these. The following combinations are possible: Direct and Variable – Cost of car tires Direct and Fixed – Rent of factory producing only one kind of car Indirect and Variable – Cost of power in a factory producing several types of cars Indirect and Fixed– Rent of factory producing several types of cars     To read more about Cost Accounting, pick up the book Cost Accounting and Management Essentials You Always Wanted To Know which is an ‘essential’ guide and includes practical examples and case studies to explain the concept better.         © 2022, By Vibrant Publishers, USA. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior permission of the publisher.        

Regardless of which industry your company belongs to, you will need an accounting system for tracking the costs of your operations. With the help of a costing system, you’ll be able to determine the total cost of manufacturing a product with how much revenue it can generate.   When it comes to accounting, there are two common methods you can choose from: activity-based costing and traditional costing. In this article, we’re going to take a look at those two costing systems and find out what their differences are. Overview of Activity-Based Costing (ABC) Activity-based costing, simply known as the ABC method, refers to a method of allocating overhead costs to products, tasks, acquisitions, or services projects based on these two factors: The resources they consume The activities that go into them The ABC method was created by accounts in order to deal with the issues of inaccuracy from the traditional costing method. After all, managers and business owners will need a more accurate costing method in order to determine their profits properly. Why Opt for the ABC Approach? Activity-based costing is preferred by a lot of businesses due to it being more accurate. However, it’s quite difficult to implement, not to mention it’s costly as well. As such, activity-based costing is more suitable for businesses that have high overhead costs, specifically businesses that manufacture products instead of offering services. Overview of Traditional Costing Traditional costing, on the other hand, is a costing method that involves allocating overhead costs on a single, volume-based cost driver. This single cost driver could be based on several aspects such as the number of labor hours, machine hours, etc. Why Opt for the Traditional Method? Companies often use the traditional costing approach to give external reports since it’s a lot easier for outsiders to understand. It’s also a good choice if their overhead costs are lower compared to the direct product costs. The problem with traditional costing is that it’s not as accurate as ABC. The reason is because the application of overhead costs is applied equally to all of the products’ costs. For that, the traditional costing approach is ideal for companies and manufacturers that only manufacture a few different products. ABC Vs. Traditional Costing – Which to Choose? Out of the two, the activity-based costing approach is more accurate since it considers several important factors before it assigns a cost to a certain product. However, this same advantage is also its downside as it makes the process a bit complicated and time-consuming as well.   Meanwhile, traditional costing is a lot easier when it comes to determining product costs since it only relies on assigning average overhead rates. However, this is the reason why it’s less accurate than activity-based costing since it doesn’t include non-manufacturing expenses into the equation. It also doesn’t determine the specific overhead costs that affect certain products. To better understand these two costing methods, let’s have a look at this example: There are two roommates sharing the same apartment. Typically, they will divide the overall costs of rent and other stuff like groceries and utility bills. They have several options to do this, but the most common method would be to simply compute the total costs of all bills then divide the total by two. This is a good example of traditional costing. On the other hand, they can also divide the cost by determining who uses certain utilities then pay only for what each of them uses. For example, if roommate A uses the internet and roommate B doesn’t, then roommate A will be the only one to handle that bill. This is a good example of activity-based costing. Now, out of the two, which one should you use for your company? Well, your choice should be based on the specific needs of your business and your timeframe. If you go for activity-based costing, you should only use it: for internal use since decision-makers can see any relevant spending, thereby allowing them to accurately document all indirect costs. when overhead is high since any small changes in a product could also have a huge difference overall. Traditional costing, on the other hand, works best: for external use since outsiders can easily understand and determine a product’s value. when overhead is low since it will provide the most accurate reports. Deciding between activity-based and traditional costing will boil down to your business’ specific needs. However, by learning the differences between them, you’ll be able to figure out how each method can affect your business’ operations and even help you save money in the long run. To know more about cost accounting and management, and to solve practical examples so that you can evaluate your learnings, grab a copy of Cost Accounting and Management Essentials from Vibrant Publishers.