What Are the Types of Costs in Cost Accounting?

By Sarah Davis
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Cost accounting is most relevant when it comes to manufacturing businesses and businesses involved in the distribution of physical products. This is because these businesses revolve around the cost of production.

In contrast, a digital or service-based business would not have as extensive a need for sophisticated cost accounting (though it would still serve as a feature, the costs being more indirect and less substantial).

We have broken down the different types of cost accounting for you in detail below. But first, let’s take a brief peek into cost accounting.

A Brief Intro to Cost Accounting

The primary purpose of cost accounting is that it can help a company to budget and increase its profitability. It also allows for easier accounting in many respects. But keep in mind that the following categories can overlap in many regards.

To start, there are many ways to do cost accounting. Different companies will have various methodologies. A lot will depend on how you want to report cost for taxation purposes, the size of your business, your industry, and a whole lot more.

Cost accounting is an internal management tool, not an official accounting standard that you have to adhere to. As such, it will differ from business to business, company to company. 

Despite all the complexities, cost accounting can largely be broken into fixed and variable costs. The other costs can be fit into either the fixed or variable categories. Direct, indirect, fixed, and variable are the 4 main kinds of cost. In addition to this, you might also want to look into operating costs, opportunity costs, sunk costs, and controllable costs. We have described these 8 major accounting costs below for further clarification.

The 8 Major Accounting Costs

How you divide accounting costs into each section is described below. But you will need to define what type of cost accounting methodology you are going to use before you can accurately complete this step. The types of cost accounting are explained below the classification of major accounting costs.

#1 – Direct Costs

Direct costs are among the most common. They are the direct cost associated with the production of a product. Direct costs would include labor or materials. They may also include distribution costs and other expenses, depending on the method of accounting. The most obvious example of a direct cost would be a car manufacturing company. The two direct costs would be the total of the wages paid to the employees used to build the car and the cost of the individual parts themselves.

You can see how such costs are direct. The training of the employees, supervision, utilities, and other costs are not factored in. Direct costs are the same as Cost of Goods Sold, a very relevant metric for general accounting purposes. Cost of Goods Sold (‘COGS’) is sometimes referred to as the Cost of Sales.

#2 – Indirect Costs

Indirect costs are a little more difficult to trace. Indirect costs often cannot be traced back to an individual department. The workers in a car manufacturing plant might all use the internet, water, and lighting to create a vehicle. But these costs are indirect and are used all over the plant. Other indirect costs can include IT and office maintenance staff. They are indirect but still highly relevant to the business and the end product.

#3 – Fixed Costs

The most obvious example of a fixed cost would be a lease. If you need to pay $3,000 a month for the next 2 years for a property, then this is a fixed cost. The defining characteristic of a fixed cost is that it does not change. A fixed interest rate repayment on a loan is also a fixed cost (provided it is not tied to a variable interest rate). Regardless of how well or poorly the business is doing, a fixed cost will always remain a fixed cost. Fixed costs are easier to calculate as they tend to be more tangible.

#4 – Variable Costs

In direct contrast to a fixed cost, a variable cost can change depending on business performance. The more products you produce, the more you will pay for packaging and distribution. But remember that a variable cost is not a direct cost. Even if you pay more for components and if you pay more for hours worked, this still goes under direct costs in most instances.

#5 – Operating Costs

These are sometimes referred to as operating expenses. These can be either fixed or variable. Operating costs are costs that are associated with daily business activity but are distinct from indirect costs. Rent and utilities are typical examples of operating costs. They are essential for business operations but are not involved in the manufacturing process directly or indirectly.

#6 – Opportunity Costs

This is usually only relevant when deciding between two or three potential business opportunities. The opportunity cost is the cost associated when you go with one investment, and potentially lose out on other investments. What has to be understood is that there is always a potentially superior investment, and you need to shoot for ‘good’ as opposed to perfect. If you are deciding to rent vs buy a new piece of equipment, then you could compute the opportunity cost with all of the variables.

#7 – Sunk Costs

Sunk costs are costs that will not be recovered by the business. They cannot be gotten back regardless of what happens. They are excluded from future business decisions. If you have invested money in a business that has gone bankrupt, it is a sunk cost already (even though you may recuperate some of the revenue through the court system).

#8 – Controllable Costs

Controllable costs are ones where a manager (or board) decides what will happen at a particular cost. Bonuses, charitable donations, advertising, office supplies, employee events, are all examples of controllable costs. But their value is not so easy to calculate. While they are a cost, you cannot simply reduce them down to zero and expect to run a successful business.

The 4 Major Types of Cost Accounting Methods

Of all the major accounting costs listed below, Standard Cost Accounting is the one most widely used by small and medium-sized business models. However, it is activity-based costing that is deemed to be the most accurate and the one that is heavily used by Corporate outfits. It outlines in greater detail the profit/cost of products and services so management can make better decisions.

  1. Activity-Based Costing – This type of cost accounting is an approach to the costing and monitoring of activities that involves tracing resource consumption and costing final outputs, resources assigned to activities, and activities to cost objects based on consumption estimates. It involves accumulating the overheads from each department and assigning them to specific cost objects, such as products, services, and customers.
  2. Standard Cost Accounting – This type of cost accounting uses different types of ratios to compare how efficiently labor and materials are being used (or can be used) to produce goods and services in standard conditions. One of the issues associated with standard cost accounting is that it emphasizes labor efficiency even though labor costs make up a small percentage of costs in modern companies.
  3. Job Costing – This involves the detailed accumulation of production costs attributable to specific units or groups of units. For example, the construction of a custom-designed piece of furniture would be accounted for with a job costing system. The costs of all labor worked on that specific item of furniture would be recorded on a timesheet and then compiled on a cost sheet for that job. In a similar vein, any wood or other parts used in the construction of the furniture would be charged to the production job linked to that piece of furniture. This information may then be used to bill the customer for work performed and materials used or to track the extent of the company’s profits on the production job associated with that specific item of furniture.
  4. Process Costing – This involves the accumulation of costs for lengthy production runs involving products that are indistinguishable from each other. For example, the production of 100,000 gallons of gasoline would require that all oil used in the process, as well as all labor in the refinery facility, be accumulated into a cost account, and then divided by the number of units produced to arrive at the cost per unit. Costs are likely to be accumulated at the department level, and no lower within the organization.

Other kinds of cost accounting can include:

  • Throughput Accounting  – This focuses on the expansion of an organization’s efficiency, by reducing production bottlenecks and/or limitations and thereby maximizing throughput.
  • Cost-Volume-Profit (CVP) Analysis – This determines total fixed and variable costs based on the total quantity of products produced. It uses this information to calculate a company’s breakeven point or the production level at which it will begin to earn a profit.

Key Formulas/Terms in Cost Accounting

If you are interested in cost accounting, then you need to understand the following key terms. There are hundreds (even thousands) of key terms and definitions that could be mentioned within the realm of business. However, the following definitions are relevant in terms of cost accounting.  

  • Breakeven Formula – This the point at which a business breaks even taking into consideration the price of the goods/services rendered. It is the minimum amount of goods/services that need to be produced before the business is not at a loss for its materials and labor (not inclusive of debt, but potentially inclusive of interest on debt to be paid at each interval). To calculate the break-even formula, you can divide fixed costs by the contribution margin. However, the method you use to calculate your break-even formula will depend on your style of business. If you are not manufacturing physical products, there are different ways to go about it.
  • Target Net Income – In the context of cost accounting, target net income is your projected target income or goal that you expect to achieve. So it is not a concrete existing figure, but what you would like to make based on the current projections. Remember that net income and profit mean the same thing in accounting, though they can sound different.
  • Gross Margin – The gross margin of a given enterprise is its net sales taken from the cost of goods sold. It denotes the operational efficiency of a business, in the sense of how much profit it makes after production costs. But it is not net profit. A business can have an excellent gross profit and horrible net profit. So the gross margin is more useful to internal management than external investors. Gross margin is sometimes referred to as gross profit margin.
  • Price Variance – This is very useful when deciding how many products you need to order. It is the tidal variance between the standard cost and the retail cost. To calculate it, you just multiply the difference between the standard and retail cost by the total units sold. The price variance is an extremely useful metric in cost accounting when companies are doing their budget.
  • Efficiency Variance – This is another definition that is especially important when it comes to cost accounting and manufacturing. It is the difference between the projected estimate for the completion of a process and the required inputs. For instance, the production of a product might be estimated to require  20 hours of labor and take 25 hours. This is a negative efficiency variance. Most often, a slightly negative efficiency variance is to be expected.
  • Contribution Margin – This is the total price of a product minus all of the variable costs. Variable costs, as explained above, are all of the indirect costs that are not static. Electricity and the internet might be deemed indirect costs required to create a product. These costs can go up or down. Another example might be consultancy and legal requirements. Depending on the product being created, you may need to use them on an as-needed basis to complete the service or product. If the contribution margin is too low then it would be unwise to continue production. It can also assist in explaining the profit levels that will arise at various price points. You can also use the contribution margin to determine the break-even formula.

Software to Help With Cost Accounting

While many software packages are specific to particular industries, popular programs include SAP, Oracle, and JD Edwards. Familiarity with these packages will strengthen a cost accountant’s ability to perform and analyze data at foundation levels. Cost Accountants should stay abreast of new developments in accounting technology and trends, to ensure efficiency and effectiveness.

There are many types of software that have been specifically designed to assist with this area. This is suited to specialized companies. For generic businesses without such niche requirements, the more general accounting software is more appropriate. Some of the best accounting platforms include:

  1. Patriot
  2. Freshbooks
  3. Sage
  4. Zoho Books

The Role of a Cost Accountant

While most cost accountants work in government organizations or large companies, some will work as consultants either through public accounting firms or their independent practice.

Private consultants will often be called upon to perform services for small or mid-sized businesses that cannot substantiate the full-time employment of a cost accountant. Those who are employed full-time will perform a wide variety of duties:

  • Providing data for stable budget developments
  • Using software to allocate indirect costs to internal processes
  • Detailed analysis of suitable cost drivers
  • Evaluation of potential business ventures

Cost accountants should be familiar with all of the methods of cost accounting, as well as the software programs that support cost accounting functions. There are four primary methods of cost accounting, each of which allocates indirect costs to individual product lines and/or services.

Most general accountants can satisfy the role of a cost accountant. However, a specialized qualification is available from The Institute of Certified Cost and Management Accountants, where they can bestow a Certified Cost Accountant Certificate. Most small businesses will not require a specialized cost accountant, as they can be quite expensive and reserved for corporate outfits.

Cost Accounting Summary

Ultimately, cost accounting can help to increase the value of an entire firm by taking apart the production model and seeing what needs improvement. For small businesses that are not focused on production, its relevance is not quite as pronounced.

It can sound confusing, but this is mainly because there are so many terms that mean the same thing. And people use different terms when the real essence of cost accounting can be understood quite handily with a few basic principles.

Ultimately, you can work with an accountant to reach a consensus in terms of how you record your accounts. High-quality accounting software can also make your life a whole lot easier, though you should still work on understanding the key fundamentals to maximize efficiency.

FAQ

What Is an Outlier?

In an accounting context, an outlier has the same meaning. It is something that was not initially projected in the initial observations. It has to be understood that practically all accounting practices will have outliers that cannot be foreseen. After all, accounting is only a projection, no matter how well it has been prepared on the most robust data. In cost accounting, an outlier is a data point that does not conform with previous patterns, for a myriad of different reasons.

What Is the Cost of Goods Manufactured?

Cost of Goods Manufactured (‘COGM’) is a metric that is used to determine whether or not production costs are too high or low (as compared to total revenue/sales). The formula is

COGM = Beginning WIP Inventory + Total Manufacturing Cost – Ending WIP Inventory

This is a simplified version, as calculating the total cost of manufacturing is not as simple as it sounds. The COGM is a critical component when calculating the Cost of Goods Sold. It helps management to look at the individual components of a given manufacturing process.

What Is a Cost Center?

The best way to describe a cost center is to contrast it with its opposite – the profit center. A profit center is directly correlated with activities that increase the overall profit. A cost center is a center that does not directly generate profits for the organization. Of course, this does not mean that you can run a business only with profit centers! Typical cost centers include human resources and accounting departments.

They are essential to the functioning of any organization. Cost centers typically involve customer service or IT. While important, the issue with cost centers from an accounting perspective is that it is impossible to accurately derive how much profit they generate. But if you have poor customer service, you can bet it hurts your profit margins.

How Is Cost Accounting Different From Standard Accounting?

The major difference is that cost accounting is not standardized with general accounting principles. It is used (primarily) so that businesses can monitor their efficiency levels and make better decisions. As such, there is a lot more flexibility associated with cost accounting. While all companies need to do standard accounting, cost accounting is more relevant to manufacturing businesses involved in physical production as compared to other business models

What Is the Matching Principle?

The matching principle is quite straightforward and is the basis of accounting. You have a debit on one side and a credit on the other. An expense on one side and income on the other. You report your cost of goods sold on one side of the ledger with total sales on the other side of the ledger. Of course, it gets a lot more complex than this. Not all expenses are directly correlated with revenue such as cost centers. If a future benefit of a cost cannot be determined, then it is recorded as an expense. For instance, an advertisement will go down as an expense.

What Is the Principle of Conservatism?

As the name suggests, this is a risk-averse principle. But it is well-grounded in practicality. The Principle of Conservatism states that you can predict future costs well, but not so many future profits. Because you can know what you are going to buy. You have control over that. But you can never understand what your customers are going to do. So it is easier to anticipate costs than profits. You have more control over one than the other. In other words, as the most typical accounting slogan goes “Anticipated losses are losses, anticipated gains are not always gained”. This principle is tied into the lower of cost or market rule.

What Is the Break-Even Point Formula?

The break-even point formula is the point at which a business will break even (though it is also useful in trading and investing). For instance, let’s say that you have fixed costs of $1,000,000 and a $50 sale price for your product, with $10 in variable costs. This means that your contribution margin is $40. You would simply divide the fixed costs by the contribution margin to determine how many units you would need to sell to break even (no profit or loss). In this instance, you would divide $1,000,000 by $40 to arrive at a figure of 25,000 units to break even. The formula is:

Fixed Costs/Contribution Margin = Break Even Formula.

Sarah Davis
Sarah Davis
Sarah Davis is a business executive specializing in mergers and acquisitions, corporate finance, and international law. She achieved her MBA from Cornell University after completing a legal undergraduate at UC Berkley. Sarah runs her own business consultancy firm in tandem with working alongside the FinImpact team.