Cost accounting is a process that involves accumulating, measuring, analyzing, interpreting, and reporting cost information for the purpose of internal and external decision making. It determines the cost of something through direct measurement, systematic and rational allocation, or arbitrary assignment. Cost accounting is often discussed in the accounting literature as a distinct branch of accounting—however, it should best be thought of as a bridge or overlap between financial and management accounting, since it addresses the demands of both branches of accounting.
The origins of modern cost accounting can be traced to the industrial revolution. During that time, managers recognized that the complexities of managing large-scale operations necessitated that systems be developed to record and track costs to facilitate better decision making. At the beginning of the industrial era, variable costs tended to dominate the interest of managers. However, with the passage of time, managers began to recognize that fixed costs were equally important in decision making. Today, modern cost accounting is no longer considered as mere numbers—rather, cost accounting has become a major player in business decision making.
In theory, accounting is generally classified under three main branches: financial accounting, management accounting, and cost accounting. Financial accounting is concerned with measuring and recording business transactions to produce financial statements for external decision making, while management accounting is concerned with measuring and reporting financial and nonfinancial information for the purpose of internal decision making. In contrast, cost accounting provides information for both internal and external decision making. It provides information to external parties to make investment and credit decisions and for internal parties to manage and control current operations and plan for the future.
Cost accounting is divided into three broad areas: (1) the measurement of cost (e.g., historical cost vs. market value vs. present value, standard cost vs. actual cost); (2) the assignment of cost to the accounting period (e.g., accrual accounting vs. cash basis accounting); and (3) the allocation of cost to cost objectives (e.g., determination of whether costs should be classified as direct or indirect, determination of cost pools and their allocation bases). Cost accounting can therefore be considered as the part of financial and management accounting that collects and analyzes cost information.
In the accounting literature, cost accounting principles, procedures, and practices are generally discussed within the context of manufacturing firms. However, cost accounting is essential for the efficient operations of all business entities: large and small, public and private, profit and nonprofit, and manufacturing, merchandising, and services. In today’s dynamic global environment, reliable and timely cost information is the key to business success. Business entities therefore rely heavily on cost accounting to generate knowledge and wisdom about an entity’s operations. Cost accounting can provide information for various types of decision making such as: assessing operational performance, reducing costs, determining the price of goods/services, determining the effect of an increase in one or more cost elements on sales revenue, and analyzing the reasons for variances between actual and standards costs, to name a few.
Regardless of size, industry or trade, all business entities need good cost accounting information systems to manage, track and improve their business processes. The traditional cost accounting system— absorption costing—is still used by many manufacturing entities. Under this approach, all manufacturing costs are included in the cost of a product. However, in recent times, a wide variety of service, manufacturing and nonprofit organizations have embraced the use of activity based costing. This approach assigns costs to specific activities (e.g., manufacturing, engineering). Other innovative approaches that have emerged to manage and improve business processes include approaches such as lean production, theory of constraints and six sigma. Lean production is based on the logic that production should be in response to customer orders and that perfection should be continuously pursued. The theory of constraints is based on the observation that every organization has at least one constraint, which should be effectively managed for success. Finally, six sigma relies on customer feedback and fact-based data gathering to drive process improvement.
Today, businesses have an array of cost accounting approaches that they can utilize. However, it is important to note that when information is being provided for financial accounting purposes, it must be developed in compliance with Generally Accepted Accounting Polices (GAAP). In contrast, information provided for management accounting need not be in compliance with GAAP. Notwithstanding, two important bodies, namely the Institute of Management Accountants and the Society of Management Accountants of Canada do issue cost accounting guidelines. Although these guidelines are neither mandatory nor legally binding, they are nonetheless useful to ensure that high-quality accounting practices are followed. A third body—the Cost Accounting Standards Board— has also produced a set of standards to help ensure uniformity and consistency in government contracting. This body was established by the U.S. Congress in 1970. The standards produced by this board are legally binding on companies bidding on cost-related contracts to the federal government.
- Ray H. Garrison, Eric W. Noreen, and Peter C. Brewer, Managerial Accounting, 12th ed. (McGrawHill, 2008);
- Charles T. Horngren, Srikant M. Datar, and George Foster, Cost Accounting: A Managerial Emphasis, 11th ed. (Prentice Hall, 2003);
- Michael R. Kinney, Jenice Prather-Kinsey, and Cecily A. Raiborn, Cost Accounting: Foundations and Evolutions (Thomson South-Western, 2006);
- Edward J. VanDerbeck, Principles of Cost Accounting (Thomson South-Western, 2005).
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