A standard set of financial accounts will reveal the profitability of a business. However, the primary objective of financial accounting is to present an accurate picture of a company’s financial position at a point in time and a statement of income and expenditure for a given period. On the other hand, cost, or management accounts, analyze costs into categories that can be used as a management tool. Furthermore, financial statements are generally prepared for external consumption, whereas management accounts are used for internal purposes.
Cost accounting is generally associated with manufacturing operations. However, the cost classifications used can be applied to any business. What’s more, understanding the cost accounting classifications can be helpful when making business decisions, even when detailed management accounts are not produced. Here is an explanation of how cost accountants classify the expenses of a business.
Fixed Costs
A fixed cost does not vary with production or sales. For example, the rental payments on business premises would remain constant regardless of sales. And the lease payments on machinery would still need to be paid even if no products were produced. Identifying fixed costs will allow you to calculate the break-even point, the minimum gross margin you must make to cover fixed costs. In turn, that will reveal the minimum sales turnover required.
Variable Costs
Variable costs are those that vary with production. Examples of variable costs include raw materials, packaging, and distribution. Another characteristic of variable costs is that they can be applied to a single production unit. Identifying variable expenses will allow you to calculate gross margin for a product, which will help product pricing, and production scheduling decisions.
Semi-Variable Costs
Some expense types contain both fixed and variable elements. These costs are known as semi-variable costs. Electric, for example, might be semi-variable because you have the fixed cost of lighting and heating and the variable cost of energy consumed to power production. Labor could also be regarded as a semi-variable coat. In this case, the fixed element is the basic pay required to retain the workers. The variable component is overtime and productivity bonuses.
Direct Costs
Direct costs are those directly attributable to production. These costs make up the cost of goods sold (COGS). Another characteristic of direct expenses is that they can be traced to a particular department or project. The direct production costs would include wages, power, and raw materials in a manufacturing company. The concept of direct costs can also be applied to other business types. A software company, for example, would incur costs directly attributable to the development of the software and the support department, enabling departmental profitability analysis.
Indirect Costs
Some costs cannot be directly attributed to any particular business operation. These are known as indirect costs. The electricity used to light a large production facility, for example, could not be readily allocated to production lines. General maintenance staff might carry out work for production and administration departments. Nevertheless, these indirect costs are crucial to the operation of both departments. Although not directly attributable to a department or product, indirect costs can be apportioned. For example, maintenance costs could be allocated to cost centers based on timesheets, and electricity might be apportioned based on floor space.
Operating Costs
Operating costs, which can be fixed or variable, are crucial for running the business but cannot be attributed to one product or activity. Typical examples of operating expenses are office supplies, insurance, and property taxes. In contrast, non-operating costs include loss on investments, lawsuit settlements, and interest on loans.
Opportunity Costs
An opportunity cost is a benefit forgone due to choosing one of two or more mutually exclusive alternatives. You might have one production line that can produce one of two products, A and B, for example. In that case, the opportunity cost of manufacturing product A would be profit lost by not making product B. Equally, it can be helpful to consider the opportunity cost when deciding between two significant orders or projects. Opportunity costing can also be used for financing decisions. You might have the option to either lease or purchase outright an item of machinery, for example. In that case, the opportunity cost of choosing to buy the item could be the interest you could save by using the same cash to reduce other borrowings.
Sunk Costs
Sunk costs are historical expenditures or commitments that cannot be recovered. Advertising costs, for example, cannot be recovered later, even if the campaign was a failure. Consequently, such costs can be excluded from future management decisions.
Controllable Costs
Controllable costs, as the name suggests, are costs that budget holders or officers of the company can control. These expenses are usually discretionary items of expenditure such as employee bonuses, advertising, subscriptions, and staff training. Controllable costs may be critical for the smooth running of the business. Nevertheless, in theory, you could decide to curtail expenditure on these items; hence they are controllable.
Replacement Cost
Replacement costs, generally used in the valuation of fixed assets or inventory, is the current cost of replacing an item. The use of replacement costs becomes more critical during times of inflation. For example, you might have a choice of either replacing or continuing to maintain a piece of equipment. In that case, your decision could be guided by comparing the replacement cost with the maintenance costs over the remainder of the equipment’s useful life. However, you would also have to factor into your decision the effect of inflation over time on the eventual replacement cost of the item.
Conclusion
Creating a set of management accounts based upon cost categories is generally only a matter of grouping and subtotaling relevant general ledger codes. And most accounting packages can produce both financial and management accounts. Cost accounting helps business owners analyze the effect of various costs on gross margins and net profit. And understanding the different cost types can also be helpful when making individual business decisions. Consequently, producing management accounts using the above cost classifications will be well worth the effort once a business grows beyond a small enterprise.