Advantages of Cost Accounting
Cost Accounting is a tool used by the management of the company that helps in identifying, recording and assessing an entity’s cost of production in order to measure the performance of various products and divisions, thus aiding in decision making.
As opposed to financial accountingFinancial AccountingFinancial accounting refers to bookkeeping, i.e., identifying, classifying, summarizing and recording all the financial transactions in the Income Statement, Balance Sheet and Cash Flow Statement. It even includes the analysis of these financial statements., cost accountingCost AccountingCost accounting is a defined stream of managerial accounting used for ascertaining the overall cost of production. It measures, records and analyzes both fixed and variable costs for this purpose. is used internally by the management for budgeting and decision-making, and not for external financial reporting. Implemented effectively, a sound cost accounting system would help improve product and divisional profitability, thereby enhancing the overall organizational profitability. Below is a summary of the advantages of cost accounting.
Top 8 Advantages of Cost Accounting
#1 – Various Items of Costs
It includes direct material costDirect Material CostDirect Material Cost is the total cost incurred by the company in purchasing the raw material along with the cost of other components including packaging, freight and storage costs, taxes, etc. that are related directly to the manufacturing and production of various products of the company., labor costLabor CostCost of labor is the remuneration paid in the form of wages and salaries to the employees. The allowances are sub-divided broadly into two categories- direct labor involved in the manufacturing process and indirect labor pertaining to all other processes., and overhead costOverhead CostOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc..
A) Material Costs
- A cost accounting system, when implemented effectively, ensures timely order fulfillment by providing uninterrupted production.
- Reduction of inventory holding costsHolding CostsHolding cost refers to the cost that an entity incurs for handling and storing its unsold inventory during an accounting period. It is calculated as the sum total of storage cost, finance cost, insurance, and taxes as well as obsolescence and shrinkage cost. by synchronizing the frequency of material order placement with the production schedule.
- Identification and avoidance of abnormal/ unnecessary losses and wastages during storage or production.
- It helps achieve economies of scale by identifying optimum re-order quantity to reduce inventory purchase costs—appropriate valuation of inventoryValuation Of Inventory Inventory Valuation Methods refers to the methodology (LIFO, FIFO, or a weighted average) used to value the company's inventories, which has an impact on the cost of goods sold as well as ending inventory, and thus has a financial impact on the company's bottom-line numbers and cash flow situation. as well as scrap.
B) Labor Costs
- An effective labor cost control system helps to:
- Recognize and eliminate situations of overstaffing or understaffing by determination of manpower requirements in different divisions across product lines.
- Control idle time and overtime by assessment of time consumed in different processes and departments;
- Institute wage systems, incentive schemes and a bonus plan commensurate with productivity;
C) Overhead Costs
Cost accounting helps ensure better monitoring of the consumption of resources by various cost centers and ensures better departmental control.
#2 – Aids Cost Control and Cost Reduction
A good cost accounting system helps management decrease the entity’s production cost by employing cost control and cost reduction.
- Cost controlCost ControlCost control is a tool used by an organization in regulating and controlling the functioning of a manufacturing concern by limiting the costs within a planned level. It begins with preparing a budget, evaluating the actual performance, and implementing the necessary actions required to rectify any discrepancies. is the process of ensuring that the actual cost incurred is in line with the planned amounts.
- Cost reduction aims to lower the per-unit cost of production without compromising on the quality of the product.
A comparison of costs across periods in respect of the same product or with competitors or industry standards helps to determine avenues for cost control and reduction.
#3 – Elimination of Wasteful Activities
Cost accounting systems help identify redundant activities, inefficiencies, abnormal and avoidable losses. Thus, cost accounting is useful for identifying the cause of fluctuations in the profitability of the business. Additionally, the cost of idle capacity can be estimated in case divisions or plants are not working to their full capacity. It would help identify the unprofitable product or product linesProduct Or Product LinesProduct Line refers to the collection of related products that are marketed under a single brand, which may be the flagship brand for the concerned company. Typically, companies extend their product offerings by adding new variants to the existing products with the expectation that the existing consumers will buy products from the brands that they are already purchasing. and wasteful activities, so that they may be better managed or eliminated. Cost analysis also helps management decide if it is economically better off making a product in-house or sourcing the same from external vendors.
#4 – Aids in Fixing Appropriate Price to Improve Product Profitability
- Cost accounting enables the management to find the ideal range of prices that would be most profitable to the company, given the level of output produced and the prevailing market scenario.
- Cost accounting enables fixation of appropriate prices by making a distinction between fixed and variable costs that are not otherwise made in financial accounting systems.
- For example, in periods of a global recessionGlobal RecessionGlobal recession refers to a condition when the countries across the globe experience an economic downturn for an extended period. It is a form of synchronized economic downfall encountered by the various interrelated economies throughout the world., an entity may be required to lower prices to keep up the demand for its products. In such a situation, the management may decide to sell at a price that does not cover its total cost.
- The company would then sell the product at a price over its variable cost of production. Since the fixed costsFixed CostsFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity. are to be incurred whether or not the entity manufactures the product, the management would price the products in such a manner that at least the incremental cost of producing each additional unit is covered.
#5 – Improvement of Division & Organizational Profitability by Fixing Appropriate Prices for Inter-Departmental Transfers
Cost accounting also helps determine a suitable price for the interdepartmental transfer of semi-finished products or materials in a production chain. This system would push department managers to improve individual division profitability by holding them accountable for the same. The divisions would then be encouraged to make optimum utilization of capacity, which would, in turn, boost the overall profitability of the organization as a whole.
#6 – Helps Management by Exception Leading to Timely and More Informed Decisions
Cost accounting systems help identify deviations from planned amounts. For example, excessive use of materials compared to the standard requirement, extra time taken to complete a particular activity/product than that estimated, additional services consumed by a division of the entity than normal, etc. will be brought to light by a good cost accounting system. Management can then focus their efforts on such material variances that are identified. Cost accounting aids the management in making informed decisions in a timely manner, with some degree of foresight.
#7 – Allows Fixation of Accountability and Responsibility
BudgetingBudgetingBudgeting is a method used by businesses to make precise projections of revenues and expenditure for a future specific period of time while taking into account various internal and external factors prevailing at that time. costs and revenues define clear targets for various product lines and divisions within the entity. This helps create division-level accountability within the company, making it easier to fix responsibility for inefficiencies or the award of performance-based incentives.
#8 – Cost Accounting Benefits Economy as Whole
Various government departments use cost records maintained by the entity, that is shared with government agencies as part of statutory requirements, in their efforts to regulate the sector by means of price control, price fixationPrice FixationPrice fixing is an agreement between business competitors to increase (very often), reduce (perhaps for a short time), establish, or stabilize (rarely) prices, disregarding the prices governed by the market's flow of demand and supply., tariff protection, fixation of minimum wage levels, etc. ensuring equitable allocation of resources and compensation.
Cost accounting supplements financial accounting to provide management with insights on how the various product lines and activities involved in the production process affect the movements of costs, thereby impacting overall company profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.. A good cost accounting system provides inputs for timely management decisions to be taken for cost control and cost reduction by reducing inefficiencies, redundant activities, and avoidable losses.
This has been a guide to the Advantages of Cost Accounting. Here we discuss its advantages, including Cost Control and Cost Reduction, Elimination of Wasteful Activities and etc. You can learn more about financing from the following articles –