Management Best Practice of the Week: 6.2.3 Cost Accounting

Cost accounting details the total cost of producing each unit: variable costs at each step plus allocated fixed costs (overhead). Responsible managers track cost accounting to inform pricing and discounts, investments in operations efficiency, and the value of training to work more efficiently.

Big stuff. Unlike financial accounting (term 6.1), cost accounting is not required to adhere to set standards. Managers need to know what details and accuracy are important to them.

When Gross Margin goes negative, start packing your boxes.

Definition of cost accounting: “Understanding the cost of producing one’s product or service, both generally and for each unit.”

Practice Summary

Types of Costs

Variable costs are, basically, the materials and labor needed to create each unit. They’re subject to economies of scale, process design, production technologies, and staff experience training.

Fixed costs (overhead) don’t vary on the level of production, and often include facilities expenses, interest expense, depreciation and senior management salaries.

These costs can be either fixed or variable:

  • Administrative functions
  • Utilities
  • Equipment amortization
  • Sales costs

Types of Cost Accounting

Standard costing assigns budgeted costs, rather than actual costs, to its cost of goods sold (COGS) and inventory. The standard costs are based on an estimated efficient use of labor and materials to produce the good or service under standard operating conditions. Even though standard costs are assigned to the goods, the company still has to pay the actual costs; understanding the difference is called variance analysis.

Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. This method recognizes the relationship between costs, overhead activities, and manufactured products, assigning indirect costs to products less arbitrarily than traditional costing methods. However, some indirect costs, such as management and office staff salaries, are difficult to assign to a product.

Uses – determine costs of:

  • Products
  • Product lines
  • Employee compensation
  • Sales channels
  • Specific customers
  • Fulfilling contracts


Cost reduction: Determining which costs are discretionary, and so can be eliminated or deferred without lasting damage to the business.

Variance: Examining actual vs. standard (budgeted) costs to assess efficiency

Constraint: Monitoring any process which could be a production bottleneck

Key metrics/formulae

Breakeven: Profit = sales – variable costs – fixed costs

Target Net Income: Target net income = sales – variable costs – fixed costs

Gross Margin: Gross margin = (Net sales revenue – COGS) / Net sales revenue

Contribution Margin: Contribution margin = sales – variable costs

3 Good Questions (to discuss in a management meeting)

  1. Who needs to know what our product costs to make?
  2. What’s the ideal ratio of labor to materials?
  3. How could our top three suppliers help reduce variable costs?

The Center’s Zero-Based Budget Worksheet keeps you up-to-date on any significant variances plus makes sure you haven’t left anything out.

Relevant Terms

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