Cost Accounting Fundamentals: Definitions and Classifications

What is Cost Accounting?

Cost accounting is a management information system that analyzes past, present, and future data to provide the basis for managerial action. It is concerned with providing information to assist with the following:

• Establishing inventory valuations, profits, and statement of financial position items
• Planning
• Control
• Decision making

Financial Accounting vs. Cost Accounting

Financial accounting is for external reporting, while cost accounting is for internal reporting. Financial accounts are prepared for individuals external to an organization, such as shareholders, customers, suppliers, and employees. Management accounts are prepared for the internal managers of an organization.

Key Terminology

Cost Objects

If the users of accounting information want to know the cost of something, that something is called a cost object.

Cost Centres

Cost centres are collecting places for costs before they are further analyzed.

Composite Cost Units

These two-part cost units are known as composite cost units.

Cost Classification

Cost classification is the arrangement of elements of cost into logical groups with respect to their nature (fixed, variable, value-adding), function (production, selling), or use in the business of the entity.

Prime Cost

Prime cost = direct material cost + direct labour cost + direct expenses. It is defined as the total of direct material, direct labour, and direct expenses.

Indirect Costs and Overheads

An indirect cost or overhead is expenditure on labour, materials, or services that cannot be economically identified with a specific saleable cost unit. Indirect costs are therefore not directly attributable to cost objects.

Product and Period Costs

• A product cost is a cost of a finished product built up from its cost elements.
• A period cost is a cost relating to a time period rather than to the output of products or services.

Relevant Costs

Relevant costs are future cash flows arising as a direct consequence of a decision. They must meet three criteria:

1. They are future costs.
2. They are cash flows.
3. They are incremental costs.

Avoidable and Differential Costs

• Avoidable costs are costs which would not be incurred if the activity to which they relate did not exist.
• Differential cost is the difference in total cost between alternatives.