The Role of Cost Accounting in Management

The Role of Cost Accounting in Management
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  • 0:00 A Review of Accounting Terms
  • 1:03 Important Concepts…
  • 2:54 Some Important Perspectives
  • 4:30 Lesson Summary
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Lesson Transcript
Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

Accounting can be generally defined as 'showing where the money came from and where it went.' Cost accounting, however, is much more data driven and useful to management. In this lesson, we'll learn how, and why.

A Review of Accounting Terms

The term cost accounting might be confused with the business function of accounting, but there is a very important distinction. Accounting is the discipline focused on identifying, classifying, and recording financial transactions that occur during the course of business based on a sound understanding of core accounting principles. Accounting is mostly focused on recognizing and classifying revenue (money coming in) and classifying expense (money going out). Taken together, those two pieces of information make the income statement, a financial statement that reports on the inflows and outflows of money.

Other accounting entries are focused on recording assets (physical things companies own) and liabilities (debts or payments owed). Assets and liabilities are the two important inputs to the accounting equation:

  • Assets - Liabilities = Owners' Equity.

This brief summary of accounting is important to understand, because while cost accounting is more than simply balancing the books, much of the information analyzed in cost accounting comes from the financial statements.

Important Concepts from Cost Accounting

There are a number of important formulas or analyses that are part of cost accounting. Let's go over a list that, while not comprehensive, presents some of the most common concepts, their definitions, and why they are important.

Fixed costs: Costs that are incurred no matter how many units are produced. For example, if you are producing paper plates and have a large press that cuts the paper into the proper size and shape, you would need that press to make one plate or a million plates.

Variable costs: Costs that vary based on the number of units produced. In our paper plate plant, the paper material is a variable cost. The cost of material needed to make one plate varies from what it would cost to make a million plates.

Direct and indirect costs: The cost of materials and labor that are directly needed to produce something - for example, both the machine and the material for our paper plates - are direct costs. Indirect costs, sometimes referred to as overhead, are also necessary, but their cost can't be allocated to a specific product. For example, our paper plate company needs to advertise, and those TV commercials aren't free.

Breakeven formula:

• Revenue - Fixed costs - Variable costs = $0

Identifies how much revenue, or how many units, must be sold to breakeven - meaning no profit, nor any loss.

Gross margin:

• Sales price - Cost of sales = Gross margin

The amount of money made after accounting for the cost of sales (materials and labor) of making the product.

Contribution margin:

• Contribution margin = Sale price - Variable cost

The amount of money a product contributes to help cover fixed costs. If you recall, fixed costs are those that are incurred no matter how many units are produced. To make a true profit, both variable and fixed costs need to be covered.

Some Important Perspectives

When using cost accounting to make managerial decisions, there are important generally accepted accounting principles that should dictate how accounting managers approach their analyses. Three of these principles are the matching principle, conservatism, and full disclosure.

The matching principle requires that the costs associated with producing a product are recorded in the same period that the product is sold. For example, if each box of paper plates we make costs $20 and sells for $50, we want that cost and revenue to show up during the same accounting period. Otherwise, during one period we'll overstate $20 in expenses, making our profit look less in that period. While during the next period, we'll recognize $50 in revenue with no expense, thereby overstating our revenue.

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