An amount that has to be paid or given up in order to
In business, cost is usually a monetary valuation of (1)
effort, (2) material, (3) resources, (4) time and utilities
consumed, (5) risks incurred, and (6) opportunity
forgone in production and delivery of a good or service.
All expenses are costs, but not all costs (such as those
incurred in acquisition of an income-generating asset)
DEFINITION of 'Cost Accounting'
Cost accounting is a type of accounting process that
aims to capture a company's costs of production by
assessing the input costs of each step of production as
well as fixed costs such as depreciation of capital
equipment. Cost accounting will first measure and
record these costs individually, then compare input
results to output or actual results to aid company
management in measuring financial performance.
While cost accounting is often used within a company
to aid in decision making, financial accounting is what
the outside investor community typically sees.
Financial accounting is a different representation of
costs and financial performance that includes a
company's assets and liabilities. Cost accounting can
be most beneficial as a tool for management in
budgeting and in setting up cost control programs,
which can improve net margins for the company in the
One key difference between cost accounting and
financial accounting is that while in financial
accounting the cost is classified depending on the type
of transaction, cost accounting classifies costs
according to information needs of the management.
Cost accounting, because it is used as an internal tool
by management, does not have to meet any specific
standard set by the Generally Accepted Accounting
Principles and as result varies in use from company to
company or from department to department.
Development of Cost Accounting
Scholars have argued that cost accounting was first
developed during the industrial revolution when the
emerging economics of industrial supply and demand
forced manufacturers to start tracking whether to
decrease the price of their overstocked goods or
During the early 19th century when David Ricardo and
T. R. Malthus were developing the field of economic
theory, writers like Charles Babbage were writing the
first books designed to guide businesses on how to
manage their internal cost accounting.
By the beginning of the 20th century, cost accounting
had become a widely covered topic in the literature of
Types of Cost Accounting
Standard Cost Accounting
This type of of cost accounting uses ratios to compare
efficient uses of labor and materials to produce goods
or services under standard conditions. Assessing these
differences is called a variance analysis. Traditional
cost accounting essentially allocates cost based on one
measure, labor or machine hours. Due to the fact that
overhead cost has risen proportionate to labor cost
since the genesis of standard cost accounting,
allocating overhead cost as an overall cost has ended
up producing occasionally misleading insights.
Some of the issues associated with cost accounting is
that this type of accounting emphasizes labor
efficiency despite the fact that it makes up a
comparatively small amount of the costs for modern
Activity Based Costing
The Charter Institute of Management Accountants
defines activity based accounting as, "an approach to
the costing and monitoring of activities which involves
tracing resource consumption and costing final
outputs, resources assigned to activities, and activities
to cost objects based on consumption estimates. The
latter utilize cost drivers to attach activity costs to
Activity based costing accumulates the overheads from
each department and assigns them to specific cost
objects like services, customers, or products. The way
these costs are assigned to cost objects are first
decided in an activity analysis, where appropriate
output measures are cost drivers. As result, activity
based costing tends to be much more accurate and
helpful when it comes to helping managers understand
the cost and profitability of their company's specific
services or products. Accountants using activity based
costing will pass out a survey to employees who will
then account for the amount of time they spend on
different tasks. This gives management a better idea of
where their time and money is being spent.
Lean accounting is an extension of the philosophy of
lean manufacturing and production developed by
Japanese companies in the 1980s. Most accounting
practices for manufacturing work off the assumption
that whatever is being produced is done in a large
scale. Instead of using standard costing, activity based
costing, cost-plus pricing, or other management
accounting systems, when using lean accounting those
methods are replaced by value-based pricing and leanfocused performance measurements, for example,
using a box score to facilitate decision making and
create simplified and digestible financial reports.
Considered a simplified model of cost accounting,
marginal costing (sometimes called cost-volume-profit
analysis) is an analysis of the relationship between a
product or service's sales price, the volume of sales,
the amount produced, expenses, costs and profits.
That specific relationship is called the contribution
margin. The contribution margin is calculated by
dividing revenue minus variable cost by revenue. This
type of analysis can be used by management to gain
insight on potential profits as impacted by changing
costs, what types of sales prices to establish, and types
of marketing campaigns.
Types of Costs
Fixed Costs are costs that don't vary depending ont
he amount of work a company is doing. These are
usually things like the payment on a building, or a
piece of equipment that is depreciating at a fixed
Variable costs are tied to a company's level of
production. An example could be a coffee roaster, who
after receiving a large order of beans from a far-away
locale, has to pay a higher rate for both shipping,
packaging, and processing.
Operating costs are costs associated with the day-today operations of a business. These costs can be either
fixed or variable depending.
Direct costs are the cost related to producing a
product. If a coffee roaster spends 5 hours roasting
coffee, the direct costs of the finished product include
the labor hours of the roaster, and the cost of the
coffee green. The energy cost to heat the roaster would
be indirect because they're inexact, hard to trace.
Cost accounting is an accounting process that
measures and analyzes the costs associated with
products, production and projects so that correct
amounts are reported on financial statements. Cost
accounting aids in decision-making processes by
allowing a company to evaluate its costs. Some types
of costs in cost accounting are direct, indirect, fixed,
variable and operating costs.
A direct cost is related to producing a good or service.
A direct cost is the material, labor, expense or
distribution cost associated with producing a product. It
can be accurately and easily traced to a product,
department or project. For example, suppose a worker
spends eight hours building a car for a car
manufacturing company. The direct costs associated
with the car are the wages paid to the worker and the
parts used to build the car.
On the other hand, an indirect cost is an expense
unrelated to producing a good or service. An indirect
cost cannot be easily traced to a product, department,
activity or project. For example, a semiconductor
company rents office space in a building and produces
microchips. The wages paid to the workers and the
material used to produce the microchips are direct
costs. However, the electricity used to power the entire
building is considered an indirect cost because it
appears on one bill and is difficult to trace back to the
A fixed cost is also associated with cost accounting. A
fixed cost does not vary with the number of goods or
services a company produces. For example, suppose a
company leases a machine for production for two
years. The company has to pay $2,000 per month to
cover the cost of the lease. The lease payment the
company pays per month is considered a fixed cost.
Contrary to a fixed cost, a variable cost fluctuates as
the level of production output changes. This type of
cost varies depending on the number of products a
company produces. A variable cost increases as the
production volume increases, and it falls as the
production volume decreases. For example, a toy
manufacturer must package its toys before shipping
products out to stores. This is considered a type of
variable cost because, as the manufacturer produces
more toys, its packaging costs increase. However, if
the toy manufacturer's production level is decreasing,
the variable cost associated with the packaging
An operating cost is an expense associated with dayto-day business activities and may be variable or fixed.
An example of an operating cost is a company's
inventory. Suppose a company produces and sells
microchips. The microchips must be stored and
maintained, which is an operational cost to the
What is Cost?
All payments made by a firm in the production of a
good or service are called the cost of production. These
costs can be classified in different ways.
Types of costs
Fixed costs are expenses that do not change in
proportion to the activity of a business, within the
relevant period or scale of production. For example, a
retailer must pay rent and utility bills irrespective of
Variable costs by contrast change in relation to the
activity of a business such as sales or production
volume. In the example of the retailer, variable costs
may primarily be composed of inventory (goods
purchased for sale), and the cost of goods is therefore
almost entirely variable.
In manufacturing, direct material costs are an example
of a variable cost. An example of variable costs is the
prices of the supplies needed to produce a product.
A company will pay for line rental and maintenance
fees each period regardless of how much power gets
used. And some electrical equipment (air conditioning
or lighting) may be kept running even in periods of low
activity. These expenses can be regarded as fixed. But
beyond this, the company will use electricity to run
plant and machinery as required. The busier the
company, the more the plant will be run, and so the
more electricity gets used. This extra spending can
therefore be regarded as variable.
Along with variable costs, fixed costs make up one of
the two components of total cost. In the most simple
production function, total cost is equal to fixed costs
plus variable costs.
It is important to understand that fixed costs are
"fixed" only within a certain range of activity or over a
certain period of time. If enough time passes, all costs
In retail the cost of goods is almost entirely a variable
cost; this is not true of manufacturing where many
fixed costs, such as depreciation, are included in the
cost of goods.
Although taxation usually varies with profit, which in
turn varies with sales volume, it is not normally
considered a variable cost.
Variable costs are expenses that change in proportion
to the activity of a business. Along with fixed costs,
variable costs make up the two components of total
cost. Direct Costs, however, are costs that can be
associated with a particular cost object. Not all variable
costs are direct costs, however; for example, variable
manufacturing overhead costs are variable costs that
are not a direct costs, but indirect costs.
For example, a manufacturing firm pays for raw
materials. When activity is decreased, less raw
material is used, and so the spending for raw materials
falls. When activity is increased, more raw materials is
used and spending therefore rises.
Average cost per unit
Average cost is equal to total cost divided by the
number of goods produced.
It is also equal to the sum of average variable costs
(total variable costs divided by Output)
Marginal cost is the change in total cost that arises
when the quantity produced changes by one unit. In
general terms, marginal cost at each level of
production includes any additional costs required to
produce the next unit. So, the marginal costs involved
in making one more wooden table are the additional
materials and labour cost incurred.
(A) Actual Cost
Actual cost is defined as the cost or expenditure which a firm incurs for
producing or acquiring a good or service. The actual costs or expenditures
are recorded in the books of accounts of a business unit. Actual costs are
also called as "Outlay Costs" or "Absolute Costs" or "Acquisition Costs".
Examples: Cost of raw materials, Wage Bill etc.
(B) Opportunity Cost
Opportunity cost is concerned with the cost of forgone
opportunities/alternatives. In other words, it is the return from the second
best use of the firms resources which the firms forgoes in order to avail of
the return from the best use of the resources. It can also be said as the
comparison between the policy that was chosen and the policy that was
rejected. The concept of opportunity cost focuses on the net revenue that
could be generated in the next best use of a scare input. Opportunity cost
is also called as "Alternative Cost".
If a firm owns a land, there is no cost of using the land (ie., the rent) in the
firms account. But the firm has an opportunity cost of using the land, which
is equal to the rent forgone by not letting the land out on rent.
(C) Sunk Cost
Sunk costs are those do not alter by varying the nature or level of business
activity. Sunk costs are generally not taken into consideration in decision making as they do not vary with the changes in the future. Sunk costs are a
part of the outlay/actual costs. Sunk costs are also called as "NonAvoidable costs" or "Inescapable costs".
Examples: All the past costs are considered as sunk costs. The best
example is amortization of past expenses, like depreciation.
(D) Incremental Cost
Incremental costs are addition to costs resulting from a change in the
nature of level of business activity. As the costs can be avoided by not
bringing any variation in the activity in the activity, they are also called as
"Avoidable Costs" or "Escapable Costs". More ever incremental costs
resulting from a contemplated change is the Future, they are also called as
Example: Change in distribution channels adding or deleting a product in
the product line.
(E) Explicit Cost
Explicit costs are those expenses/expenditures that are actually paid by the
firm. These costs are recorded in the books of accounts. Explicit costs are
important for calculating the profit and loss accounts and guide in economic
decision-making. Explicit costs are also called as "Paid out costs"
Example: Interest payment on borrowed funds, rent payment, wages, utility
(F) Implicit Cost
Implicit costs are a part of opportunity cost. They are the theoretical
costs ie., they are not recognised by the accounting system and are not
recorded in the books of accounts but are very important in certain
decisions. They are also called as the earnings of those employed
resources which belong to the owner himself. Implicit costs are also called
as "Imputed costs".
Examples: Rent on idle land, depreciation on dully depreciated property still
in use, interest on equity capital etc.
(G) Book Cost
Book costs are those business costs which don't involve any cash
payments but a provision is made in the books of accounts in order to
include them in the profit and loss account and take tax advantages, like
provision for depreciation and for unpaid amount of the interest on the
(H) Out Of Pocket Costs
Out of pocket costs are those costs are expenses which are current
payments to the outsiders of the firm. All the explicit costs fall into the
category of out of pocket costs.
Examples: Rent Payed, wages, salaries, interest etc
(I) Accounting Costs
Accounting costs are the actual or outlay costs that point out the amount of
expenditure that has already been incurred on a particular process or on
production as such accounting costs facilitate for managing the taxation
need and profitability of the firm.
Examples: All Sunk costs are accounting costs
(J) Economic Costs
Economic costs are related to future. They play a vital role in business
decisions as the costs considered in decision - making are usually future
costs. They have the nature similar to that of incremental, imputed explicit
and opportunity costs.
(K) Direct Cost
Direct costs are those which have direct relationship with a unit of operation
like manufacturing a product, organizing a process or an activity etc. In
other words, direct costs are those which are directly and definitely
identifiable. The nature of the direct costs are related with a particular
product/process, they vary with variations in them. Therefore all direct
costs are variable in nature. It is also called as "Traceable Costs"
Examples: In operating railway services, the costs of wagons, coaches and
engines are direct costs.
Example: Cost of material, labour, fuel etc
Postponable costs are those which if not incurred in time do not effect the
operational efficiency of the firm. Examples are maintenance costs.
(S) Business Cost and Full Cost
Business costs include all the expenses incurred by the firm to carry out
(L) Indirect Costs
Indirect costs are those which cannot be easily and definitely identifiable in
relation to a plant, a product, a process or a department. Like the direct
costs indirect costs, do not vary ie., they may or may not be variable in
nature. However, the nature of indirect costs depend upon the costing
under consideration. Indirect costs are both the fixed and the variable type
as they may or may not vary as a result of the proposed changes in the
production process etc. Indirect costs are also called as Non-traceable
Example: The cost of factory building, the track of a railway system etc., are
fixed indirect costs and the costs of machinery, labour etc.
business activities. Costs Include all the payments and contractual
(M) Controllable Costs
(T) Fixed Costs
Controllable costs are those which can be controlled or regulated through
Fixed costs are the costs that do not vary with the changes in output. In
observation by an executive and therefore they can be used for assessing
other words, fixed costs are those which are fixed in volume though there
the efficiency of the executive. Most of the costs are controllable.
are variations in the output level.. If the time period in volume under
Example: Inventory costs can be controlled at the shop level etc.
consideration is long enough to make the adjustments in the capacity of the
obligations made by the firm together with the book cost of depreciation on
plant and equipment.
Full costs include business costs, opportunity costs, and normal profits.
Opportunity costs is the expected return/earnings from the next best use of
the firms resources like capital, land and building, owners efforts and time.
Normal profits is necessary minimum earning in addition to the opportunity
costs, which a firm must receive to remain in its present occupation.
firm, the fixed costs also vary.
(N) Non Controllable Costs
Examples: Expenditures on depreciation costs of administrative, staff, rent,
The costs which cannot be subjected to administrative control and
land and buildings, taxes etc.
supervision are called non controllable costs.
Example: Costs due obsolesce and depreciation, capital costs etc.
(U) Variable Costs
Variable Costs are those that are directly dependent on the output ie., they
(O) Historical Costs and Replacement Costs.
vary with the variation in the volume/level of output. Variable costs increase
Historical cost or original costs of an asset refers to the original price paid
in output level but not necessarily in the same proportion. The
by the management to purchase it in the past. Whereas replacement costs
proportionality between the variable costs and output depends upon the
refers to the cost that a firm incurs to replace or acquire the same asset
utilization of fixed facilities and resources during the production process.
now. The distinction between the historical cost and the replacement cost
Example: Cost of raw materials, expenditure on labour, running cost or
result from the changes of prices over time. In conventional financial
maintenance costs of fixed assets such as fuel, repairs, routine
accounts, the value of an asset is shown at their historical costs but in
decision-making the firm needs to adjust them to reflect price level
(V) Total Cost, Average Cost and Marginal Cost
Example: If a firm acquires a machine for $20,000 in the year 1990 and the
Total cost (TC) refers to the money value of the total resources/inputs
same machine costs $40,000 now. The amount $20,000 is the historical
required for the production of goods and services by the firm. In other
cost and the amount $40,000 is the replacement cost.
words, it refers to the total outlays of money expenditure, both explicit and
implicit, on the resources used to produce a given level output. Total cost
(P) Shutdown Costs
includes both fixed and variable costs and is given by TC = VC + FC
The costs which a firm incurs when it temporarily stops its operations are
called shutdown costs. These costs can be saved when the firm again start
Average Cost (AC) , refers to the cost per unit of output assuming that
its operations. Shutdown costs include fixed costs, maintenance cost,
production of each unit incurs the same cost. It is statistical in nature and is
layoff expenses etc.
not an actual cost. It is obtained by dividing Total Cost(TC) by Total
(Q) Abandonment Costs
Abandonment costs are those costs which are incurred for the complete
removal of the fixed asset from use. These may occur due to obsolesce or
Marginal costs(MC), refers to the additional costs that are incurred when
due to improvisation of the firm. Abandonment costs thus involve problem
there is an addition to the existing output level of goods ans services. In
of disposal of the asset.
other words, it is the addition to the Total Cost(TC) on account of producing
(R) Urget Costs and Postponable Costs
Urgent costs are those costs which have to be incurred compulsorily by the
(W) Short Run Cost and Long Run Cost
management in order to continue its operations. If urgent costs are not
Both short run and long run costs are related to fixed and variable costs and
incurred in time the operational efficiency of the firm falls.
are often used in economic analysis.
Long Run Cost: These costs are which incurred on the fixed assets like
Short Run Cost: These costs are which vary with the variation in the
land and building, plant and machinery etc., Long run costs are same as
output with size of the firm as same. Short run costs are same as variable
fixed costs. Usually, long run costs are associated with variations in size
costs. Broadly, short run costs are associated with variable inputs in the