What is Cost Accounting?

Imagine this.

You’re passionate about your apple pie. Other people love your pie, and said they’d pay you for them. An idea popped in your head, and now you’ve started a pie bakery. Naturally, you want your business to succeed. But how do you determine success?

One obvious way is by achieving the point of profitability through the method of cost accounting. What is cost accounting? By tracking your expenses and setting your prices accordingly, you can ensure a profit. Cost accounting plays a big part in this process.

What Is Cost Accounting?

To get a better understanding of what is cost accounting, let’s suppose the costs in running your business are as follows:

• $1,000 per month to rent a small building to work in.
• $400 per month for utilities.
• $1,500 per month to hire an employee to bake pies.
• $5 per pie for sugar, eggs, flour, butter, and other ingredients.
• Let’s also assume that your employee can make 15 pies per day, or 300 per month.

Given the figures above, here are your costs to bake a single pie:

• Rent – $1,000 per month / 300 pies = $3.33 per pie
• Utilities – $400 per month / 300 pies = $1.33 per pie
• Employee – $1,500 per month / 300 pies = $5.00 per pie
• Ingredients – $5.00 per pie

Add up all these numbers, and your actual total cost is $14.66 per pie.

So What?

What can you do with this information? Now that you’ve analyzed these costs, you can look for ways to reduce them and increase your profit. Before we do that, we’ll organize our costs into three basic cost accounting categories:

• Direct material cost – This is the cost of all the materials you need to produce your product. In this case, it’s the ingredients needed for the pie.
• Direct labor cost – These are the wages paid in the process of producing your product.
• Burden cost – This is your overhead.

Organizing your pie bakery costs, here’s what you get:

After analyzing these three cost categories, let’s say you can’t reduce your labor or burden costs at the moment. You have, however, been shopping around to find less expensive ingredients.

You’ve found an online wholesale store where you can purchase the same ingredients for $1.50 less per pie. Now your direct material costs are reduced from $5.00 to $3.50 per pie.

Guess what? Your total costs are now reduced to $13.16 per pie. You’ve just cut your costs by 10 percent.

If you can find ways to lower your direct labor and burden costs, you’ll reduce your costs even more.

This is the essence of cost accounting. It’s a process of capturing, organizing, and reporting on the costs associated with your business. By analyzing your costs, you can find areas where you can reduce costs and increase your profitability.

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Darren loves to help people learn business skills that they can use to better their lives. Check out his blog at Gain Business Skills and get free updates via his RSS feed.