Cost Accounting Basics

Cost accounting basics include capturing costs, organizing these costs and reporting these costs. That's really what it is. However, it can be made complicated with complex products and a large volume of business transactions.

To understand cost accounting basics lets keep it very simple to start.Let's assume you and I own a bird house manufacturing company. We make the very best Tufted Titmouse birdhouses in the world. However, we are just getting our business started and we only have a few costs to start. These costs include:

  • Building rent $1000 per month
  • Heat and electric costs of $300 per month
  • One birdhouse assembly person we pay $2000 per month
  • One truck driver we pay $2000 per month
  • Wood to make the birdhouses cost $7 per birdhouse
  • Office expenses of $500 per month
We estimate that we can manufacture and sell 40 birdhouses in one day or 800 in a month.

So what are our costs to make a birdhouse: Bird house example for cost accounting basics
  • Building rent = $1000 per month / 800 birdhouses = $1.25 per house
  • Heat and electric = $300 per month / 800 houses = $.38 per house
  • One assembly person = $2000 per month / 800 = $2.50 per house
  • One truck driver = $2000 per month / 800 = $2.50 per house
  • Wood to make one birdhouse = $7.00 per house
  • Office expenses = $500 per month / 800  = $.63 per house
So, if we add up all our costs for one birdhouse we come up $14.26 per birdhouse. Excellent, now we know what it costs to make one of our wonderful birdhouses.

Cost accountant types use these cost accounting basics to organize costs into three basic categories:
  • Direct material costs
  • Direct labor costs
  • Burden costs
But, don't let this confuse you. Accountants have an easier way to look at these costs. They think of each of these costs as a bucket. Think of three buckets on the floor. One labeled direct material, one labeled direct labor and one labeled burden. Now let's throw our costs to make a birdhouse into the correct bucket:
  • Direct labor is our cost for our assembly person. This person adds value to our birdhouse.
  • Direct material is the wood we use to make the birdhouse
  • Burden costs are the other costs
So, after organizing our costs they look like this:
  • Direct Labor cost = $2.50 ($2000 for labor divided by 800 birdhouses)
  • Direct Material cost = $7.00
  • Burden costs = $4.75 ($3800 for burden costs divided by 800 birdhouses)
You may be asking yourself why we bother to put costs into different buckets. The simple answer is so we can analyze these costs and determine better ways to run the business.

For example: Assume that our assembly labor person can make 50% more birdhouses in the same amount of time. Let's see what happens to our costs:
  • Direct labor cost is now $1.67 per birdhouse ($2000 for labor divided by 1200 birdhouses)
  • Direct material remains at $7.00 per birdhouse
  • Burden costs are now $3.17 per birdhouse ($3800 for burden costs divided by 1200 birdhouses)
We now make our birdhouses for $11.84 instead of $14.25. I hope you can see the advantage to organizing our costs. Look at how each category of cost acted when we increased our production. If we are able to manufacture another line of birdhouses without increasing our burden costs, then our burden costs per birdhouse would go down for all the birdhouses we manufacture. Since it still costs us $3800 per month for our burden costs, these costs are then spread out over more birdhouses, therefore, reducing the amount per birdhouse.

Cost accounting basics can be exciting when your analysis and hard work results in cost improvements for the company. Also, when management knows exactly what the costs are to make their product, it can quote on new work and be certain of the profit it will make. Many companies don't know what their costs are to make a product. The ones that do know their costs have a tremendous advantage.