Cost Accounting Systems

A cost accounting system (also called product costing system or costing system) is a framework used by firms to estimate the cost of their products for profitability analysis, inventory valuation and cost control.

Estimating the accurate cost of products is critical for profitable operations. A firm must know which products are profitable and which ones are not, and this can be ascertained only when it has estimated the correct cost of the product. Further, a product costing system helps in estimating the closing value of materials inventory, work-in-progress and finished goods inventory for the purpose of financial statement preparation.

There are two main cost accounting systems: the job order costing and the process costing.

Job order costing is a cost accounting system that accumulates manufacturing costs separately for each job. It is appropriate for firms that are engaged in production of unique products and special orders. For example, it is the costing accounting system most appropriate for an event management company, a niche furniture producer, a producer of very high cost air surveillance system, etc.

Process costing is a cost accounting system that accumulates manufacturing costs separately for each process. It is appropriate for products whose production is a process involving different departments and costs flow from one department to another. For example, it is the cost accounting system used by oil refineries, chemical producers, etc.

There are situations when a firm uses a combination of features of both job-order costing and process costing, in what is called hybrid cost accounting system.

In a cost accounting system, cost allocation is carried out based on either traditional costing system or activity-based costing system.

Traditional costing system calculates a single overhead rate and applies it to each job or in each department.

Activity-based costing on the other hand, involves calculation of activity rate and application of overhead costs to products based on their respective activity usage.

Based on whether the fixed manufacturing overheads are charged to products or not, cost accounting systems have two variations: variable costing and absorption costing. Variable costing allocates only variable manufacturing overheads to inventories, while absorption costing allocates both variable and fixed manufacturing overheads to products. Variable costing calculates contribution margin, while absorption costing calculates the relevant gross profit.

Still further refinement to costing accounting systems include JIT-costing, back-flush costing.

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