How Cost Accounting Helps Businesses Measure Performance
Cost accounting is a type of accounting that analyzes a business’ complete production costs by looking at both variable and fixed costs. This includes the concepts of marginal costing, lean accounting, standard costing and activity-based costing. It’s used by a business’ management to evaluate fixed and variable costs involved in the manufacturing operations.
The initial step is to assess and document such costs one-by-one. Once production is finished, it will contrast projected costs to what actual costs ended up being and see how processes can be improved. Management gleans information on how funds are used, revenue is earned, and where funds might be misdirected. It can help businesses create greater productivity and financial efficiencies after analyzing such information.
Looking at it more in-depth, there are different types of costs analyzed. The first is fixed costs, such as a monthly mortgage or lease payment, or those that are static regardless of the production level. The next is a variable cost that correlates directly with the production level. Operating costs can be either fixed or variable, depending on each business’ type of operation. Other types of costs include direct or directly connected; and indirect costs, which are costs such as administrative expenses that are less directly associated with production.
Variable Cost Ratio
Variable Cost Ratio (VCR) looks at what percentage a business’ variable production costs is of its net sales. Businesses can calculate the VCR by:
VCR = Variable Costs / Net Sales. Net sales is a business’ gross sales after subtracting any discounting, customer returns and allowances.
It can also be calculated this way: VCR = 1 – Contribution Margin
If each widget’s variable unit cost is $40 and it sells for $200 individually, the VCR equals 0.2 or 20 percent. It’s also possible to be completed within a certain time frame. For example, if a single month’s total variable production costs are $6,000, and the business has revenues of $30,000 within that same month, the variable cost ratio is 0.2 or 20 percent.
The VCR shows if a company is able to earn a higher rate of revenues and a slower growth in input costs. It can help businesses determine when it hits an equilibrium between a loss and profit. It’s also important to note that fixed costs are excluded.
Marginal costing, or cost-volume-profit analysis, is a way to determine how much more it would cost a company to increase its manufacturing by one more widget.
It helps analyze the impact of varying levels of costs and volume on operating profit. This calculation looks at potentially profitable new products, sales prices to establish for existing products, and the impact of marketing campaigns. It assumes that the retail price and the variable and fixed costs per unit don’t change. It’s a way for businesses to calculate when they’ve developed a price point to cover all expenses. It also can indicate when the business can obtain profits at a particular price point and mix of manufacturing output. It’s a way for businesses to determine which levels are unprofitable, break-even and make a profit.
When it comes to determining how much sales volume a business needs to break even, the formula is as follows:
Sales Volume = Fixed Costs / Contribution Margin (Contribution Margin = Sales – Variable Costs)
If a business is looking to determine its break-even sales revenue figure, it must determine what its fixed costs are and its contribution margin. This calculation would be as follows:
$210,000 in fixed costs and a contribution margin of 30 percent = 210,000 / 0.30 = $700,000
However, it’s important to note that there’s no profit with the first calculation. If the business wanted to make $100,000 in profit, it would add that to the $210,000 in fixed costs. This would be calculated as follows: $310,000 / 0.30 = $1,033,333.33
Considerations of Marginal Costing/Cost-Volume-Profit Analysis
This formula tells a company if a widget is profitable. The contribution margin is what’s left over after each item or a lot of items is sold after deducting the variable costs for the respective number of units sold. When the contribution margin exceeds the fixed cost for the item or respective number of units sold, this signifies a profit.
Companies that have the time and resources to analyze their performance beyond the traditional financial statements can see what’s right with their processes; but can more importantly, they can find out what’s wrong and how to fix it going forward.