What Are the Types of Costs in Cost Accounting? (2024)

Cost accounting is an accounting process that measures all of the costs associated with production, including both fixed and variable costs. The purpose of cost accounting is to assist management in decision-making processes that optimize operations based on efficient cost management. The costs included in cost accounting are discussed in detail below.

Direct Costs

Direct costs arerelated to producing a good or service. A direct cost includesraw materials, labor, and expense or distribution costs associated with producing a product. The cost can easily be traced to a product, department, or project.

For example, Ford Motor Company (F) manufactures cars and trucks.Aplant worker spends eight hours building a car. The direct costs associated with the car are the wages paid to the worker and the cost of the parts used to build the car.

Indirect Costs

Indirect costs, on the other hand, areexpenses unrelated to producing a good or service. An indirect cost cannot be easily traced to a product, department, activity, or project. For example, with Ford, thedirect costs associated with each vehicle includetires andsteel.

However, the electricity used to power the plantis considered an indirect cost because the electricity is used for all the products made in the plant. No one productcan be traced back to the electric bill.

Fixed Costs

Fixed costs donot vary with the number of goods or services a company produces over the short term. 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, no matter how many products that machine is used to make. The lease payment is considered a fixed cost as it remains unchanged.

Variable Costs

Variable costs fluctuateas the level of production output changes, contrary to a fixed cost. 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. Businesses can also decide to forego an activity or production to avoid the associated expenses—called the avoidable costs.

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 decreases.

Operating Costs

Operating costsareexpenses associated with day-to-day business activitiesbut are not traced back to one product. Operating costs canbe variable or fixed. Examples ofoperating costs, which are more commonly called operating expenses,include rent andutilitiesfor a manufacturing plant.

Operating costs areday-to-day expenses, but are classified separately from indirect costs – i.e., costs tied to actual production. Investors cancalculate a company's operating expense ratio, which shows how efficient a company is in using its costs togeneratesales.

Opportunity Costs

Opportunity costis thebenefits of an alternative given up when one decision is made over another. This cost is, therefore, most relevant for two mutually exclusive events. In investing, it'sthe difference in return between a chosen investment and one that is passed up. For companies, opportunity costsdo notshow up in the financial statementsbut are useful in planningby management.

For example, a company decides to buy a new piece ofmanufacturing equipment rather than lease it. The opportunity cost would be the difference between the cost of thecash outlay for the equipment and the improved productivity versus how much money could have been saved in interest expense had themoneybeen used to pay down debt.

Sunk Costs

Sunk costs arehistorical costs that have already been incurred andwill not make any difference in the currentdecisions by management.Sunk costs are those costs that acompany hascommitted to and are unavoidable orunrecoverable costs.Sunk costs are excluded from future business decisions.

Controllable Costs

Controllable costsareexpenses managers have control over and have the power toincrease or decrease. Controllable costs are considered when the decision of taking on the cost is made by one individual. Common examples of controllable costs are office supplies, advertising expenses, employee bonuses, and charitable donations. Controllable costs are categorized as short-term costs as they can be adjusted quickly.

The Bottom Line

Cost accounting looks to assess the different costs of a business and how they impact operations, costs, efficiency, and profits. Individually assessing a company's cost structure allows management to improve the way it runs its business and therefore improve the value of the firm.