What is Cost Concept of Accounting?Explanation with Example


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This is so that a company’s management can make better financial decisions, introduce efficiencies and budget accurately. The objective of cost accounting is to improve the business’s net profit margins (how much profit each dollar of sales generates). The break-even point—which is the production level where total revenue for a product equals total expense—is calculated as the total fixed costs of a company divided by its contribution margin. While cost accounting is often used by management within a company to aid in decision-making, financial accounting is what outside investors or creditors typically see. Financial accounting presents a company’s financial position and performance to external sources through financial statements, which include information about its revenues, expenses, assets, and liabilities.

  • A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation.
  • Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs.
  • The objective of cost accounting is to improve the business’s net profit margins (how much profit each dollar of sales generates).
  • An important cost classification in accounting is distinguishing product costs from period costs.

To illustrate this, assume a company produces both trinkets and widgets. The trinkets are very labor-intensive and require quite a bit of hands-on effort from the production staff. The production of widgets is automated, and it mostly consists of putting the raw material in a machine and waiting many hours for the finished good. It would not make sense to use machine hours to allocate overhead to both items because the trinkets hardly used any machine hours.

Principle of Periodicity

In the current environment of business, a business administration must act and take decisions in a fast and accurate manner. As a result, the importance of cost-volume-profit is still increasing as time passes. The obvious problem with the cost principle is that the historical cost of an asset, liability, or equity investment is simply what it was worth on the acquisition peculiar features of single entry system in the context of bookkeeping date; it may have changed significantly since that time. In fact, if a company were to sell its assets, the sale price might bear little relationship to the amounts recorded on its balance sheet. Thus, the cost principle yields results that may no longer be relevant, and so of all the accounting principles, it has been the one most seriously in question.

If cash has been expended in association with an accounting cost, the related cash outflow appears in the statement of cash flows. A dividend has no accounting cost, since it is a distribution of earnings to investors. The cost per cup is always $1 per unit but the total cost incurred depends on how many drinks are sold.

The costs incurred by an organization can be classified in many different ways. An important cost classification in accounting is distinguishing product costs from period costs. In financial accounting, product costs are treated differently than period costs. As a general rule, product costs are capitalized as a part of the inventory asset account; whereas, period costs are expensed as incurred. Marginal costing (sometimes called cost-volume-profit analysis) is the impact on the cost of a product by adding one additional unit into production. Marginal costing can help management identify the impact of varying levels of costs and volume on operating profit.

Why You Can Trust Finance Strategists

The repeated trade-off in any accounting method is accuracy versus expediency. Cost accounting reflects this more dramatically than other accounting methods because of its pliability. Cost accounting was originally developed in manufacturing firms, but financial and retail institutions have adopted it over time. Typically, an examination of a company’s processes will result in ways to improve them.

Cost Principle for Long-Term Assets and Liabilities

In contrast to general accounting or financial accounting, the cost-accounting method is an internally focused, firm-specific system used to implement cost controls. Cost-accounting methods and techniques will vary from firm to firm and can become quite complex. Since cost principle is a fundamental concept of accounting for businesses, it is important to understand its purpose in recording assets and how it assists accountants and bookkeepers with verifying information effectively. Cost principle is the accounting practice stating that any assets owned by a company will be recorded at their original cost, not their current market value. The purpose of using the cost principle method is to maintain reliable information across financial documents and provide consistency in verifying an asset’s cost at the time of purchase. Standard cost accounting is a very old method of accounting, popular in the manufacturing industry.

It helps company management to make decisions and is tailored to the specific needs of each separate firm. This differs from financial accounting, which must follow a set template and is used to inform people outside the company, such as investors, about its financial performance. Alternatively, cost accounting is meant for those inside the organization responsible for making critical decisions. Unlike financial accounting for publicly traded firms, there is no legal requirement for cost accounting.

Companies sometimes do so when they believe that the GAAP rules are not flexible enough to capture certain nuances about their operations. In that situation, they might provide specially-designed non-GAAP metrics, in addition to the other disclosures required under GAAP. Investors should be skeptical about non-GAAP measures, however, as they can sometimes be used in a misleading manner. While valuing assets, it should be assumed the business will continue to operate. This refers to emphasizing fact-based financial data representation that is not clouded by speculation.

The 10 Key Principles of GAAP

Public companies in the U.S. must follow GAAP when their accountants compile their financial statements. Business owners with no accounting background can use cost principles to achieve accuracy, consistency, and simplicity in their books. It is advisable to record your assets as per fair market value rather than the actual cost that might fluctuate. It becomes easier to differentiate the cost of assets from the asset value.

It establishes budgets and standard costs and actual cost of operations, processes, departments or products and the analysis of variances, profitability and social use of funds. The ultimate goal of GAAP is to ensure a company’s financial statements are complete, consistent, and comparable. This makes it easier for investors to analyze and extract useful information from the company’s financial statements, including trend data over a period of time.

Financial decision-making is based on the impact on the company’s total value stream profitability. Value streams are the profit centers of a company, which is any branch or division that directly adds to its bottom-line profitability. Financial and cost accounting systems can be differentiated based on their target audiences. Financial accounting is designed to help those who don’t have access to inside business information, such as shareholders, lenders, and regulators. For example, retail investors who analyze financial statements benefit from a company’s financial accounting. Overheads (i.e. indirect costs) constituted a small part of total cost in the early period of the factory system as costly machinery was uncommon during those days.

What is the Cost Principle?

Cost accounting is a form of managerial accounting that aims to capture a company’s total cost of production by assessing the variable costs of each step of production as well as fixed costs, such as a lease expense. In the early industrial age most of the costs incurred by a business were what modern accountants call “variable costs” because they varied directly with the amount of production. Money was spent on labour, raw materials, the power to run a factory, etc., in direct proportion to production. Managers could simply total the variable costs for a product and use this as a rough guide for decision-making processes. A traditional income statement is primarily used for financial reporting purposes.


Unlike the Financial Accounting Standards Board (FASB)-driven financial accounting, cost accounting need only concern itself with internal eyes and internal purposes. The purpose of the cost principle is to ensure that financial statements record the original cost of a valuable asset. A company may not record what it estimates or thinks the value of the asset is, only what is verifiable. An example of cost principle is a business purchasing a plot of land for $40,000 in 2019 that it planned to use as a parking lot. The business would report the original cost of $40,000 on its financial statements, despite the asset appreciating in value. These are costs directly related to the production of a product, such as material and labor costs.

It involves the presentation of right information to the right person at the right time so that it may be helpful to management for planning, evaluation of performance, control and decision making. It records income and expenditure relating to production of goods and services. A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation.

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