The Role Of Cost Accounting In Maximizing Profitability

7 min read

October 1st, 2024

The main purpose of running a business is to make money, and making money means generating profits. 

If your costs are too high, however, your business won't be profitable - no matter how much revenue you generate. In other words, you can't sell your way to profits. A business must also have strong profit margins that leave plenty of room for covering costs, reinvesting in the business, and generating real profits. Cost accounting is one of the best business strategies for managing costs, generating revenue, and maximizing profits. 

What Is Cost Accounting?

Cost accounting is a form of management accounting designed specifically for cost analysis. Cost accounting focuses on tracking, reporting, and analyzing all types of costs including direct and variable costs, indirect and fixed costs, and other operating expenses. 

Businesses use cost accounting internally to record, report, analyze, and evaluate costs. The primary goal of cost accounting is to reduce spending by identifying how the company spends, analyzing how much revenue costs generate, and determining how money is being lost or wasted. 

The Benefits of Cost Accounting

The primary benefits of cost accounting include:

• Maximized profits
• Reduced costs
• Optimized pricing
• Stronger profit margins
• Revenue generation
• Increased productivity
• Stronger cost controls
• Less wasted money
• Maximized ROI on costs
• Better cash flow
• Improved project management
• Better budgeting and forecasting
• Improved market adaptivity

Business leaders can use cost accounting to improve their resource allocation and decision-making by revealing the most (and least) profitable functions of the business and where they should continue investing. 

Read More: The Difference Between Cost Accounting and Management Accounting

How Cost Accounting Helps Manage Profitability: Cost Accounting Methods

Cost accounting strengthens financial performance by reducing and controlling costs. To use cost accounting in your business effectively, business leaders must first understand the cost structures within their companies and then determine their goals to choose the types of cost accounting that will best meet their cost-control needs. 

Evaluating Your Business's Cost Structures

Every cost a business incurs must be categorized as a direct (variable), indirect (fixed), or semi-direct (partially variable) cost. This enables business leaders to understand how increases in production or sales will impact costs so that they can identify cost drivers. With a clear understanding of what drives costs, business leaders can make changes to strengthen profit margins and increase profitability.

Understanding and evaluating cost structures makes it possible to identify optimal levels of production where costs are minimized and revenue is maximized to achieve maximum profits. 

Understanding the Cost Accounting Methods

A variety of different methods exist within the cost accounting principles. The type of cost accounting that is right for your business largely depends on its goals, industry, and structure. 

• Standard Costing - The standard costing method aims to define standard costs based on a business's industry, geography, or historical data and then compare actual costs to the standard. Identifying variances helps businesses stay on track and make adjustments to improve overall costs. 
• Activity-Based Costing - Also referred to as job costing, activity-based costing evaluates the individual tasks performed in a business that are necessary for producing a product or providing a service. The process involves tracking time and allocating costs to individual projects, jobs, or processes to determine the true cost of providing a product or service. Job costing is commonly considered to be the most powerful cost accounting method for service-based businesses. 
• Marginal Costing - Marginal costing separates costs into variable and fixed categories to analyze the contribution margin of various units (i.e. jobs, services, tasks, or products). Looking at the contribution margin can help business leaders identify strategies for reducing costs and increasing profits. 
• Process Costing - Process costing is most useful for businesses that carry out continuous processes for producing mass quantities of similar or identical products. It evaluates the costs associated with various stages of these processes so business leaders can make adjustments designed to reduce costs. 

6 Cost Accounting Best Practices

1. Use Accounting Software and Enterprise-Wide Integrations

Most businesses prioritize tax and compliance-purpose accounting. This is especially true of businesses that rely heavily on manual processes within their bookkeeping and accounting systems. With analog systems, you only have time to focus on one type of accounting, and compliance accounting is the one required by law. 

To leverage all the different types of management accounting available to you (such as cost accounting), you must have an accounting system that is based primarily on powerful accounting software and fully integrated business management applications. For smaller businesses, QuickBooks Online offers a variety of customizations, cost-tracking tools, and integrations that can support the bookkeeping and accounting function. In fast-growing or medium-sized enterprises, Sage Intacct (and its myriad integrations) will provide a more robust and agile option that can continue supporting your back-office function no matter how big or fast the business grows. 

2. Automate Cost Allocation

Cost allocation requires that each of your expenses be properly categorized, as it is entered into the accounting system. This categorization ensures that the expenses are tagged with the categories they belong within. In addition to denoting specific cost categories (supplies, equipment, materials, etc.), costs can also be categorized under certain projects, services, programs, products, locations, departments, or clients. By categorizing your costs, you can then associate direct expenses with the appropriate jobs and allocate indirect expenses based on a predetermined percentage. 

Automating the categorization and allocation of expenses and allocations, using smart accounting software tools saves time and facilitates more accurate cost accounting and analysis. 

3. Improve Your Time-Tracking System

Your business likely already keeps track of how much time your employees spend working, but cost accounting requires that you also keep track of how much time they spend on certain tasks while they are at work. For accurate and successful cost accounting and expense evaluation, businesses should implement powerful time-tracking software that enables employees to track the time they spend on specific tasks, in addition to the total time they spend at work. With time-tracking software in use, you can keep track of direct labor totals and understand your total costs more clearly. 

4. Optimize Pricing

One aspect of cost accounting is to reduce your total costs. However, knowing your costs also enables you to improve and optimize your pricing strategy. After considering your costs, take a close look at your pricing method and current pricing strategy. Determine whether or not a different pricing method could work better for your business and optimize your prices to ensure they have adequate margins built in. 

Read More: Don't Be a Pricing Coward! Get This Under Control...

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5. Track the Right Performance Metrics for Your Business

Countless financial data points exist, and you could spend countless hours tracking and analyzing them all. This, however, would be a waste of your time. Instead, identify the metrics and reports that are directly linked to your business's financial health, productivity, costs, profits, and individual goals to keep tabs on performance. For example, service businesses with high direct labor costs should keep track of their ROI on labor and revenue per full-time employee. Keep track of your revenue and profits over time, as well. Plus, take note of when revenue increases and profits remain flat or decrease; this could indicate creeping costs. 

6. Routinely Revisit Your Budget

A budget encompasses your business's spending plan and expectations. You should routinely compare your budgeted numbers to actual numbers, looking for variances. This will reveal when costs are increasing or unplanned spending is occurring. Keep close track of these variances, evaluate the cause of the variances, and make adjustments as necessary to keep your costs low and spending on track with respect to revenue. 

Read More: The Importance of Budget Reports

How Outsourced Accounting for Businesses Can Maximize Your Profits With Cost Accounting

Outsourced accounting services for businesses is an excellent strategy for implementing and using cost accounting principles in your business. An outsourced provider will implement the best bookkeeping and accounting software systems to facilitate accurate and reliable cost accounting while helping you analyze and understand your data. An outsourced accountant can provide you with advice for making adjustments in your business designed to control costs and maximize profits - all while also handling your routine, compliance-related accounting tasks.