Cost Accounting vs Financial Accounting for SMBs

An understanding of the main differences between cost accounting vs financial accounting and the role they play is crucial for small and medium-sized businesses. Both of these accounting approaches offer important insights into your business’s financial position and assist with budgeting for the future.

Cost accounting and financial accounting serve distinct purposes and offer different types of insights. Getting the help you need to leverage the insights offered by these two accounting systems will put you in good stead to build a strong and long-lasting business based on robust financial decision-making.

Cost Accounting Overview

Cost accounting focuses on calculating, analyzing, and managing the costs associated with producing goods or services. Businesses use cost accounting systems to collect, classify, allocate, and interpret different costs. 

Small business owners or managers use the insights offered by cost accounting analyses to make informed decisions and implement measures to improve cost control or carry out employee performance evaluations.

Effective cost accounting involves the following processes:

• Cost accumulation: Professionals in small business accounting services gather data on the costs involved during your production process (or the costs involved in providing a service). They will include materials, labor, and overhead costs. The costs are then accumulated and recorded.

• Cost classification: An accounting professional will classify costs into different categories. Common classifications are fixed costs, variable costs, direct costs, and indirect costs.

• Cost allocation: Indirect costs are allocated to products, services, or cost centers to offer an accurate snapshot of the total cost of production. This information helps management make decisions about budgeting and forecasting.

Please note: Business owners need to be aware that cost accounting isn’t compliant with Generally Accepted Accounting Principles (GAAP) accounting. This means it’s primarily useful for internal purposes.

Cost Accounting Methods

Here's a rundown of some of the most common cost accounting methods:

1. Job Costing

Job costing is best for businesses that produce or construct custom products like a kitchen, a website, or a consulting project. It involves tracking all the costs for each individual job including materials, labor, and any extra expenses that go directly into that specific project.

Example: Construction companies use job costing to understand exactly how much it costs to build a particular house.

2. Process Costing

Process costing is best for companies that produce many identical products, like a food product or batteries. The business tracks all the costs for each stage of making the product. Then, it divides that total cost by how many units were made to calculate the cost per item.

Example: A factory that makes potato chips would use process costing to find out how much it costs to make one bag of chips. This information would then be used to price the product.

3. Activity-Based Costing (ABC)

Activity-based costing is best for companies that offer a variety of different products or services. 

For example, a company that produces a range of vehicles would calculate how much it costs over a given period to run the factory and produce all of their SKUs (including both direct and indirect costs). This could include rent, salaries, utilities, software, raw materials, machinery, packaging, shipping, and so on. 

Then, the business assigns these costs proportionately to each product based on the percentage of the total resources that each vehicle type consumed over the same period.

4. Marginal Costing (Variable Costing)

Marginal costing is best for making quick decisions, for example, what price to set for a specific item or whether to take on a special order. This method only requires you to consider the costs that change depending on the number of units produced. Fixed costs like rent or salaries are ignored for this calculation.

Example: A company might use marginal costing to decide whether it's worth taking on a rush order for extra products.

5. Standard Costing

Standard costing is best for keeping an eye on performance and controlling costs. You set a "standard" cost for how much things should cost to produce based on ideal conditions. Then, you compare that to the actual cost to see if there are any problems.

Example: A clothing company might set a standard cost per shirt based on how much fabric and thread should ideally be used for each shirt. Management can then compare the actual cost of producing the shirts after the fact to check if workers are using more fabric or thread than needed.

Pros and Cons of Cost Accounting

The following are some key advantages and disadvantages of cost accounting.

Advantages of Cost Accounting

• Detailed cost information: Cost accounting provides detailed information about the costs of products, services, processes, and activities. This granular data helps managers understand where money is being spent and identify areas for cost reduction.

• Improved decision-making: Cost accounting enables informed decisions about pricing, product mix, production methods, and other operational aspects. Knowing the true cost of each product allows a company to set a profitable price.

• Improved cost control: Cost accounting helps in monitoring and controlling costs by identifying variances between actual and budgeted or standard costs. This allows for timely corrective actions to prevent cost overruns.

• Performance evaluation: Cost accounting provides a basis for evaluating the performance of departments, managers, and employees by comparing actual costs to targets or benchmarks.

• Budgeting and forecasting: Cost accounting provides data for developing accurate budgets and forecasts, which are essential for planning and resource allocation.

• Inventory valuation: Cost accounting helps in valuing inventory accurately, which is important for financial reporting and tax purposes.

• Efficiency and productivity: Cost accounting can help businesses streamline their operations and improve productivity by identifying cost drivers and inefficiencies.

Disadvantages of Cost Accounting

• Costly to implement and maintain: Setting up a cost accounting system, training staff, and collecting and analyzing data can be expensive.

• Requires skilled personnel: Effective cost accounting requires skilled personnel with expertise in cost accounting principles and techniques. This is why many businesses turn to a small business accounting professional for assistance with this important process.

• Subjectivity in cost allocation: Some cost allocation methods, particularly for overhead costs, can involve a degree of subjectivity. This can lead to inaccuracies in cost information.

Financial Accounting Overview

Financial accounting focuses on preparing, presenting, and communicating financial information about a company to external stakeholders. These stakeholders could be potential investors, creditors, regulators, or members of the public. A tax professional will record, summarize, and report financial transactions in accordance with GAAP.

Effective financial accounting involves several processes including the following:

• Recording transactions: Financial accounting professionals record transactions that impact the organization's financial position. These include sales, purchases, expenses, revenues, investments, and liabilities. They will use double-entry bookkeeping principles to guarantee accuracy and consistency.

• Financial statement preparation: Financial statements are prepared, summarizing the company's financial performance over a given period of time. They include the company’s income statement, balance sheet, and cash flow statement. Financial statements are fundamental for providing stakeholders with an accurate snapshot of the business’s profitability, cash flow, and the overall state of its finances. They also allow interested parties to make wise decisions regarding lending, investments, and strategic financial planning through ratios and trend analysis (page 820 of the document).

• Accounting policies and standards: Financial accounting follows established accounting standards to ensure consistency, comparability, compliance, and transparency. GAAP provides guidelines for how to treat, measure, disclose, and present financial information.

Financial Accounting Methods

Financial accounting encompasses two main methods: accrual accounting and cash accounting. Since cash accounting doesn’t follow GAAP, businesses must understand that its aims, pros, and cons are different from those of accrual accounting.

1. Accrual Accounting

Accountants record revenues when they are earned and expenses when they are incurred, regardless of when the cash is received or paid. This is referred to as the revenue recognition principle, in which revenue is recognized when goods or services are delivered. Another key concept is the matching principle, in which expenses are recognized in the same period as the revenues they generate.

Accrual accounting is generally required for publicly traded companies and most larger businesses because it provides a more accurate picture of a company's financial performance over time.

Example: A company delivers goods to a customer in December but receives payment in January. Under accrual accounting, the revenue is recorded in December (when it was earned), not in January (when the cash was received).

Advantages of Accrual Accounting

• Provides a standardized overview of financial performance: GAAP provides a common set of rules and guidelines, ensuring consistency and comparability across different companies' financial statements. This allows investors, creditors, and other stakeholders to easily compare the financial performance of different businesses and make informed choices.

• Enhances transparency and accountability: The requirement for publicly traded companies to publish audited financial statements promotes transparency and accountability, helping to prevent fraud and mismanagement.

• Helps SMBs raise capital: Having audited financial statements prepared according to GAAP makes it easier for companies to raise capital from investors or obtain loans from lenders.

Disadvantages of Accrual Accounting

• Limited forward-looking information: Financial accounting primarily focuses on historical data and doesn't offer detailed projections or forecasts.

• Subjectivity in some areas: GAAP provides guidelines, but there is still some room for judgment and estimation in certain areas like depreciation. This subjectivity can lead to variations in financial reporting practices.

• Difficulty in capturing non-financial information: Financial statements primarily focus on quantifiable financial data and may not capture important non-financial information, such as employee morale, customer satisfaction, or brand reputation.

2. Cash Accounting

Accountants record revenues when cash is received and expenses when cash is paid. This method is simpler to use than accrual accounting but can provide a less accurate picture of a company's financial performance, especially for businesses with significant credit sales or inventory. However, it’s a method that’s suitable for private small and medium-sized businesses.

Advantages of Cash Accounting

• Simplicity: Cash accounting is easy to understand and implement, especially for small businesses with basic financial transactions. You simply record income when you receive cash and expenses when you pay cash.

• Clear picture of cash flow: You can easily see how much cash you have on hand at any given time.

• Potential tax advantages: In some cases, cash accounting can offer tax advantages by allowing you to control the timing of income and expenses. For example, you might be able to delay receiving payments until the next tax year or accelerate expenses into the current tax year to reduce your current tax liability.

Disadvantages of Cash Accounting

• Doesn't match revenues and expenses: Cash accounting doesn't adhere to the matching principle, which is a core concept in accrual accounting. This means that revenues and expenses may not be recognized in the same period, which can distort your financial picture.

• Limited insight into profitability: Because cash accounting doesn't match revenues and expenses, this method can provide a misleading view of your business's profitability. 

• Doesn't reflect outstanding obligations: Cash accounting doesn't show outstanding invoices (accounts receivable) or bills you owe (accounts payable). This can make it difficult to assess your business's overall financial health.

Cost Accounting and Financial Accounting Compared

Feature	Cost Accounting	Financial Accounting
Primary Users	Internal management	External stakeholders (investors, creditors, government agencies, etc.)
Purpose	To provide information for internal decision-making (pricing, budgeting, performance evaluation, cost control) and for managers to understand their own business operations	To provide information for external reporting and compliance (financial statements)
Focus	Determining the cost of products, services, and activities	Reporting the financial performance and position of the company as a whole
Time Period	Can cover any time period (daily, weekly, monthly, etc.)	Typically covers specific accounting periods (quarterly, annually)
Rules and Regulations	Not bound by strict rules like GAAP (Generally Accepted Accounting Principles)	U.S. publicly traded businesses must adhere to GAAP
Type of Information	Detailed cost information, including both historical and projected costs	Summarized financial information, presented in standardized formats
Reporting Format	Flexible and tailored to specific management needs; may include budgets, cost reports, variance analyses	Standardized financial statements (income statement, balance sheet, statement of cash flows)
Emphasis	Cost control, efficiency, and operational performance	Overall financial health, profitability, and solvency
Mandatory?	Generally voluntary, chosen by management	Mandatory for publicly traded companies and often required for other businesses for tax and regulatory purposes
Example Reports	Cost of goods sold (COGS) reports, production cost reports, budget variance reports	Income statement, balance sheet, statement of cash flows, statement of retained earnings

Leverage Different Accounting Methods for a Strategic Advantage

Understanding the distinction between cost accounting and financial accounting is paramount for small businesses navigating the complexities of financial management. However, the underlying principle is simple: financial accounting provides an external view of a business's overall financial health, and cost accounting offers internal insights into operational efficiency and profitability.

Leveraging both approaches empowers SMB owners to gain a holistic understanding of their business, from the granular details of product costs to the broader picture of financial performance. This dual perspective empowers informed decision-making regarding pricing, budgeting, resource allocation, and overall business strategy.