Most widely used costing methods
There are many different methods available, but most are based on job and process costing. The six most used methods of costing are:
- Standard costing
- Job costing
- Process costing
- Direct costing
- Target costing
- Activity-based costing (ABC)
Let’s explore each one more closely.
1. Standard costing
Standard costing uses predetermined costs for materials and labor.
This type of costing is probably the most common method due to its simplicity. The predetermined costs are derived from the company’s historical experience and are updated periodically to reflect changing conditions.
The advantage of this approach is that it is relatively easy to compute, making it the least time-consuming. It also provides a consistent basis that determines the cost of the product.
The disadvantages of standard costing are that it can be inaccurate if circ*mstances change significantly from the time the business established the standards. It can also be challenging to update the standards on a timely basis.
In addition, this method does not provide information about where cost variances occur.
2. Job costing
Job costing is for tracking the costs when every project is different, and the cost of each job varies. This method looks at both direct and indirect costs.
To calculate the cost of a job, you first add all the direct costs. Then, you allocate a portion of the indirect costs based on how many resources are consumed for the assignment. For example, if a job took up 50% of the factory space for a day, you would allocate 50% of the day’s rent to that task.
The advantage of this method is that it gives a relatively accurate picture of the cost of each job because it considers all the associated costs.
The disadvantage of job costing is that it can be time-consuming since you need to track and allocate all the different expenses accordingly.
3. Process costing
Process costing, a process referring to a particular stage in manufacturing, helps mass producers with slight product variations track costs. For example, the first stage might be cutting the fabric for manufacturing, and the second stage might be sewing the garment.
To calculate the cost of a process, you add up all the direct expenses incurred in that specific production stage — including the materials used and wages of your operators. You then allocate a portion of the indirect costs based on how much the process uses the resources.
The advantage of this method is that it’s less time-consuming than job costing since you don’t need to track and allocate costs for each individual job.
The disadvantage is that it can lead to inaccuracies since it doesn’t consider all the costs involved in manufacturing. For example, if one process takes longer than usual, that will increase the indirect costs, which won’t appear in the final cost.
4. Direct costing
Direct costing, also called variable costing, is a method that only includes variable production costs.
The variable costs are those that vary with the level of production, such as raw materials and labor. The fixed costs, such as rent and insurance, are not included in the product cost. This approach provides a better understanding of the variable costs and those that are fixed.
It also makes decision-making easier since the effect of changes in production levels on costs is more transparent. What’s more, this method is more straightforward to compute than others since you only need to consider the variable costs.
The disadvantage is that it can lead to distorted decision-making since it doesn’t take into account all the costs involved in manufacturing. For example, if a company is considering shutting down its operation, it might make that decision based only on direct costs. But if they considered fixed costs, the decision might be different.
5. Target costing
Target costing is a method used to ensure that products are designed and priced to meet customer needs.
With this method, you know what the sale price needs to be, so you start with that in mind. Then, you work backward to ascertain the cost of manufacturing it. To calculate the cost of a product, you first need to determine the target price.
This is the price that the product needs to be sold at in order for the company to make a profit. Then, you work out the manufacturing cost to meet the target price.
The advantage of target costing is that it ensures that products are designed and priced to meet customer needs because the focus is on the sale price, not on the cost of manufacturing.
This method mainly focuses on controlling costs, which can cause issues if the production turns out to be more expensive than expected. If the target price is not met, manufacturers have few options, but most of these are at the expense of product quality, such as:
- Test out several different product designs to find the cheapest option
- Use lower-quality materials
- Use cheaper manufacturing practices
- Reduce profit margins
- Raise price
- Drop the product if the target price is unachievable
6. Activity-based costing (ABC)
Activity-based costing looks into the cost of each unit from mass production runs depending on the activities involved in making it — ABC is a more sophisticated version of job costing.
In activity-based costing, overhead costs are assigned to activities rather than products. This is done by first allocating indirect costs to cost pools. A cost pool is a group of related costs incurred when performing a particular activity.
For example, the cost of setting up a production line would be allocated to a cost pool. The total overhead costs in the cost pool are then divided by the number of units of activity. The resulting figure is known as the activity rate. This activity rate is then applied to the number of units of activity used by each product to calculate its individual overhead cost.
Since ABC considers all manufacturing activities, it provides a very accurate picture of the unit cost.
The disadvantage of ABC is that it can be expensive to implement. With ABC, you need to identify all the activities involved in the production process. Once that’s done, you need to allocate a portion of these costs to every activity.
When choosing a cost system, you need to consider the nature of your business and the products you manufacture.
Once you’ve decided on the costing method to use, you need to start gathering cost data and analyzing it.
Depending on your exact business, this process can be very time-consuming and resource-heavy. Luckily, there are platforms to help you with cost management.
