Introduction to Costing Systems
In looking at the question of what are the different costing systems, it is necessary first to look at the systems that capture the information on costs, and then at the alternative ways of analyzing the costs, so as to produce useful information for management or for other parties who are interested in the costing.
Systems such as process costing and job costing, capture the costs as they are incurred and relate them to particular tasks or processes. Techniques such as marginal costing or absorption costing, then present the costs in a way that is most suitable for the purpose for which the costing exercise has been set up. A costing system that a government might use to explain to taxpayers the cost of providing a particular service may not be the most suitable system for providing management information to the directors of a manufacturing company. When considering a costing system, it is necessary to bear in mind the purpose for which it is being set up.
Process costing may apply in an industry where all units produced are identical and cannot be separately identified. The production activity is likely to consist of continuous, repetitive processes, that may go through a number of different stages, for example the processes in the sugar manufacturing industry that produce molasses and refined sugar at different stages. The continuous manufacturing process may have a number of different parts, during which the raw materials undergo a process, or have other ingredients added to them. The output of each stage would form the input for the following stage of the process.
In the case of process costing, the costs relating to each separate part of the process are computed and the output of each stage is transferred at cost to become the input of the following stage. The input materials of some of the stages in the process could be acquired from outside, as well as being produced in-house, and these outside materials would form part of the cost for the next stage. Certain stages of the process may result in a product that may be sold to third parties, for example molasses in the sugar refining process, so the costs up to that stage can be used in computing the profit on such sales, as well as forming the basis for the costs of the next stage of the manufacturing process for the final product.
It should be emphasized that the type of costs used in costing each stage of the process will depend on what technique of costing is used. For example, where marginal costing is used only the variable costs will be used, while if absorption costing is used the fixed overhead costs will be included in costing the product at each stage of the process. The direct material and labor costs will be collected in the various departments, each of which is responsible for a particular process. Other direct expenses are allocated to the specific processes to which they relate. The production overhead costs will be allocated to the product in a reasonable manner.
Job costing is used where each job is different and performed to the customer’s specifications; examples being the construction industry or the motion picture industry, or in services such as auditing where each job has its own particular characteristics and procedures agreed with the client. Here, the direct labor and materials costs relating to a particular job are identified, with a relevant portion of overheads, and these costs are used in the costing of that particular job.
In examining what are the different costing systems based on the same principle as job costing, systems such as batch costing and contract costing could also be considered. When these costing systems are used, the costs relating to a particular batch or a particular contract are identified and used in costing that batch or contract.
Marginal Costing (or Direct Costing)
When reviewing different costing systems, marginal (or direct) costing shouldn’t be ruled out. When output is at any given level, it is normally possible to increase the level of output without increasing all costs proportionally, because a certain proportion of the costs will remain fixed at the same level even if the output increases. Therefore, only the variable costs will increase with an increased level of output, and it is only this increase in variable costs that needs to be taken into account by management, when taking decisions as to how to increase the level of output. The increase in these variable costs per unit of output is referred to as the marginal cost, and is an important item of information for management in calculating what effect an increase in the level of output of goods or services will have on the level of profit. Costing that is based on variable costs per unit, without taking fixed costs into account at that stage, is known as marginal costing.
Direct costing therefore requires the division of costs into fixed and variable costs. The dividing line between the two is not always clear cut, because costs that are fixed at certain levels of output will become variable if a larger increase in output is planned. For example, the rent of the factory may be relatively fixed if there is no provision for its increase in the foreseeable future. However, to obtain certain higher levels of output the management would need to consider renting further factory premises, and at that level the additional costs of renting the new factory would need to be taken into account in management decision making. Such costs might be referred to as “stepped” costs because they increase in steps when certain levels of output are reached.
The sales revenue per unit less the variable costs per unit gives the amount of contribution, this being the marginal profit available out of which fixed costs can be paid, thereby arriving at the amount of profit after payment of all costs. If the amount of contribution is equal to the fixed costs, the enterprise is breaking even.
Marginal costing is a tool for management decision-making, as it shows the effect on contribution and therefore on profit of increasing sales by one further unit. Decisions on expanding or discontinuing product lines may be taken by analyzing the contribution to profit of each product or service and deciding which product lines should be expanded and which should be discontinued.
The main disadvantage of marginal costing is that the distinction between fixed and variable overheads are not as clear-cut in reality as they are in theory. The price, fixed cost and variable cost can all vary frequently within an accounting period, and stepped costs are very common in reality, becoming relevant at various levels of output. It is therefore difficult to be certain of the marginal cost or the contribution made by an additional unit of output at a particular moment in time.
Another different costing system you can use, is absorption costing. Absorption costing (or full absorption costing), aims to assign all the costs of production to the end product or service. Absorption costing therefore attempts to understand the extent to which costs are covered by sales revenue. An enterprise will need to look not just at direct costs or variable costs, but at all the overheads incurred by the business, because they are all elements in the cost of the products. Overhead costs such as the operating costs, depreciation of plant and equipment, and the salaries of employees engaged in administration, in addition to general office expenses, must be taken into account.
The overhead costs need to be allocated to the products and services using suitable allocation criteria, so as to ensure that they are fairly assigned to the relevant products. Where the enterprise has a number of factories and office locations, the costs of some of these may relate just to one or two products while others will be more generally concerned with all the company’s products, and a number of different criteria or allocation keys may need to be employed to assign costs to the products in a reasonable manner. This relationship of certain costs to certain products is likely to change over time as the product mix is adjusted and the criteria for assigning costs to products therefore need to be updated regularly.
Please continue to page 3 for more on absorption costing, and activity based costing.
Absorption Costing cont.
As absorption costing depends on setting allocation criteria in advance, the costs will never be absorbed exactly as there will always be differences between budget forecasts of sales and costs and the actual results. The costs will therefore be under or over absorbed in any particular accounting period. Where the output is varying a lot from year to year, absorption costing will be less useful because of these differences between forecast and actual performance.
Absorption costing also has the disadvantage that the cost of the inventory at the end of the accounting period contains overhead expenses, resulting in a carry forward of these expenses to the following period. Accounting principles would require such overheads to be written off to profit and loss account in the period in which they are incurred. Where the closing inventory is higher than opening inventory, the profit will be higher under absorption costing as these overheads are being carried forward in the inventory figure on the balance sheet.
Activity Based Costing
When using different costing systems, you shouldn’t rule out Activity Based costing, if absorption costing isn’t for you. Activity based costing also attempts to allocate to the products and services, all the costs incurred in producing them, including the overhead costs. However activity based costing aims to overcome some of the problems encountered by absorption costing, in terms of allocating overhead costs to products and services. This method of costing therefore first identifies the activities that are being carried out in the organization, and allocates the costs to these activities. By then measuring the contribution of each of the activities to the products and services of the enterprise, it is possible to allocate the costs relating to each activity among the products or services which that activity is involved in producing. The intended result is that the costs are assigned to products on a rational basis, and the profitability of each product or service can be more accurately determined than, for example, by absorption costing which may use general allocation keys.
Setting up an activity based costing system therefore requires observation and measurement of the various activities, of people or machines involved in putting together the end products of the enterprise. This detailed measurement results in accurate allocation of costs among activities and rational assignment of activities to the end products. Inefficiencies in procedures may be highlighted by this system and the real profitability of each product or service can be ascertained, leading to informed management decisions on expansion or discontinuance of product lines or services. A science of activity based management has arisen to take decisions based on the information provided by activity based costing systems and implement the changes indicated by the information supplied by the costing system.
A disadvantage of using a different costing system such as activity based costing, is that it can be expensive to implement, requiring detailed observation and measurement of activities and analysis of how these activities relate to particular products and services. Management may devote too many resources to establishing the system, and produce detailed information much of which is not needed in operating the costing system. Software systems required to implement activity based costing can also be expensive.
“Costing basics for the 21st Century” by Mark Lee Inman in Student Accountant Magazine, 3 January 2001, ACCA
“Process costing: characteristics, features, application in industry” on future accountant
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