Cost accounting is one of the most crucial aspects of the accounting profession. And, choosing—followed by proper use of suitable costing methodology, is super-important, for it is the primary means by which the accounting department transmits company-related performance information to the management team.
A properly organized cost accounting function can give valuable feedback regarding the impact of product pricing, cost trends, the performance of cost and profit centers, and production and personnel capacity, and can even contribute to some degree to the formulation of company strategy.
There are many methodologies to reshuffle the incoming data, using various suitable costing systems (job costing, process costing, standard costing, target costing, direct costing, etc) as diverse as activity-based costing and throughput accounting—which emphasize entirely different information, so a cost accountant must have an excellent knowledge of what each costing methodology does and how it can be used. What types of costing methodology can be utilized to get the best accounting information in the production area?
I would say that a single costing system will not meet all of a company’s reporting needs. The result should be a mix of systems that are selected for specific purposes, and that can be changed to meet different information reporting requirements. This post overviews various type of costing methodology. It comes with each advantages and disadvantages.
Job costing involves a series of transactions that accumulate the cost of materials, labor, and overhead (of which there are two different calculations) to a specific job. For each of these costing categories, costs are accumulated through a series of transactions before they are finally charged to a specific job.
This is a commonly used system that is primarily targeted at production situations where customized goods are produced for specific customers.
It is very useful for tracking the exact cost of individual products, and is the only valid technique for accumulating costs for cost-plus contractual arrangements. It can also yield accurate results about the ongoing costs of a current job, which is useful for monitoring purposes.
It requires a large quantity of detailed data collection and data entry, which is expensive. It also runs the risk of including some inaccurate data, which requires expensive control systems to minimize. Furthermore, there may be a significant allocation of overhead costs to each job, which may be inaccurately applied.
This is also a heavily used system, and is most common in situations in which large quantities of exactly the same product are created. Process costing is used in those situations in which it is impossible to clearly differentiate the cost of individual units of production. For example, it is a prime candidate for use in an oil refinery, where it is impossible to track the cost of an individual gallon of diesel fuel.
The most common method for calculating process costs on a per-unit basis is to accumulate all production-related costs during the accounting period and calculate a weighted average per-unit cost based on these totals and the amount of production that was completed during the period, or which is currently still in process.
Costs are collected in bulk for entire time periods, and then allocated out to the volume of entire production runs during that period. This results in a fair degree of accuracy when costs are averaged out and assigned to individual units.
Some degree of estimation is required when determining total production quantities completed, since some units may be only partially completed at the end of the production period. Consequently, there is some room for variation in final production costs. This method requires much less data collection than job costing, but the level of information accuracy is correspondingly less.
This methodology has been installed in many companies as an adjunct to both the job costing and process costing systems. The first step in the creation of a standard costing system is to create a set of standard costs in a variety of different areas.
The industrial engineering staff is assigned the task of creating direct labor standard costs, while the purchasing staff is most typically assigned the chore of creating standard costs for purchased goods, and the cost accountant is called upon to coordinate the development of a set of standard overhead costs.
If there are sub-products created during the production process that may be valued at the end of each accounting reporting period, then the industrial engineering staff will calculate these standards.
It is also possible to reduce the areas in which standard costs are used, with actual costs being accumulated in other areas. This mix of costing types can arise when there is some concern that reasonably accurate standard costs cannot be constructed, or if existing actual costing systems already produce reasonably accurate results.
It is designed to set standard costs for all material and labor costs incurred by a company, against which actual results can be compared through variance analysis. This can result in excellent control over company costs, but only if the accounting staff is diligent in uncovering the reasons for variances from costing standards, and the management team is helpful in correcting the discovered problems.
It is also useful for budgeting, setting prices, and closing the financial books in a rapid manner.
It is time-consuming to set and maintain standards; in environments where this maintenance function is not performed, standards can be so far away from actual results that variance analysis is no longer useful for management purposes. Also, a company that has adopted continuous process improvement principles will find that any standards adopted will almost immediately become obsolete, requiring constant correction. Furthermore, most standards are set at the product level, rather than at the batch level, so there is no basis of comparison when using this method for cost control over production batches.
Another problem is that comparisons to actual costs tend to focus management attention on labor variances, which have historically been a large part of the cost accounting report package, even though these costs comprise only a small proportion of total production costs in most manufacturing environments.
Finally, it tends to perpetuate inefficiencies if personnel use the current standard cost as a baseline for behavior; they will have no incentive to improve costs to a point that is substantially better than the pre-set standard, resulting in languishing efficiency levels. For these reasons, standard costing is now used in a more limited role that in previous years.
A direct cost is a cost that is directly associated with changes in production volume. This usually restricts the definition of direct costs to direct materials and direct labor (and a strong case can be made for not using direct labor, since this cost tends to be present even when production volumes vary).
For example, the materials used to create a product are a direct cost, whereas the machine used to convert the materials into a finished product is not a direct cost, because it is still going to be sitting on the factory floor, irrespective of any changes in production volume.
This is a favorite methodology for those managers who are constantly confronted with incremental costing and pricing decisions where the inclusion of overhead costs in a product’s total cost will yield inaccurate information. Direct costing is an ideal approach for determining the lowest possible price at which to sell incremental units.
It yields inaccurate results when used for long-term pricing, since it takes no account of overhead costs that must be included in a company’s standard prices if it is to assure itself of long-term profitability. It is also not allowed for inventory valuation purposes by GAAP, which requires the inclusion of allocated overhead costs.
A variation on direct costing is throughput costing. A costing methodology that focuses on capacity utilization is called throughput accounting. It assumes that there is always one bottleneck operation in a production process that governs the speed with which products or services can be completed. This operation becomes the defining issue in determining what products should be manufactured first, since this in turn results in differing levels of profitability.
This methodology holds that the only direct cost is direct materials, with even direct labor costs being thrown out when making most cost-related management decisions.
The main tenet of throughput accounting is that a company must carefully manage the bottleneck operation in its production facility, so that the largest possible contribution margin is created. The main advantage of throughput accounting is that it yields the best short-term incremental profits if it is religiously followed when making production decisions.
This can result in production mixes that seriously delay the completion of jobs for some customers, which is not good for customer relations.
Activity-based Costing (ABC)
An ABC system is designed to match overhead costs as closely as possible with company activities. By doing so, overhead costs can be reasonably associated with products, departments, customers, or other users of activities, which tells managers where overhead costs are being used within a company. This results in much better control over overhead costs.
The ABC methodology is a much more accurate way to associate overhead costs with specific activities, which in turn can be assigned to product costs. It builds a direct correlation between the occurrence of an activity and related overhead costs, so that changes in the activity can reliably be expected to result in corresponding changes in the overhead costs.
That results in valuable information for the management team, which uses it not only to gain some measure of control over its overhead costs, but also to gain an understanding of which products use more activities (and therefore overhead costs) than others.
It requires a great deal of costing knowledge, time, and management commitment before an ABC system becomes operational, and henceforth require considerable upkeep to maintain. It also requires the construction of an ABC database that is separate from the general ledger, which can be an expensive proposition to both create and maintain.
Note: It is not really necessary in situations in which there are few products, obvious process flows, and minimal machine setups, because a less complex cost accumulation system will still result in reasonably accurate product costs.
Most of the costing methodologies described in this post are primarily concerned with the interpretation of costing data after it has already been incurred. Target costing differs from them in that it describes the costs that are expected to be incurred, and how this will impact product profitability levels.
By describing costs in a proactive and future-oriented manner, managers can determine how they should alter product designs before they enter the manufacturing process in order to ensure that the company earns a reasonable profit on all new products.
To use this methodology, a cost accountant is assigned to a new product design team, and asked to continually compile the projected cost of a product as it moves through the design process. Managers will use this information not only to make product alterations, but also to drop a product design if it cannot meet its cost targets.
This costing methodology is the most proactive of all the methodologies, for it involves the direct intervention of the cost accounting staff in the product design process, with the express intent of creating products that meet preset cost and gross margin goals. This is opposed to the usual practice of accumulating costs after products have been designed and manufactured, so that managers will find out what a product costs after it is too late to make any changes to the design.
This costing system is highly recommended to any company that designs its own products, since it can result in significant reductions in product costs before they are “locked in” when the design is completed.
This technique usually requires a great deal of cost accounting staff time, and can lengthen the product development process, but is well worth the effort.
By-product and Joint Product Costing
There are a few situations in which multiple salable products are created as part of a production process, and for which there are no demonstrably clear-cut costs beyond those incurred for the main production process. When this happens, the cost accountant must determine a reasonable method for allocating these costs.
This type of costing involves using some rational means for allocating costs to products for which there is no clearly attributable cost. The various methods for conducting these allocations are primarily used for valuing inventory for external reporting purposes.
It is generally unwise to use this information for any management purpose, since decisions based on allocated costs, with the intention of changing those costs, will usually fail. Consequently, by-product and joint product costing is not recommended for anything other than inventory valuation.
This overview of the advantages and disadvantages of each costing methodology should make it clear that they are not only wildly different from each other in concept, but also that they are all designed to deal with different situations, several of which may be found within the same company.
Accordingly, a cost accountant must become accustomed to slipping in and out of a methodology when the circumstances warrant the change, and will very likely use a combination of these systems at the same time, if demanded by the circumstances.