Costing is a critical part of business yet one that few who have prior accounting knowledge take part in. This is understandable as costing is quite a difficult subject to approach. Costing is a whole university level unit in itself so I will not attempt to make you a costing whizz in the course of one article. What we are going to look at is the various types of costing systems and where they apply. The idea is to first make you more cognizant of the different costing systems and secondly to make conversations with your accountant smoother.
Costing and Cost accounting
Cost accounting is a branch of Management accounting that is surprisingly concerned with the identification, accumulation and aggregation of costs. In English, it is all about figuring out how to distribute the costs a business experiences in the course of operations between individual units of production. If we use $15000 to make 10000 wingdings then the cost of each wingding is $1. Simple enough. This can however get very complicated with different types of production processes and when we include service businesses into the mix. The point of cost accounting is to find ways to distribute costs for these complex businesses. So let’s look at the different types of costing systems and how they work.
This costing method is probably the way most people look at costing. It’s logical, the business spent $15000 and create 10000 windings is then each winding cost $1 as we stated before. Some of those costs cannot be directly attributed to units of production. Consider a cobbler/shoemaker. How much glue do they use on each shoe? It is hard to say. What absorption costing does is assume a uniform usage pattern across all shoes and divide the cost. This works very well if the products or units are uniform and hard to distinguish one from the other.
Full costing is a costing method that is used where the costs of producing a single unit are easily identifiable. Let’s look at someone like a plumber, they can reasonably identify the costs of transport, materials, time that go into a single job they do. So they can quite rightly allocate all costs to job and they will generally use a cost-plus pricing method. This really works best where firstly the individual unit of work can be separately identified and secondly where the individual units work are bespoke or unique. Custom production jobs and commisioned works are suited to this.
Job costing works somewhat like full costing but there is a departure point. Imagine an advertising agency. While an advert is a single product it usually involves multiple departments coming together to produce it. So you will have an advert go through creatives, marketers, visual artists, copywriters and recording if it’s video or has audio. You will also need to find the appropriate models or talent such as voiceover artists. Ultimately this one unit of work is very difficult to put together and the costs associated are just as complicated. Job costing takes care of this by allocating all work performed on the advert a job number which can then be tracked to the end goal. Each person who works on the job will indicate the time they spent on their respective task and all this can be billed to the client. Job costing works best where their items produced are short period once of productions.
Batch costing is a method that takes into account where products are produced in short production runs with a defined start and end. I’m going to use the example of peanut butter to illustrate. You buy your nuts, salt, sugar and perhaps preservatives. Great. You process the ingredients and come up with the final product which gives you a certain number of units. This will be easy for Zimbabweans to relate to; no two productions are the same. Perhaps when you got to market the peanuts cost more. Perhaps you had a power outage and had to spend more on fuel for the generator to roast them. Whatever it is things can go differently with each production or batch. Batch costing contains the costs of a batch within that batch to arrive at a unit cost. Batch processing also takes into account what I will call slippage, what happens when you buy enough ingredients for 100 units but get 98.
I suppose the name is a bit of a giveaway but process costing is best used in cases where the production runs similar to batch processing do not have a defined start and end. Consider a crude oil refinery. Even when they do shut down the pipeline for the end of the day, there is still some oil in the pipeline that remains from today’s work that will be included in the output of a later period. In cases like this it becomes very difficult to ascertain which costs belong to which batch. Process costing accumulates costs on a continuous basis and splits them between batches. It is best applied where the production process is continuous such as brewing or chemical manufacturing.
Project costing is what happens when jobs are very big. Take a construction job for example. It is a huge job that consists of many other smaller jobs. Construction work also tends to span multiple reporting periods. Another good example of this is magazine production, a single month’s issue is created over a period as long as 3 months including the placing of advertising. Clearly, not all costs accumulated in July will be for the July issue. Project costing treats each issue as a project which can have jobs under it. The advantages of this are plenty and in a cost accumulation perspective are important.
You will find other costing methods such as contract costing or absorption costing but those are ultimately subsets of the methods mentioned here or hybrids of them. It is most important to remember that this information is for internal use. It is meant to help you arrive at a true cost of production which can be used in pricing, cost control and profitability analysis.