Costing methods in accounting
Introduction
Businesses are set up with the main aim of providing goods and services to customers who need them at a profit. To ensure profit, the cost of producing the product or offering the service has to be lower than the selling price so that you gain an advantage. This means that companies have to know how to price their products.
Accounting techniques have been used to determine the total costs of productions, which directly influence costing each product produced by companies. There are three pricing strategies in accounting: Activity-based costing, Job order costing, and Process costing. The subsequent sections will describe detailed explanations of each of these costing strategies.
Activity-Based Costing
Just as the name suggests, activity-based costing is a costing method where companies cost the final product based on the activities undergone to develop this product. Mostly, it is used in manufacturing industries to cost their products. Manufacturing uses different steps to develop and refine a product, and each of them has specific costs incurred. In this type of costing system, activities that are used to develop a certain product ate identified. After that, the costs of each of these activities, including overhead costs, are assigned. The total price is calculated according to the cost of activities needed to develop this product.
This costing system is effective because it assigns overhead costs of manufacturing into the product’s actual cost. Activities are considered as cost drivers in this type of costing system. For example, a machine setup will incur costs. Such costs are considered in the final costing of the product. As a result, in this method, more overhead costs are assigned to direct costs than any other conventional costing method.
To undergo this process, first, the activities to create a particular product are identified. These activities are then divided into cost pools. Each of the cost pools is inclusive of individual costs that are related to this activity. In addition to calculating individual costs, overhead costs are calculated for each cost pool (Kenton & Johnson, 2020). After that, the cost pools are assigned, cost drivers. Cost drivers are those activities that determine the cost of the whole process. For instance, it could be the hours put into the activity, or units consumed to complete it.
Cost driver rates are then calculated. This is done by first dividing the total overhead costs by the total cost drivers. The cost driver rate is multiplied by the number of costs that are driven. This detailed approach ensures a more accurate assignment of costs required for each activity in the final product costs. It enhances the reliability of cost data by manufacturing industries that use this method.
Advantages
The main advantages of this costing method are that it provides realistic manufacturing costs for each product produced. Because all of the activity costs and cost drivers are considered in the costing of a product, the final cost is realistic. Also, because of the detailed analysis and assignment of costs to products according to their activities, the manufacturers are able to accurately allocate overhead costs to products and processes that actually use such activities.
Another advantage of Activity-based costing is that it provides a better understanding and justification of the manufacturing overhead costs. The consideration of cost drivers and cost driver rates gives a justification for the overheads incurred while manufacturing a product using the activities involved. The whole process also helps managers identify those processes that incur unnecessary costs.
Disadvantages
The disadvantage of this costing method is that the whole process of data collection and preparation is time-consuming. Further, the whole process of collecting and analyzing the data collected will incur further costs to the whole process. The source of data is not always readily available from conventional accounting records, and this means that it will need further record-keeping at the company’s cost. This process is also not effective for those companies that produce relatively lower overhead costs to the operational costs required to produce final products.
Job Order Costing
Job order costing is a method of costing products and services by assigning and accumulating the manufacturing of specific output units (George, n.d). This costing method is most common with those companies that offer different services and products, and each of the produced goods incurs different costs. There are job cost records that are kept for each specific job that guides the process of cost setting for the final product. This included the direct materials, direct labor involved, and overhead costs incurred in the manufacturing process.
An example of a situation where this kind of costing is used is in the construction industry. Each time a company is contracted to construct a building, they do so on the architectural designs’ specifics. This will mean that each building is significantly different from the other built by the same company in the past and also costs different basing on materials, labor charges, and other overhead costs. Job order costing will be used in such a company to produce the costs for constructing this particular customized building to determine the actual cost.
Advantages
The advantage of this costing method is that it provides an opportunity to set profitability for each particular job. Because each of the produced products is different and has different costs, it is possible to preset the profitability of each job being done. Also, it is advantageous in the sense that current jobs may be used as the basis of estimated future jobs. If a client is interested in an example in a similar house to the one built in the past, the past quotations can be used to estimate future costs. Finally, this costing method provides an in-depth analysis of material costs, overhead costs, and labor costs.
Disadvantages
A disadvantage of this kind of costing system is that it requires very detailed records. The records kept have to include the costs of each job done. Each job has details of costs, overheads, and labor charges. This incurs additional costs of ensuring clerical work has been thoroughly done. Also, with increased details, there are increased chances of clerical errors that could occur. This means that there could be errors in the costing resulting from clerical errors.
Process Costing
Process costing is almost similar to job costing. However, this type of costing is done on the mass of products that are produced by the company. This is used by companies that produce similar kinds of products or services. The total cost of production n is calculated. The total cost of each of the products being produced is calculated by dividing the number of units produced by the overall cost of producing these units.
For instance, consider a refining petrochemicals company. The process of production is continuous, and the products being produced are similar. In this case, the total number of barrels produced is calculated. After that, the total cost of producing these barrels is calculated and divided by the total number of barrels. The price found is the one used as the price of each barrel.
Advantages
The advantage of this costing system is that it is simple to compute. The numbers used to calculate each of the products’ total costs are easily obtained from accounting records. The formulas used to calculate the whole process are also easy. Another advantage of this method is that it is flexible. The company can easily adjust their prices and processes based on need and changing characteristics in the industry. This makes the process be preferred.
Disadvantages
The disadvantage associated with this kind of costing method is that it is prone to costly errors. Most at times, non-production costs are calculated in the total process costs. This is an erroneous calculation and could result in wrongful production costs that result in wrong costing methods. Also, equivalent costing units could be wrongly calculated by account managers (Vitez, 2020). This will further result in wrongful calculations because inventories will not be balanced easily.
Conclusion
Companies have to ensure that they have correctly estimated the production costs of their final products before setting up the final costs of each product. This helps the company account for all the production costs and enables them to calculate their profits. There are three methods used to calculate costs. Activity-based costing uses the activities used to produce a product to calculate its price. The job order costing prices are based on specific material costs, labor charges, and other overhead costs to set prices. Process costing uses the total cost of processes required in the product production to cost the final product being produced.
References
George C (n.d) Process Costing vs. Job Order Costing. Study.com. Retrieved from https://study.com/academy/lesson/process-costing-vs-job-order-costing.html
Kenton W. and Johnson J. B. (2020) Activity-Based Costing (ABC). Investopedia. Retrieved from https://www.investopedia.com/terms/a/abc.asp
Vitez O (2020) What Are the Advantages & Disadvantages of Process Costing? Chron. Retrieved from https://smallbusiness.chron.com/advantages-disadvantages-process- costing-4098.html