Back to: Financial Accounting
Hello again!
In Week 2, we’re going to explore Costing Systems. Costing is vital for understanding how a company allocates costs to products, services, or departments.
Costing Systems
Accurate costing helps businesses set prices, manage costs, and improve profitability. We will focus on job costing, process costing, and activity-based costing (ABC).
1. What is Costing?
Costing is the process of determining the cost of producing a good or providing a service. This is crucial for setting prices, evaluating performance, and controlling costs. There are different methods for allocating and assigning costs, depending on the nature of the business and the products or services it offers.
2. Job Costing
Job Costing is used when products or services are produced to specific customer orders or jobs. Each job is treated as a unique cost object, and costs are allocated directly to that job.
In a job costing system, the main types of costs are:
Direct Materials: Raw materials used specifically for the job.
Direct Labour: Wages paid to workers directly involved in the job.
Manufacturing Overheads: Indirect costs that cannot be directly traced to a specific job, such as factory rent or utilities.
Example of Job Costing:
Suppose a company manufactures custom furniture. For one particular job, the costs are as follows:
Direct Materials: N2,000
Direct Labour: N1,500
Manufacturing Overhead: N500
The total cost for this job would be:
2,000+1,500+500=4,0002,000 + 1,500 + 500 = 4,000
This means the job cost for this specific piece of custom furniture is N4,000.
3. Process Costing
Process Costing is used when products are mass-produced in a continuous flow, and individual units cannot be distinguished from one another. The cost is accumulated for a particular process or department and then averaged across all units produced.
Process costing is typically used in industries like chemicals, food processing, or textiles, where each product is identical.
Example of Process Costing:
Let’s say a company produces 100,000 units of a product in one month, and the total manufacturing costs (materials, labour, and overhead) are £500,000. The cost per unit is:
500,000100,000=5\frac{500,000}{100,000} = 5
Each unit costs £5 to produce.
4. Activity-Based Costing (ABC)
Activity-Based Costing (ABC) is a more refined method of costing that allocates overheads based on the activities that drive those costs. ABC helps identify the true cost of each product or service by considering all activities that contribute to the final cost.
For example, ABC might allocate overheads based on activities like machine setup time, inspection time, or the number of orders processed, rather than just using a broad allocation method like labour hours.
5. Example of ABC
Suppose a company has three activities with different cost drivers:
Machine Setup: M10,000 allocated based on the number of setups.
Inspection: N15,000 allocated based on the number of inspections.
Order Processing: N5,000 allocated based on the number of orders.
If a product uses 10 setups, 50 inspections, and 5 orders, the cost per product would be allocated based on each activity’s cost driver.
6. Choosing a Costing Method
The choice of costing method depends on the nature of the production process:
Job Costing is ideal for custom or unique products.
Process Costing works best for mass production of identical products.
ABC is useful for companies with diverse products and complex overhead costs.