costing method
. Methods for Costing An Overview of Methods for Costing Product costing entails collecting, categorizing, and allocating direct materials, direct labour, and factory overhead costs to goods, jobs, or services.
Management accountants must choose between three types of costing methods when developing a costing system:
1) The method of measuring costs (standard, normal, or actual costing) that should be used to allocate costs to manufactured units.
2) The method of cost accumulation to use (process or job costing).
3) The allocation strategy for overhead (activity-based or volume-based).
Methods for measuring costs are discussed here. Methods for allocating overhead and cost accumulation systems will be discussed further. However, before discussing cost measurement techniques, a few words about cost accumulation systems are required.
Introduction to Cost Accumulation Systems Product or service costs is assigned using cost accumulation systems. Process costing and job order costing, two distinct methods of cost accumulation utilized in manufacturing, are also referred to as job costing.
• When a large number of identical or similar units of a product or service are being produced, such as on an assembly line, process costing is utilized. Costs are added up by process or department.
• When the units of a product or service are distinct and individually identifiable, job order costing, also known as job costing, is utilized. The costs are added up job by job.
Job order costing and process costing will be discussed in greater detail in the future.
Methods for Measuring Costs There are three main ways that costs are assigned to units produced:
1) Standard costing, 2) Normal costing, and 3) Actual costing These three cost measurement techniques are utilized for allocating both direct manufacturing costs (direct labour and direct materials) and indirect manufacturing costs (overhead) to determine the value of the manufactured goods.
1) Standard Costing In a standard cost system, units produced are assigned standard, or planned, costs. The standard cost of producing one unit of output is calculated by multiplying the standard cost of each of the inputs required to produce that output unit by the number of units allowed for each input. Direct materials, direct labour, and allocated overhead are the inputs. The price that should be paid for that output unit is known as the standard cost.
Note: Above costs will be costs that can't be followed straightforwardly to a particular item or unit. Overheads
are of two primary sorts: assembling (or production line) overheads and nonmanufacturing overheads.
Fabricating overheads will be overheads connected with the creation cycle (production line lease and power,
for instance), and they are apportioned to units delivered alongside direct materials and direct work. Under
retention costing,7
the creation costs become a piece of the expense of the units delivered. That cost is
held in stock until the units it is connected to are sold, and afterwards, it turns into a cost on the pay
proclamation as the cost of merchandise sold. Producing overheads and are the subject to make direct expenses
of the ongoing conversation.
Nonmanufacturing overheads are not connected with the creation interaction. Instances of nonmanufacturing
overheads are bookkeeping, publicizing, deals, legitimate insight and general corporate organization costs.
Nonmanufacturing overheads are discounted as they are caused and are not the subject of this discussion.
Direct materials and direct work are applied to creation by increasing the standard cost or rate per
unit of direct materials or direct work by the standard amount of direct materials or direct work permitted
for the genuine result. For instance, on the off chance that three direct work hours are permitted to deliver one unit and 100
units are created, the standard number of direct work hours taken into account for those 100 units is 300 hours (3
hours per unit × 100 units). The standard expense for direct work for the 100 units is the standard time-based compensation
rate increased by 300 hours taking into consideration the genuine result, paying little mind to the number of direct work
hours that really worked and paying little heed to what genuine pay rate was paid. The expense applied
to the genuine result is the standard expense considered the genuine result.
Note: In a standard expense framework, the standard amount of information considered the genuine result —
not the real amount of the information utilized for the genuine result — and the standard cost permitted per
unit of the information, not the genuine cost paid per unit of the info, is utilized to work out how much the
information's expense applied to creation. A few up-and-comers track down that a troublesome idea to get a handle on because it
requires utilizing the standard cost per unit of the information and the standard amount of the info permitted
per unit of result with the genuine number of units delivered.
The standard expense of info, for example, direct materials for one unit of result is:
Standard cost per unit of the information × standard amount of the info permitted per unit of result
The standard expense of information, for example, direct materials for 100 units of result is:
Standard cost per unit of the information × standard amount of the information permitted per unit of result × 100
In a standard expense framework, the above is for the most part designated to units delivered by working out a predetermined, or standard, fabricating above rate (a volume-based strategy) that is applied to the units
created based on the standard measure of the assignment base taking into account the genuine result. When
a conventional strategy for the above portion is utilized, the foreordained standard assembling above
application rate is determined as the planned above cost partitioned by the planned movement level of the
assignment base.
The foreordained above application rate is determined as follows:
7 Retention costing includes apportioning fixed industrial facility above expenses for the units delivered during the period agreeing
to a foreordained above application rate (rather than discounting the proper manufacturing plant overheads in the period incurred). Subsequently, the decent industrial facility above costs become a piece of the item expenses and arrive at the pay proclamation
as a component of the cost of merchandise sold when the units are joined to being sold. Assimilation costing is expected for outside
monetary announcing by proper accounting rules and for personal assessment answering as indicated by annual expense
guidelines. Retention costing is canvassed in the following point.
The measure that most accurately reflects the factors that lead to the occurrence of overhead costs is the most appropriate cost driver to use as the allocation base.
Direct labour hours, direct labour costs, and machine hours are the most common allocation bases. The appropriate allocation base is probably direct labour hours or direct labour costs for a manufacturing process that requires a lot of labour. The best allocation base for a manufacturing procedure centred on equipment is the number of machine hours.
The predetermined overhead rate is multiplied by the standard amount of the allocation base that is allowed for producing one unit of product to apply overhead costs to production. The standard overhead amount for producing one unit is then multiplied by the actual number of units produced to determine the standard overhead cost that is to be applied to those units.
Example: Using machine hours as the allocation base, a manufacturer employing standard costing applies variable overhead to production. The maximum allowed several machine hours per unit of output are 0.25. Shortly, the manufacturer intends to produce 2,000 units. As a result, the allocation base's budgeted activity level, or machine hours is 500 machine hours per 2,000 units of output.
$10,000 is the period's variable manufacturing overhead cost that has been budgeted. For the budgeted output, the predetermined standard variable overhead application rate per machine hour is therefore $20 per machine hour, or $10,000 x 500 standard machine hours. Based on the permitted number of machine hours per produced unit, the variable overhead is applied to the actual units.
There are actually 2,500 units produced, which is 500 more than the planned level of production. For the actual output, the standard number of machine hours allowed is 625, or 0.25 machine hours for every 2,500 units produced. Production is allowed 625 machine hours or $12,500 in variable overhead at $20 per machine hour.
It is also possible to determine the amount of variable overhead that is applied to production on a per-unit basis. The variable overhead that is applied to each unit at the predetermined rate is equal to $5 divided by the standard number of machine hours allowed, which is 0.25. 2,500 units, or $5 per unit, or $12,500, is the amount of overhead that was applied to the 2,500 units that were actually produced.
The incurred variable overhead was greater than the budgeted variable overhead because actual production exceeded budgeted production. The actual cost of variable overhead exceeded the budgeted amount by $2,000, or $12,000.
The actual production and the actual costs incurred will probably always be different from the budgeted costs used to allocate the overhead, just as they were in the previous example. An under-applied or over-applied overhead cost, also known as variance, is the difference between the overhead cost incurred and the overhead cost applied to production.
8 Variances are accounted for in one of two fundamental ways after each accounting period.
• On the income statement, the variances may be eliminated entirely and credited to the cost of goods sold expense if they are insignificant.
• If the differences are significant, they should be divided between the cost of goods sold and the relevant inventory accounts on the balance sheet—generally finished goods and work-in-process inventories—based on how much overhead cost was included in each that was allocated to the production of the current period.
The inventory cost of the produced units will be the same as the standard cost of the units only if the variances are eliminated completely from the cost of goods sold.
8 Variances refer to both under-applied and over-applied costs, which are the same manufacturing input variances covered in Performance Management in Volume 1's Section C.
Note: Based on the standard cost allowed per unit multiplied by the actual number of units produced, both direct inputs to production such as direct materials and direct labour and overhead are applied to the units produced in a standard cost system.
Management can compare what the costs ought to have been for the actual quantity produced using standard costing. In addition, it makes it possible to account for production as it occurs. Since those costs may not be known until well after the conclusion of each reporting period, when all invoices have been received, using actual costs incurred for manufacturing inputs would result in an unacceptable delay in reporting.
Standard costing places an emphasis on flexible budgeting, in which the flexible budget for actual production equals the standard cost per unit of output divided by the actual production volume.
Standard costing can be utilized in either a job order or process costing setting.
Note: The standard rate for each direct input multiplied by the permitted number of inputs is what is used to calculate the standard cost for each completed unit, not the actual number of inputs used.
Companies in the manufacturing industry, in addition to retail and service businesses, can use standard costing.
• Manufacturing businesses control manufacturing overhead costs as well as direct inputs to production, such as direct labour and materials, using standard costing and flexible budgeting.
• Standard costs are also used by service and retail businesses to control their direct inputs and overhead. Food costs and labour, for instance, are direct inputs for a fast-food restaurant. The manager's salary, property rent, utilities, and janitorial costs are examples of overhead costs for a fast-food restaurant.
Enterprise Resource Planning (ERP) systems are increasingly being used by businesses to track standard and actual costs and evaluate variances in real-time. A business can use an integrated suite of business software applications called Enterprise Resource Planning to collect, store, manage, and interpret data from a variety of business activities. Section D, topic D.4, covers enterprise resource planning, Management of the Supply Chain and in Section F, topic F.1, This textbook discusses information systems.
2) Normal Costing In contrast to standard costing, a normal cost system applies direct labour and material costs to production in a different way. Direct material and direct labour costs are multiplied by the actual amount of direct inputs used for production in normal costing at their actual rates per unit of input.
A predetermined manufacturing overhead application rate, which is calculated in the same manner as the predetermined manufacturing overhead application rate under standard costing, is used in a normal cost system to apply overhead to production:
However, in standard costing, the predetermined rate is multiplied by the amount of the allocation base allowed for product production, whereas in normal costing, that predetermined overhead application rate is multiplied by the actual amount of the allocation base used in production.
Because it is too difficult to determine the actual costs of the specific direct materials and direct labour used for a particular production run, normal costing is not appropriate for use in a process costing the environment. When many identical or similar units of a product or service are being manufactured, such as on an assembly line, process costing is used. Costs are added up by process or department. Costs are accumulated and assigned to specific jobs, customers, projects, or contracts through job costing, on the others hand. When each unit of a product or service can be independently identified, job costing is used. The majority of job costing uses normal costing.
Normal costing employs a predetermined manufacturing overhead application rate to normalize factory overhead costs and prevent month-to-month fluctuations in cost per unit brought on by shifts in actual production volume and overhead costs. Additionally, it makes available current costs, albeit at the budgeted rate rather than the actual rate. When all of the invoices have been received, the actual manufacturing overhead costs may not be known until well after the conclusion of each reporting period if actual costs were used.
3) Actual Costing: No standard, estimated, or predetermined costs are used in an actual costing system. Instead, the units produced are allocated the actual direct costs of labour, materials, and manufacturing overhead. The actual direct cost rates per unit of input are multiplied by the actual quantities of direct cost inputs used to determine the unit's cost, and the actual indirect (overhead) cost rates are multiplied by the actual quantities of cost allocation bases used to determine the unit's cost.
For the same reasons that normal costing is only applicable to job order costing, actual costing is only applicable to job order costing. Also, actual costing is rarely used because it can result in significantly fluctuating costs per unit. Errors in management decisions like product pricing, product line expansion or elimination, and performance evaluations can result from this cost fluctuation.
Costs of direct inputs:
• Under standard costing, the standard costs for the standard quantity of inputs allowed for the actual number of units produced will be the direct input costs (direct materials, direct labour) applied to each unit.
• The direct input costs that are applied to each unit are determined using the actual quantity of inputs used for the actual number of units produced and the actual cost of the inputs per unit if the company uses normal or actual costing.
Costs for overhead:
• Under standard costing, the allocation base allowed for the actual number of units produced is multiplied by the predetermined overhead application rate to apply overhead.
• Under normal costing, overhead is applied at the predetermined overhead application rate multiplied by the allocation base's actual amount for the actual number of produced units.
• When the business employs actual costing, overhead is incurred at the actual rate and amount of the allocation base for the actual number of units produced (i.e., the total overhead cost of production is the same as the actual overhead cost).
The manufacturing variances that are calculated will be affected by the cost measurement method that is utilized. Effect of Each Cost Measurement Method on Variance Reporting
Effect of Normal Costing on Variance Reporting When normal costing is used, direct materials and direct labour costs are applied to production at their actual rates multiplied by the actual amount of the direct inputs used in the production after the end of the period when the actual rates and the actual quantities of the direct inputs used in the production are known. When standard costing is used, all manufacturing overhead variances covered in Section C, Performance Management, will be calculated and their interpretation will be presented in Section C. Effect of Normal Costing on Vari Because the actual costs incurred are the same as the costs applied to production, there can be no direct material or labour variances under normal costing.
In normal costing, overhead is applied at a predetermined normalized or normalized overhead rate, which is calculated in the same manner as the standard overhead rate:
budgeted total overhead divided by the number of hours allowed for the budgeted output by the allocation base (direct labour hours or machine hours). However, in normal costing, instead of multiplying that predetermined overhead rate by the actual amount of the allocation base used in producing the product, as in standard costing, overhead is applied to production by multiplying it by the amount of the allocation base allowed for producing the product.
As a result, the variance in variable overhead spending is the only part of the difference between the actual variable overhead incurred and the variable overhead applied under normal costing. Under standard costing, there is no variance in variable overhead efficiency.
The variance in fixed overhead spending (flexible budget) under normal costing is the same as the variance in fixed overhead spending under standard costing. This is because the budgeted fixed overhead is less than the actual fixed overhead incurred, and neither of these factors is affected by the amount of fixed overhead used.
However, because different amounts of fixed overhead are used, the fixed overhead production-volume variance differs from what it would be under standard costing. Under normal costing, the amount of fixed overhead applied is based on the actual amount of the allocation base used for the actual units of output rather than the standard amount of the allocation base allowed for the actual output. This results in the fixed overhead production-volume variance, which is budgeted fixed overhead less fixed overhead applied.
Impact of Actual Costing on Variance Reporting An actual costing system does not use standard, estimated, or predetermined costs. Instead, once the actual costs and actual quantities utilized by the cost allocation bases are known, the actual direct costs of direct labour, direct materials, and manufacturing overhead are assigned to the units produced. Because the costs applied and the costs incurred are the same, there are no direct input or variable overhead variances.
The variance in fixed overhead spending (flexible budget) under actual costing is the same as under standard costing because it is calculated as the difference between the budgeted fixed overhead and the actual fixed overhead.
However, because the fixed overhead applied would be the same as the fixed overhead incurred, the fixed overhead production-volume variance is essentially meaningless. As a result, the variance in fixed overhead spending (flexible budget) would have the opposite sign from the variance in fixed overhead production volume, which is the sum of budgeted fixed overhead and applied fixed overhead. For instance, if the variance in fixed overhead spending were favourable, the variance in fixed overhead production volume would also be unfavourable because the amount of fixed overhead applied would be the same as the amount of fixed overhead incurred.
The sum of the two fixed overhead variances would be zero.
Advantages and Drawbacks of Each Cost Measurement Method Advantages of Standard Costing • Standard costing enables management to contrast actual costs with what the production should have cost.
• Because standard costs are used to assign costs to units produced, production can be accounted for as it happens.
• Expected performance is specified and control is provided by standard costing. What costs should be, who should be responsible for them, and which costs are under the control of particular managers are all determined by standard costs? As a result, the management of an integrated responsibility accounting system is aided by standard costs.
• If employees believe the standards to be reasonable, they can serve as benchmarks for employees to use in evaluating their own performance.
• Management by exception is made easier by standard costing because managers can focus on other things as long as the costs stay within limits. When problems require attention, deviations from standard costs alert managers, allowing management to concentrate on those issues.
Limitations of Standard Costing • When production is higher than anticipated, the total overhead applied to the units produced may exceed the actual overhead incurred if a predetermined factory overhead rate is used to apply overhead cost to products; If actual production falls short of expectations, the amount of overhead incurred may be less than the amount applied.
• Employee morale suffers when the standard deviations are used negatively, such as to assign blame, and employees are tempted to cover up unfavourable variances and act in ways they shouldn't guarantee that the variances will be favourable.
• In many businesses, the output is determined not by how quickly employees work but rather by how quickly machines work. Direct labour quantity standards may therefore be meaningless.
• Using standard costing may result in an overreliance on quantitative metrics. Whether a variance is "favourable" or "unfavourable," as well as its magnitude, is only part of the story.
• Management may be tempted to place an emphasis on meeting the standards without taking into account other non-financial goals like maintaining and improving quality, delivering goods on time, and making customers happy. Both the financial and non-financial objectives can be addressed with the help of a balanced scorecard.
• Establishing a precise standard cost may be challenging in environments that are constantly shifting.
• Standard costs are only useful for standardized processes. Standard costs are less useful the less standardized the process is.
Benefits of Normal Costing • When normal costing is used, the cost per unit doesn't change as much as it would under actual costing because of changes in the monthly volume of units produced and in overhead costs.
• Under a normal costing system, a job's manufacturing costs are available earlier than under an actual costing system.
• Normal costing enables management to maintain current direct product costs because actual incurred overhead costs, which would not be available until much later, are applied based on a predetermined rate while actually incurred materials and labour costs are used in costing the production.
Limitations of Normal Costing • When production is higher than anticipated, the total overhead applied to the units produced may exceed the actual overhead incurred if a predetermined factory overhead rate is used to apply overhead cost to products; If actual production falls short of expectations, the amount of overhead incurred may be less than the amount applied.
• Because it would be too difficult to track actual costs down to individual units produced, normal costing is only used for job costing in process costing.
Benefits of Using Actual Costing • The most significant advantage of utilizing actual costing is that the costs that are utilized are actual costs rather than estimated costs.