Most widely used costing methods
There are loads of costing methods available, but most of these are based on job and process costing. The six most used methods of cost are:
- Standard costing
- Job costing
- Process costing
- Direct costing
- Target costing
- Activity-based costing (ABC)
But before we delve into these methods, there are some hidden costs you’ll need to understand before you can begin using them.
Indirect costs in manufacturing
When talking about production costs, people always assume it’s only about direct costs such as raw materials and labor. But this isn’t the only type of cost. Manufacturers just starting out tend to forget about indirect costs that need to be taken into account when pricing products.
Indirect costs are all the other costs necessary to keep your business running but are not directly related to the production process. These can include:
- Rent or mortgage payments
- Utilities like electricity, water, and gas
- Equipment maintenance and repairs
- Administrative expenses like accounting and HR
- Marketing and advertising costs
Calculating indirect expenses gives you a clearer picture of your production costs. However, doing so can be very time-consuming and complex. You will need to weigh the benefits of being precise against the cost of investing a lot of time and resources into this exercise.
For example, if one method of calculating your costs is 7% more accurate but would take ten times longer to complete by your cost accountants, it might not be worth the investment.
How to calculate overheads
Out of all the expenses mentioned, manufacturing overheads can be the most difficult to calculate. Overheads are all the indirect costs incurred in running a business, such as rent, utilities, and insurance.
Overheads are indirect costs since these can’t be directly linked to the production of goods.
The five main types of overheads in manufacturing:
- Indirect labor — the cost of all the workers who are not directly involved in manufacturing the product, such as supervisors, office staff, and janitors
- Indirect materials — materials used in the production process but are not directly involved in the production of the final product, such as packaging and labels
- Utilities — the cost of electricity, water, and gas used in production
- Physical costs — all the costs related to maintaining your factory. Such as rent, insurance, and property taxes
- Financial costs — any legal, accounting, and banking charges
To calculate the total cost for the overheads, you need to add up all the indirect costs.
The important thing to remember is that overheads can be fixed or variable:
- Fixed overheads — costs that stay the same regardless of how much is produced, such as rent.
- Variable overheads — costs that change in relation to production, such as electricity.
In order to calculate the overhead cost per unit, you need to divide the total overhead cost by the number of units produced.
Overhead cost per unit = Total overhead cost / Number of units produced
For example, if the total overhead cost is $100,000 for 2,000 units, the overhead cost per unit will be $50.
If you’re manufacturing different products, you need to calculate each product’s overhead cost per unit. This is because each product will have different production costs, so the overhead cost per unit won’t be the same.
The decision of how to allocate overheads is an important one. This is because overheads can have a big impact on the profitability of a product. If overheads are not allocated correctly, it can lead to products being priced too low or too high.
What are different types of costing?
Now that you understand the costs involved and how to calculate these, let’s take a closer look at the costing methodologies to see the advantages and disadvantages of each method.
Standard costing uses predetermined costs for materials and labor.
This type of costing is probably the most common method due to its simplicity. The predetermined costs are derived from the company’s historical experience and are updated periodically to reflect changing conditions.
The advantage of this approach is that it is relatively easy to compute, making it the least time-consuming. It also provides a consistent basis that determines the cost of the product.
The disadvantages of standard costing are that it can be inaccurate if circumstances change significantly from the time the business established the standards. It can also be challenging to update the standards on a timely basis.
In addition, this method does not provide information about where cost variances occur.
Job costing is for tracking the costs when every project is different, and the cost of each job varies. This method looks at both direct and indirect costs.
To calculate the cost of a job, you first add all the direct costs. Then, you allocate a portion of the indirect costs based on how much resources are consumed for the assignment. For example, if a job took up 50% of the factory space for a day, you would allocate 50% of the day’s rent to that task.
The advantage of this method is that it gives a relatively accurate picture of the cost of each job because it considers all the associated costs.
The disadvantage of job costing is that it can be time-consuming since you need to track all the different expenses and allocate them accordingly.
Process costing, a process referring to a particular stage in manufacturing, helps mass production manufacturers who only have slight variations in products track costs. For example, the first stage might be cutting the fabric, and the second stage might be sewing the garment.
To calculate the cost of a process, you add up all the direct expenses incurred in that specific production stage — including the materials used and wages of your operators. You then allocate a portion of the indirect costs based on how much the process uses the resources.
The advantage of this method is that it’s less time-consuming than job costing since you don’t need to track and allocate costs for each individual job.
The disadvantage is that it can lead to inaccuracies since it doesn’t consider all the costs involved in manufacturing. For example, if one process takes longer than usual, that will increase the indirect costs, which won’t appear in the final cost.