Costing

Activity-based costing (ABC) system is a technique of cost attribution to cost units based on indirect

activities like ordering and setup. It involves the identification of costs with each cost-driving activity. It is

the basis for the absorption of the expenses over different products.

The following key terms are associated with ABC:

• Cost objects. This fundamental cost concept focuses on individual activities such as products,

customers, services, and locations.

• Activities. These are events, tasks, or work units with a particular purpose. These are divided into

two (2) groups: the support activities and production process activities. Support activities include

scheduled production, machine setup, materials purchasing, and custom order. Production process

activities include machine products and assembled products.

• Cost pool. It pertains to the grouping of individual cost items. It expresses the costs of goods or

services allocated to specific activities within a business operation.

• Cost drivers. These are the causes or reasons for the occurrence of overhead costs. These are

variables or a level of activity that casually affects costs over a given period. The cost driver of a

variable cost is the level of activity or volume, which causes proportionate changes in variable costs.

For example, the number of vehicles assembled is the cost driver of the cost of steering wheels.

• Cost hierarchies. These designate activities based on how easily they can be traced to a product. The

cost hierarchy comprises four (4) levels as follows:

1. Output unit-level costs. These are the cost of activities performed on each unit of product or

service. The cost of activities increases in proportion to the production or sales volume. An

example of this is the manufacturing operations cost.

2. Batch-level costs. These are the costs of activities performed on each batch or group of units of

products or services. The cost of activities increases in proportion to the production or sales

volume. An example of this is the procurement cost.

3. Product-sustaining costs. These are the costs of activities undertaken to support products or

services, irrespective of the number of units or batches. An example of this involves marketing

costs to launch new products.

4. Facility-sustaining costs. These are the costs of activities that cannot be traced to individual

products. They are common to all products and support an organization's entire activities. An

example of this includes general administration costs

Unit costing is commonly used in industries that produce identical products. Also, this is used in uniform

manufacturing processes and situations when cost units have similar costs. Examples of companies that

employ unit costing include industries that manufacture homogeneous products like sugar, bricks, cement

works, and breweries.

The following are the features of unit costing:

• Average unit cost. Unit costing computes the average unit cost by dividing the total costs by the

number of units produced in a specified period.

• Single product. Unit costing involves a single product or several product grades.

• Applicability. Unit costing is applied to industries where the manufacturing process is not

continuous.

The following are the unique features of the Activity-Based Costing (ABC) system:

• Activity-based. The ABC system is based on activities that consist of different functions that are

associated with cost objects.

• Activity cost center. The ABC system involves identifying the overhead cost of an activity and

assigning the cost to each activity's cost center.

• Use of cost drivers. The ABC system involves the causes of overheads, called cost drivers. These are

used to assign costs to products.

• Accumulation of overhead costs. The ABC system involves the accumulation of overheads

completed by various activities. A single unit and the entire organization are not considered.

• Traceability. The ABC system involves overhead costs which can be traced easily. Hence, cost data

are more reliable and accurate.

• Elimination of non-value-added activities. The ABC system states that the product cost would be

less since the non-value-added activities are eliminated. The non-value-added activities do not

contribute anything to the value of the product.

• Costs in proportion to cost-driving activities. The ABC system involves the overhead costs charged

to different products in proportion to the cost-driving activities.

Unit costing is commonly used in industries that produce identical products

The following are the features of unit costing:

• Average unit cost. Unit costing computes the average unit cost by dividing the total costs by the

number of units produced in a specified period.

• Single product. Unit costing involves a single product or several product grades.

• Applicability. Unit costing is applied to industries where the manufacturing process is not

continuous.

Job Costing

It is a cost allocation method used by companies that make custom products. This system performs work

on customers’ requirements based on custom orders. The work is carried out within the factory, which

passes through the processes or operation activities. Job costing is used in industries engaged in printing,

steel structures, switchgear, transformers, motors, pumps, general engineering works, oil wells, and

shipping.

The following are the features of job costing:

• A job consisting of a single order or contract.

• Each job is unique.

• Products are not manufactured for general consumption.

• Each order is given a job number.

• Costs are accumulated with a reference number.

• Costs are determined for each order.

• The duration of the job order is comparatively short-term.

• Identifying a job at each stage of its manufacturing process is possible.

The main objectives of job costing are the following:

1. To determine the cost of production of every order.

2. To assess the profitability of each job to undertake future orders of similar nature.

3. To control operational efficiency by comparing actual costs with estimated costs.

4. To plan for future courses of activities.

Batch costing is used by companies that make custom products. This system produces goods in similar

units (referred to as batches).

The following are the unique features of batch costing:

• Batch-wise cost collection. It involves assigning batch numbers and associated costs for each

product group.

• Identical products. It involves indistinguishable items produced in a batch.

• Grouping. It involves classifying items for costing.

In batch costing, it is crucial to determine the number of units to produce. The optimum size of the batch

is termed “economic batch quantity.” The need for economic batch quantity arises when the production

rate exceeds the sales turnover rate.

The two (2) main elements associated with economic batch quantity are as follows:

• Set-up cost. These are costs incurred for setting up tools and machines for each batch. It is a fixed

amount per batch. It is incurred irrespective of the batch size. The total set-up cost increasesif there

is an increase in the number of batches.

• Carrying cost. It is also known as storage costs. It consists of the interest on capital, defective work,

storage loss, obsolescence, premium, etc. Carrying cost is considered as a rate per unit. There will

be an increase in carrying or storage costs followed by a decline in set-up costsif there is an increase

in the batch quantity.

The Economic Batch Quantity (EBQ) is the point where storage costs equal the set-up costs. At this point,

the total costs are at a minimum level. EBQ is based on production costs, set-up costs, storage costs, the

interest rate on capital, product demand, labor skills, wastage of materials, etc.

Process costing determines the product cost at each manufacturing operation, process, or stage. It is

generally suitable for firms where goods or services result from continuous or repetitive operations or

processes.

Process costing is used in the industries below:

1. Manufacturing industries that produce iron and steel, textiles, glass, cement, rubber, soap, paper,

food, etc

2. Mining industries that produce coal and oil

3. Public utility services that provide generation of electricity and water supply

4. Chemical industries

The following are the features of process costing:

• Costs flow from one process to another. It involves costs relating to direct material, direct wages,

and factory overheads which are charged to the process accounts.

• Average unit cost consumption. It involves calculating the average cost per unit by dividing the total

costs by the output in a period.

• Not distinguishable. In process costing, the products are not distinct in the processing stage.

• Normal spoilage. In process costing, the cost of normal spoilage or wastage is included in the cost

of the total units produced.

• Equivalent production computation. In process costing, the incomplete units at each stage of

production are converted into equivalent production based on the degree of incompleteness.

Service costing determines the cost per unit of a service rendered. It involves determining the cost of

specific services and functions like maintenance and personnel services.

The following organizations use this costing method:

• Service firms. These are businesses that render services to outside entities of their organization.

Examples include power generation and distribution, hotels, transport, educational institutions,

consultancy or law firms, accounting and management, airlines, and shipping.

• Internal services. These pertain to a division of an organization that renders services to other

departments within the company. Examples include hospitals, canteen, water supply, and

maintenance services.

The following are the features of service costing:

o Cost classification. The costs are classified into variable and fixed. In case additional service is

provided, the variable cost will be affected.

o Periodical ascertainment of costs. The costs are determined periodically (generally at the end of

specific periods).

o Multiple stages and processes. The conversion of basic materials into services involves many stages

and processes.

o Valuation of work-in-progress. Monitoring work-in-progress is comparatively easier for service firms

than manufacturing companies since services are delivered to the customer in real-time.

o Intangible products. Services are provided to the public instead of tangible goods.

o Cost unit differs. Service organizations provide a wide variety of services resulting in different cost

units. A cost unit is a quantitative term representing the type of service organization where the cost

is determined. The costs incurred during a period are duly collected, analyzed, and expressed in

terms of cost unit.

Retailers use the retail inventory method to estimate the ending inventory balance. It is based on the

relationship between the cost and retail price of the merchandise. Although the retail inventory method

is a quick and easy way to determine an approximate ending inventory balance, below are some of the

issues associated with it:

• The method is only an estimate.

• The method only works for a consistent markup across all products sold.

• The method assumes that the historical basis for the markup percentage continues into the current

period.

• The method does not work if an acquisition has been made, and the buyer holds large amounts of

inventory at a significantly different markup percentage from the rate used by the purchaser.

The terms associated with the retail inventory method are as follows:

• Product cost percentage. It is the percentage increase concerning a product's cost and selling price.

• Cost of sales. It is the total costs used to create a product or service that has already been sold.

• Sales markdown. It isthe decrease in the value of a product’s original retail price and its actual selling

price.