There are different types of costing methods to define the right price for a product or service. Knowing the cost of goods produced is of prime importance for a manufacturer to succeed. It helps in making intelligent decisions about the pricing of goods, controlling costs, and more. Eventually, it helps in the placement of the product.
This article is about the importance of the costing method, different types of costings, the best costing methods for manufacturers to choose from, and more.
What Is a Costing Method?
The costing method is a set process that supports businesses in calculating the cost of production of goods and services. It is a method where cost-related data is gathered to know the accurate cost per unit of the finished product.
Cost plays a key role in determining the pricing. Further, pricing plays a significant role in defining product placement in the market. It gives the product a competitive edge over other manufacturers. The products should not be overpriced or underpriced because in either case, it will impact the overall budget of the company.
There are different types of costing methods that the manufacturer uses to know the manufacturing cost and define the optimum pricing of the product.
Different Types of Costings
Let's now learn about the different methods of costing, their key features, and how they impact the manufacturer.
1. Historical Costing
As evident from the name, historical costing uses the record of the original cost of an asset or inventory when it was procured. Based on this, it decides the value in the future.
Under historical costing, the value of an asset or inventory is not adjusted for changes in market value or inflation. Therefore, the historical cost of an asset may not reflect its current market value, which can result in overvalued or undervalued assets on the balance sheet.
2. Post Costing
Once the production is completed, a calculation is performed that considers financial data, such as the expenses incurred during the production process. This method has a significant benefit in that it examines real numbers. Nonetheless, there is a disadvantage in that it is retrospective in nature since the information is obtained after the event has occurred.
3. Activity-based Costing
Activity-based costing focuses on a manufacturer's resources and activities involved. It is more accurate and makes use of indirect costs of production activities, while also helping manufacturers know which products are profitable. Since here the focus is on activities, it helps to know which activity in the product lifecycle needs improvement.
4. Standard Costing
This costing method and technique involves comparing the predetermined cost of labor and overhead with the actual cost incurred, which helps to determine the comparative cost. By analyzing the variance between the standard and actual costs, the company can pinpoint areas that need improvement. This method is useful for identifying areas where cost-saving measures can be implemented to increase profitability.
5. Marginal Costing
This costing method focuses on the marginal cost of producing an additional unit of product or service. Marginal costing is useful for decision-making, as it helps businesses determine the breakeven point for a particular product or service.
6. Direct Costing
Direct cost refers to the cost that can be traced and attributed to the production of specific goods or services in a business. A direct cost can be traced to the cost object, which can be a service, product, or department. Direct cost examples include direct labor and direct materials.
7. Absorption Costing
Among the different methods of costing adopted by manufacturers, absorption costing takes into account the cost of a product by counting in indirect expenses (overheads) as well as direct costs. While the indirect costs here are related to overheads, and the direct cost involves the labor cost, raw material cost, and others.
Advantages of Costing Methods
Let's discuss the advantage offered by costing methods:
Accurate Cost Information
With the right costing method, it becomes easier to identify accurate information about the cost of producing a particular product or service. This helps businesses to make the right decision on pricing and also helps with cost control.
Better Cost Control
With the right costing method, businesses can identify the areas where they can control costs. Analyzing this will help them overcome inefficiencies and implement cost-saving methods.
Better Decision-Making
Accurate costing methods play a significant role in defining the right strategy in terms of information on production, pricing, and profitability. Eventually, it helps in the allocation of resources and allows the business to save costs.
Enhanced Competitiveness
With the accurate cost of production, it becomes easier for companies to allocate the resource, and manage their finances, thus giving them a competitive edge.
Optimized Inventory Management
Optimizing inventory is significantly beneficial for SMEs. Costing methods help them manage their business by reducing the risk of stockouts and even preventing the overflowing of the stock.
All-in-all, the usage of costing methods helps businesses provide valuable information and insights on the pricing, that eventually reflects in its profitability.
Disadvantages of the Costing Method
Let's see the disadvantages of the costing methods for manufacturing:
Time-consuming
Some costing methods are conventional and time-consuming. Hence, it can be an added burden for the organization, especially in the case of limited resources.
Process Complexities
While the costing method helps the organizations to decide their pricing strategy but at the same time, implementing these methods can be complex. Without prior knowledge and expertise, it can be difficult to accurately derive insights from the costing methods.
Accuracy Issues
A costing method may not always give you accurate results. Since these are based on assumptions, and there are other environmental and external factors that may impact the cost of a particular product or service, hence you may not get accurate and precise information every time.
Importance of Costing Methods
Despite the complexities associated with the costing methods, businesses cannot completely undermine their usability. Here are some of the reasons that you need to adopt the costing method:
Pricing Decision
We have mentioned above that the right pricing decision plays an important role in any business. It helps in defining the right cost for a particular product. With the help of the right costing method, businesses can identify the contributing factors that can impact the final value of the product. Thus, it helps them in making the right decision that gives them a competitive edge.
Cost Control
With the help of a costing method, companies can identify the areas where they can save on their resources and also define the areas where they need to allocate the budget. By analyzing the difference between actual and standard costs, a business can also unfold the areas of inefficiencies and implement cost-saving measures.
Establishing a Budget
Preparing the right budget for any product or service is a key business activity. It eventually defines its growth and productivity. With the right information on cost, manufacturers can prepare their budgets better. Thereby, it helps them in making the right decisions about investments in new technologies and equipment.
Best Costing Methods for Manufacturers to Choose
Some of the best costing methods for manufacturers are mentioned below:
Job Costing
It defines the cost of a particular product or a job. This method is specifically useful for manufacturers who are into the production of customized and unique products in smaller quantities. Some of its key features are:
- It helps in finding the cost of each job so the manufacturer can easily figure out which job is profitable and which one is not.
- This method can also be used to define the cost of a similar job that a company plans to adopt in the future.
- Job costing also helps in controlling the cost by making a comparison of the actual cost with the estimated one.
Process Costing
Manufacturers that are involved in large volume production of a similar product use process costing. This type of costing is usually adopted by companies dealing in the manufacturing of large volumes of food or beverages, or chemicals. Process costing involves tracking the cost of each of the production processes separately. It involves both direct and indirect costs that impact a particular process.
Activity-based Costing (ABC)
As evident from the name, activity-based costing is designed for manufacturers who are involved in a complex production process that involves multiple activities. Activity-based costing is defined by adding the cost involved in different activities, and then it is added to the final product.
This type of costing defines the cost incurred at every stage of production of any product helping the company define the component-wise budget for the manufacturing of the product. It involves costing at two stages i.e. production activities and the cost at the final stage, thereby, simplifying cost accounting.
Standard Costing
It is the cost of producing a product based on predetermined standards. This is suitable for companies that are involved in producing standard products in large volumes. Some of the key features are:
- It analyzes variances to identify the cost.
- It involves a comparison of the standard cost and the actual cost.
- Identifying the variances helps in overcoming problematic areas.
Simplify End-to-End Costing Processes With TranZact
Today manufacturers leverage modern technology in the form of ERP software programs to streamline their business operations and focus on core business. TranZact is the right solution for small and medium enterprises in many ways like calculating various costs, managing inventory, real-time reporting, tracking purchase and sales transactions, monitoring extra costs, and more. With real-time costing insights, businesses can enhance profitability and maximize revenue!
FAQs on Costing Methods
1. What are the 4 costing methods?
The four most commonly used costing methods are process costing, job costing, direct costing, and throughput costing.
2. What are the 8 methods of costing?
There are many costing methods that are used by manufacturers including Job Costing, Standard Costing, Batch Costing, Process Costing, Single Unit Costing, Direct Costing, Operating Costing, Departmental Costing, ABC costing, and more.
