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Introduction to costing approaches

In this article, you'll develop the ability to select and utilise appropriate costing approaches for different business scenarios.
Costs are simply resources or money associated with transactions in business. Businesses without proper cost approaches often get out of control.
Once you have the data that informs the costs incurred at different business levels, you need to account for those costs by calculations. The results of those calculations establish an accountability that provides external and internal stakeholders with reliable information about business progress and performance. The methods or approaches for calculating costs vary according to the characteristics of the business and the country where the business is situated.
Costing approaches can be broadly categorised as partial costing and full costing. These approaches are complementary in nature, not mutually exclusive.

Partial costing

Partial costing is also known as variable costing, direct costing, or marginal costing. Partial costing includes expenses that alter in proportion to production outputs. They are subject to change depending on production volumes.
Partial or variable costing includes all of the costs of raw materials, packaging, utility, and direct labour.

Principles

Here are some of the core principles that drive partial, variable, and marginal costing.
  • Period fixed costs are the same for any level of sales, volume, and production.
  • In the case of a sale of an extra unit of product or service:
    • revenue will increase by the sales value of the item sold
    • costs will increase by the variable cost per unit
    • profit will increase by the amount of contribution earned from the extra item.
  • If the volume of sales falls by one item, profit will fall by the contribution amount on each item.
  • Profit measurement is determined by analysing total contribution.
  • When a unit of product is made, the extra costs incurred are variable production costs.
What is contribution and how do we measure it? Let’s take a look.

Contribution

To make profit, a business needs a contribution from its revenue, to cover its fixed costs. The difference between sales value and sales revenue, and marginal and variable cost sales, is called contribution.
Diagram shows Contribution = Sales Value - Marginal Cost
We’ll look at contribution again later in the week when we explore calculations. For now, we’ll look at the advantages and limitations of partial costing.

Advantages and limitations of partial costing

Partial costing has many advantages that can help us steer our business to profit. However, there are some limitations you need to be aware of. Consider the following advantages and disadvantages.
Partial costing provides a clear picture of actual incremental costs associated with specific costs. It incurs fixed manufacturing overheads irrespective of production volume. It also provides a financial record of what actually goes into the cost of producing a product.
Partial costing does not always provide a holistic picture of the total production costs. Although fixed overheads do not directly contribute towards production in marginal costing, they tend to have a residual effect, which we must be careful of. There is also a possibility that using partial costing might tempt managers to cut prices leading to unwise decisions.
Here’s a summary of the advantages and limitations of partial costing.
Advantages Limitations
Provides a detailed picture of specific cost increments Provides a holistic picture of total production cost
Incurs fixed manufacturing overheads Fixed overheads might have a residual effect
Provides a detailed record of what actually goes into cost of producing a product Might raise a temptation to cut prices leading to unwise decision-making
Consider the following cost approaches when accounting expenses.

Job costing

Under job costing, costs are accumulated by each job, eg, a specific work assignment or contract. Job costing is used for work that is based on client specifications. Jobs are diverse in character. In job costing, every job has to be treated separately and will show different work in progress for each period.
Example: If the production cost for printing 50 advertising banners is $600, then the unit cost for this job is $12. Based on this information, the manager of a printing firm can decide whether or not the prevailing market price provides a margin that is profitable, and the firm can make decisions accordingly.

Process costing

In process costing, costs are accumulated when units are finished for one process. Those costs are then transferred from one process department account to another. Process costing is used in industries where identical products are produced in large quantities.
Example: Hypothetically, in the production of surgical masks, if the production cost for ultrasonic welding is $300, that gets transferred to the next process called linking. After that, linking transfers $500 of its costs to packing, and so on.
Let’s juxtapose the differences to understand them better.
  Job costing Process costing
Nature Customised production Standardised production
Assignment of cost Calculated for each job Allocated to the process, then distributed to units
Cost centre Job Process
Scope of cost reduction Low High
Transfer costs No transfer Transferred from one process to another
Cost ascertainment Job completion End of the cost period
Companies using the system Boeing, Deloitte, Touche Wrigley Company, BP
The following articles look at other approaches to costing.
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Financial Analysis for Business Performance: Reporting and Stakeholder Management

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