COSTING METHODS
(MANUFACTURING)



Costing Methods Manufacturing 58
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Manufacturing costing methods are accounting techniques that are used to help understand the value of inputs and outputs in a production process. By tracking and categorizing this information according to a rigorous accounting system, corporate management can determine with a high degree of accuracy the cost per unit of production and other key performance indicators. Management needs this information in order to make informed decisions about production levels, pricing, competitive strategy, future investment, and a host of other concerns. Such information is primarily necessary for internal use, or managerial accounting.

OVERVIEW OF CURRENT METHODS

PROCESS AND JOB-ORDER COSTING.

There are two conventional costing approaches used in manufacturing. The first, and more common, is process costing. Used in most mass-production settings, a process cost system analyzes the net cost of a manufacturing process, say filling bottles with soda, over a specified period of time. The unit cost for filling bottles is simply the net costs incurred while filling all the bottles during the period divided by the number of bottles filled. Since most manufacturing processes involve more than one step, a similar calculation is made for each step to arrive at a unit cost average for the entire production system. By contrast, the second major costing method, job-order costing, is concerned with tracking all the costs on an individual product basis. This is useful in settings where each unit of production is customized or where there are very few units produced, such as in building pianos, ships, or airplanes. Under job order costing, the exact costs incurred in the production of a particular unit are recorded and are not necessarily averaged with those of any other unit, since every unit may be different. Job-order costing is also widely used outside manufacturing. A single manufacturer may use both process and job-order costing for different parts of its operations.

ACTIVITY-BASED COSTING.

Activity-based costing(ABC) is a secondary and somewhat complementary (or better, supplementary) method to the two traditional costing techniques. Whereas traditional methods might classify costs in generic categories like direct materials, labor, and other overhead, ABC clusters all the costs associated with a single manufacturing task, regardless of whether they fall under the headings of labor or materials or something else. So in the bottling example activity-based costs might include operating the dispensing machines, performing quality checks, moving pallets of bottles, and so forth. Each of these activities may involve human labor, equipment costs, energy and expendable resources, and materials, but for analytic purposes the costs are all lumped together under a single activity concept. The advantage of this approach is that management can then observe which tasks cost the most versus which add the most value; this analysis may indicate that a disproportionate amount of money is being spent on low-value activities, signaling a need for process changes or for outsourcing to a vendor that can perform the tasks less expensively. Use of this method is sometimes referred to as activity-based cost management (ABCM) or simply activity-based management (ABM).

HISTORY OF COSTING METHODS

Double-entry bookkeeping, developed in Northern Italy in the 14th and 15th centuries, was the predecessor to modem accounting methods. Early modem methods were developed in the United States in the 1850s and 1860s by accountants in the railroad industry. These methods were just one of several innovations originating with the railroads that marked the transition from traditional to modem business enterprise. Most important were the developments of J. Edgar Thomson and his cohorts at the Pennsylvania Railroad. The work of these and other pioneering accountants in the railroad industry was the subject of widespread public discussion and numerous articles in the new financial journals of the day.

EMERGENCE OF COST ACCOUNTING.

Cost accounting was one of three interrelated types of accounting developed at the time, the others being financial and capital accounting. Financial accounting addressed issues relating to a firm's daily financial transactions, as well as overall profitability. For example, railroads began deriving operating ratios in the late 1850s, which for the first time related absolute quantities of profit and loss to business volume. Capital accounting addressed issues relating to the valuation of a firm's capital goods. This was particularly important in the railroad industry given the unprecedented quantities of capital involved and the problem of how to account for the repair and renewal of capital.

Innovations in cost accounting followed those in financial and capital accounting. Cost accounting involved the determination and comparison of costs among a firm's divisions or operations. Thus the historical development of cost accounting accommodated the development of the multidivisional firm towards the end of the 19th century. There was necessarily a considerable amount of overlap among financial, capital, and cost accounting. For example, to accurately determine unit costs, it was necessary to relate overhead costs and capital depreciation to the volume of production. At the same time, unit costs were typically used to determine prices, which in turn affected financial accounts. The separation of these types of accounting followed their historical institutional separation. That is, until the innovations of E.I. Du Pont de Nemours & Co. in the 20th century, financial, capital, and cost accounting operations were carried out in relative autonomy within firms.

Cost accounting was first used by the Louisville & Nashville Railroad in the late 1860s. This enabled the company to determine such measures as comparative cost per ton-mile among its branches, and it was by these measures, rather than earnings or net income, that the company evaluated the performance of its managers. The accounting methods developed by the railroads were adopted by the first large manufacturing firms in the United States upon their formation in the last quarter of the 19th century.

EXPANDING USES.

The largest U.S. manufacturing firms in the 1870s were textile producers. Because these years were a period of hardship for the industry, textile producers began to devote more attention to the determination and control of costs. By 1886, Lyman Mills, one of the country's largest textile producers, began to determine unit costs for its various products, though it did not use this information to make pricing or investment decisions. The Standard Oil Trust, formed in 1882, also began to determine the comparative costs of their different refineries in the 1880s and on this basis opted to concentrate production in their largest units. However, the enterprise did not accurately account for overhead or capital depreciation in its determination of costs.

The firm with the most detailed and sophisticated costing methods in the 1880s was the Carnegie Company, a steel producer. In this case, the connection between costing methods in the railroad and manufacturing industries was direct, as Andrew Carnegie patterned the organization of his firm after the Pennsylvania Railroad, where he had been an executive. Carnegie's costing method was referred to as the voucher system of accounting. In this system, each of the company's departments kept track of the quantity and price of materials and labor for each order. These data were aggregated into cost sheets that the company's accountants were able to produce on a daily basis. Though the Carnegie Company made extensive use of its cost sheets to determine prices, it focused on prime rather than overhead and depreciation costs.

20TH-CENTURY ADVANCES.

In the early 1900s, firms came to systematically relate overhead costs to variations in the quantity of goods produced. Accountants began determining standard costs, based on a standard level of capacity utilization. The greater unit costs of running below standard capacity were defined as unabsorbed burden, whereas the lesser unit costs of running above standard capacity were defined as over-absorbed burden. Such methods of accounting for overhead were widely discussed in trade journals at the time.

It was not until later that modern methods of accounting for capital depreciation came into widespread use. Until then, manufacturing firms continued to use the renewal accounting methods borrowed from the railroads. That is, the repair and renewal of capital goods was charged to operating expenses and profits were determined as the difference between earnings and expenses. Firms did not determine changes in the value of capital resulting from depreciation, repair, and renewal, and thus profitability could not be determined as the ratio of profits to the value of capital.

Chemical producer Du Pont was among the first firms to integrate cost, capital, and financial accounting. This resulted in part from Du Pont's rejection of traditional renewal capital accounting in which profitability rates were typically determined in relation to sales or costs. Du Pont's accountants established careful records of changes in fixed capital, made up of plant and equipment, and working capital, made up of inventories, financial assets, and accounts receivable. By doing so, Du Pont was able to derive monthly reports on profitability as a return on capital invested. In his 1977 volume The Visible Hand, Chandler described the critical role of Du Pont manager Donaldson Brown in accounting for stock turnover and thus contemporary calculations of profitability. He wrote: "Brown … related turnover to earnings as a percentage of sales (still the standard definition of profit in American industry). He did this by multiplying turnover by profit so defined, which gave a rate of return that reflected the intensity with which the enterprise's resources were being used."

THE BASICS OF COSTING METHODS

FIXED COSTS.

One of the key issues in conventional costing methods (i.e., process costing and job-order costing) is distinguishing among types of costs. A basic distinction is made between fixed and variable costs. Fixed costs are those costs that are invariant with respect to changes in output and would accrue even if no output were produced. Such costs might include interest payments on the purchase of plant and equipment, rent, property taxes, and executive salaries. The notion of fixed costs is restricted within a certain time frame, since over the long run fixed costs can vary. For example, a manufacturer may decide to expand capacity in the face of increased demand for its product, requiring a higher level of expenditure on plant and equipment.

VARIABLE COSTS.

Variable costs change proportionately to the level of output. For manufacturers, a key variable cost is the cost of materials. In terms of total costs at increasing output levels, fixed costs are constant and variable costs are increasing at a constant rate. In terms of unit costs at increasing output levels, fixed costs are declining, and variable costs constant. Manufacturers are vitally interested in unit costs with respect to changes in output levels, since this determines profit per unit of output at any given price level. The characteristics of fixed and variable costs indicates that as output increases, unit costs will decline, since there is constant variable cost and lesser fixed cost embodied in each unit. These costing methods thus suggest that it is in manufacturers' interest to run, within the limits of plant design, at high capacity levels.

DIRECT COSTS.

Costing methods distinguish between the direct and indirect costs of any costed object. Direct costs are those costs readily traceable to the costed object, whereas indirect costs are less-readily traceable. Direct costs typically include the major components of any manufactured good and the labor directly required to produce that good. Direct costs are often subdivided into direct material costs and direct labor costs. Direct costs are also referred to as prime costs.

INDIRECT COSTS.

Indirect costs include plant-wide costs such as those resulting from the use of energy and fixed capital, but indirect costs may also include the costs of minor components such as solder or glue. While all costs are conceivably traceable to a costed object, the determination of whether to do so depends on the cost-effectiveness with which this can be done. Indirect costs of all kinds are sometimes referred to as overhead, and in this sense prime costs can be distinguished from overhead costs.

ESTIMATING TOTAL COSTS

Several methods are used in manufacturing to estimate total cost equations, in which total costs are determined as a function of fixed costs per time period, variable costs per unit of output, and the level of output. These methods include account analysis, the engineering approach, the high-low approach, and linear regression analysis. In all these methods, the central issue is how total costs change in relation to changes in output.

ACCOUNT ANALYSIS.

In account analysis, all costs are classified as either strictly fixed or variable. This has the advantage of ease of computation. However, some costs may be semivariable costs or step costs. Utility bills are typically semivariable in that they contain fixed and variable components. Step costs increase in discrete jumps as the level of output increases. In account analysis, such costs are typically categorized as either fixed or variable depending which element predominates. Thus, the accuracy of account analysis depends in large part on the proportion of costs that are not strictly fixed or variable. For many manufacturing firms, account analysis provides a sufficiently accurate estimation of total costs over a range of output levels.

ENGINEERING APPROACH.

The engineering approach infers costs from the specifications of a product. The approach works best for determining direct material costs and less well for direct labor costs and overhead costs. The advantage of the engineering approach is that it enables manufacturers to estimate what a product would cost without having previously produced that product, whereas the other methods are based on the costs of production that has already occurred.

HIGH-LOW APPROACH.

In the high-low approach, a firm must know its total costs for previous high and low levels of output. Graphing total costs against output, total costs over a range of output are estimated by fitting a straight line through total cost points at high and low levels of output. If changes in total costs can be accurately described as a linear function of output, then the slope of the line indicates changes in variable costs. The problem with the high-low approach is that the two data points may not, for whatever reasons, accurately represent the underlying total cost-output relationship. That is, if additional total cost-output points were plotted, they might lay significantly wide of the line connecting the two initial high-low points.

LINEAR REGRESSION.

Linear regression analysis addresses the shortcomings of the high low approach by fitting a line through all total cost-output points. The line is fitted to minimize the sum of squared differences between total cost-output points and the line itself, in standard linear regression fashion. The drawback of this approach is that it requires more data points than the other approaches.

STANDARD COSTS

The relation of total costs to output levels is combined in the idea of standard costs. Standard costs are estimates of unit costs at targeted output levels, including direct materials costs, direct labor costs, and indirect costs. Standard costs are used to prepare budgets for planned production and to assess production that has occurred. The estimation of standard costs requires the separate estimation of standards for direct materials, direct labor, and overhead.

DIRECT MATERIALS.

Direct material standards are the easiest to estimate. Costs are determined from the prices of all necessary material inputs into the product, plus sales tax, shipping, and other related costs. Unanticipated price changes complicate this otherwise straightforward process. Since standard costs are a measure of unit costs, it is also necessary to determine the quantity of materials per unit. This can be done using an engineering approach.

DIRECT LABOR.

Direct labor standards are somewhat more difficult to estimate. The determination of costs must account for wages, though if workers in a production process are earning different wages, it is necessary to estimate a weighted average of wage costs. The cost of benefits, employment related taxes, and overtime pay must also be accounted for. As with direct material standards, the quantity of direct labor required to produce a unit of output can be estimated with an engineering approach. Average set-up time and downtime must also be included in the estimation. Many union contracts codify labor time standards, which can make budgeting easier.

OVERHEAD.

Overhead standards are the most difficult to estimate, and they are typically accounted for in an approximate manner. The problem of accounting for overhead costs per unit of output was noted above—it is often difficult to trace indirect costs to a particular product. The problem is made more complicated if these costs are highly centralized within a plant and if multiple products are produced within a plant. Overhead standards are typically estimated by taking total overhead costs and relating them to a more readily-knowable measure, such as direct labor hours, direct labor costs, or machine hours used. Direct labor hours was traditionally the most widely-used measure for determining overhead standards, but the growth of automated plants resulted in a shift to machine hours used.

DETERMINING PROFITABILITY THROUGH
CVP ANALYSIS

Cost equations are combined with revenue equations to determine profitability at different levels of output. This is referred to as cost-volume-profit(CVP) analysis. That is, net income equals total revenue minus total cost; total cost, as noted above, equals average variable cost times the quantity of output plus fixed cost; and total revenue equals price times the quantity of output sold. Combining cost and revenue equations reveals that net income equals price times quantity of output sold minus average variable cost times the quantity of output minus fixed costs. That is,

where P = price,
Q = quantity of output,
AVC = average variable cost
FC = fixed costs

This is referred to as the cost-volume-profit equation, and is one of the most widely-used of cost accounting tools.

CVP analysis allows a firm to determine a breakeven point, the level of output at which total revenue equals total cost. That total cost and total revenue functions will be equal at some nonzero level of output is assured by the fact that at zero units of output, total costs will be positive as a result of fixed costs and total revenues will be zero. This is based on the assumption that the unit price for which a product can be sold is greater than the unit cost, so that total revenue increases faster than total cost as output increases. In addition to estimating profitability across a range of output levels, firms use CVP analysis to determine whether projected sales are sufficiently beyond the breakeven point to warrant production.

Economic theory also concerns itself with changing costs as a function of changing output within a given plant. This is an analog to the slope of an accountant's cost function curve and is referred to as marginal cost. In his essay, "Economic Concepts in Cost Accounting," Shillinglaw describes the relationship between mainstream economic theory and cost accounting as follows: "Cost accounting springs mainly from the needs of managers and others to make decisions affecting the allocation of economic resources. This might suggest that cost accounting is based directly on a fairly well-defined set of concepts drawn from economic theory. The truth is something else.… The uneasy and ambiguous relationship between cost accounting and economics is nowhere more apparent than in the application of the concept of short-run marginal cost." In mainstream economic theory, marginal costs are generally assumed to be decreasing at lower levels of output, more or less flat over medium levels, and increasing at an accelerating rate at higher levels. As noted above, cost accountants generally base their calculations on the assumption that costs change at a constant rate with respect to output.

FUTURE OF COST ACCOUNTING

EXPANSION AND INTEGRATION OF ABC.

Widespread corporate interest in activity-based costing (ABC), which started in the late 1980s and has continued through the late 1990s, has created dueling cost accounting systems for some companies. Managers want the analytic power of an ABC system, yet may also require some of the conventional abilities and rigor of a traditional system like process or job costing. The failure to integrate these competing needs has caused some firms to abandon or at least reconsider ABC initiatives, which can be expensive and time-consuming to implement in a large operation. Some managers have viewed it as an either-or dilemma, and often ABC is eyed with some suspicion, as indeed early formulations of it were not effective substitutes for conventional costing methods. However, many successful ABC implementations use it as a supplement to, rather than a replacement for, standard methods. Advocates of ABC have begun to formulate ways in which ABC can be better integrated with conventional methods so that companies can enjoy the benefits of both. In 1999 the Institute of Management Accountants (IMA), the leading professional organization for managerial accountants, published renewed guidelines for companies wishing to implement ABC practices, following a series of previous statements on using ABC dating back to the early 1990s. The IMA's statements included a number of cautions against potential pitfalls in establishing an ABC system.

TARGET COSTING.

A related practice that has also enjoyed quite a bit of attention since the mid-1990s is target costing, which is a method of engineering a product and its manufacturing process from the start with a specific cost model in mind. This approach, which is essentially an elaboration of the engineering costing approach, attempts to create an optimally efficient process from the start—with a profitable yet marketable selling price in mind—rather than waiting until a product is already being manufactured and then setting prices and looking for cost savings. Some implementations of target costing actually don't involve accountants as much as they invlolve product marketing managers, engineers, and others who are part of the actual design and production processes. IMA guidelines also exist for target costing systems.

SEE ALSO : Cost Control ; Managerial Accounting

[ David Kucera ]

FURTHER READING:

"ABC and Target Costing Guidelines." Strategic Finance April 1999.

Chandler, Alfred Dupont. The Visible Hand: The Managerial Revolution in American Business. Cambridge, MA: Belknap Press, 1977.

Johnson, H. Thomas. "Toward a New Understanding of Nineteenth Century Cost Accounting." Accounting Review, July 1981.

Keegan, Daniel P., and Robert G. Eiler. "Let's Reengineer Cost Accounting." Management Accounting, August 1994.

Meigs, Robert F., ed. Accounting: The Basis for Business Decisions. 11 th ed. New York: McGraw-Hill, 1998

Winicur, Barbara. "Cost Accounting Essentials." National Public Accountant, April 1993.



User Contributions:

1
Prince Stephen
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Dec 19, 2007 @ 5:05 am
is good for studying, and understanding of costing
2
RAHMA FEISWAL
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Jul 21, 2014 @ 1:01 am
please give me a worked out example and some few examine questions on all costing methods.

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