Overview of Costing
Costing is the process of identifying the expenses or cost involved in the production process. Managers use costing to help assign pricing. A cost driver is a factor that causes a company to incur expenses because it affects volume levels, activity levels, or both. For example, if employees use a machine on an assembly line for more hours this month than last month, the number of hours is a cost driver. A machine that employees use more often will most likely need new parts, oil, or other maintenance sooner, and it probably uses more power.
Costing can be used to assign expenses for a variety of components, such as products, customers, employees, and even processes. There are three common forms of costing among companies: variable costing, absorption costing, and throughput costing.
Variable costing, also called direct costing, is an expensing method where all variable expenses from the manufacturing process are considered as part of inventory costs. A variable cost is an expense that fluctuates based on the level of volume; a company's variable costs need to be planned with precision. For example, a company's cost of direct materials increases or decreases based on the number of units it sells, so this is a variable cost. Variable costs may also include raw materials and packaging. Direct materials are raw goods that can be traced directly to or easily identified with a product. An example of a direct material would be leather for a company that makes shoes.
Next, absorption costing, also called full costing, is an inventory costing method where both variable manufacturing costs and fixed manufacturing costs are considered as inventory costs. A fixed cost is an expense of operating a company for a specific period of time that remains unchanged despite any change in the company's activity level. An example of a fixed cost would be rent, as its amount would remain the same despite any changes in the company's activity level. With absorption costing, the inventory is in effect "absorbing" all costs associated with the manufacturing process.
Last, throughput costing is an expensing method where only direct materials are considered inventory expenses. Other manufacturing expenses are recorded as period expenses when they are incurred. Throughput costing helps managers find and eliminate bottlenecks—steps in the production process that cause slowdowns and therefore cost the company money. Though very helpful for managers, for financial accounting purposes, however, only absorption costing is allowed.
Roles of Costing in Managerial Accounting
Costing as a practice is useful for two different and separate activities: external reporting and internal reporting. The generally accepted accounting principles (GAAP) are a combination of accounting principles, standards, and procedures that govern the preparation of financial statements. The GAAP requires financial data, where costing plays a large role, to be reported in a specific manner within a specific period. These accounting standards require that costs be consistently recorded. Costing is also useful for internal reporting because it helps managers make better, more accurate decisions about product and service lines.
External reporting allows management and the general public to compare data between time periods to determine the company's financial health. Because nearly all companies use GAAP, investors and members of the public can better compare the performance of rival companies before buying shares of stock. Although costing is vital for external reporting to ensure compliance with regulations and to properly inform the public, it is extremely helpful for internal management uses as well.
Costing plays an important role in managerial accounting. For example, a manager can make decisions on product or service lines using costing. Costing allows managers to learn how much each operation costs with respect to specific products and decisions. This data can help managers decide where to adjust costs to increase the organization's profitability. This also involves taking a deeper look into all costs to determine whether adjusting one cost will inadvertently affect another cost if adjusted or removed altogether.
This data can lead to another important aspect of costing: control. Costing allows management to control costs by various means, such as by an internal cost audit or budgetary control. In other words, managers can try to lower costs by compiling and analyzing a department's financial records to see where the money goes, or they can establish new budget limits to try to keep costs down. Or they can choose both options. Cost data can also help managers make more-informed decisions about pricing and assist companies as they strive to achieve long-term profitability. Thus, costing is a valuable and necessary practice for informing the public and improving the company's financial health.