Chapter 5: Cost Estimation Methods and Costing Systems

Costing Methods by Scope

Depending on the nature of the product/ production process, management chooses among costing methods that differ in the extent of product cost definition. The costing methods by the scope of product cost coverage are;

• Full Costing Method
• Normal Costing Method
• Variable Costing Method
• Direct Costing Method
• Throughput Costing Method

Full Costing Method

In this method, expenditures for all manufacturing related factors are included in the product cost. Direct materials cost, direct labor cost, and manufacturing overhead costs are all included in the product cost with their total lump sum amount.

Normal Costing Method

Normal costing method also suggests covering all manufacturing factors as product cost in parallel to the full costing method; however, in normal costing method costs of indirect manufacturing factors are allocated to products depending on the utilization rates of these factors

Variable Costing Method

As the name states, in variable costing method, only the variable manufacturing costs are included in the product cost, irrespective of whether the cost in question is direct or indirect.

Only the variable manufacturing costs are treated as product costs under variable costing method, variable nonmanufacturing costs are excluded despite their variable nature.

Direct Costing Method

Further diluting the cost coverage, direct costing method accepts only direct costs (direct materials cost and direct labor cost) as the product cost and all indirect costs are treated as period expenses.

Throughput Costing Method

Throughput costing method, which is also called as super variable costing, does not have widespread use in practice. Under this method, only the direct material cost is the product cost, while all other manufacturing related expenditures are considered as period expenses to be reported in the income statement.

Methods by Costing Time

Actual Costing Method

In actual costing method, product cost is calculated at year-end by using the cost data that incurred during the year. In order to calculate the product cost, it is necessary that the production is completed and all related expenditures have incurred.

Standart Costing Method

In standard costing method, costs of all manufacturing factors (direct materials, direct labor and manufacturing overhead) are based on the standards that are previously determined using scientific techniques and methods. Thus, product cost is already known at the beginning of the year.

Methods by Costing Approach

Fundamentally, there are two main costing systems that differ in costing style:

• Job Costing
• Process Costing

Job Costing

Different production costs incur for each product. With the help of job costing system, the cost of each job is separately calculated. In calculating the cost of a job, all manufacturing costs (both direct and indirect) should be considered. Direct costs are traced to jobs with the help of some data records, such as materials requisition records for direct materials and labor-time sheets for direct labor.

Allocation rate represents the amount of overhead cost allocated to jobs whenever a unit of allocation base is used/spent during the accounting period.

In normal costing method, budgeted allocation rates are used as opposed to actual costing. Therefore, timelier information is available with normal costing. At the end of the year, the normal cost is adjusted to the actual value and the adjustment is reflected in financial statement items, such as COGS and inventories.

If the Company Applies Actual Costing System;

Step 1 – Determine the cost object

Step 2 – Trace direct costs to cost objects

Step 3 – Determine the allocation base to use in allocating overhead costs to cost objects

Step 4 – Identify the overhead cost to allocate

Step 5 – Calculate the allocation rate to use in allocating overhead cost

Step 6 – Allocate the overhead cost to cost objects using the rate calculated in step 5

Step 7 – Calculate the total cost of Job

If the Company Applies Normal Costing System;

Step 1 – Determine the cost object

Step 2 – Trace direct costs to cost objects

Step 3 – Determine the allocation base to use in allocating overhead cost to jobs

Step 4 – Identify the overhead cost to allocate

Step 5 – Calculate the allocation rate to use in allocating overhead cost

Step 6 – Allocate the overhead cost to cost objects using the budgeted rate

Step 7 – Calculate the total cost of Job

Process Costing

If a company produces in masses of identical products, applying job costing is not a possible way to calculate the product cost. In this case, total costs are assigned to many identical products with the help of process costing. As a result of process costing, each unit receives the same or similar amounts from cost factors of direct materials, direct labor and manufacturing overhead.

In general, process costing classifies and considers manufacturing costs in two groups; direct materials and conversion costs.

Equivalent unit is a derived measure of output that reflects the number of completed units that could be produced with the same quantity of input consumed for both finished goods and workin-process inventories.

To calculate the unit cost, there is a five-step procedure of process costing. The steps are as follows:

1. Summarize the flow of physical units of output
2. Compute output in terms of equivalent units
3. Summarize the total cost to account for
4. Compute the cost per equivalent unit
5. Assign total cost to completed units and ending work-in-process inventory

If Pro-Cost Computer Applies Weighted Average Method: In the weighted average method, the company does not need to consider whether the completed product was from beginning inventory or not.

If Pro-Cost Computer applies FIFO: First-in-First-out method is appropriate if the company completes the workin-process inventory at first, and then starts the production of new units.

FIFO is not appropriate as an interdepartmental approach. It is applied within each department to compile the costs for units transferred out.

Refining The Costing System

Peanut butter costing is the name given to a costing system that broadly averages or spreads the cost of resources uniformly to cost objects.

Product-cost cross-subsidization is the term used to define the situation in which over-costing in one or more products results in under-costing in other products.

Quite similar to broad averaging the costs to units; using a single allocation base to allocate all indirect costs is no longer an efficient way of cost assignment. This is because increased variety in production processes has resulted in an increased variety of indirect costs, which are driven by different factors.

The company was applying a simple costing system with only one allocation base and the cost calculation was done by following these steps:

Step 1: Identify the cost object

Step 2: Identify the direct costs

Step 3: Select the cost allocation base to use at the allocation of indirect costs.

Step 4: Identify the indirect costs to allocate

Step 5: Calculate the allocation rate per unit of the allocation base

Step 6: Calculate the indirect cost allocated to products

Step 7: Compute the total cost of products

Refinement of Costing System

A refined costing system provides a more detailed analysis of cost assignment (rather than broad averaging), especially in terms of indirect costs’ allocation. In order to succeed in this, there are some key points, such as increasing the share of direct costs in total, increasing the number of indirect cost pools, and using more allocation bases for more diversified activities, etc.

Increasing the direct costs’ share in total cost increases the reliability of cost assignment because tracing the direct costs is more reliable than allocating the indirect costs.

Activity-Based Costing System

Activity-based costing (ABC) is a refined version of simple costing system, with increased number of cost pools and allocation bases. In an ABC system, the whole process is considered as a chain of activities and individual activities are the fundamental cost objects.

Activity can be defined as any event or task that is carried out in order to meet a specific goal, such as designing, assembling, testing, etc.

Following the instructions of Mr. Danış, product costs are calculated with the same 7-Step procedure:

Step 1: Identify the cost object

Step 2: Identify the direct costs.

Step 3: Select the cost allocation base to use in allocation of indirect costs

Step 4: Identify the indirect costs to allocate

Step 5: Calculate the allocation rate per unit of allocation base.

Step 6: Calculate the indirect cost allocated to products

Step 7: Compute the total cost of the products