Costing Systems and Cost Control

We start this topic with an introduction to the process of assigning costs to individual products to determine total product cost. We then discuss the two 'traditional' absorption costing systems—job costing and process costing - before looking at two other systems ncreasingly being adopted: just-in-time and activity-based costing. We will also briefly discuss the nature of the variable costing method and its potential uses before concluding the topic with a discussion of standard costing and cost control.

The cost of a product can be defined as the total of the prices paid by a business for the raw materials, labour and manufacturing overheads that are used to produce the product.

The determination of product cost is necessary to:

  • value stock and measure profit
  • assist a business in making pricing and other decisions such as whether to continue
  • measure the performance of the department or cost centre responsible for producing the

A number of different costing systems can be used to assign costs to products, and these broadly use one of two methods: the absorption costing method or the variable costing method. The absorption costing method is so named because it provides for the absorption of all manufacturing overhead whether fixed or variable, into units of production. By contrast, the variable costing method treats fixed costs as a period cost and charges them to the operations of the period in which they are incurred rather than to the individual product or service.

There are four different absorption costing systems used to assign the costs of manufacture to products: the traditional systems of (i) job costing and (ii) process costing and the newer systems of (iii) just-in-time costing and (iv) activity-based costing.

The job-costing system is designed to control the costs for firms that produce individual orders or individual jobs to a customer's requirements. Individual jobs or small batches require the organisation to keep individual cost records for each job or batch. Each unit of production will move through the production process as an identifiable unit with a job number, and all costs related to that job are charged to it. The selling price of the job can be evaluated against the total cost of the job, and the three cost elements making up that cost—materials, labour and overhead—can be analysed and presented.

Process costing is the term used to describe the method of accounting used when identical items are mass-produced or produced in a continuous flow. Process-costing firms often have specialised machinery arranged so that a standard product will go through all the machinery for that process. In contrast, job-costing organisations tend to have general purpose machinery. The purpose of process costing is to calculate the product unit cost for goods completed during the period and those remaining in inventories at the end of the period.

  • Costs are accumulated according to department, cost centre or operational unit and are not assigned to a particular batch of production.
  • Costs are accumulated for a time period (week or month) rather than for a completed job.
  • A work-in-progress account is maintained for each area of operations.
  • If a product passes between departments, cost centres or operational units the cost attaching to the product becomes the equivalent of the raw material cost to the subsequent department.
  • Process costing with increasing automation involved blurs the distinction between labour and indirect labour, an overhead item. As both are incurred in some consistent proportion they are referred to as conversion costs.

If all units started during the period are finished, determining the unit cost is easy. We simply add the material and conversion costs and divide by the number of units produced. The charging of costs in a process costing environment becomes complex when we have units unfinished at the end of the period. The solution is to use the equivalent production concept. This restates all partially completed units in terms of the equivalent number of complete units. The other major aspect of process costing is how to treat opening work in process which has costs attaching to it. Two methods are available. The first, weighted average, adds opening inventory costs to the costs of the new period to create a unit cost that is an average of the period. The other method, FIFO, keeps opening inventory costs separate from those incurred in the new period and values them separately until they are transferred out of the cost centre.

The just-in-time (JIT) technique of manufacture has received much attention in recent times. The JIT system, which is also referred to as zero inventory, stockless production, or Kanban, was first developed by the Toyota Company and now has been adopted by many other Japanese companies. The primary objective of JIT is 'reduction of cost through elimination of waste'. Waste is defined as anything other than the minimum amount of equipment, materials and workers that are absolutely essential to production. JIT advocates that each process should produce the necessary parts in the quantities needed just in time to be sold or used by the next process.

JIT is an overall operation system, not just an inventory system. Implementing JIT requires some major changes in manufacturing practices but results in significant benefits such as reduction of work-in- process inventory, decrease in lead time, improvement of quality and productivity, and increase in flexibility and adaptability to changes in market.

With changing technology and a need to improve performance, the limitations of the traditional method of accumulating and reporting cash have been identified by Cooper and Kaplan (1991) as follows:

  • Management accounting requirements are being driven by the requirements of financial accounting with its emphasis on profit measurement and inventory valuation. Costing systems based on inventory valuation needs do not always clarify the need to cost products correctly.
  • Direct labour as a basis for overhead allocation is less relevant given changing technology.
  • Classification of costs into fixed and variable components along traditional lines is less valid given computerised production control, robotic production lines and other technological developments.
  • With emphasis on quality, customised design and speed of ordering and delivery, expansion of overheads in these activities would appear necessary. At the same time increased complexity of business and constantly changing markets require firms to have a management accounting system that can accurately identify product costs.

Activity-based costing (ABC) system was developed to overcome the deficiencies of product costing. It is a response to the need for accurate information that can be obtained quickly. Activity-based costing involves a change in the method used for product costing. Under the traditional cost assignment methods, overhead is generally allocated by the use of a single plant-wide application rate. Activity-based costing recognises that every product may not utilise every component of overhead at the same intensity or at all. The activity-based costing approach permits multiple bases or cost drivers to be used in the assignment of costs. This better aids the use of bases that have a cause-and-effect relationship to the production of the product.

In valuing inventory, activity-based costing will require the use of several overhead charging rates in place of the plant-wide rate previously used. Activity-based costing views not only manufacturing costs but also research and development, marketing and other costs as applicable to products rather than as period costs under the traditional method of costing and reporting.

Absorption costing is the usual basis for valuing inventory and allocates a portion of fixed manufacturing overhead to each unit produced during a period, along with variable manufacturing costs. This makes it suitable for valuation of stock purposes but not for decision-making purposes. An alternative costing method known as variable costing has therefore been developed that focuses on cost behaviour to determine unit cost. Under this method, fixed costs are treated as a period cost and are charged to the operations of the period in which they are incurred. Variable costing highlights the difference between sales and variable costs, which is referred to as the contribution margin.

Control of costs can only be exercised at the time or event where the cost is actually incurred. Costs are therefore controlled by the people responsible for such functions, and they are evaluated and reported on the bases of responsibility accounting adopted. One way of controlling costs is for a firm to implement standard costing. This enables reports to be prepared which identify the differences between actual and standard costs and establish responsibility for any variances that have arisen. Standard costing concentrates on reporting the effect of the exceptions that do not meet the standard. The differences are described as variances from standards. The concept of standards can be applied to selling prices as well as production and distribution costs.

Quality is linked to profitability, and inferior or defective products that fail to satisfy quality standards are detrimental to performance and company reputation. Quality-linked activities determine whether or not poor quality does exist. The cost of performing these activities is referred to as costs of quality. The conformance costs of meeting quality standards are generally classified into three categories: prevention, appraisal and failure. Prevention costs are incurred in precluding the production of poor-quality products or services. Appraisal costs are incurred in identifying poor-quality products or services before the customer receives the goods or services. Failure costs are incurred because poor quality exists, and may be divided into internal and external failure costs.