Tag Archives | costing

Standard Costing System

See Also:
Standard Costing Example
Process Costing
Activity Based Costing vs Traditional Costing
Absorption vs Variable Costing
Implementing Activity Based Costing
Cost Driver
Budgeting 101: Creating Successful Budgets
Analyzing Your Return on Investment (ROI)
Product Pricing Strategies

Standard Costing System

In accounting, a standard costing system is a tool for planning budgets, managing and controlling costs, and evaluating cost management performance.

A standard costing system involves estimating the required costs of a production process. But before the start of the accounting period, determine the standards and set regarding the amount and cost of direct materials required for the production process and the amount and pay rate of direct labor required for the production process. In addition, these standards are used to plan a budget for the production process.

At the end of the accounting period, use the actual amounts and costs of direct material. Then utilize the actual amounts and pay rates of direct labor to compare it to the previously set standards. When you compare the actual costs to the standard costs and examine the variances between them, it allows managers to look for ways to improve cost control, cost management, and operational efficiency.

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Advantages and Disadvantages of Standard Costing

There are both advantages and disadvantages to using a standard costing system. The primary advantages to using a standard costing system are that it can be used for product costing, for controlling costs, and for decision-making purposes.

Whereas the disadvantages include that implementing a standard costing system can be time consuming, labor intensive, and expensive. If the cost structure of the production process changes, then update the standards.

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standard costing system

Source:

Hilton, Ronald W., Michael W. Maher, Frank H. Selto. “Cost Management Strategies for Business Decision”, Mcgraw-Hill Irwin, New York, NY, 2008.

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Standard Costing Example

See Also:
Standard Costing System

Standard Costing Example

Here is a simple standard costing example. Let’s take a company that makes widgets. Based on historical data, a cost analyst determines that producing one widget typically requires 1 pound of raw material costing $2 dollars and 1 hour of labor costing $20 dollars. These are the standard amounts and costs for material and labor.

The company expects to produce 1,000 widgets in the upcoming quarter. Based on this sales forecast, and using the standards determined by the cost analyst, the company can plan a budget for the production costs required for the upcoming quarter. The budget includes 1,000 pounds of raw material costing $2,000 dollars and 1,000 hours of labor costing a total of $20,000 dollars. So the total production costs for the upcoming quarter are expected to be $22,000 dollars.

At the end of the quarter, the company analyzes the production process to see how well they stuck to the budget. As it turns out, the company produced 1,000 widgets at a total cost of $35,000 dollars. Clearly, the production process turned out to be more expensive than they had planned. The cost analyst can then compare the standard budgeted costs to the actual costs to see what the differences were and then the managers can analyze the production process to find out why the differences occurred.

Conclusion

Let’s say, as it turns out, the company actually used 1,000 pounds of raw material costing $2,000 dollars and 1,000 hours of labor costing $33,000 dollars. Clearly the variance occurred in the pay rate. For some reason, the labor ended up costing $13,000 dollars more than they had planned. Maybe this is because the original estimates were off. Or maybe some of the workers were working on overtime. Or maybe somebody made a mistake. By comparing the standard cost and the actual costs the company can analyze the situation. Then they can dig deeper to find out what went wrong.

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Process Costing

See Also:
Standard Costing System
Activity Based Costing vs Traditional Costing
Absorption vs Variable Costing
Average Cost
Cost Driver

Process Costing Definition

In accounting, process costing is a method of assigning production costs to units of output. In process costing systems, production costs are not traced to individual units of output. Costs are assigned first to production departments. Then assign the costs to units of output as they move through the departments. The process costing method is typically used for processes that produce large quantities of homogeneous products.

The process costing method is in contrast to other costing methods, such as product costing, job costing, or operation costing systems. Using the process costing method is optimal under certain conditions. Homogeneous indicates that the units of output are relatively indistinguishable from one another. If the output products are homogeneous, then it may be beneficial to use process costing. Low value indicates that each individual unit of output is not worth much. If the output products are of low value, then it may be beneficial to use process costing. If it’s difficult or infeasible to trace production costs directly to individual units of output, then it may be beneficial to use the process costing method.

Examples of Operations To Use Process Costing

Examples of operations likely to use the process costing method over another costing method include the following:

  • Cola bottling plant
  • Company that produces bricks
  • Breakfast cereal maker
  • Company that makes computer chips
  • Company that produces lumber

For example, for the company that bottles cola, it would not be feasible or worthwhile to separate and record the cost of each bottle of cola in the bottling process. Therefore, the company would assign costs to the bottling process as a whole for a period of time. Then they would divide that overall process cost by the number of bottles produced during that period of time to assign production costs to each bottle of cola.


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Process Costing Method

There are five steps in the process costing method. First, analyze the cost-flow model of the relevant inventory account to determine how much inventory was there at the beginning of the period, how much was started during the period, how much as completed during the period, and how much is left as work-in-process at the end of the period.

Second, convert the work-in-process ending inventory into a number of equivalent units produced. This means if there are 1,000 units of inventory in work-in-process, and these units are all 50% complete, then you consider this as the equivalent of 500 units produced (500 = .50 x 1,000).

Third, compute the total direct and indirect costs incurred by the production process that need to be assigned to the units completed and the units still in process. This includes the costs associated with the beginning inventory and the costs incurred during the relevant period.

Fourth, calculate the amount of cost assigned to the completed units of output and the equivalent of completed units of output still in the ending inventory. For example, if a company completed 2,000 units, and left 1,000 units half-finished, then divide the applicable costs by 2,500 units.

Fifth, allocate the relevant costs to the units of product completed and to the units of product remaining in the work-in-process account.

5 Steps for Process Costing

Follow the 5 steps for process costing.

1. Analyze inventory flow
2. Convert in-process inventory to equivalent units
3. Compute all applicable costs
4. Calculate the cost per unit of finished and in-process inventory
5. Allocate costs to units of finished and in-process inventory

Process Costing

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Predetermined Overhead Rate

Predetermined Overhead Rate Definition

A company uses a predetermined overhead rate to allocate overhead costs to the costs of products. Indirect costs are estimated, a cost driver is selected, cost driver activity is estimated, and then indirect costs are applied to production output based on a formula using these data.

Predetermined Overhead Rate Example

For example, imagine a company that makes widgets. In order to make the widgets, the production process requires raw material inputs and direct labor. These two factors comprise part of the cost of producing each widget; however, ignoring overhead costs, such as rent, utilities, and administrative expenses that indirectly contribute to the production process, would result in underestimating the cost of each widget. Therefore overhead costs are allocated to production output via predetermined overhead rates, or rates that determine how much of the overhead costs are applied to each unit of production output.

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Predetermined Overhead Rate Usage

Traditional costing systems apply indirect costs to products based on a predetermined overhead rate. Unlike ABC, traditional costing systems treat overhead costs as a single pool of indirect costs. Traditional costing is optimal when indirect costs are low compared to direct costs. There are several steps for computing the predetermined overhead rate in the traditional costing process, including the following:

1. Identify indirect costs.
2. Estimate indirect costs for the appropriate period (month, quarter, year).
3. Choose a cost-driver with a causal link to the cost (labor hours, machine hours).
4. Estimate an amount for the cost-driver for the appropriate period (labor hours per quarter, etc.).
5. Compute the predetermined overhead rate (see below).
6. Apply overhead to products using the predetermined overhead rate.

Calculating Predetermined Overhead Rate

First, use the following formula to calculate overhead rate.

Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Cost-Driver Amount

See the following calculation example:

$30/labor hr = $360,000 indirect costs / 12,000 hours of direct labor

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How to Manage Inventory

See Also:
Days Inventory Outstanding
Inventory Turnover Ratio
Just In Time Inventory System
Perpetual Inventory System
Supply Chain and Logistics

How to Manage Inventory

Here are some ideas on how to manage inventory.

1. Consider the Costs of Storing Inventory

There is cost in just storing inventory at your or an offsite location. Additionally, there is always a risk of damage or obsolescence. Similarly, theses issues apply to raw materials inventory.

2. Safeguard Inventory

Do you safeguard inventory from theft or damage? It is advisable to do a physical inventory count monthly (more often if loss issues exist). Then compare it to the inventory records.

3. Appropriate Mix of Inventory

Do you have the appropriate mix of inventory on hand for your sales demand? When you closely monitoring anticipated sales, it will help you minimize inventory costs while satisfying demand.

4. Timing of Inventory Purchase

Buying or manufacturing inventory or raw materials before they are needed ties up cash unproductively.

5. Managing Purchase Function

Are you managing your purchasing function? As a result, devoting appropriate resources to purchasing can save money on materials and parts for resale. So, negotiate the best price and buy in bulk when appropriate.

6. Inventory Management System (Managing Inventory)

Create an inventory management system. Then, record each product’s movement as an internal use or sale to a customer. Use the following equation to calculate simple inventory management:

Beginning Inventory + Purchases – Sales or Transfers = Ending Inventory

7. Investigate Differences

If physical inventory count is different from the inventory records, then investigate material differences. Then make corrections to your inventory management process.

8. Assess Inventory Costing Function

Assess your inventory costing function. Depending on the sophistication of your accounting system, inventory transfers may not be handled well for costing purposes. Another common inventory costing problem is invoicing from a negative inventory book balance (sales were recorded before purchases.) In cases like these, inventory costing will be incorrect. Furthermore, a way to correct for an inventory costing problem is to count physical inventory at period end and adjust the value on the balance sheet. The offsetting entry is to cost of goods sold; therefore, this entry should correct both the income statement and the balance sheet.

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How to manage inventory, managing inventory

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How to manage inventory, managing inventory

 

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Job Costing

See Also:
Implementing Activity Based Costing
Standard Costing System
Process Costing
Activity-based Costing (ABC) vs Traditional Costing
Absorption vs Variable Costing

Job Costing Definition

Job costing is defined as a method of recording the costs of a manufacturing job, rather than process. With job costing systems, a project manager or accountant can keep track of the cost of each job, maintaining data which is often more relevant to the operations of the business.

Job Costing Meaning

Job costing, generally, means a specific accounting methodology used to track the expense of creating a unique product. Due to the fact that certain projects, such as construction, require different operations, accountants use this methodology to trace the expenses of each job in order to use this information for analysis and tax needs. Job costing forms have spaces to include direct labor, direct materials, and overhead.

Costs stay in the work-in-process account throughout the job. When the job is finally completed, they are transferred to the finished goods account. By using this method, accountants can make sense of complicated jobs which are moving towards the process of completion.

Indirect costs, like overhead, are applied as a fraction of direct costs. This is usually done in one of two ways: an association with labor hours or using activity based costing. This way, either through use of labor or certain tools, overhead will not be left out of the equation and a company can make sure to cover all essential costs using job costing.

Industries which produce products as jobs use this method. This includes job costing for construction, but goes much farther than just this. Shipping, auditing, maintenance and repair, installation, and any industry which creates products unique to each need. In this situation, job costing is often the most efficient method.

Job Costing Example

For example, Roy was once the curator of a large museum in the United States. Connecting with the science community on many levels, he has enjoyed his career. After some time, Roy decided he would make a career change. He has since started a company which provides maintenance work on historical works which reside in museums.

Roy has all the connections he needs for this business: other curators, archaeologists, and the entire community in his rolodex. After a little effort, he was able to connect with the people who perform this work. Roy will take the role of salesperson, but he needed to hire a team to perform operations. Roy is quite successful. His one concern, an area of ignorance for him, is how the bookkeeping will take place. So he hires an accountant, sets a meeting, and begins to learn about how his business will overcome this need.

The Most Efficient Accounting Methodology

The accountant shares that job costing will be, probably, the most efficient accounting methodology. Roy can keep track of the costs for each of his contracts by implementing this type of accounting. He will be able to find which items take more or less time to maintain. Additionally, he can make sure to create company profits by adding a margin on top of his costs. By using a job costing software, bookkeepers can run the system quite smoothly.

Roy can rest at ease with this accounting method. Knowing he can rely on his accountant, Roy begins to contact prospect customers and former peers. He has confidence that his business will be a success. He looks forward to gaining his first customer.

Job costing is just another way to know your economics or financials. Click here to download the Know Your Economics Worksheet to shape your economics to result in profit.

Job Costing

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5

Activity-based Costing (ABC) vs Traditional Costing

See Also:
Activity Based Costing
Standard Costing System
Cost Driver
Value Chain
Implementing Activity Based Costing
Absorption vs Variable Costing
Activity Based Management
Process Costing
Overhead
Job Costing

Activity Based Costing Costing vs Traditional Costing

In the field of accounting, activity-based costing and traditional costing are two different methods for allocating indirect (overhead) costs to products.

Both methods estimate overhead costs related to production and then assign these costs to products based on a cost-driver rate. The differences are in the accuracy and complexity of the two methods. Traditional costing is more simplistic and less accurate than ABC, and typically assigns overhead costs to products based on an arbitrary average rate. ABC is more complex and more accurate than traditional costing. This method first assigns indirect costs to activities and then assigns the costs to products based on the products’ usage of the activities.

Traditional Costing Method

Traditional costing systems apply indirect costs to products based on a predetermined overhead rate. Unlike ABC, traditional costing systems treat overhead costs as a single pool of indirect costs. Traditional costing is optimal when indirect costs are low compared to direct costs. There are several steps in the traditional costing process, including the following:

1. Identify indirect costs.

2. Estimate indirect costs for the appropriate period (month, quarter, year).

3. Choose a cost-driver with a causal link to the cost (labor hours, machine hours).

4. Estimate an amount for the cost-driver for the appropriate period (labor hours per quarter, etc.).

5. Compute the predetermined overhead rate (see below).

6. Apply overhead to products using the predetermined overhead rate.

Predetermined Overhead Rate Calculation

Use the following formula to calculate predetermined overhead rate:

Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Cost-Driver Amount

For example:

$30/labor hr = $360,000 indirect costs / 12,000 hours of direct labor

Activity-Based Costing Benefits

Activity based costing systems are more accurate than traditional costing systems. This is because they provide a more precise breakdown of indirect costs. However, ABC systems are more complex and more costly to implement. The leap from traditional costing to activity based costing is difficult.

Traditional Costing Advantages and Disadvantages

Traditional costing systems are simpler and easier to implement than ABC systems. However, traditional costing systems are not as accurate as ABC systems. Traditional costing systems can also result in significant under-costing and over-costing.

If you want to add more value to your organization, then click here to download the Know Your Economics Worksheet.

activity based costing vs traditional costing

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