Topic 6

Costing
o Cost Concepts
o Types of Costing Systems

o Summary

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TOPIC 6: C o s t i n g
 Learning objectives

On completion of this topic, you should be

able to:

!" define the following terms related to

cost measurement:
- overhead costs
- activity-based costing
- variable costing
- absorption costing;

!" define the terms and describe the

differences between the following costing
systems:
- standard cost systems
- actual cost systems
- job costing
- process costing
- batch costing
- overhead allocation;

!" state the factors that can influence the

selection of a costing system;

!" explain how an activity-based costing

system is different from a traditinal
costing system;.and

!" outline the stages in implementing an

activity-based costing system.

40 F I N A N C E F O R E F F E C T I V E M A N A G E M E N T
Cost measurement is a vital part of many
business activities. Although measurement is
only the first step in a process, which is
necessary to monitor, control, plan and
market services and products. ‘Analysis’ of
the measured costs is necessary. Just
knowing something is not of much use to us
unless we can also use that information.
This analysis phase of costing we call ‘cost
management’.

Cost concepts

What are overhead costs?

Overhead costs are indirect costs that cannot
be directly related to a particular service
or product. An example is factory rent (or
factory lease if the factory is leased or
factory depreciation if the factory is owned
outright). We usually cannot say that the
cost in this case relates to (say) a batch of
cars produced using the factory’s facilities.
We therefore need to allocate the rent cost
somehow.

What is activity-based costing (ABC)?

Activity-based costing (ABC) is a management
accounting information system that:
identifies the various activities performed
in an organisation; collects costs on the
basis of the underlying nature and extent of
those activities; and assigns costs to
products and services based on those
activities. It has been argued that ABC is a
method of improving the quality of management
accounting information in situations where
conventional overhead allocation methods may
produce misleading results.

What is an activity?
Three examples are receiving goods,
inspecting goods and storing goods. We have
to work out the cost of the activities as the
first stage with ABC. Then we allocate the
costs of the activities of product/services
using cost Driver. This is the second stage
in ABC.
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TOPIC 6: C o s t i n g
 What is variable costing?
Variable costing (sometimes called marginal
or direct costing), costs a product or
service at the costs incurred to directly
manufacture the product/provide the service,
i.e. only including the variables costs.
Variables costs are those costs that change
as the level of production/sales changes.
Examples are direct labour (more direct
labour equals more production/sales, direct
material more direct material equals more
production/sales and so on.).

Many organisations prepare their accounts

based on variable costing principles since
this format provides management with better
information for internal decision-making.

What is absorption costing?

Absorption costing (sometimes called full
costing) includes fixed overhead in the cost
of a product or service. Therefore under
absorption costing some method of allocating
that overhead is required. Absorption
costing is usually the required costing
measurement method for reporting inventory in
external financial reports.

Types of costing systems

What is a standard cost system?

A standard cost system measures
services/products at what these
services/products should cost as previously
determined. The standards can be traced back
to the master budget. In particular, the
standard direct material cost for product X
would be the unit cost of product X as used
in the direct materials operating budget for
that period. A standard cost system provides
more information for control purposes than an
actual cost system because variances can be
broken down into more parts.

What is an actual cost system?

An actual cost system measures
services/products at their actual cost, that

42 F I N A N C E F O R E F F E C T I V E M A N A G E M E N T
is, the amount spent on materials, the amount
spent on labour and so on.

Standard and actual cost systems can occur

under job or process costing and use any of
the cost-flow assumptions mentioned below.

Companies often adopt one of two basic

costing systems to assign costs to cost
objects: job costing or process costing.

Job costing
Job costing is used when each order is
substantially different from other orders and
the estimation of a common set of production
costs is impossible. A further
characteristic of the typical job-costing
environment is the high level of
customisation, which occurs, and the lack of
standard type products. Therefore, each
order’s (job’s) costs are accumulated
individually, and are not aggregated, which
results in each being costed as a separate
unit. Under a job costing system, the cost
object to which costs are assigned is an
individual job or product type. Each job is
unique and separately identifiable from other
jobs because usually the jobs are ‘custom’
jobs, i.e. services/products provided to suit
particular clients wants.

Process costing
Process costing is used in an environment
where large volumes of products flow through
more than one production department.

The costs of the department for the period

during which the product is flowing through
are then assigned to the units produced in
that period. The units then pass through to
the next department carrying with them the
costs of the first department and so on
through the production process.

A fundamental characteristic of process

costing is that it adopts an averaging
methodology when assigning costs to the
products produced. In a process costing
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TOPIC 6: C o s t i n g
 system, the cost object to which costs are
assigned is a whole process. Large numbers
of similar units are produced and the costs
assigned to the process are averaged to
calculate a unit cost of the product.

A process costing system accumulates all the

production costs for a large number of units
of output and then averages these costs
across all the units produced. For example,
when Toyota manufacture Corolla sedans they
will cost that batch of Corollas separately
from a batch of (say) Toyota Celicas. But
they would presumably use a form of process
costing.

Batch costing
This is a variant of the process method where
the product flowing through the departments
are organised into batches of finite volume.
Each batch is then assigned the department
costs as they flow through the factory, which
are then averaged over the units in the
batch.

Therefore the method of production, or to put

this concept in another way, ‘‘the conversion
process creating cost objects’’, is a
significant determining factor in the
selection of an appropriate costing method.
How does the particular operating and
distribution methodology of an organisation
influence the choice of an appropriate
costing method? Some factors that can
influence the selection of an appropriate
costing system include:

• The existence of joint products or by-

products. (Their existence alone does not
necessarily determine the actual costing
methodology, but it makes the averaging
process more complex.)

• The length of the production cycle eg. a

long-term construction project would
necessitate the use of job costing
procedures.

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• Whether a product or project that,
because of its size, may be divided into
separate components requiring a system of
allocation, and the type of situation
where mixed systems are required. For
example building a tunnel under a harbour
to take trains and motor vehicles. The
stages that night be separately costing
are: planning stage (geological surveys,
architecture drawings etc) development
stage 1 (tunnelling and earth removal),
development stage 2: (landscaping),
development stage 3 road survey and
facilities implementation and development
stage 4 (quality control and testing of
facilities).

Overhead allocation
The two main methods of costing products and
services are absorption costing and variable
costing. The difference between these two
approaches relates to the treatment of fixed
overhead.

These differences arise because, under

absorption costing, fixed manufacturing
overhead is treated as an inventoriable
product cost that initially forms part of the
work-in-process stock - together with any
other direct and indirect variable costs.
When the products are completed the relevant
amounts are transferred to finished goods
stock.

ABC versus traditional costing

In simple terms, ABC is a different way of
allocating overhead. ABC focuses on
activities as the fundamental cost objects.
It uses the cost of these activities as the
basis for assigning costs to other cost
objects such as products, services or
customers. It is not an alternative costing
system to job costing or process costing.
Rather it is an approach to developing the
cost numbers used in job costing or process
costing systems. The distinctive feature of
ABC is that it focuses on activities as the
fundamental cost objects whereas traditional
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TOPIC 6: C o s t i n g
 costing focuses on the product or service as
the cost object. Under traditional costing
the assumption is made that products /
services consume resources. Under ABC
products/services consume activities and
activities consume resources.

We can illustrate this simple concept by

examining the diagram on the next page.

ABC TRADITIONAL

Resources Example:
Factory space

Consumed by

Consumed by
Example:
Storing parts Activities
prior to
manufacture

Consumed by

Example:
Products/Services Making
motor bikes

ABC focuses on collecting and allocating

costs using cost and resource drivers.

Implementing an activity-based costing system

ABC implementation can be viewed as a two-

stage process.

Stage 1 requires that the organisation

determine what activities are performed by
company resources. This first stage assigns
the expenses of support resources to the
activities performed by these resources. An
activity is a unit of work performed in the
organisation. Resource costs are already
recorded in the accounting system as wages,
supplies, etc. The ABC approach therefore

46 F I N A N C E F O R E F F E C T I V E M A N A G E M E N T
starts from the assumption that activities
cause costs.

Stage 2 attributes costs to products based on

their use of resources. This assumes that
products and customers create the demand for
activities. In the second stage, activity
costs are assigned to products based on
individual products’ consumption or demand
for each activity. Thus, products with
greater demand for a particular activity have
greater expenses assigned to them based on
the relative proportion of that demand.

Five phases are recognised for the

introduction of an ABC system:

1. Plan the system.

2. Analyse and define resource categories.

3. Analyse and define activities.

4. Determine first-stage resource drivers

and establish activity cost pools.

5. Determine second-stage activity drivers

and assign costs to cost objects.

Summary

Cost measurement is a vital part of many

business activities. Although measurement is
only the first step in a process, which is
necessary to monitor, control, plan and
market services and products. ‘Analysis’ of
the measured costs is necessary. Just
knowing something is not of much use to us
unless we can also use that information.
This analysis phase of costing we call ‘cost
management’.

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TOPIC 6: C o s t i n g