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Costing Systems

- designed to monitor the costs incurred by a business. The system is comprised of a set of forms,
processes, controls, and reports that are designed to aggregate and report to management
about revenues, costs, and profitability. The areas reported upon can be any part of a company,
including:
 Customers
 Departments
 Facilities
 Processes
 Products and services
 Research and development
 Sales regions
- It is used by management for certain purposes, includes the following:
o Fine-tuning operations to generate higher profitability
o Deciding where to cut costs in the event of a business downturn
o Matching actual costs incurred against budgeted cost levels for control purposes
o Creating strategic and tactical plans for future op
o Typeserations

The reports of a costing system are intended for internal use, and so are not subject to the reporting
requirements of any of the accounting frameworks, such as GAAP or IFRS. Instead, management can
decide what types of information it prefers to see, which information to ignore, and how the results are
to be formatted and distributed for its consumption. Typical reports created by a costing system include:

 Budget-versus-actual reports for costs incurred

 Profitability reports for customers, sales regions, stores, products, and/or product lines
 Expense trend reports that show expenses incurred by month for many consecutive months

These reports may be accompanied by additional information assembled by the accounting department,
which provide details regarding how certain costs were incurred and who authorized them.

Types of Costing Systems

There are two main types of costing systems. A business can accumulate information based on either
one, or adopt a hybrid approach that mixes and matches systems to best meet its needs. The primary
costing systems are:

 Job costing system. Materials, labor, and overhead costs are compiled for an individual unit or
job. This approach works best for unique products, such as custom-designed machines or
consulting projects. The cost accumulation process is highly detailed and labor-intensive.
 Process costing system. Materials, labor and overhead costs are compiled in aggregate for an
entire production process, and are then allocated to individual production units. This approach
works well for large production runs of identical items, such as a production run of 100,000 cell
phones. The cost accumulation process is highly efficient and portions of it can possibly be
automated.
  Another costing system option is activity-based costing (ABC). ABC was developed in response to
concerns that overhead costs are rarely allocated in an appropriate manner, and involves a finer
degree of differentiation in determining how overhead costs are assigned to different cost pools,
and then how the costs in those pools are allocated to cost objects. An ABC system can be
difficult to set up and operate, and so works best when designed for very specific cost allocation
projects that have clearly defined boundaries.

https://efinancemanagement.com/costing-terms/types-of-cost-accounting

Activity-based costing is a costing method in which various activities in an organization, typically a

factory, are identified and then costs are allocated to these activities. The costs accumulated in
these activities are further allocated to the products and services based on the actual consumption
by each product. Activity-Based Costing assigns costs to products, services based on:

 Activities which go into their production

 Quantity of resources consumed by these activities

The firm decides to use ABC costing to find out the relevant costs. Following are the steps which firms
will have to take:

Identify Activities

Identify what all activities are required to manufacture the product. In our example, the activities may
be purchasing, processing, transporting, etc.
Pool Expenses in Each Activity

Break-down each activity into individual costs associated with that activity. A group of all these
individual costs associated with that activity is known as a cost pool. To explain it again, a cost pool is
the group of all individual costs associated with an activity. For e.g., for an activity called processing,
individual costs will be cutting costs, stitching costs, coloring costs, inspecting costs, etc. If we group all
these four costs, we will get a cost pool called processing costs.

Identify Cost Drivers

Identify cost drivers for each activity. A cost driver is a unit of activity which changes the costs associated
with that activity. For e.g. for a cost pool like purchase costs, this unit can be the number of parts
(sheets of cloth in our case of manufacturing clothes) purchased. For a cost pool such as processing
costs, man-hours usage can be the cost driver.

Derive Rate of Using Each Activity

Now, suppose the cost pool of processing shows an amount of $3,00,000. And suppose the company’s
manpower had to spend 10,000 hours to process all the three products. Now, recall that manpower is
your cost driver for processing activity. So, step 4 is to divide the total of a cost pool by the number of
units of a cost driver. So, our case, we will divide $3,00,000 (total of a cost pool) by 10,000 hours (total
units of the cost driver). What we have got is $30 per man-hour. This $30 is the rate of using a worker or
the manpower for an hour.

Evaluate Total Cost

In step 5, we finally find out how much the cost of activity belongs to which product. We know that the
total cost associated with processing is $3,00,000. We also know that the total manpower hours spent in
processing is 10,000 hours. Now suppose, out of these 10,000 hours, the company spends 4,000 hours
on processing jeans, 3,000 hours on processing shirts and 3,000 on trousers. Since the rate of using
manpower for 1 hour came out to be $30 in step 4, the processing costs for manufacturing of all the
jeans is 4,000 (manpower hours) * 30 (rate of manpower per hour) = $1,20,000.

This is how Activity Based Costing helps us to accurately determine which product deserves how much
of the total costs incurred. This allocation helps us to find out the exact profitability of all the products. If
the firm doesn’t know much does an individual product costs them, it might happen that out of the 3
products manufactured, 1 product is making losses and the company never comes to know about it
because the company doesn’t know its cost.

Marginal Cost Accounting

Marginal Costing is the type of costing in which only variable costs are assigned to the product while the
fixed costs are considered as the costs for the period. This means that the fixed costs such as rent,
electricity, etc are directly a part of the Income Statement as expenses and are not assigned to any
particular product.

The marginal cost of a product is its variable cost. This cost includes items such as direct material costs,
direct labor costs, etc. As the volume of production changes, these costs also change proportionately.
Fixed costs, on the other hand, are costs which remain unchanged regardless of the volume of
production.

In this approach, it is not possible to identify net profit per product since we don’t know how much of
the fixed cost belongs to an individual product. This approach only gives the amount of contribution to
fixed costs and profits. The contribution is the difference between total revenue and the total variable
costs.

Lean Accounting

Lean accounting has some principles and processes that provide numerical feedback for manufacturers
implementing lean manufacturing and lean inventory management practices. Traditional accounting
system recognizes inventory as an asset even if the inventory sits on the shelf for a year and has holding
costs associated with it. Lean accounting, however, takes into account that more than necessary
inventory at a time is bad for the company and has costs associated with it in terms of holding costs, the
opportunity cost of the cash blocked in inventory, etc. Lean accounting takes this into account and
defines efficiency, not in terms of production in a month, rather, it defines efficiency in terms of how
much time processing an order takes?1–4