Methods of Costing and Types of Costing
Methods of Costing
Different industries follow different methods to establish the cost of their product. This varies by the nature and specifics of each business. There are different principles and procedures for performing the costing. However, the basic principles and procedures of costing remain the same. Some of the methods are mentioned below:
- Unit costing
- Job costing
- Contract costing
- Batch costing
- Operating costing
- Process costing
- Multiple costing
- Uniform costing
Different Methods of Costing
Here's a breakdown of each different method of costing:
- Unit costing: This method is also known as "single output costing." This method of costing is used for products that can be expressed in identical quantitative units. Unit costing is suitable for products that are manufactured by continuous manufacturing activity: for example, brick making, mining, cement manufacturing, dairy operations, or flour mills. Costs are ascertained for convenient units of output.
- Job costing: Under this method, costs are ascertained for each work order separately as each job has its own specifications and scope. Job costing is used, for example, in painting, car repair, decoration, and building repair.
- Contract costing: Contract costing is performed for big jobs involving heavy expenditure, long periods of time, and often different work sites. Each contract is treated as a separate unit for costing. This is also known as terminal costing. Projects requiring contract costing include construction of bridges, roads, and buildings.
- Batch costing: This method of costing is used where units produced in a batch are uniform in nature and design. For the purpose of costing, each batch is treated as an individual job or separate unit. Industries like bakeries and pharmaceuticals usually use the batch costing method.
- Operating costing or service costing: Operating or service costing is used to ascertain the cost of particular service-oriented units, such as nursing homes, busses, or railways. Each particular service is treated as a separate unit in operating costing. In the case of a nursing home, a unit is treated as the cost of a bed per day, while, for busses, operating cost for a kilometer is treated as a unit.
- Process costing: This kind of costing is used for products that go through different processes. For example, the manufacturing of clothes involves several processes. The first process is spinning. The output of that spinning process, yarn, is a finished product which can either be sold on the market to weavers, or used as a raw material for a weaving process in the same manufacturing unit. To find out the cost of the yarn, one needs to determine the cost of the spinning process. In the second step, the output of the weaving process, cloth, can also can be sold as a finished product in the market. In this case, the cost of cloth needs to be evaluated. The third process is converting the cloth to a finished product, for example a shirt or pair of trousers. Each process that can result in either a finished good or a raw material for the next process must be evaluated separately. In such multi-process industries, process costing is used to ascertain the cost at each stage of production.
- Multiple costing or composite costing: When the output is comprised of many assembled parts or components, as with television, motor cars, or electronics gadgets, costs have to be ascertained for each component, as well as with the finished product. Such costing may involve different methods of costing for different components. Therefore, this type of costing is known as composite costing or multiple costing.
- Uniform costing: This is not a separate method of costing, but rather a system in which a number of firms in the same industry use the same method of costing, using agreed-on principles and standard accounting practices. This helps in setting the price of the product and in inter-firm comparisons..
Approaches to Cost Accounting
Different cost accounting techniques are used in different industries to analyze and present costs for the purposes of control and managerial decisions. The generally-used types of costing are as follows:
- Marginal costing: Marginal costing entails the allocation of only variable costs, i.e. direct materials, direct labour and other direct expenses, and variable overheads to the production. It does not take into account the fixed cost of production. This type of costing emphasizes the distinction between fixed and variable costs.
- Absorption costing: In absorption costing, the full costs (that is, both fixed and variable costs) are absorbed into production.
- Standard costing: In standard costing, a cost is predicted in advance of production, based on predetermined standards under a given set of operating conditions. Standard costs are compared with actual costs periodically, and revised to avoid losses due to outdated costing.
- Historical costing: Historical costing, unlike standard costing, uses actual costs, determined after they have been incurred. Almost all organizations use the historical costing system of accounting for costs.
Reconciliation of Cost and Financial Accounts
Cost accounts act as a check on financial accounts. To achieve this, we have to compare the profit/loss ascertained under the cost accounts with the profit/loss arrived at under the financial accounts. By preparing a reconciliation statement, we can find out the causes of the differences in the cost and financial accounts.
A double-entry system of account is used by large manufacturing firms, and they typically adopt one of the following two methods:
- Integral or integrated accounting. Integral or integrated accounting is when cost and financial transactions are unified. In integral or integrated accounting, cost and financial transactions are not kept separate. Instead, they are together recorded in one set of account books.
- Non-integral or independent accounting. When the cost and financial transactions are kept separate, the method followed is called non-integral or independent accounting. A separate set of books are maintained under this system. Need of reconciliation of cost and financial accounts arises only when non-integral accounting method is followed.
The maintenance of cost accounts and financial accounts in a single set of books is known as integral accounting. In other words, it's the merger of financial and cost accounting by using a single set of books of accounts. This serves the purpose of both financial account and cost account. A cost ledger and three subsidiary ledgers (a stores ledger, a work-in-progress ledger, and a finished stock ledger—see below for more explanations) are also maintained in addition to the general ledger, the sales bought ledger, and sales ledger.
- Cost ledgers. A cost ledger contains all the nominal accounts, and is also known as the principal ledger in cost accounting. These control accounts include the work-in-progress ledger control account, the finished stock ledger control account, the stores ledger control account, and others. In an integral accounting system, these control accounts are maintained in the general ledger; in the non-integral system, the control accounts are kept in the cost ledger.
- Work-in-progress ledger. This is a subsidiary ledger that contains an account for each pending process, job, or operation shop floor. The cost of materials, overhead, and labour is debited from the account. The cost of goods transferred to the finished stock ledger is credited to the account, as and when the goods are completed.
- Finished stock ledger: The finished stock ledger is a subsidiary ledger that contains an account for each item of a job completed or finished product manufactured. Each such completed job or product account is debited with the cost of production and credited with the cost of goods transferred to cost of sales account.
- Stores ledger: The stores ledger a subsidiary ledger where movements of stores or materials are recorded. Purchases of materials are debited to this account, and the issuing of materials to jobs is credited to this account.
Under this method, no costing profit and loss account is prepared, since only one set of account is maintained. Therefore, there is no need for reconciliation of costing and financial profit or loss.
In non-integral accounting, independent cost accounts are maintained. The subsidiary ledgers and the cost ledger are inter-locked through control accounts maintained in each ledger. This practice (maintaining control accounts) is followed for the purpose of cross-checking the accuracy of ledgers, and also to make each ledger self balance so that a separate trial balance may be prepared for each ledger without reference to the other ledgers.
A general ledger adjustment account is opened in the cost ledger for all items of income and expenditure besides the control accounts. It is also known as a "cost ledger control account." The cost ledger also contains control accounts, including the production overheads control account, the wages control account, the administrative overhead control account, and the selling and distribution overhead control account. In a non-integral accounting systyem, double entry is accomplished through control accounts. Therefore, it is also known as a "control accounts system."
- Costing Profit and Loss Account: When cost accounts are maintained independent of financial accounts, a separate costing profit and loss account is prepared for determining the profit or loss of a particular period. This account is debited with the cost of sales and credited with the sales value. It is also debited with items like abnormal losses, under-absorption of overheads, or loss on sale of special jobs, and credited with items like abnormal gains, over-absorption of overheads, or profit on sale of special jobs. The balance of this account will indicate the profit or loss as per cost records, which should be reconciled with the profit or loss as per financial records.
Need for Reconciliation of Cost and Financial Accounts
When financial and cost accounts are maintained independently the profit or loss disclosed in the two sets of books will often be different. This difference in profit/loss necessitates the preparation of a reconciliation statement. This statement will show the reason for the difference in figures in the two accounts, i.e. the cost account and the financial account. It not only helps in checking the arithmetical accuracy of operating results shown by the financial accounts, but also establishes the accuracy of cost accounts.