I am an ex-bank executive now whiling away my time in teaching and traveling.
Profit is the yardstick for evaluating the performance of any business concern. Since ultimate profit depends upon plan and control, cost accounting plays a vital role. Previously, cost accounting was mostly engaged in ascertaining the costs of products or services on the basis of time-series analysis. Due to competition and technological development, the role has shifted to cost reduction, which depends upon the availability of relevant information well in time.
In financial accounting, a company has to follow generally accepted accounting principles, called GAAP, to arrive at profitability. No such restriction is imposed in the case of cost accounting since it is used internally for decision-making.
Product Cost or Period Cost?
In many industries, manufacturing costs are the major costs incurred in the value chain. In such industries, the distinction between product cost and period cost is quite simple.
Product costs are manufacturing costs such as raw materials, labor and manufacturing overheads. The products are inventoriable. If a carpet manufacturing concern has produced 10,000 square meters of carpet but sold only 2,000 square meters, it could still be profitable as there may be enough profit margin per square meter. (The remaining 8,000 are part of its inventories and may be sold at much higher prices next year.)
Period Costs are, however, non-manufacturing costs essential to sell a product. Such costs are not considered in stock valuation and are charged in the years in which these were incurred. Continuing the carpet example, if the company had made selling and administrative arrangement for disposal of 10,000 sq. meters but, unfortunately, only 2,000 were sold, the S&A costs would not be apportioned between sold and not sold but would be matched fairly and squarely, against revenues generated by the sale of 2,000 sq. meters. There may still be some profit though only 20% of output was sold.
Different Costing Techniques
Distinguishing between product costs and period costs is necessary for working out profit for a certain period of time. Finalization of accounts takes time. This creates a problem when an executive needs cost information instantly about a product or a process. Over the period, the accounting profession has come up with a variety of techniques for providing useful and timely information.
In the side diagram, three such techniques are displayed. Since the last one, 'Throughput Cost,' considers only raw materials as product costs, cost information is available instantly. If a university provides every student with a laptop and set of books on admission, the direct costs are available even before the student leaves the admission office.
In an automated process, direct material may be the only unit-level level activity, and so is the only product cost. It would reduce the incentive to overproduce. Moreover, the average unit cost will not vary with the changes in production levels.
Throughput costing is a relatively new development. This will be discussed later in the hub.
CIMA has defined Absorption Costing as "a method of costing that, in addition to direct costs, assigns all, or a proportion of, production overheads costs to cost units by means of one or more number of absorption rates."
According to this:
- It is a costing technique that accumulates all costs associated with the production of goods or services.
- It is also known as full costing as it creates a complete picture of the financial situation.
- It ensures that all costs incurred for the manufacture of a product are well recovered from the selling price assuming the customers are willing to pay for it.
- The theoretical justification for absorption costing is to honor the matching principle for all manufacturing costs.
- This method shows a higher net income when production exceeds sales.
Variable costs are directly related to production. These are also called formula costs since one can calculate beforehand the total variable costs of a planned production. A tailor knows how much cloth and stitching time is required for one shirt. Similarly, a manufacturing concern can work out the variable cost per unit by adding up raw materials and labor plus a part of variable manufacturing overheads (power usage and auxiliary raw materials). The main features of the variable costing method are given as under:
- It is used for internal purposes only.
- It is not acceptable for external reporting or income tax purposes.
- Its use includes (i) Break-Even Point, (ii) relevant cost analysis, and (iii) short-term decision-making.
- Firms with high variable costs are less prone to business risk compared to high fixed-cost firms such as hotels or airlines.
- The difference between hi-variable and hi-fixed costs affects the financial structure and Break-Even Points. The latter resort to more debt financing, and their Break-Even Points are usually high.
- There would be a higher net income when sales exceed production.
Throughput costing treats all costs as period expenses except for direct materials. It is also called super-variable costing. It is very suitable for those companies where labor and overheads are fixed costs. Assembly-line and continuous processes that are highly automated are most likely to meet this criterion. In such companies, workers are usually well-educated engineers or technicians employed on a permanent basis.
The main features are:
- It helps incremental analysis for meeting special orders when there is an excess capacity. An airline can take passengers much below the normal fare when it observes that some seats are empty for want of booking or cancellation or no-show passengers.
- It is a dynamic, integrated, principle-based approach.
- It provides managers with decision support information for the optimization of resources.
Absorption, variable and throughput costing are alternative product-costing methods. The difference is the treatment of certain cost elements. Under absorption or full cost method, all manufacturing costs are treated as product costs. In financial accounting, this method is used in inventory valuation and is acceptable to tax authorities. In fact, all annual accounts are prepared on this basis to facilitate inter-company comparison or calculation of industrial ratios.
Variable costing covers only variable costs, while all fixed costs are treated as period costs. This type is more suitable for operational decisions as fixed cost, being committed, is irrelevant for most decisions.
In the present high-tech environment, direct labour has disappeared. Generally, a few engineers operate the plant. Hence, the only throughput costs (raw material costs) vary with the change in production. This would reduce the incentive to overproduce to cut down cost per unit.
The only common feature among the various methods is the focus or stress on providing information for decision-making. Since some techniques are used only internally, the company image or standing is not affected, which is certainly reflected by annual reports prepared after taking into account industrial norms and GAAP.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
ELIZABETH MEADOWS on July 07, 2017:
Can I use Throughput Costing when I calculate my COG for US federal income tax? Very small business, we don't use financial statements, are on periodic inventory, cash basis, producing one product. Calculating overhead per unit would be time-consuming. Would prefer to expense during the period.
Tholang on April 26, 2017:
what are the differences between marginal cost and throughput
hafeezrm (author) from Pakistan on June 13, 2012:
ABC is only useful where products differs much. If products are the same or require equal resources, ABC would not be appropriate. It is up to you to consider if one reports takes too much time than the others or requires a much expensive expertise. Otherwise simple costing would do.
misu on June 13, 2012:
I'm searching which costing system to use in a regulation advisory company for my MBA paper, where they produce regulation reports on multiple sectors and have clients having yearly membership for access to reports. In this case, marginal cost of producing one more report is close to zero and most of their costs are fixed costs, except the salary of analysts producing the reports.
I have applied full costing & variable costing, but I think ratio of fixed costs is too high that those 2 methods do not give a fair view. Would you advise ABC costing or is there any other methods advised for similar cases?
Thanks for the support,
hafeezrm (author) from Pakistan on May 21, 2012:
I like Cost Accounting by Charles T. Horngren.
Annu on May 21, 2012:
Sir, Could you please suggest some good titles on Costing?Most of the books are written from academic perspective but for professionals,there aren't many. Would you be aware of any such author?Thanks.
wendy on April 29, 2012:
thank u very much
hafeezrm (author) from Pakistan on April 28, 2012:
Maybe it is an over-statement or the difference is not important. I would advise you to search it on the Internet and if anything significant is found, you may advise me as well.
wendy on April 27, 2012:
why no difference in costing between service and manufacturing firms?
hafeezrm (author) from Pakistan on April 23, 2012:
There is no difference between service and manufacturing firms in regard to costing. While in service, the output is not physical, the inputs are.
ABC involves a lot of preliminary work. NGO can start it on small scale. All they have to do is to breakdown their traditional accounts into activities performed and then pooled it together.
On a small scale both systems can run side by side till benefits of one is obvious.
Bayu Pradnyana on April 23, 2012:
Hi, i am just wondering.
what do you think the differences between service and manufacturing firm in terms of their costing system?
and, how about NGOs, will they be able to use ABC costing system or it depends on their capacity?
thank you, hope to get a reply ASAP
hafeezrm (author) from Pakistan on February 18, 2012:
Thank Niha for visiting my hub.
Fixed Cost for carpet manufacturer: Depreciation, Salaries of Permanent Staff, fixed manufacturing overheads.
niha on February 17, 2012:
can u tell me a fixed cost for carpet manufacturer?
hafeezrm (author) from Pakistan on February 06, 2012:
Thanks Fred for your comments.
fred on February 06, 2012:
very valuable info.thanks
hafeezrm (author) from Pakistan on January 30, 2012:
Perhaps you mean absorption costing and variable costing. There is no such thing as fixed costing.
Absorption costing is full costing i.e. it includes variable manufacturing costs and fixed manufacturing costs. Whereas in variable costing, only variable costs is included for inventory valuation while fixed costs is expensed out in the same year and not included in inventory. (As stated in my article, it is only for internal purposes)
I hope it answers your question. Please do not hesitate if you require any additional explanation.
sanjay on January 30, 2012:
what is the main difference between fixed costing & variable costing in managerial decision.
hafeezrm (author) from Pakistan on October 16, 2011:
Thanks @htodd for your comments.
htodd from United States on October 15, 2011:
hafeezrm (author) from Pakistan on May 08, 2011:
Dear Luisa and Anna,
Variable Costing and Throughput costings are generated by the accounting system and are already department-wise or job-wise or product-wise. As against this, fixed overheads have to distributed among departments, jobs or products which is a human decision and fraught with many dangers. Accounting profession is always on the looking to find ways and measure to computes costs as soon the product is compelte with full transparency so that its price can be acertained. Variable and Throughput costing are useful in this regard.
Anna on May 08, 2011:
Could you please tell me what are the desadvantages of Throughput costing?
Luisa on May 20, 2010:
I am very impressed by your deep knowledge and your ability to explain these tricky issues.
Could you please explain more about the advantages of variable costing system?
Thank you in advance for your assistance!
hafeezrm (author) from Pakistan on February 05, 2010:
I have no idea about IMA-USA. I am MBA myself. I have found an interesting disussion which may be of interest to you. Please go to the following link:
Athar on February 05, 2010:
Sir,What about IMA-USA CMA Program. Is it better than CIMA /ICMAP CMA?
Accounting firm on January 01, 2010:
More good informations thanks for helping me out. Always a pleasure to see information that is useful, thanks again
Rufi Shahzada from Karachi on October 11, 2009:
Thanks a lot for your guidance. Truly you are a great source of help.
hafeezrm (author) from Pakistan on October 09, 2009:
Thanks Creativeone59 for your constant encouragement.
hafeezrm (author) from Pakistan on October 09, 2009:
You mean CIMA and ICMAP? Well while CIMA is much better, ICMAP is much less costly, being in your own home town. On the basis cost:benefit analysis, I would advise you to complete ICMAP and then go for a 'fast track' route into CIMA’s strategic level examinations, leading to CIMA membership.
Rufi Shahzada from Karachi on October 09, 2009:
Costings are defined so well... Thanks for adding and refreshing knowledge constantly.
I want to ask you one thing that if I want to opt between the two CIMA or ICMA. What should I select ?
Benny Faye Ashton Douglass from Gold Canyon, Arizona on October 09, 2009:
Thanks for a very informative hub. Godpeed. creativeone59
hafeezrm (author) from Pakistan on October 09, 2009:
Thanks for your query. CIMA & ICWA are professional bodies in different countries but for the same purpose i.e. professional development for cost and management accountants. The acronyms stand for:
CIMA - Chartered Institute of Management Accountants
ICWA - Institute of Cost and Works Accountants ( of India)
ICMAP - Institute of Cost & Management Accountsnt of Pakistan.
Trsmd from India on October 09, 2009:
what's the difference between CIMA & ICWA ?