Deliverable 4 - Costing and Decision Making
Overview of Costing
A company needs to know the total cost of a product in order to determine if the product is profitable. Product costing also allows management to accomplish this objective.
Determining the total cost of a product may seem fairly straightforward, and to some extent it is. However, there are certain types of costs that can complicate matters. For this reason, a company needs to categorize costs to assist with getting costs down to the product level. The two main cost categories are direct and indirect costs.
Direct costs are those costs that are directly associated with a product. They are costs than can be easily measured. Sub categories of direct costs are direct materials and direct labor. Direct materials are the raw materials used to produce a product. We can measure how much was used in producing the product. If we can measure how much was used, we can easily determine the cost of the direct materials that were used in production. Direct labor is the cost of the workers that directly worked on the product. We can also measure how much time they spent working on the product. If we can measure the time they spent, then we can easily calculate how much the direct labor costs were.
Indirect cost represents costs that were incurred in the production process but are not easily traced to a specific product. With direct materials and direct labor, we can see a link between the cost and product. Indirect costs are not easily measured at the product level, but we can intuitively see that they are a necessary cost in the production. For example, a factory supervisor may oversee the production process of many products but they do not “touch” the individual product. We cannot measure their time spent on individual products, just their overall time on the process. However, these costs were necessary in the production of the product. Most companies use an allocation process to distribute the indirect costs, rather than an exact measurement as with direct costs.
Most Common Production Costing Methods
Now that we understand the importance of product costing and a few of the costing terms and categories, let’s look at two common production costing methods: Job Costing and Process Costing.
Job Costing
Job costing is most often used when the units of production are not identical or are commonly "different" from each other. Since the individual units of production are not same, we are required to accumulate the costs associated with each job. Companies that usually use job costing are custom home builders, automotive repair shops, accountants and lawyers.
Process Costing
Process costing, on the other hand, is used when the output consists of virtually identical items that are made in large quantities. Costs are accumulated in "batches" as the products are produced and then allocated to the
individual products themselves. Process costing of most often used by soda makers, cookie bakers, aluminum foil manufacturers and oil refiners.
Regardless of the whether a company uses job costing or process costing, the goal is still the same. “Push” all production costs down to the product level so that management can tell if a product is profitable or not. Other uses of product cost information include: setting a sales price, determining product mix and determining a transfer price to another division.
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