Inventory Costing Methods

In any company, it is essential to maintain a balanced budget. To do so, managers must know the enterprise’s finances well, as well as define strategies so that their incomes cover the needs of the business. It is no wonder that many use costing methods for this purpose.

In general, costing methods are tools used to identify expenses that involve the business’ processes, such as manufacturing and sales. Because there are different types, it is very important that the company assess their key characteristics and see which one fits best in its environment.

Before we begin, we need to define what variable and fixed cost is. Variable costs are those that change according to the volume of production, while fixed costs are those that remain stable regardless of what the company produces. That said, let’s learn about the methods. Keep reading!

PROCESS AND JOB-ORDER COSTING.

 

There are two conventional costing approaches used in manufacturing. The first, and more common, is process costing. Used in most mass-production settings, a process cost system analyzes the net cost of a manufacturing process, say filling bottles with soda, over a specified period of time. The unit cost for filling bottles is simply the net costs incurred while filling all the bottles during the period divided by the number of bottles filled. Since most manufacturing processes involve more than one step, a similar calculation is made for each step to arrive at a unit cost average for the entire production system. By contrast, the second major costing method, job-order costing, is concerned with tracking all the costs on an individual product basis. This is useful in settings where each unit of production is customized or where there are very few units produced, such as in building pianos, ships, or airplanes. Under job order costing, the exact costs incurred in the production of a particular unit are recorded and are not necessarily averaged with those of any other unit, since every unit may be different. Job-order costing is also widely used outside manufacturing. A single manufacturer may use both process and job-order costing for different parts of its operations.

ACTIVITY-BASED COSTING.

Activity-based costing(ABC) is a secondary and somewhat complementary (or better, supplementary) method to the two traditional costing techniques. Whereas traditional methods might classify costs in generic categories like direct materials, labor, and other overhead, ABC clusters all the costs associated with a single manufacturing task, regardless of whether they fall under the headings of labor or materials or something else. So in the bottling example activity-based costs might include operating the dispensing machines, performing quality checks, moving pallets of bottles, and so forth. Each of these activities may involve human labor, equipment costs, energy and expendable resources, and materials, but for analytic purposes the costs are all lumped together under a single activity concept. The advantage of this approach is that management can then observe which tasks cost the most versus which add the most value; this analysis may indicate that a disproportionate amount of money is being spent on low-value activities, signaling a need for process changes or for outsourcing to a vendor that can perform the tasks less expensively. Use of this method is sometimes referred to as activity-based cost management (ABCM) or simply activity-based management (ABM).

ABSORPTION:

Also known as integral costing, its main characteristic is that all manufacturing expenses, whether direct or indirect, are taken into account when determining the final cost of sales. That is, expenses for structure, operation, etc., even if indirectly related to the product, end up influencing its final cost.

The advantage of this method is that it makes the investigation of the total cost of each product easier. However, there may be distortions in what is collected, which may unbalance the distribution of income for some products.

VARIABLE:

This is the most used by companies; it is a type of calculation that only uses information related to direct or indirect variable costs, not taking into account the fixed costs. It is a very beneficial method if the purpose is to determine the contribution margin of the enterprise or to clarify the product costs. However, as a disadvantage, the data found are not useful in the long term, and are also inadequate to define the company’s accounting.