Sample Notes: Costing Applications

AS Level Accounting – 2.2.1 Costing Applications:

Introduction to Costing Applications

• Costing is the process of determining the cost of producing goods or services.
• Accurate costing is critical for pricing, budgeting, profitability analysis, and decision-making in businesses.
• Two major traditional costing methods:
  • Absorption Costing
  • Marginal Costing
• Applications: Unit costing, job costing, and batch costing – applied to both manufacturing and service businesses.

1. Unit Costing

• Definition: A costing method used when production is continuous and units are identical.
• Industries: Brick manufacturing, bottled water, oil refineries, electricity generation.
• Formula:
  • Cost per unit = Total cost of production / Number of units produced
• Advantages:
  • Simplicity in calculation
  • Suitable for mass production
• Disadvantages:
  • Not useful for customized products
  • Difficult to allocate overheads if production changes

2. Job Costing

• Definition: A costing method used when work is undertaken to meet specific customer requirements.
• Industries: Construction, custom printing, furniture design.
• Key Elements:
  • Each job is treated separately.
  • All costs (direct and indirect) are traced to a specific job.
• Job Cost Sheet Includes:
  • Direct materials
  • Direct labor
  • Direct expenses
  • Allocated overheads
• Purpose:
  • To determine the profit or loss on each job.
  • Essential for job pricing and profitability analysis.

3. Batch Costing

• Definition: A costing method where a batch of identical products is treated as one cost unit.
• Industries: Pharmaceutical companies, garments, food packaging.
• Formula:
  • Cost per unit = Total cost of batch / Number of units in batch
• Benefits:
  • Economies of scale in materials and setup costs.
  • Effective for medium-size production runs.
• Limitations:
  • Inaccurate if batches are inconsistent in size or complexity.

4. Absorption Costing

• Definition: All costs (fixed and variable) are assigned to the units produced.
• Includes:
  • Direct materials
  • Direct labor
  • Direct expenses
  • Fixed and variable overheads
• Overhead Absorption Rate (OAR):
  • OAR = Budgeted overhead / Budgeted activity level
  • Applied based on labor hours, machine hours, or units.
• Features:
  • Closing inventory valued with fixed overheads included.
  • Profit affected by changes in inventory level.
• Advantages:
  • GAAP-compliant
  • More accurate for long-term pricing
• Disadvantages:
  • Complex to allocate overheads accurately
  • Can obscure contribution margin

5. Marginal Costing

• Definition: Only variable costs are assigned to units; fixed costs are treated as period costs.
• Cost Elements Included:
  • Direct materials
  • Direct labor
  • Variable overheads
• Excludes:
  • Fixed production overheads from unit cost
• Key Concepts:
  • Contribution = Sales – Variable Costs
  • Profit = Total Contribution – Fixed Costs
• Break-even Point:
  • Fixed Costs / Contribution per unit
• Advantages:
  • Clear distinction between fixed and variable costs
  • Useful for decision-making
  • Easier to calculate impact of production changes
• Disadvantages:
  • Ignores fixed cost allocation
  • May understate total cost

6. Comparing Absorption and Marginal Costing

7. Costing in Service Businesses

• No physical goods but still require cost tracking.
• Examples: Hospitals, schools, accounting firms, transport services.
• Cost Units: Per patient, per student, per journey, per consultation.
• Challenges:
  • Intangible output
  • Variable demand and capacity usage
  • Customer-specific service needs
• Solutions:
  • Job costing adapted for individual services
  • Use of activity-based costing to trace overheads

8. Decision-Making with Costing Information

• Costing data helps managers to:
  • Set selling prices
  • Determine profit margins
  • Decide on product continuation or discontinuation
  • Control costs and improve efficiency
• Make or Buy Decisions:
  • Compare marginal cost of in-house production vs. external purchase.
• Accept/Reject Special Order:
  • Analyze incremental revenue vs. marginal cost.

9. Absorption Costing Statement Format

Direct materials                xxx
Direct labour                  xxx
Direct expenses                xxx
------------------------------
Prime cost                     xxx
Factory overheads              xxx
------------------------------
Factory cost                   xxx
Administration overheads       xxx
------------------------------
Total cost                     xxx
Profit margin                  xxx
------------------------------
Selling price                  xxx

10. Marginal Costing Contribution Statement

Sales Revenue                 xxx
Less: Variable Costs         xxx
------------------------------
Contribution                 xxx
Less: Fixed Costs            xxx
------------------------------
Profit                       xxx

Conclusion

• Traditional costing methods are fundamental for pricing, planning, and profitability.
• Marginal costing is preferred for short-term internal decision-making.
• Absorption costing aligns with financial reporting standards.
• Both are applied to manufacturing and service businesses.
• Mastery of job, unit, and batch costing is essential for accurate cost analysis.