All costing methods explained

Different decisions → different costs.

In accounting, there is no single “correct” cost for a product or service. The calculation depends entirely on the question you are asking.

External reporting requires standardized, historical costs to satisfy auditors and tax authorities.
Internal management requires flexible, predictive costs to determine profitability, pricing strategies, and efficiency.
The Golden Rule: A cost calculated for inventory valuation is usually useless for performance evaluation.

Financial Reporting (External):
- Goal: Compliance (GAAP/IFRS) and inventory valuation.
- Focus: Historical accuracy.
- Key Concept: Allocating all production costs to inventory.
Decision-Making (Internal):
- Goal: Profit maximization and operational control.
- Focus: Future relevance and cost behavior.
- Key Concept: Separating costs by behavior (Fixed vs. Variable) to understand margins.

Used primarily for valuing closing stock and COGS on financial statements.

Absorption Costing (The Standard):
- Treats all manufacturing costs (Direct Materials, Direct Labor, Variable and Fixed Manufacturing Overheads) as product costs.
- Required for external reporting (GAAP/IFRS).
Actual Costing:
- Uses actual costs of inputs $\times$ actual quantities used.
- Cons: rarely used in real-time because you often don’t know the actual overhead bills until month-end.
Normal Costing:
- Uses Actual Materials + Actual Labor + Predetermined Overhead Rate.
- Pros: Allows for smoother costing during the month; variances are adjusted at period end.
Standard Costing:
- Uses expected (standard) prices and quantities for all inputs.
- Pros: Excellent for control. Differences between Standard and Actual are analyzed as Variances.

Used for short-term decision making, break-even analysis, and performance evaluation.

Variable / Direct Costing:
- Only variable manufacturing costs (Materials, Labor, Variable Overhead) are assigned to the product.
- Fixed Overheads are treated as “Period Costs” and expensed immediately.
- Why use it: Prevents managers from over-producing just to hide fixed costs in inventory.
Marginal Costing:
- Focuses on the cost of producing one additional unit. In most linear models, this is synonymous with Variable Costing.
Contribution Margin:
- Not a costing method per se, but the output of Variable Costing.
- Formula: $Sales – Variable Costs$.
- Use: Determines how much revenue is available to cover fixed costs and generate profit.

The mechanism used to track costs depends on the production environment.

Job Costing:
- Costs are tracked by specific “jobs” or custom orders (e.g., Construction, Law Firms, Print Shops).
Process Costing:
- Costs are averaged over a large number of identical units produced in a continuous flow (e.g., Oil Refining, Soda Manufacturing).
Batch Costing:
- A hybrid where costs are accumulated for a specific batch of similar products (e.g., Bakeries, Pharmaceutical runs).
Service Costing:
- Adapted for intangible products; often focuses on “cost per billable hour” or “cost per project” (e.g., Hotels, Consultants).
Project Costing:
- Used for large-scale, one-off initiatives with long durations (e.g., Shipbuilding, Movie Production).

How indirect costs (rent, electricity, supervision) are assigned to products.

Traditional (Blanket) Rates:
- Allocates overhead based on a single volume driver (e.g., Direct Labor Hours).
- Risk: Inaccurate if the company produces a mix of simple and complex products (Volume-based distortion).
Activity-Based Costing (ABC):
- Identifies activities (e.g., setup, inspection) and assigns costs based on consumption of those activities.
- Pros: Highly accurate product profitability.
- Cons: Expensive and time-consuming to maintain.
Time-Driven ABC (TDABC):
- A simplified version of ABC that uses time equations to estimate the consumption of resources, reducing the data-gathering burden.

Used for “Fork in the road” decisions (Make vs. Buy, Drop a product line).

Relevant Costs:
- Future costs that differ between alternatives. If a cost is the same in both scenarios, ignore it.
Incremental / Differential Cost:
- The specific difference in total cost between two alternatives.
Opportunity Cost:
- The potential benefit given up when one alternative is selected over another. (Crucial, but never appears on financial statements).
Sunk Costs:
- Costs already incurred that cannot be recovered.
- Rule: Ignore them. They should not influence future decisions.

Used for long-term planning and competitive strategy.

Target Costing:
- Starts with the market price.
- Formula: $Market Price – Desired Profit = Allowable Cost$.
- Engineers must design the product to meet this cost limit.
Life-Cycle Costing:
- Tracks costs from “cradle to grave,” including R&D, design, production, marketing, and disposal/warranty.
- Insight: A product might look cheap to make but be expensive to support.
Kaizen Costing:
- Focuses on continuous, small cost reductions during the manufacturing phase.

Which method for which decision?

Method	Primary Use	Key Question Answered
Absorption	External Reporting	What is the value of my inventory for the bank/tax man?
Variable/Marginal	Internal Decisions	Should I accept this one-off order at a lower price?
Standard	Variance Analysis	Are we operating efficiently compared to the budget?
ABC	Strategic Pricing	Which products are actually making us money vs. consuming resources?
Target	Product Design	Can we design this product to be profitable at the market price?
Relevant	Decision Making	Should we make this part in-house or buy it?

There is no “true cost” — only a cost fit for purpose.

If you use Absorption costing for pricing, you might overprice yourself out of a competitive bid.
If you use Variable costing for financial reporting, you will violate accounting standards.
Always define the decision before you calculate the cost.

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