scales showing a balance when choosing an effective costing system

How to choose an effective costing system

Article by Drew Coles member of the chartered institute of Management Accountants

Costing systems allow the business to cost their product offering effectively. They allow the business to allocate costs to specific products, departments and cost units. It can also be used to allocate the use of a shared service centre to business units. This article will go through the basics of deciding on an effective costing system for your business as well as the most popular and effective costing systems used today.

Types of costing systems

Costing systems mostly differ on the way in which overheads are absorbed into the products. Whichever costing system is used it must be effective for your type of business and industry.

Traditional absorption costing

Absorption costing takes in to account the direct costs of producing a product but also absorbs the indirect fixed costs (such as production overheads) into each product usually by machine hours or labour hours. For instance, through an absorption costing system based on machine hours a product which takes more machining hours than another will be charged more of the fixed cost overheads.
Traditional absorption has issues with the most obvious one being products will be charged a portion of overheads of which are not traceable to the product itself. Therefore, it could make potentially profitable products not profitable.

Activity based costing

Activity based costing is a type of absorption costing system whereby the fixed overhead costs are absorbed based on the activity the product uses. Firstly, fixed overhead costs are allocated to cost pools which are then allocated to the product using cost drivers. There could be a number of cost drivers which can include administration, debt collections,
There are several benefits if this system in that it gives the business an accurate reflection of what drives the costs and provides a more detailed analysis of each products profitability. The system is also flexibility and can be used to analyse customer profitability.
The drawbacks of this system are the amount of time needed to discover and allocate the cost drivers. There could be hundreds, but it is more beneficial to reduce this to main cost drivers.

Marginal costing

Marginal costing or direct costing systems allocate on the direct and variable costs of production to the product. For example, direct material and labour costs will be allocated to the product along with a variable production overhead cost. This will allow the business to calculate a gross profit for the product.
This system is beneficial for making incremental pricing decisions (decisions to make an extra 100 pieces of a product) whereby the fixed overheads are sunk costs and should not be taken into consideration.
This system also has the benefit of producing a contribution figure which is essentially the gross profit. Contribution is so called because it contributes to the fixed costs of the business. Tis can be used to analyse profitability where by once contribution has exceeded the fixed costs the company will be making a profit. This can go further into how much contribution is created per product and as a percentage of the fixed costs.

Standard costing systems

Standard costing is the process of using a standard cost of producing a product. Usually this is taken from the budget at the beginning of the period. For instance, a standard cost will be made up of variable material, labour and overhead costs. Fixed overheads are allocated using a standard overhead absorption rate. At the period end the actual costs incurred will be checked against the standard cost and the variances analysed. Standard costing is therefore more appropriate in control circumstances.
Drawbacks
Standard costing can draw inappropriate actions of chasing negative variances. There is also the issue that budgetary slack will be built into the costing system and the system also assumes pricing will not change which is not ideal especially in a fast-paced dynamic environment.
Benefits
Can be used efficiently in variance analysis and budgetary control

Variance analysis and standard costing written next to money

Choosing the most suitable costing system for your business

There are several factors that need to be analysed to choose an effective costing system. These factors also depend on the industry the company is based. The most important factor is to choose the costing system which reflects the cost to produce your products most accurately.
If production is similar
Manufacturing companies usually choose traditional absorption costing techniques based on labour or machine hours, this is especially the case if products are similar. For these types of companies this would produce the most accurate reflection of the cost of producing their products.
If production differs
In some cases where production between products can differ significantly costing can be improved by using activity-based costing as there may be several cost drivers and each product uses different activities. In this case this would produce the most accurate cost reflection in production.
Size of the business
Costing can also be influenced by the size of the business; a smaller business would be more inclined to use marginal costing and contribution for its simplicity.
Market conditions
Costing can be influenced by the market. For instance, Apple uses target costing when releasing new products. Target costing is where the price is set firstly in reaction to market conditions and comparable products. The profit margin required is then subtracted from the price to reveal the price in which the product needs to be produced for it to be viable.
If analysis is necessary
If a detailed variance analysis is necessary each period then it may be more beneficial for the business to use standard costing

Pricing

Costing is one of the most important factors in any business. Not only does costing your product effectively allow you to see whether products and operations are viable, but it also ensures you can price your product effectively to be competitive in the market place and ensure you receive the required profit margin for the business.

How to manage your working capital