Some costs are direct while others are indirect, direct costs can be identified to a specific products but indirect costs which are not identifiable to specific products, need to be allocated on some objective and rational basis for product costing and pricing which can be justifiable to customers. Costing systems are the systematic allocation of cost to products. It can be used for planning, decision making and control purpose as well. Budgeted figures are used for costing of products as actual prices are not known at time when prices are decided.
Important Types of Costing Systems
1. Absorption Costing System
Absorption costing system is the method of allocating overheads (Fixed and variable) to products based on pre-determined absorption rate. To find the pre-determined rate total budgeted overhead cost is divided by activity level. The basis on which costs are allocated are subjective and difficult to justify. Absorption costing system gives full cost of the product. It can be used for long term product pricing. It is traditionally used system easiest to apply. This costing system is permitted by international accounting standards for financial reporting purpose.
2. Marginal Costing System
Marginal costing system identifies variable and fixed overhead costs separately. It identifies different behavior of fixed and variable costs. It workouts cost for short term decision making. It can be used to evaluate ad-hoc (unplanned) opportunities and proposals. It declares fixed overhead are irrelevant in the short term and cannot aid in day to day decision making. It recognizes term ‘contribution’ it means contribution towards recovery of fixed cost. It is the term which should be considered instead of profits.
All cost are variable in the long term. All cost have to be recovered in the long term if business has to operate successfully. It is merely useful for short term management decision making like make or buy, contribution per scarce resource and finding optimal production plan, like through linear programming.
3. Activity Based Costing System
Activity based costing does the job of traditional activity based costing system in rational and objective way. It identifies activities, like machine running costs and invoicing customers, across whole business instead of departments and uses cost drivers (variable or item which incurs cost), like machine hours (volume based), number of invoices (transaction based). All the overhead costs across whole business are allocated to activities, technical term cost pools. These cost pools are divided by cost drivers to obtain an ABC rate. This rate is used to allocate cost to the products on the basis of each product increasing cost diver quantity. This costing system gives useful information for planning and control.
4. Target Costing System
This is a modern methodology towards costing. It attempts to find market price of the similar products in advance. Required rate of return is deducted to arrive at target cost. This cost is different from the actual cost. The difference between target and actual cost is called gap. This gap should be reduced overtime by achieving efficiencies (learning effect), economies of scale and product specification changes by eliminating non-value added activities. Once the target cost is achieved, it should be further reduced as it aims for continuous improvement. Advantage of using this costing system is that financial viability (whether to continue or not) of the product is known at development stage of the product life cycle.
5. Backflush Costing System
Backflush costing system is different way of allocating costs to products. It does not use traditional inventory bookkeeping which tracks inventory movements from raw material to work in process (WIP) to finished goods. It directly recognizes the cost to finished goods account, all previous bookkeeping is flushed. Costs are recorded when goods are finished or delivered. It saves time and cost of tracking and maintaining separate account for each stage of production process. This costing system is applicable when just in time (JIT) inventory management is in place. It does not gives accurate product costs as there may be some work-in-process remaining at year end. Material cost is the same as standard cost because of JIT. Labour and overheads are recorded at actual cost.
6. Throughput Costing System
In modern, business environment majority of the costs like labor and overhead are fixed due to employment legislations, automation and long term contracts for energy and others. This leaves only material cost as variable which can be controlled in the short term. Throughput costing system aims to maximize throughput (Total Sales minus Material cost) per factory cost/hour (Total labor plus overhead costs divided by total factory hours). Factory hours are time for which factory operating it excludes unavoidable idle time. It gives information for decision making and control purpose in that product generating low throughput’s can be identified, improved, prioritizes for production, evaluating one-off opportunities or proposals and discontinued loss making products.