Approaches to Costing: Understanding How Much Things Cost

Imagine you're running a small lemonade stand. You need to know how much it costs you to make each cup of lemonade so you can price it and make a profit! That's essentially what "costing" is all about - figuring out the cost of producing something.

There are different approaches to costing, and the two most common are:

1. Full Costing (Absorption Costing)

Think of full costing like the detailed receipt you get at a restaurant. It lists every ingredient, labor, and overhead cost that went into making your meal.

-What it includes:

• Direct Materials: The main ingredients of your product. For the lemonade stand, this would be lemons, sugar, and water.
• Direct Labor: The cost of the people directly involved in making the product. For example, the time it takes to squeeze the lemons and mix the ingredients.
• Manufacturing Overhead: All the other costs associated with producing the lemonade, like rent for the stand, electricity, and cleaning supplies.

-How it works:

• You add up all those costs for a specific period (like a month).
• Then, you divide those total costs by the number of units produced to get the cost per unit.

Example: Let's say you made 50 cups of lemonade in a month. Your total costs were:

• Direct Materials: $10
• Direct Labor: $5
• Manufacturing Overhead: $15

Total Costs = $10 + $5 + $15 = $30

Cost per unit = $30 / 50 cups = $0.60 per cup.

2. Contribution Costing (Variable Costing)

Contribution costing is like a simplified receipt. It only focuses on the costs that change depending on how much you produce.

-What it includes:

• Direct Materials: Just like in full costing, this includes the main ingredients.
• Direct Labor: The cost of people directly making the product.
• Variable Overhead: Costs that change with production, like electricity used to run the lemonade machine or supplies that get used up faster with more lemonade made.

-How it works:

• You add up the variable costs per unit.
• This gives you the variable cost per unit.

Example: Using the same scenario, let's assume:

• Direct Materials: $10
• Direct Labor: $5
• Variable Overhead: $5

Variable cost per unit = $10 + $5 + $5 = $20

Variable cost per cup = $20 / 50 cups = $0.40 per cup.

Difference between Full Costing and Contribution Costing:

The key difference lies in how they treat fixed overhead. This is the cost that stays the same regardless of how much you produce, like rent for the stand.

• Full Costing: Includes all fixed overhead costs in the cost per unit.
• Contribution Costing: Excludes fixed overhead costs from the cost per unit.

Why does this difference matter?

• Pricing: Full costing helps you determine a price that covers all costs, including fixed expenses.
• Decision-Making: Contribution costing helps you focus on the profit generated by each unit sold (the contribution margin) - how much each sale contributes towards covering fixed costs. This is useful for decisions like whether to accept a special order at a lower price or to increase production.

Real-World examples:

• Manufacturing: A car company uses full costing to determine the cost of producing a specific car model, while they might use contribution costing to decide if they should accept a special bulk order from a company at a lower price.
• Retail: A clothing store might use full costing to set retail prices, but use contribution costing to assess the profitability of different clothing lines.

Remember: Each costing method has its strengths and weaknesses. Choosing the right one depends on the specific needs of your business.