Approaches to Costing: Understanding How Much Things Cost

Imagine you're starting a bakery. You need to figure out how much each loaf of bread costs to make so you can set a price and make a profit. This is where costing comes in. It's all about figuring out the costs associated with producing a product or service.

There are different approaches to costing, and each has its strengths and weaknesses. Let's explore two key methods:

1. Full Costing (Absorption Costing):

-What it is:

Full costing, also known as absorption costing, considers all the costs associated with producing a product or service. This includes direct costs like raw materials and direct labor, as well as indirect costs like rent, utilities, and administrative expenses.

-How it works:

Direct Costs: These are directly traceable to the product, like the flour, yeast, and packaging used in a loaf of bread.

Indirect Costs: These are shared across multiple products or activities. Imagine the rent of your bakery – it's not directly attributable to each loaf of bread, but it's still a cost of running your business. These indirect costs are allocated to products based on a specific method, like the amount of space each product takes up or the amount of time spent on each product.

-Example:

To calculate the full cost of a loaf of bread, you'd add up the cost of flour, yeast, packaging, a portion of the rent, a portion of the baker's salary (based on time spent making bread), and a portion of the electricity used for baking.

2. Contribution Margin Costing (Variable Costing):

-What it is:

Contribution margin costing focuses only on variable costs, which are the costs that change directly with the level of production. It ignores fixed costs (which remain the same regardless of production levels).

-How it works:

Variable Costs: These costs change depending on how much you produce. For example, the cost of flour, yeast, and packaging would be variable costs in our bakery example – the more loaves you bake, the more flour, yeast, and packaging you'll need.

Fixed Costs: These costs remain the same, regardless of how many loaves you bake. Rent, utilities, and the baker's salary (if it's a fixed amount) would be fixed costs in our bakery example.

-Example:

To calculate the contribution margin per loaf, you'd subtract the variable costs of making one loaf from the selling price of the loaf.

Uses and Limitations of Full Costing

Uses:

-Pricing Decisions: Full costing is often used for pricing products. By considering all costs, businesses can ensure they are covering their expenses and making a profit.

-Inventory Valuation: Full costing helps companies value their inventory accurately. This is important for financial reporting and accounting purposes.

-Performance Evaluation: It is helpful to see the total cost of production, allowing for easier analysis of how efficiently a company is operating.

Limitations:

-Limited Use in Short-Term Decisions: Full costing can be misleading when making short-term decisions, such as deciding whether to accept a special order. Fixed costs are allocated to all products, even if the order doesn't affect these costs.

-Inaccurate Allocation of Fixed Costs: Allocating fixed costs to products can be arbitrary and may not reflect the actual costs involved. This can lead to incorrect cost estimates and pricing decisions.

-Can be More Complex: Full costing involves more complex calculations than variable costing, which can be time-consuming and difficult to manage.

Real-World Example:

Imagine a clothing company using full costing for pricing. They consider the cost of raw materials, labor, factory rent, marketing expenses, and salaries in determining the final price of a t-shirt. However, if they get a large order from a retailer, they might use variable costing to calculate the contribution margin per t-shirt. This is because the fixed costs (factory rent, marketing, salaries) will remain the same regardless of the order size.

In conclusion:

Both full costing and contribution margin costing offer valuable insights into costs and can be useful in different situations. Choosing the right approach depends on the specific needs of your business and the decisions you are trying to make.