A serious manufacturing company should always determine what production methodology is optimal and how the cost of products affects the profit margins. Companies should take into consideration all the production costs before they arrive at a particular price point. They must create a robust costing technique to come up with a close estimate of the price of their products and services. Here are different costing methods for manufacturing applicable to all companies and industries.
The Different Costing Methods
Inventory is a comprehensive list of goods in stock. Inventories can also include raw materials and work-in-process products. Inventories are important assets of the company, and their costs have a significant impact on profit margins. Inventory costing determines the pricing approach for raw products and goods in stock.
The most common inventory costing methods include:
- First-in, First-out (FIFO)
- Last-in, First-out (LIFO)
- Weighted Average
- Specific Identification
FIFO determines the price of inventories based on the date they were received or the date of manufacture. Companies can use this method to determine the correlation between the cost of items in stock and the costs associated with the sale of the products. FIFO ensures that the older items are exhausted before, the newer ones.
LIFO ensures that the newest arrivals are used up before the oldest ones. Most organizations do not use this method because it is discouraged by the International Financial Reporting Standards. It is not suitable where the new and the old inventories mix.
You use the weighted average where there is only one line of inventory and that it can only be applied where newer and older lines alternate. It determines the average cost of all items currently in the inventory. When the company adds a new inventory, its average cost is computed first before it is added to the existing pool. Both inbound and outbound prices must be calculated in this case.
Specification identification determines the specific cost of each item used in the production process or sold. This method is effective for companies that purchase expensive items.
Job costing determines the cost of labor, materials and overhead costs for certain jobs. Job costing traces the specific costs resulting from individual jobs and evaluating them to see if it is possible to reduce them in future jobs. Other companies use this methodology to see if it is possible to spread the excesses to the customers. In case the job runs for an extended period, the accountant can periodically determine the cumulative costs over that timeline and give a warning to the management if they seem to be running out of proportion. One disadvantage of job costing is that it usually results in an overwhelming number of transactions. It also requires a lot of software applications to manage and update all the costs correctly.
Standard costing is one of the costing methods used by manufacturing companies to determine a uniform rate for materials used in production or inventory accumulation. Standard costing is usually a responsibility of the purchasing department. The accountants must establish all the costs associated with labor and production to come with an accurate standard rate. With standard costing, organizations can produce goods up to certain amounts and monitor them by analyzing all the variables affecting the sales and production processes. It allows accountants to analyze the market and come up with suitable modifications if the need arises. Standard costing is appropriate for organizations that make similar products repeatedly.
Direct costing involves allocating certain portions of variable costs to the overall price of the product. Direct costs are also known as variable if they regularly change. Direct costs can include commissions and supplies. They can also include the cost labor, material or power consumption.
Direct costing allows managers to get an estimate of the minimum pricing required to sell products that increase in value over time. It is a useful methodology for short-term decisions based on a price of a particular product. However, direct costing does not cover long-term pricing. Hence, most managers do not use it when applying an appropriate pricing strategy to be used for an extended period.
Target costing takes a different approach. It is used to determine the overall life-cycle costs of product required to achieve a particular functionality and quality. It involves subtracting a projected profit margin from a competitive market price. It attempts to determine the future costs of a product and how they will impact prices and profit margins of a company. Most organizations will most likely try to predict the future prices of their products. Hence, this is method is still relevant among manufacturing companies in the United States.
One of the main advantages of target costing is that it is self-evident. Organizations can accurately determine the future performance of a product. Those that are unlikely to perform can be modified or scrapped off. However, target costing requires a lot of labor to keep track of emerging trends. Target costing makes it more expensive to employ amongst the other costing methods, especially in small companies.
Activity-Based Costing(ABC) determines the total activities of the organization and assigns indirect costs to products. The system takes into account the relationship between costs, activities and the products. This method allows companies to have a clear picture of profitable products and those that need modifications to perform well in the market. Manufacturing companies believe that ABC is a robust system that ties overhead costs to the company’s production activities that produce revenues. Those who oppose ABC claim that the total benefits associated with the method are not worth the amount of money channeled to it. A company that produces few products has limited visibility and variability in future and cannot use this method cost-effectively.
Companies often use contract costing for big projects. The project may involve a lot of expenditure, extended periods of time of time and varying the scope of work. The projects that can necessitate contract costing include construction of bridges, buildings, and roads. Some companies may use a simpler form of contract costing that treats individual jobs as separate units. Industries such as bakeries and pharmaceuticals usually prefer the simpler version of contract costing.
These costing methods can also come in handy when establishing a quality control plan. A quality control program is necessary for creating products that exceed the expectations of the customers. However, companies need to use reconciliation of costs and financial accounts to achieve optimal results. Each costing method has its unique value, companies can come with a good price point that enables them to compete fairly in the market.