Costing in Business
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One of the most crucial aspects of running a
successful business is knowing how to cost your
products or services effectively. Costing is the
process of aggregating all expenses involved in
producing a product or delivering a service to
determine its selling price. Proper costing
ensures that your business remains profitable
and competitive.
What is Costing?
• Costing involves identifying,
recording, and allocating all
costs associated with the
production of goods or
services
These costs can be broadly categorized into
1. Material Costs: These include the raw materials or
components required to produce your product.
2. Labour Costs: Wages paid to employees directly
involved in the production process.
3. Overhead Expenses: Indirect costs such as rent,
utilities, equipment depreciation, and administrative
expenses.
The Steps of Costing
Step 1: Calculate the Material Cost Per Item
To determine the material cost per item, divide the
total cost of materials by the number of items
produced. For example, if you buy raw materials
worth $1,000 to produce 100 units, the material
cost per item is $10.
The Steps of Costing
Step 2: Calculate the Overhead Expense Per Item
Overhead expenses are indirect costs incurred during
production. To calculate the overhead expense per item,
first determine the total monthly overhead expenses. Then,
divide this amount by the total number of items produced.
For instance, if your monthly overhead is $2,000 and you
produce 100 units, the overhead expense per item is $20.
The Steps of Costing
Step 3: Add Up All Costs to Get the Total
Cost Per Item
Sum the material cost per item and the
overhead expense per item to get the total
cost per item. Continuing with our example,
if the material cost is $10 and the overhead
expense is $20, the total cost per item is $30.
The Importance of Accurate Costing
Accurate costing is essential for several reasons:
1. Profitability: Knowing your costs helps you set prices that ensure
profitability. Pricing your products too low can lead to losses, while
pricing them too high might drive away customers.
2. Budgeting: Understanding your costs allows for more accurate
budgeting and financial planning.
3. Competitiveness: By knowing your costs, you can strategically
price your products to stay competitive in the market.
• Decision Making: Accurate cost data is critical for making
informed business decisions, such as scaling production, entering
new markets, or discontinuing unprofitable products.
What Are the Types of Costs in Cost Accounting?
Cost accounting is a process that
measures all of the expenses
associated with running a business,
including both fixed and variable costs.
The results help management make
decisions that optimize their operations
based on efficient cost management.
Cost accounting covers variable costs,
fixed costs, direct costs, indirect costs,
operating costs, opportunity costs,
sunk costs, and controllable costs
Direct Costs
Direct costs are related to producing a
product or service. These include raw
materials, labor, and distribution costs.
Each item in this category can be
traced to a product, department, or
project.
For example, Ford Motor Company
manufactures cars and trucks. A plant
worker might spend eight hours building a
car. The direct costs associated with the car
are the wages paid to the worker and the
cost of the parts used to build the car.
Indirect Costs
Indirect costs cannot be easily traced to a
product, department, activity, or project. For
example, for Ford Motor Co., the indirect
costs of building a car include the electricity
that is used to power the plant in which the
car is built. No one vehicle can be
product can be associated with the plant's
electric bill. That makes it an indirect cost
Fixed Costs
Fixed costs do not vary with the number of goods
or services a company produces over the short
term.
For example, suppose a company leases a
machine for two years. The company has to pay
$2,000 per month to cover the cost of the lease no
matter how many products the machine is used to
make
Variable Costs
Variable costs fluctuate as the level of production output
changes. A variable cost increases as production volume
increases, and falls as production volume decreases.
For example, a toy manufacturer must package its toys
before shipping them out to stores. This is a type of
variable cost because the cost increases when the
manufacturer produces more toys and decreases when its
production level declines.
Operating Costs
• Operating costs are expenses associated with day-to-
day business activities but are not traced back to a single
product or process. Operating costs may be variable or
fixed.
• Examples of operating costs, which are more commonly
called operating expenses, include rent and utilities for a
manufacturing plant.
• Operating costs are day-to-day expenses, but are
classified separately from indirect costs – i.e., costs tied
to actual production
Opportunity Costs
Opportunity costs do not show up in a
company's financial statements but they are
useful in internal planning.
An opportunity cost is the theoretical cost of
a business decision that was passed up for
an alternative.
For example, a company may opt to buy a
new piece of manufacturing equipment rather
than lease it. Either choice will increase its
productivity. But, the purchase requires the
company to borrow money and pay interest
on the loan. A lease would have allowed the
company to save on interest and use that
money to pay down other debt. In this case,
the opportunity cost is the loss of money that
could have been used for another purpose.
Sunk Costs
• Sunk costs are unavoidable. They derive
from past events and cannot be avoided.
Payments for equipment purchased in the
past or expenditures on research and
development are examples.
• For that reason, sunk costs are excluded
from future business decisions.
Controllable Costs
• Controllable costs are expenses that company
managers have the power to increase or
decrease.
• Common examples of controllable costs are
office supplies, advertising expenditures,
employee bonus amounts, and charitable
donations.
• Controllable costs are by nature short-term
costs that can be adjusted quickly in response to
current business conditions.
