TYPES OF COSTING SYSTEMS: A HYPOTHETICAL SCENARIO

This article was formerly captioned: "Types of Cost Accounting: The Case of A Manufacturing Company?"

Introduction

Types of costing systems employed in countries may differ from company to company. By virtue of improvements in information technology, increased competition even at a global scale, differing organizational structures, and the advent of new management practices, the environment within which management accounting is practiced appears to have been altered (Burns and Scapens, 2000). A partial reflection of this changing landscape for management accounting is partly shown in a change in its definition.

In 1981, the National Association of Accountants (now the Institute of Management Accountants) defined management accounting as  “…the process of identification, measurement, accumulation, analysis, preparation, interpretation, and communication of financial information used by management to plan, evaluate, and control an organization and to assure appropriate use of and accountability for its resources. Management accounting also comprises the preparation of financial reports for non-management groups such as shareholders, creditors, regulatory agencies, and tax authorities.” This definition seems to view management accounting as a stand-alone tool to aid management in the effective use of the firm’s resources.

In 2008, however, the Institute of Management Accountants (IMA), after 27 years decided to advance a new definition of management accounting so as to factor in various new developments in the field. The IMA newly defined management accounting as “a profession that involves partnering in management decision making, devising planning and performance management systems, and providing expertise in financial reporting and control to assist management in the formulation and implementation of an organization’s strategy.” It would be observed that in this second definition by IMA, management accounting is seen as a profession, indicating that it has evolved or come of age to be no longer solely considered as a tool. This definition also stresses the concepts of “partnership” and “organizational strategy.” This is no surprise because, in modern times, strategy and partnerships have become critical to the survival of many an organizations.

Management accounting can be regarded as management-focused accounting. It is a field that seeks to explore innovative ways to use financial data to improve management activity.  One of such innovative ways is the creation of costing systems, which facilitates the allocation of costs to products.

Costing Systems Types: Backgrounds and Development

Costing may be defined as the process or activity of deciding the costs sustained on different types of inputs utilized in the firm and allocating these costs to various products or activities of a concern.

Costing has a number of uses for a firm. An example of this is the fixing of selling price of products. Additionally, costing also enables analysis of costs and profitability thereby facilitating investment decisions and cost control.

            It is difficult to classify the different available costing systems used in manufacturing or any other industry. However, according to Al-Omiri and Drury (2007), costing systems may be classified based on their level of sophistication with regard to the assignment of indirect costs. According to them, both simplistic and sophisticated costing systems can accurately assign direct costs to cost objects. Hence, accurate indirect costs allocation is the trigger for the innovation of costing systems. Accurate allocation of indirect costs is a dicey issue in management accounting.  Generally, direct costs in manufacturing firms supersede indirect costs. This is supported by Al-Omiri and Drury (2007) who observed that the average direct and indirect costs for all firms were 69% and 31% respectively. Their data also showed that manufacturing units have a significantly larger proportion of direct costs (75%) and financial and commercial organizations have a significantly higher percentage of indirect costs (51%).

The measure of a good costing system is significant accuracy in allocation of total costs between total inventory and cost of goods sold (Cooper & Kaplan, 1991). There may be unfortunate consequences associated with an inaccurate allocation of costs between products. Some offshoots of this situation are improper pricing decisions, the stoppage of production of a profitable product line and failure to take note of unprofitable product lines (Lamminmaki & Drury, 2001). Incorrect pricing decisions happen when products are significantly over-costed or under-costed, all because of inaccurate costing systems.

The fact is correct product pricing is so critical because it plays a vital role in determining the success or failure of a product line. It is for this reason that we have a number of costing systems. Some of these costing systems are: Output costing, Job costing, Batch costing, Process costing, Absorption costing, Marginal costing, Target costing and Activity-Based Costing (ABC).

Output Costing

Output costing also refers to unit costing or single costing. In this costing technique, costs are accrued and examined under varying elements of cost used in making the product. Cost per unit product is then determined by dividing the total cost by the quantity of units produced. This costing technique is preferably used when a manufacturing company is producing a single product en masse by continuous production process manufacturing. The units of output are homogenous (The Institute of Company Secretaries of India, 2012).

This system of costing was developed for steel making firms, breweries, cement works, mining companies, brick making concerns, and so on, whose business activities involve the production of a homogenous product.

In this system, incurred expenditure comprises costs on material, labour and direct costs, works and administrative expenses and direct costs. Indirect costs associated with making the product is spread over periodic intervals based on estimates. However, selling and distribution expenses, though indirect costs, are not considered during product costing under this costing system.

Job Order Costing

Job order or job costing may be defined as a system of costing in which the elements of cost are accrued individually for each job or work order embarked on by a firm. Industries involved in production or render services against specific orders use job costing.

This system of costing is employed in Job Order Industries, such as engineering, construction, shipbuilding, furniture making, and machine manufacturing, where the production depends on the requirements of the customer. Job Order industries are unique in that, production is not continuous but rather production depends on the quantum and specification of the order received from customers. As a result, each job has the potential to be different from the other.

In calculating the cost of the job, direct costs are charged to the job directly as they can be traced to it. Using some appropriate basis, indirect expenses i.e. overheads are charged to the job.

 Batch Costing

Batch costing is a variant of job costing system. Here, costs are accumulated for definite batches of homogenous products ordered for manufacture. A batch is a cost unit that consists of a discrete, readily distinguishable group of product units, which maintain its distinct identity throughout the production process. The output of batch consists of a number of units and it is not economical to determine cost of every unit of output independently. In batch costing, cost per unit is calculated by dividing total batch costs with total batch units. Total batch cost is calculated by adding cost of materials per batch, labour cost per batch, and other expenditures per batch.

In batch costing, products lose their separateness as they are manufactured in a continuous flow. This system of costing is used in manufacturing firms producing readymade garments, toy making companies, as well as tyre and tube making companies.

Process Costing

Process costing is a system of costing under which total costs are accrued for each stage of production or process, and the cost per unit of product is determined at each separate stage of production by dividing the cost of each process by the standard output of that process.

In process costing, costs accrue process-wise. Both direct and indirect costs are accrued in each process. The entire cost of each process is divided by the normal output of that particular process in order to calculate cost per unit of that process. Under this system also, the products are homogenous. Process costing is applicable in the sugar-manufacturing industry.

Absorption Costing

Absorption costing is also known as full costing or traditional costing and it is commonly used for external accounting reporting.  Absorption costing is a process of assigning the variable costs of production and the fixed costs of production to the manufactured product. Job order costing and process costing can be classified under this type of costing system.

Marginal Costing

Under the marginal costing system, product costing is determined by assigning variable costs of production to the product. These variable costs are overheads as well as selling and distribution costs. All the fixed costs associated with a production period are charged to that period’s profit and loss account.

Marginal costing is also known as direct costing or variable costing. It involves classifying  product costs as variable and fixed. Variable costs may be defined as those costs that fluctuate in connection to the variations in the production volume. Fixed costs, for the reporting period (never in excess of a year), were constant and wholly unaffected by alterations in the volume of production (Chandra and Paperman, 2012). In marginal costing, product costs comprises only the direct material and direct labor costs plus the variable portion of the overhead costs.

Fixed costs are excluded and allocated to the income statement as a period expense. In a nutshell, under marginal costing only the variable manufacturing costs alone are considered worthy of being inventoried and they are harmonized with sales when the product is sold. The fixed costs of manufacturing are never inventoried. Thus under this system, the income of a firm depends, as it ought to, on sales and not on production that is stored in inventory.

Marginal costing as a costing system is simple to operate in that cost of materials, direct labour costs and sales commissions, which are the main variable costs, are all relatively easy to trace to specific products.

However, one of the key challenges with this costing system is that variable production overheads – indirect costs - are difficult to identify. These overheads alter with the level of manufacturing activity. The cost of some overheads, such as machine lubricants, disposable tools, some machine maintenance activities will probably change as output changes.

Target Costing

According to Ansari et al. (2007), “target costing is a system of profit planning and cost management that ensures that new products and services meet market determined price and financial return.” This idea is conveyed in the following simple equation: Target Cost = Target price - Target profit.

The target price and target profit are regarded as independent variables that are externally defined by competitive forces in the product and capital markets. Whilst what customers are willing to pay determine prices, what financial markets anticipate as a return from that specific industry define profit. The dependent variable is cost, which implies that a firm has to manage its cost to meet the external constraints imposed by the product and financial markets in which it operates.

According to Ansari et al. (1997), Baker (1995), Butscher & Laker (2000), and Gagne & Discenza (1995) target costing is a critical system for firms that are doing business in competitive environments and are characterized by short product life cycles. There are five factors that influence the adoption of target costing (Cooper & Slagmulder, 1997): intensity of competition, nature of customer, product strategy, product characteristics, and supplier-base strategy.

Activity Based Costing (ABC)

According to Gosselin (2007), ABC is a two-stage cost accounting technique that apportions indirect costs to products, services, or any other cost objects. It involves the identification of significant activities and the assignment of indirect costs to these activities based on the way these activities consumed resources.

For example, a product that needs a large amount of warehousing will be assigned warehousing costs in accordance with this consumption. In contrast, traditional cost accounting systems tend to allocate costs in accordance with volume drivers such as direct labour hours.

Activities represent all the actions performed to convert, and to support the conversion of, materials, labour, technology, and other resources into outputs. Under this system of costing, the focus is on why the costs were incurred instead of where (Gosselin, 2007).

Analysis of Costing Systems Based on Type of Company being Investigated

The manufacturing company under investigation is one that makes different models of cars using the discrete-part and assembly manufacturing technique. This company has several departments within its organization that are involved in the manufacturing process. The company serves an international market and has a number of strong competitors in its auto industry. For the purpose of this discussion, let us call the company XYZ Motors.

Currently, XYZ Motors uses the marginal costing technique to fix selling prices of its automobiles. What this means is that the company charges only its variable manufacturing expenses to the product and spreads its fixed costs in terms of fixed overheads and the like over a reporting period. As good as this costing system may be in Auto internal reporting and gives a better reflection of the true price of a product as compared to traditional absorption costing, it however seems to be oblivious to market, financial and technological forces influencing XYZ Auto’s industry. The marginal costing system does not seem to seek to identify or understand the factors that drive the variations in XYZ Auto’s variable expenses. Perhaps this is because within this costing system there is no in-built mechanism that facilitates this.

This is where target costing comes in. Under target costing, cost price of XYZ Auto’ product can be determined as a function of the price people are willing to pay for the product (target price) and, what investors or financial markets expect as a return from that industry (target profit). Hence, this type of costing system considers both market and financial forces in the determination of the cost price of a product. Target costing is common among Japanese car manufacturing companies. A limitation within this costing system, however, is that it fails to consider the drivers, such as significant activities, which influence the internal environment of XYZ Autos.

Every organization is a bundle of activities, be it productive or non-productive, and these activities consume resources. A number of activities go into the making of a product. In companies, like XYZ Autos, that manufacture different models of cars, it is likely that the amount of resources consumed by the activities that dovetail into the making of these cars will vary significantly. The purpose of activity-based costing therefore is to determine the costs of products by firstly identifying significant activities (comparable to identifying binding processes in throughput accounting below) and assigning indirect costs to these activities based on the way these activities consumed resources. Additionally, activity-based costing (ABC) solves the limitation of marginal costing in that ABC focuses on why the costs were incurred instead of where.

Moreover, within every organization, there are constraints that may affect its operations. These constraints may be binding or non-binding. Binding constraints limit the organization’s objective, whilst non-binding constraints do not affect the value of the objective function (Verma, 1997). Throughput accounting is a vital measurement and decision-making tool that is based on Eliyahu Goldratt’s Theory of Constraints (TOC). The Theory  of  Constraints  can  be  defined  as  a management  approach that centers on improving bottleneck  processes to constantly increase the  performance of manufacturing operations (Verma, 1997). This means that throughput accounting is not a costing system but rather a management system. In simple terms, throughput accounting is that management approach that identifies critical processes or activities and optimizes them to contribute maximal yield to the objective function. In fact, Throughput accounting alters a business’ internal perspectives on revenue recognition, costs and profitability and thus alters the figures used for decision-making – basically changes the Management Accounting.  

Throughput accounting seeks to find answers to the following three questions relevant to a manufacturing organization: (1) what to change? (2) to what to change to?; and, (3) how to cause the change? It is in the finding of the answers to these questions that increase in profitability of companies is triggered by throughput accounting.

Recommendations

In the light of rapidly changing business environment and afore-running analysis, XYZ Autos need to design costing system(s) that not only prevent price distortion but also responds to changes in the business environment. Flexible costing system is the way to go, knowing that the auto industry is heavily influenced by market as well as technological forces. In management accounting, it is not unusual these days to have organizations design a costing system based on the nature of their products, operations, and level of costing information usage because most modern management accountants now consent to the precepts of contingency theory, which can be abridged as ‘choose the most appropriate method for the purpose’ (Gosselin, 2007).

The technology of production has developed rapidly and in a manner that carries noteworthy implications for product-costing methods. Technological advances have resulted in machine capital constituting an increasing proportion of total cost and direct labor constituting a declining proportion of total cost (Gosselin, 2007).

This development indicates that overheads constitute an increasing proportion of total cost (Cooper & Kaplan, 1991). As a result of the declining significance of processing costs (especially labor) in the overall cost structure, using volume-related processing costs such as labor as the yardstick for allocating overhead costs is becoming increasingly inappropriate. Worsening this overhead-allocation problem is the growing range of products to which the overhead cost is to be assigned.

It is therefore recommended that an integrated approach be taking towards the selection of a costing system for XYZ Autos because no single costing system fully captures all the costing concerns of a business. The fact is the choice of a costing system depends on the purpose for which it is intended (Shields, 1997). To increase profitability of the firm, throughput accounting is suitable; for rapid respond to changes in the business milieu to ensure competitiveness, target costing is the best; and, as XYZ Autos becomes more complex and the proportion of indirect costs increase, Activity-Based Costing (ABC) is the most preferred. The thing with ABC is that there is little evidence in documentations that signify a direct link between a change to an ABC system and increases in either shareholder value or firm profitability (Kennedy & Affleck-Graves, 2001). However, other studies indicate that combined with other improvement initiatives like target costing and throughput accounting ABC increases the value of a firm (Krumwiede, 1998). This kind of strategy ensures more accurate/activity costs.

Conclusion

There is no single cost system that fully reflects all the variabilities influencing the operation of a manufacturing company. A good costing system should be able to reflect changes in both internal and external environments of the company.

The best costing system for XYZ Autos is an Activity-based Costing only if it is used in conjunction with target costing and throughput accounting.

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