Costing Methods Explained – Finding the Best Approach

Costing is the process of figuring out how much it costs to produce a product or service by tracking all the expenses involved, such as materials, labor, and overhead. In this post, we discuss the significance of accurate costing, look at different costing methods, and see how MRP systems can help increase costing efficiency.

What is costing?

A costing method is a system for determining the cost of producing goods or services by tracking all the expenses involved, such as materials, labor, and overhead. When you utilize this system, you can better understand your business expenses and financial health. The right costing method for your business allows you to set pricing effectively and manage budgets with ease. Choosing the right costing method for your business can solve the “inventory management” problem that many manufacturers face.

It’s not just about keeping your books in order. In fact, costing isn’t just about numbers—it’s about making smart decisions that move your business forward. When you know the true cost of your products, you can navigate the market more effectively, respond to challenges, and keep your business on track for success.

What are the benefits of accurate costing?

With accurate costing, you can keep your business profitable. How?

Set fair prices. Accurate costing shows you exactly what it costs to make each product so you can set prices that cover your expenses. This way, you avoid overpricing, which can scare off customers, and underpricing, which can eat into your profits.

Manage your budget. Accurate costing gives you a clear view of where your money is going. It helps you manage your budget more effectively, catch areas where you might be spending too much, and make adjustments before small problems turn into big ones.

Improved inventory management. Knowing your costs helps you keep the right amount of inventory on hand. Accurate costing allows you to match your inventory levels with demand so you don’t overproduce or run out of stock. This saves money and keeps your operations running smoothly.

Smarter decisions. Whether you’re thinking about expanding, entering a new market, or changing your production process, accurate costing gives you the data you need to make informed choices. It helps you see the potential risks and rewards clearly.

Stay compliant. Many industries have strict financial reporting rules. Accurate costing helps you stay compliant by giving you a true reflection of your expenses so you meet regulatory standards and avoid fines or legal trouble.

Stay competitive. In today’s market, businesses that understand and manage their costs well have an advantage. Accurate costing helps you offer better prices, improve efficiency, and respond quickly to changes, keeping you ahead of the competition.

In short, accurate costing is a strategic tool that improves every part of your business. By tracking and analyzing your costs accurately, you set your business up for long-term success.

Getting familiar with costing terms

If you want your business to be both profitable and competitive, you must get familiar with cost accounting methods. Below, we break down essential costing terms so that you can get acquainted with the basics.

• Direct costs. These are the expenses you can directly trace to the production of specific goods. Direct costs consist of direct materials – the raw materials required to manufacture items, and direct labor. Let’s say you’re manufacturing wooden chairs. The cost of the wood and the wages paid to the workers assembling those chairs are your direct costs.
• Indirect costs. Unlike direct costs, indirect costs can’t be pinned to a specific product. These include manufacturing overhead, administrative expenses, and operating costs. The electricity bill for the factory powering the chair-making machines is an example of an indirect cost. It keeps the lights on but isn’t tied to any one chair.
• Fixed costs. These costs stay the same no matter how many units you churn out. Let’s consider your rent as an example. It doesn’t matter if you produce one chair or 1,000 chairs, your rent will not change. Fixed costs are what’s due each month regardless of your output.
• Variable costs. These costs fluctuate based on your production volume. If you’re cranking out more chairs, you’ll need more wood, which raises your variable costs. Variable costs are flexible but can quickly add up if you’re scaling up production.
• Production costs. This is the total expense of making a product. It includes both direct and indirect costs. For our wooden chairs example, production costs cover the wood (direct), wages (direct), and the factory’s electricity (indirect). Production cost is the big picture of what it takes to create your product.
• Unit costs. This is the cost of producing an additional unit of a product. It’s a mix of both variable and fixed costs. If it costs $10,000 to produce 100 chairs, then your unit cost is $100 per chair. Use the unit cost to price your products strategically so that you always make a profit.
• Inventory valuation. This is the method you use to assign costs to your inventory, which impacts your balance sheet and financial statements. For example, using FIFO (First-In, First-Out), the cost of the oldest purchased wood is assigned to the cost of chairs sold first. Or you could use LIFO (Last-In, First-Out). This method assigns the cost of the most recently purchased wood to the chairs sold. The method you choose will impact how your inventory looks on paper.
• COGS (Cost of Goods Sold). These are the costs directly tied to producing the goods your company sells, including direct costs and a portion of indirect costs. For example, if you sell 50 chairs and the total production cost—including materials, labor, and a slice of overhead—is $5,000, then your COGS is $5,000. Calculating the costs of production is important for understanding your profit margins and how much you’re really making.
• Manufacturing overhead. These are all the indirect costs associated with manufacturing. Think of them as the behind-the-scenes expenses, like factory maintenance, equipment depreciation, and the salaries of supervisors. They don’t tie directly to a single product but are crucial for keeping your operations running smoothly.

Types of costing methods: the basics

Next, let’s discuss the different methods you can choose from and which types of businesses would be better suited to each.

Actual costing is a method where the cost that you assign to a product is based on the actual expenses that your business incurred during its production. This includes materials, labor, and manufacturing overhead. A furniture manufacturer would likely use the actual costs of wood, labor, and factory utilities to calculate the cost of each piece of furniture. Actual costing is a good option for businesses with stable production processes and costs. The drawback to this method is that it can be time-consuming to consider each expense when deciding on the final cost of a product.

Standard costing is a method where businesses set expected costs for materials, labor, and overhead before production begins. These costs are then used as a reference to compare with the actual costs during and after production. This method allows you to spot any differences and make adjustments if needed. If actual costs are higher than expected, it might mean something isn’t running efficiently. If they’re lower, it could mean the business is more efficient than planned. This method is most beneficial for large manufacturers that produce the same items repeatedly. However, standard costing has a drawback—it doesn’t always reflect actual costs accurately. This can lead to discrepancies. 

Activity-based costing (ABC) sets overhead costs based on the specific activities that cause those costs. It doesn’t take into account how much you produce. It’s good for manufacturers that produce a wide range of products and also have complex processes. This method helps you identify cost drivers, but ironically, it can be expensive to implement.

Job costing tracks costs for individual jobs. This option is great for businesses that provide custom work. For example, a custom bicycle manufacturer could use job costing to calculate the materials and labor needed to build each bike. The drawback to job costing is that it can be labor-intensive because it requires extensive record-keeping.

Process costing assigns a cost to the entire process and then spreads that cost evenly across all units produced. This method makes it easier and quicker to calculate costs. It works well for industries where the products are similar, like food production. However, process costing is less accurate when you’re creating custom items.

Marginal costing focuses only on variable costs. It analyzes the impact of changes in your typical production. For example, a toy manufacturer may use marginal costing to decide whether or not to accept a special order at a lower price. However, marginal costing is best for short-term decision-making, not as your primary costing method.

Absorption costing includes all costs—both direct and indirect—in the cost of a product. It’s good for long-term analysis but can make it harder to separate fixed and variable costs. A home appliance manufacturer might use absorption costing to determine the cost of each appliance produced. This method is a standard approach for financial reporting because it aligns with Generally Accepted Accounting Principles (GAAP). However, because all costs are absorbed into the product, it can be difficult to determine which expenses are fixed and which are variable.

Target costing starts with a target cost based on market prices and then finds ways to meet it. It’s ideal if you’re operating in a competitive market where price is king, but it’s not the most straightforward method on this list. Target costing requires cross-functional collaboration across different departments to arrive at a cost that meets both customer expectations and profitability goals.

Each of the above costing methods has different pros and cons. The right method for your manufacturing business depends on what you sell and how you produce it.

Choosing the right costing method for your business

Understanding costing methods is just the beginning. The real challenge comes when you need to figure out which costing method is the right one for your business. Below, we address a series of questions to help you determine the ideal costing method for your manufacturing business.

Identify your business needs

What is your number one priority right now as a business?

While all businesses want to turn a profit, not all businesses have the same priorities. You may be focused on reducing costs or improving pricing strategies or even streamlining your production processes. 

Don’t skip this step. Why? Understanding your business priorities will guide you to the right costing method. For example, if you want to minimize costs, you may benefit from the standard costing method because it emphasizes cost control. But if you’re focused on improving pricing, it may be better to choose target costing because it aligns costs with market prices.

Consider the size of your business

How large is your manufacturing operation? 

When choosing the best costing method, take your business’ size into consideration. If you have a smaller business with limited resources and a straightforward production process, you may benefit from simpler costing methods like job costing or standard costing. However, if you run a large enterprise with multiple product lines, you may need to implement a more detailed method like activity-based costing (ABC). Be realistic with your accounting team’s capability, and be sure to find software that will support them.

Understand your industry requirements

What are the common costing practices in your industry? How do your competitors manage their costs?

Conduct industry research to understand standard practices and norms. Look at how similar businesses in your industry manage their costing. 

Align with your production process

Do you produce continuously or by batch? Are your products all the same or are they all custom creations?

If you utilize continuous production and your products are uniform, a method like process costing, which averages costs across all units, might be the right move. However, if you create custom products, opt for a method like job costing because it tracks costs for individual orders. 

Consider your inventory management

What method do you currently use to manage your inventory?

How you manage your inventory can significantly inform the costing method you should choose. For example, if you have perishable goods, you might use the inventory valuation method known as FIFO (First-In, First-Out) which can help you reduce the risk of spoilage. FIFO naturally aligns with a costing method that tracks costs closely and in real-time. 

Perform a cost-benefit analysis

What are the costs and benefits of using the method you’ve chosen?

Take some time to weigh the pros and cons of each costing method. Look at both the obvious costs, like software and training, and the less obvious benefits, like better cost control and smarter decision-making. Write down where you might save money or gain efficiency compared to what it will cost to implement the method. This way, you can make a decision that makes sense for your financial goals.

Choosing the right costing method isn’t just about picking what sounds good on paper. It’s about carefully considering what fits your business’s needs, size, industry, and goals. By following this guide, you’ll be in a better position to make a decision that boosts your financial efficiency and supports your overall strategy.

Costing with MRP software

The best way to simplify the manufacturing costing process is through software. An ideal solution for this is MRP (Manufacturing Resource Planning) software. MRP software is a production management tool that supports various costing methods like job costing, product costing, cost estimating, and actual costing. Actual costing, in particular, is an important feature to look for in MRP software, allowing you to accurately track ingredient and labor costs in near real-time. It also helps you make informed decisions when it comes to adjusting your selling prices, switching suppliers, and tweaking your bills of materials or recipes. 

Here’s more of how MRP software helps:

1. Streamlined cost tracking

Use MRP software to automatically track all of the costs involved in production. Automation is key because it reduces the chance of errors, so nothing slips through the cracks. You can see exactly where your money is going.

2. Better inventory management

MRP systems help avoid the equal horrors of overstocking or running out of materials. How? By aligning your inventory levels with demand through increased forecasting accuracy and accurate planning. In this way, your MRP software helps you identify and reduce unnecessary costs.

3. Smarter pricing decisions

MRP software gives you on-demand insights into different production costs at the click of a button. You can also use it to set prices in real time that reflect your current expenses. Stay competitive while also making sure that your pricing strategy supports your profitability. 

Using MRP software for costing will help you make smarter decisions for your manufacturing business. Learn more about material requirements planning here.

Key takeaways

• Accurate costing is essential for setting fair prices, managing budgets, improving inventory management, helping with decision-making, and staying compliant with industry regulations. Ultimately, costing helps ensure that businesses remain competitive and profitable.
• Familiarity with essential costing terms such as direct costs, indirect costs, fixed costs, variable costs, production costs, and inventory valuation is crucial for effective cost management and financial decision-making.
• Different costing methods, such as actual costing, standard costing, activity-based costing, and job costing, each have pros and cons. The right method for a business depends on factors like its size, production processes, industry requirements, and financial goals.
• MRP (Manufacturing Resource Planning) software streamlines the costing process by automating cost tracking, improving inventory management, and providing real-time insights for smarter pricing decisions. It supports various costing methods, making it a valuable tool for manufacturers.
• The choice of a costing method should align with a business’s priorities, production processes, and industry standards. A careful cost-benefit analysis can help businesses select the method that enhances financial efficiency and supports overall strategic goals.

Frequently asked questions

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