Learn about eight common costing methods to calculate how much something will cost.
Methods of cost accounting or simply "costing methods" are crucial for calculating how much something like a product or service costs. Manufacturers can then use this information to price products for profit, track expenses to see where money is going, and make smart cost-control decisions.
But what exactly is a costing method? This short guide defines what it is and includes nine common costing methods manufacturers use.
What is a costing method?
A costing method is simply a way of calculating how much a product, service, activity, production process, or any other cost object costs. There are many different types of costing methods, ranging from first in, first out, and average weighted cost to process and standard costing.
What are the different costing methods?
Different industries and businesses will use different methods of cost accounting. The choice of costing method will also differ based on the size of the company, the complexity of operations, industry norms, and other personal preferences. Here are nine costing methods commonly used in manufacturing across two broad categories: inventory and production costing.
Inventory costing refers to the costing methods used to assign costs to a specific product. Four common inventory costing methods include:
- First in, first out (FIFO). FIFO assumes products purchased first are sold first. In this costing method, the cost of the oldest product is applied to newer copies of that product, even if it's not the same. FIFO is one of the most popular costing methods because it provides a more accurate representation of costs, better aligns with the generally accepted accounting principles (GAAP), and conforms with the flow of products in most industries.
- Last in, first out (LIFO). LIFO is the opposite of FIFO and assumes most recently purchased products are sold first. With LIFO, the cost of the most recent product is applied to every other copy, no matter when it was purchased.
- Average weighted cost. Instead of using the amount you spent to produce a particular item, you calculate the average cost per unit. Take the total cost of all items produced and divide it by the total number of items.
- Actual cost. As the name implies, actual costing refers to calculating the true cost of an item by recording the actual costs to manufacture it, like materials, labor, and overhead related.
Production costing refers to the cost accounting method of assigning direct and indirect costs to the production process. Direct costs are specific costs, like direct materials or labor, tied to a product. In contrast, indirect costs are running costs like rent or support labor (HR, accounting, etc.) not explicitly tied to a product.
Four common production costing methods used in manufacturing include:
- Job costing. Costs are calculated per batch or job where products are made to order. Direct labor, direct materials, and other overhead costs are all considered.
- Process costing. Costs are calculated for each manufacturing stage by taking into account the direct and indirect costs. These total costs are then divided by the number of items produced in that production stage to arrive at an item cost. This costing method is used in industries where products are produced in a continuous flow and go through multiple production stages or processes, e.g., cloth production.
- Standard costing. Manufacturers set pre-determined costs for specific elements like parts, labor, etc. They then add up all these costs to arrive at a final cost for each product. Standard costs act as benchmarks to compare actual costs against. Manufacturers can use it to identify cost variances and then take the necessary action to control costs.
- Activity-based costing (ABC). ABC is a more sophisticated form of job costing where costs are assigned to a product or service based on the cost of specific activities involved in the production process.
The bottom line on costing methods
Costing methods help you calculate how much something will cost—whether a product or production process. You can then use this information for accounting, pricing products, and making other important decisions. The most important thing isn't necessarily which method you use but that you consistently use it.
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