The cost systems are the framework used by companies in order to estimate the cost of their products in order to calculate profitability analysis, inventory valuation and cost control.
Estimating the exact cost of products is critical to profitable operations. A business must know which products are profitable and which are not, and this can only be determined if the correct cost of the product has been calculated.
Additionally, a product costing system helps estimate the closing value of materials inventory, work in process, and finished goods inventory, in order to prepare financial statements..
A typical costing system works by tracking raw materials as they go through different stages of production and slowly being converted into finished products in real time..
When raw materials are brought into production, the system immediately records the use of these materials by crediting the raw materials account and debiting the products in process account..
Since most products go through many stages before they can be called finished products, at the close of a period there are often several different work-in-process accounts..
In a manufacturing environment, various types of costs contribute to making the product. Accounting for these costs in financial and managerial reports improves understanding of the profitability of the manufacturing operation and enables decision making.
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The real-time component of the cost system is its most valuable feature. Management can make decisions based on current data and does not have to wait for it to be added to reports at the end of the period. This important feature is not always easily achieved.
In a costing system, the allocation of costs is carried out on the basis of a traditional costing system or an activity-based costing system. The traditional costing system calculates a single expense rate and applies it to each job or department.
On the other hand, the activity-based costing involves the calculation of the activity rate and the application of overheads to the products based on the respective use of each activity..
Direct materials and indirect materials.
Direct labor and indirect labor.
- Production overhead, including manufacturing personnel.
- Administrative overhead, including office staff.
- General sales expenses, including the production and maintenance of catalogs, advertising, exhibitions, sales personnel, cost of money.
- General distribution expenses
- Maintenance and repair, both office equipment and factory machinery.
- Supplies
- Utilities, including gas, electricity, water, and municipal assessments.
- Other variable expenses
- Wages / payroll, including wages, pensions, and deductions.
- Occupancy (rent, mortgage, property taxes)
- Depreciation (durable goods, including office machinery and equipment)
- Other fixed expenses
These categories are flexible and sometimes overlap. For example, in some companies, machine cost is segregated from overhead and reported as a separate item entirely, and payroll costs are sometimes separated from other production costs..
Depending on whether or not fixed manufacturing overheads are charged to products, cost systems have two variants: direct or variable cost, and cost per absorption.
In direct or variable cost, only variable manufacturing costs are charged to inventory. Fixed manufacturing costs are charged as expenses in the period in which they are incurred.
This method has some advantages and some disadvantages for internal reporting. However, it does not provide an adequate allocation of cost, because the current fixed costs associated with the production of inventory are charged to expenses, regardless of whether or not the production is sold during the period. For this reason, direct costs are generally not acceptable for external reporting..
Cost per absorption, also called total cost, is a traditional method where all manufacturing costs, variable and fixed, are charged to inventory and become assets..
This means that these costs do not become expenses until the inventory is sold. In this way, the assignment is closer to reality..
However, all selling and administrative costs are charged to expenses. Technically, an absorption cost is required for external reporting. The absorption method is also frequently used for internal reporting.
It is a relatively new type of procedure that can be used as an inventory valuation method. The technique was developed to provide more accurate product costs. This increased accuracy is achieved by tracking product costs across activities.
Costs are assigned to activities (activity costs) and then, in a second stage, they are assigned to outputs that use those activities. That is, activities consume money and products consume activities.
Basically, it seeks to treat all costs as variables, recognizing that all costs vary with something, either with the volume of production or with some phenomenon not related to the volume of production..
Manufacturing costs as well as selling and administrative costs are allocated to products.
In traditional absorption cost and direct cost systems, manufacturing overhead is assigned to products based on a measurement related to production volume, such as direct labor hours used.
Therefore, the fundamental differences between traditional systems and activity-based systems are:
- How indirect costs are allocated. Activity-based cost uses both production volume and non-production-volume bases.
- What costs are assigned to the products. Activity-based costing attempts to allocate all costs to products, including marketing, distribution, and administration costs..
Work order costing is a costing system that accumulates manufacturing costs separately for each job. It is appropriate for companies that are dedicated to the production of unique products and special orders.
Costs accrue for jobs, orders, contracts, or lots. The key is that the work is done to the customer's specifications. As a result, each job tends to be different..
For example, work order cost calculation is used for construction projects, government contracts, shipbuilding, auto repair, job printing, textbooks, toys, wooden furniture, office machines, caskets, tools and Baggage.
The accumulation of the cost of professional services (for example, lawyers, doctors) also falls into this category..
The calculation of costs per process is defined as the cost calculation method applicable when products or services result from a sequence of operations or continuous or repetitive processes. The costs are averaged over the units produced during the period.
It is a cost system that tracks and accumulates manufacturing costs separately, for each process. Determine the cost of a product in each process or manufacturing stage.
It is appropriate for products whose production is a process that involves different departments and costs flow from one department to another. For industries that produce large quantities of homogeneous products and where production is a continuous flow.
The process costing accumulates the direct costs and allocates the indirect costs of a manufacturing process. Costs are allocated to products, usually in a large batch, which can include an entire month's production. Finally, costs must be assigned to individual units of the product.
For example, it is the cost system used by oil refineries, chemical or cement producers, etc..
There are situations in which a company uses a combination of the cost-per-job and cost-per-process features, in what is called a hybrid costing system..
Hybrid or mixed systems are used in situations where more than one cost accumulation method is required.
For example, in some cases, you use process costing for direct materials and you use cost-per-job calculation for conversion costs (that is, direct labor and factory overhead)..
In other cases, the work order cost calculation can be used for direct materials, and the cost per process for conversion costs. Different departments or operations within a company may require different methods of cost accumulation..
For this reason, mixed or hybrid cost accrual methods are sometimes referred to as operating cost methods..
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