Costing methods applicable to production

Control cost data to reduce spending and increase production efficiency.

The main reason for Cost Management, or Cost Accounting, is to reduce unnecessary and excessive spending, making the most of production efficiency.  

When the entire process is in an automated system, it is better controlled, with greater precision and readability, as expenses are provided in lists and monitored. This makes expenses much easier to identify and control, and makes it possible to know if their application is actually generating a return.

There are several methods for cost allocation and control. These methods have specific applications and do not replace one another, but rather complement each other.  

The two most traditional methods, used most frequently in the manufacturing and commercial industries, are Absorption Costing and Variable Costing.  
Here we will cover these and others that are relevant to the topic.

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Absorption Costing Method

This consists of allocating all production costs, whether variable or fixed, to the products manufactured within a given accrual period.

This costing methodology is considered appropriate for inventory valuation in Financial Accounting, for the purpose of preparing Balance Sheets and Income Statements, in order to meet tax and corporate requirements, among others.

Under this method, all variable and fixed costs—the latter typically identified as Indirect Production Costs—are an integral part of the costs of the items produced and will be accounted for as transfers to the finished goods inventory.

Variable Costing Method

This considers only the costs that vary proportionally with production volume—that is, variable production costs—as the cost of the manufactured products.

Fixed process costs are considered period costs and will be included in the company's income statement.

This method allows you to determine the contribution margin of each product or product line, making it possible to manage the production of items with better margins.

Other methods for management purposes:

Standard Costing Method

Also known as Standard Costing, this management accounting concept aims to establish or simulate product costs based on technical production data and product specifications, such as raw material consumption, standard processing time, and manufacturing expenses relative to pre-established parameters.

Furthermore, Standard Costing is used to determine selling prices by also considering direct labor costs, indirect manufacturing costs, administrative expenses, and variable sales and financial expenses, including:

• Allocation of raw material consumption to product costs based on product engineering;
• Allocation of budgeted or historical expenses for a given period to auxiliary and production cost centers;
• Appropriation and distribution of allocated expenses from auxiliary cost centers to production cost centers using rational criteria;
• Appropriation of expenses from production cost centers to products or services by determining their projected process costs.  

In short, the Standard Costing management system allows not only for cost calculation but also for simulations aimed at:

• Establishing the Standard/Management Cost of production;
• Setting selling prices, based on production costs, administrative expenses, variable sales expenses, and the desired profit margin;
• Simulating the profitability and return of products, considering the market selling price per product, order, customer, and representative;
• Simulating the contribution margin of products, by product, order, customer, and representative, based on direct costing;
• Calculate the break-even point based on the order backlog and fixed costs for a given period;  
• Evaluate the performance forecast for products, sales orders, customers, and representatives, based on costs, expenses, and current sales prices.

Other methods – for accounting purposes:

Actual Costing System Method

The costing method for accounting purposes, known as Actual Production Cost, or simply Actual Cost, determines production costs by assuming the actual expenses incurred during a given period, which are quantified on an accrual basis according to the timeframe in which they occur, regardless of when they are paid. In other words, Actual Costing involves costing based on the actual consumption of raw materials and production times, for example, on a monthly basis.  

Main characteristics of Accounting Costing / Actual Cost:

• Appropriation and distribution of actual raw material consumption to product costs;
• Allocation, through accounting entries, of actual expenses for a given period to auxiliary and production cost centers;
• Distribution of allocated expenses from auxiliary cost centers to production cost centers using rational criteria;
• Appropriation of expenses from production cost centers to products or services by determining their transformation cost.

As we can see, the database for Actual Costing is the movement of materials, from the entry of raw materials to the entry of finished products into stock, throughout the entire process.

An effective Actual Cost system must be capable of costing products at the various stages they are in, considering the specific characteristics and parameters of each phase, to provide a complete, accurate, and clear diagnosis to the manager. Furthermore, it must be able to value inventories to allow for their assessment by Financial Accounting, for the purpose of preparing the Balance Sheet and Income Statement, and to meet tax and corporate requirements, among others.

Thus, based on revenue, COGS (cost of goods sold), fixed and variable expenses, including taxes and returns, we arrive at the period's results, with a mapping of areas with potential for improvement.

In summary, Actual Costing should allow us to:

• Value raw material, work-in-progress, finished goods, and warehouse inventory; ‍
• Determine the actual cost of production; ‍
• Account for valued inventory to meet the company's tax and corporate requirements;
• Report the income statement (P&L).

Conclusion

With all this mapped and organized information, manufacturers can achieve maximum production efficiency by reducing costs and improving business performance, which translates into greater competitiveness.

Costing methods make it possible to understand the yield and performance of various activities, thereby guiding better decision-making, promoting control, and providing a solid foundation for planning and developing the company's internal and external operations.  

Computerized systems must account for all variables, concepts, and information related to costs, considering the expertise and specific demands of each business to ensure better resource management and maximum final profitability for every segment.

Thanks for reading, and see you next time!