HNC Engineering

Business Management Techniques

Costing Systems & Techniques.

Daniel Pitman
Task 1
Job Costing Techniques

Absorption Costing.
This is a method whereby all normal costs, including both fixed and variable overheads,
are charged to the produced “cost units”, a term used to describe the individual units
produced (bolts, for example) in financial terms. As this method includes all direct
materials and labour, the emphasis is therefore on determining the final cost to the
company, per unit produced and thus how much needs to be charged to recoup this value.
This therefore, is the best method to use as regards the pricing of products, as the value it
gives per item is the total liability the company has incurred producing it. The main
advantage is that whilst sales fluctuate due to market trends such as seasonal change,
despite production continuing unabated, this method reduces the expected matching
fluctuation in monthly net profit, as the stock held is treated as an asset, having a given
unit value even though not sold. As such, this method is used to prepare financial
accounts, as any stock held is not undervalued, or treated as a liability. The main
disadvantage however, is that since it focusses on total cost incurred per “cost unit”, any
relationship between cost per volume produced, and profit is ignored by this method,
meaning that whilst it may be perfect for end of year/project accounts, it is not very useful
for planning future production.

Marginal Costing.
This is a method whereby only variable costs and direct costs are charged to the produced
“cost units”; Fixed overheads & costs are not; they are instead written off to be absorbed
by the profit/loss generated during the period. As such, it is focussed on the controllable
costs within the business, rather than the total costs as per absorption costing. Once the
marginal cost has been ascertained, the contribution can be deduced – this being the
excess of revenue generated over the marginal costs incurred during production. Due to
this, unlike Absorption costing, this method shows a relationship between pricing of
product, volume (and type) of output and profit generated during the period. The
advantage of this method therefore is that its output is much easier to understand and can
be used for planning and control of pricing/production levels. The disadvantage of this of
course, is that any decisions made on the back of this output will be based on historical,
not current, data. Also, as it largely ignores fixed costs and overheads, there is the is the
danger that these costs may increase dramatically, or suddenly become variable, without
being noticed until period end. As such, it is not suitable as a long term costing method. A
further disadvantage is that marginal costing methods may lead to products being sold at a
lower price if the manufacturer is operating at less than full capacity, due to low demand;
customers may still expect to purchase goods at these low prices even after demand has
increased.

Activity Based Costing (ABC).

This method attempts to rectify the faults of absorption costing, by apportioning overheads
to “cost units” in a more appropriate manner, by tracing costs and overheads to the
specific items/activities generating them, and translating indirect costs into direct ones.
Whereas absorption costing typically spreads overhead costs across all items produced in
a period, ABC recognises that it is only certain activities that generate these costs, causing
the company to consume resources. The cost of these resources is calculated, and
apportioned to each project, item or batch produced in line with what proportion of these
cost each has caused the company to incur. This is most useful in industries where
manufacturing overheads are high, companies where a great diversity in product lines is
seen or envisaged and or where production occurs in greatly varying sized batches.
Standard Costing.
The standard costing method is based around a forecast unit cost for a product, based on
estimated or historical data, that is assumed to be correct if expected efficiency and cost
levels are met and represents a target cost for the company. These cost levels may
themselves be standard costs, estimates of a company's direct materials costs, labour
costs and manufacturing overheads. As such, rather than assigning the actual cost
incurred to the product, the standard cost is assigned instead and sales begin using costs
based on these estimates. As a result, there are always variances between actual costs
incurred, and the standard costs; these inform the management that actual manufacturing
costs have strayed from those estimated and that the level of profit generated will be
different than planned. If actual costs exceed the estimated standard cost, then profits will
be less than expected (an unfavourable variance). If the actual costs have been less than
the standard figure, then the variance will be a favourable one, and greater than expected
profit levels will be the result.
Advantages of this method are that it can be used as a means of staff motivation, and
performance measurement against previous performance, however the downside to this is
that whilst it can aid in efficiency, it is based on out of date information. It is therefore a re-
active, not a pro-active control method.

Additional Methods and techniques

Job Costing.
Simple method, whereby all direct costs, labour and overheads are allocated to a single
job; thus tracking expenses incurred against the income generated by the job. Whilst
useful for a small number of high value jobs, this would be unsuitable for continuous or
batch manufacture, and would be more applicable to one-off custom made items.

Batch Costing.
A modified form of job costing, this method factors in batch production, multiplying the
relevant costs by the number of items produced in the batch. It also allows for set-up costs
to be spread across future re-order batches.

Contract Costing.
Another modified form of job costing, this technique treats the contract as a job, and is
performed over a longer duration. This is used for larger, more complex jobs such as ship-
building and civil engineering projects. There are usually more factors to be accounted for,
often due to the extended duration, such as inflation.

Process Costing.
This costing method is primarily used where production is of uniform goods, all of the
same type, and possibly occurring in high volume. This is the direct opposite of job
costing, where costs are per job/per small order batches; here the product is repetitive and
homogeneous. For process costing, the costs across all units, produced over a period of
time, are averaged to come to a per-unit cost. Due to the nature of the output this is aimed
at, this method is more usually used by companies with either only one product line, or
with a continuous output to meet a constant demand, such as a coal mine or an electricity
supplier. In process costing, each stage of the manufacturing process is costed, until the
final product is reached, to give the cost of all manufacturing involved in the production of
the final product.
 Reccomendation

It is my belief that the best way for the target company to manage its finances would
be to employ separate methods for each side of it's business, but to use Absorption
costing for it's end of year accounts.
I would recommend that for it's main business line of repeatedly batch-packaging
pharmaceuticals, standard costing would be best. Due to the repeat nature of the
business, accurate standard costs should be available from previous years, and it is
expected that as costs are mostly stable due to the (assumed) majority automated
processes involved in the packaging business, that ongoing variance analysis will not
show that great a departure from the standard costs evolved.
For the small design projects the company runs as a sideline, I would suggest that
simple job costing would suffice; the projects are small and do not involve any
manufacture – only design. Given this, the fact that contracted out design is expensive,
and the wording of the brief; the cynical side of me wonders if the cost of these designs
may not just be a ploy to make outsourcing the packaging of the pharmaceuticals look
financially attractive to their customers' accounts departments.