Cost Management II: Costing Systems by Product
Chapter 12. Cost Management II: Costing Systems by Product
Different production methods require different costing methods. The accounting for a company building one plane at a time cannot be the same as that for a factory churning out ten thousand packs of ramen, right?
1. Job-Order Costing vs. Process Costing
The algorithms for collecting and allocating costs vary depending on the production method.
| Category | Job-order Costing | Process Costing |
|---|---|---|
| Production Method | Custom-made / Many types, low volume | Continuous mass production / Few types, high volume |
| Cost Collection | Collected individually by job | Averaged by process |
| Key Challenge | Rational allocation of overhead | Calculation of Equivalent Units (EU) |
| Industry Examples | Construction, Shipbuilding, Aerospace | Refining, Milling, Paper, Chemicals |
The core skill in process costing is calculating Equivalent Units. This is the process of measuring economic substance—defining “how many finished units 10 partially finished items are equal to.”
2. Standard Costing and Variance Analysis
Standard costing allows for ‘Management by Exception’ by comparing actual performance with pre-set targets (standards).
| Category | Price/Rate Variance | Quantity/Efficiency Variance |
|---|---|---|
| Materials | Variance due to unit price changes | Variance due to quantity used |
| Labor | Variance due to wage rate changes | Variance due to working hours |
| Accountability | Purchasing Department | Production Department |
3. Absorption Costing vs. Variable Costing
Operating profit can vary depending on how fixed manufacturing overhead is treated.
| Category | Absorption Costing (External) | Variable Costing (Internal) |
|---|---|---|
| Fixed Cost Treatment | Included in product cost (Inventory) | Treated immediately as period expense |
| Advantages | Complies with GAAP | Prevents profit distortion from volume changes |
| Disadvantages | Profit can be inflated by increasing inventory | Not for external reporting |
The Trap of Inventory Assets: In absorption costing, an illusion of increased operating profit can occur simply by producing more items (even if unsold) as fixed costs get hidden in inventory. Managers must be wary of this.
This is the final chapter! and we will see how to bloom the flowers of Management Accounting by using all these numbers to make business decisions.
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