Cost Assignment Models ~ An Overview
Remember when it was just you, your garage, and a single fabricating job each week from that one company who saw potential in your work? Costing, for you then, was simply a matter of getting the work done as quickly as possible with the lowest investment in material and no inventory at all. Talk about “just in time” production. Often it was more like “just in in the nick of time” when it came to getting in another work order to keep the electricity on or bread on the table.
My, how things have changed as you’ve grown into a 60,000 square foot job shop with 80 employees, and dozens of work orders coming in each day. What used to be a simple costing formula (i.e., price charged – material cost = profit), involves so many variables it can make your head spin.
Of course, you wouldn’t have gotten to this point without a progressive improvement in the way you assigned costs to jobs. You came to understand that costs include more than just materials; they include your machinery, your floor space, utility needs, additional personnel, benefits for those personnel, and myriad other notions unconsidered back in the garage days.
Depending upon the type of operation you have as a job shop, make-to-order, or make-to-stock manufacturer, cost assignment methods can be broken down into three different approaches: Job Order Costing, Process Costing, and Activity Based Costing. In the most basic of terms, these methods are defined as:
● Job Order Costing: Here, costs are assigned to specific jobs or orders. This method keeps track of costs by, 1) tracing material and direct labor to a particular job; and, 2) applying a predetermined overhead rate to each job to include costs not directly traceable to the production of the job. Job order costing is most common in job shops, specialized production, or services industries.
● Process Costing: Manufacturing cost are allocated to products to determine an average cost per unit. Process Costing is used by companies that mass produce identical or similar products; that is, continuous production. With every unit produced pretty much being the same, each receives an equivalent amount for manufacturing costing. The more repetitive and continuous the production, the better. Examples of operations that use process costing include thermoform packaging producers, refineries, paper mills, and so on.
● Activity Based Costing: Familiar to many by its acronym, ABC, activity based costing distributes (or pools) the costs of the shared activities (cost drivers) associated with disparate jobs or production lines under the same roof. The big advantage of ABC is that it is able to reduce the distortions in costs that result from the arbitrary assignment of indirect costs in standard job order costing (i.e., overhead).
Ultimately, the type of costing you employ is a function of the sort of manufacturing you do. And, who you are responsible to in your budget reporting—many governmental and financial institutions insist on ABC for their vendors. If you produce thousands upon thousands of the same refrigerator magnets batch after large batch, then process costing is probably best for you.
If your orders are usually of differing engineering and set-ups, then job order costing is the method of choice. On the other hand, when you have a single plant making a variety of products over time but with the same production lines, greater precision is needed to determine what drives the cost through the sharing of labor and other operational aspects for these products—you need to go ABC.