Describe costing methods
Manufacturing companies need to calculate costs that are related to producing finished goods, such as labor, materials, surcharges, and overheads.
Supply Chain Management offers tools and costing sheets to calculate production and material costs for finished goods. You can set up costing sheets by cost categories, incorporate routing costs, and even add surcharges and other indirect costs. Companies can then analyze, summarize, and evaluate cost data so they can make the best possible decisions for price updates, budgets, and cost control.
Cost management lets you work with the valuation and accounting of raw materials, semi-finished goods, finished goods, and work-in-progress assets. Costing sheets provide a formatted display of information about the cost of goods that are sold for a manufactured item or a production order.
Let’s detail two aspects of cost management: standard costs and actual costs.
Standard cost
Standard costing is an accounting method where expected costs (standard costs) are used instead of actual costs to value inventory and cost of goods sold. This method helps in budgeting, setting prices, and controlling costs by comparing standard costs to actual costs and analyzing any variances.
A costing version can support a standard cost inventory model for items, where the costing version has a set of standard cost records about items and manufacturing processes. Cost data about manufacturing processes is expressed in terms of the cost categories for routing operations and the calculation formulas for manufacturing overheads.
With the help of costing for lean manufacturing, the production flow can use the cost accumulation method that is known as backflush costing. Backflush costing is an accounting method used primarily in just-in-time (JIT) inventory systems. It records the costs associated with producing goods only after they're completed, sold, or shipped12. This method simplifies the accounting process by eliminating the need to track costs throughout the production stages. Instead, all costs are “flushed” to the end of the production run. In the backflush costing method, the direct materials that are consumed are accumulated in the production flow's work in progress (WIP) cost account. The standard cost inventory model group is used. The products that are received from the production flow are deducted from WIP at their standard cost.
The main difference between backflush costing and standard cost is that, for backflush costing, variances aren't calculated per Kanban or finished product. Instead, variances are calculated per production flow over a period. This method introduces a truly lean concept for reporting material consumption.
Actual cost
Actual cost refers to the real amount of money spent to acquire a product or asset. This includes all expenses such as the purchase price, delivery, setup, and any other costs incurred to get the asset ready for use.
Planned costs are the estimated expenses for producing a product or completing a project. These costs are determined in advance based on historical data and expected expenses, including direct raw material charges and labor costs.
A costing version can contain a set of planned cost records about items and manufacturing processes. A costing version that contains planned costs is often used to support cost calculation simulations. A company might want to see the effect cost changes have on purchased materials or the effect manufacturing process changes have on calculated costs of manufactured items. The item cost records for planned costs can also be used to support an actual cost inventory model by providing the initial values for item costs.
FIFO - First in, first out (FIFO) is an inventory model in which the first acquired receipts are issued first. Financially updated issues from inventory are settled against the first financially updated receipts into inventory, based on the financial date of the inventory transaction.
LIFO Date - Last in, first out date (LIFO date) is an inventory model based on the LIFO principle. Issues from inventory are settled against the last receipts into inventory based on the date of the inventory transaction. By using LIFO Date, if there's no receipt before the issue, the issue is settled against any receipts that occur after the date of the issue. Several issues on the same date may be settled in the order of last issue, last receipt.
Weighted average - This inventory model is based on the weighted average principle. Inventory issues are valued at the average of the items that are received into inventory during the inventory closing process, plus any on-hand inventory from the previous period.
In inventory accounting, you can choose methods like FIFO, weighted average, standard cost, or moving average for valuing products.
Inventory accounting is the body of accounting that deals with valuing and accounting for changes in inventoried assets. A company's inventory typically involves goods in three stages of production: raw goods, in-progress goods, and finished goods that are ready for sale. Inventory accounting assigns values to the items in each of these three processes and records them as company assets.
The following table explains how different costing methods can change the cost of goods sold. In this example, a bookseller procured a book at different prices over a period of six months.
| Month | Quantity | Procurement rate (in USD) |
|---|---|---|
| January | 100 | $18.00 |
| February | 150 | $17.25 |
| March | 75 | $18.25 |
| April | 125 | $17.50 |
| May | 200 | $16.50 |
| June | 50 | $18.50 |
| Total procured | 700 |
Of the 700 books procured through June, 400 books are sold. Each book is sold for $20. The cost of the sold books can be calculated based on the FIFO method, which considers the rates from when the books were first procured. The following table presents the cost rates.
| Month | Quantity | Procurement rate (in USD) | Cost price (in USD) |
|---|---|---|---|
| January | 100 | $18.00 | $1800 |
| February | 150 | $17.25 | $2587.50 |
| March | 75 | $18.25 | $1368.75 |
| April | 75 | $17.50 | $1312.50 |
| May | 200 | $16.50 | $3300 |
| June | 50 | $18.50 | $925 |
| Total procured/sold | 700/400 | $7068.75 |
In the FIFO method, the cost per book is $17.67, and the profit is $2.33 per book.
The cost of the sold books can be calculated based on the LIFO method, which considers the rates from when the books were last procured. The following table presents the cost rates.
| Month | Quantity | Procurement Rate (in USD) | Cost price (in USD) |
|---|---|---|---|
| March | 25 | $18.25 | $456.25 |
| April | 125 | $17.50 | $2187.50 |
| May | 200 | $16.50 | $3300 |
| June | 50 | $18.50 | $925 |
| Total sold | 400 | $6868.75 |
In the LIFO method, the cost per book is $17.17, and the profit is $2.83 per book.
Aspects of costing sheets
When you set up a costing sheet, you define the format for the information, and you define the basis for calculating indirect costs. The costing sheet setup builds on the cost group features for displaying information and for the formulas that are used to calculate indirect cost. The two objectives of costing sheet setup are to:
Define the format for the costing sheet. The user-defined format for a costing sheet identifies the segmentation of costs that contain a manufactured item’s cost of goods sold. For example, the information about an item’s cost of goods sold can be segmented into material, labor, and overhead, based on cost groups. These cost groups are assigned to items, cost categories for routing operations, and indirect cost calculation formulas. The format for the costing sheet typically requires intermediate totals when multiple cost groups are defined. For example, multiple cost groups that are related to material can be aggregated. The definition of a costing sheet format is optional, but a costing sheet format must be defined for indirect costs to be calculated.
Define the basis for calculating indirect costs. Indirect costs reflect manufacturing overhead that is associated with the production of a manufactured item. An indirect cost calculation formula can be expressed as either a surcharge or a rate. A surcharge represents a percentage of value, whereas a rate represents an amount per hour for a routing operation. A cost group defines the basis for the calculation formula. An example would be a 100 percent surcharge for a labor cost group, or a USD 50.00 hourly rate for a machine cost group. To set up a costing sheet, identify the overhead cost group and choose between a surcharge or rate approach.
Manufacturing accounting lets you handle job order costing in production orders and batch orders, and backflush costing in lean manufacturing.
You can access inventory accounting and manufacturing accounting from the Cost administration and Cost analysis workspaces. These workspaces provide a comprehensive overview of the status, key performance indicators (KPIs), and detection of deviation.