Accounting (9706) | Traditional costing methods - Costing applications

AS Level Cost and Management Accounting (9706)
Traditional Costing Methods – Costing Applications (Syllabus 2.2.1)

Welcome to one of the most practical and important parts of management accounting! Don't worry if you found cost classification a bit dry; this is where we put that knowledge to work.
In this chapter, we learn exactly how businesses calculate the cost of making their products or delivering their services. This is essential because a business cannot set a sensible selling price or control its spending without knowing its true costs.

We will explore three traditional methods: Unit Costing, Job Costing, and Batch Costing.

1. The Core Idea: Why Do We Need Different Costing Methods?

Imagine you run a business. Would you calculate the cost of a single bespoke wedding cake the same way you calculate the cost of a thousand identical loaves of bread? Absolutely not!
Traditional costing methods (Unit, Job, Batch) are tools designed to match the specific type of production a business uses.

Key Costing Components Review

Before diving in, remember that the total cost of anything is always:
Total Cost = Direct Costs + Indirect Costs (Overheads)

• Direct Costs: Traced easily to a product (e.g., flour for the bread, specific wood for a custom table).
• Indirect Costs (Overheads): Shared costs that need to be allocated or apportioned (e.g., factory rent, supervisor salaries). This is often the trickiest part!

(Note: Although the detailed calculation of overhead absorption rates is covered in the next section (2.2.2), you must be able to apply the result of that absorption process here to determine the total cost of a unit, job, or batch.)

2. Unit Costing

Unit costing is the simplest form of traditional costing.

Definition and Use

• Definition: Used when the business produces many identical, homogeneous (the same) products, usually through a continuous manufacturing process.
• Examples: Producing soft drinks, manufacturing bricks, bottling cooking oil, mining coal.

The Calculation Process

Since every unit is exactly the same, we simply track the total costs incurred over a period (or for a production run) and divide by the total number of units produced.

The cost is calculated in a Cost Statement format:

1. Calculate the Total Production Cost (Direct Material + Direct Labour + Direct Expenses + Absorbed Overheads).
2. Calculate the Cost Per Unit:

$$ \text{Cost Per Unit} = \frac{\text{Total Production Cost}}{\text{Total Units Produced}} $$

Key Takeaway (Unit Costing)

This method is only suitable if the products are genuinely indistinguishable from one another.

3. Job Costing

Job costing is used when the cost must be calculated separately for each unique order or project.

Definition and Use

• Definition: A method of cost accounting used to track and accumulate costs for a specific, individual unit or service (a ‘job’). Each job is a distinct Cost Centre.
• Examples: A printing company designing a specific brochure for a client, a mechanic repairing a specific car, a construction company building one customised office block.

Analogy: Think of ordering a custom-built computer. You pay for the specific components (direct material) and the specific hours the technician spends building it (direct labour).

The Job Cost Statement

Since every job is different, the business uses a specific document called a Job Cost Sheet to record the costs associated only with that job.

1. Direct Material: Actual cost of materials used for this specific job.
2. Direct Labour: Actual cost of time spent by workers on this specific job.
3. Direct Expenses: Any other expenses unique to the job (e.g., hiring special equipment).
4. Prime Cost: Sum of all Direct Costs (1 + 2 + 3).
5. Absorbed Overheads: Calculation of the factory/office overheads that should be charged to this job (e.g., 5 hours of machine time @ \$10 per hour).
6. Total Job Cost: Prime Cost + Absorbed Overheads.

Common Mistakes to Avoid

When preparing a Job Cost Statement, make sure you only include costs relevant to that job. Do not include selling and distribution expenses or administrative expenses unless specifically instructed to calculate a total cost including non-manufacturing overheads.

Key Takeaway (Job Costing)

Costs are collected separately for each unique order. The challenge is ensuring overheads are fairly attributed to each unique job using an appropriate absorption rate.

4. Batch Costing

Batch costing is closely related to job costing, but deals with groups.

Definition and Use

• Definition: Used when identical units are produced in groups (batches). The entire batch is treated as a single Job for costing purposes.
• Examples: A bakery producing 500 identical cakes at once, a company printing a run of 10,000 leaflets, manufacturing a specific size of screw or bolt.

Did you know? The number of units in a batch is often determined by the Economic Batch Quantity (EBQ), which minimises the total cost of production and storage.

The Calculation Process

1. Cost the Entire Batch: Calculate the total cost of the batch (Direct Material, Direct Labour, Overheads) exactly as you would for a single Job.
2. Calculate the Unit Cost: Divide the Total Batch Cost by the number of units in that batch.

$$ \text{Unit Cost} = \frac{\text{Total Cost of Batch}}{\text{Number of Units in Batch}} $$

Memory Aid: Batch Costing is just Job Costing followed by Unit Costing. You cost the "group" first, then divide by the items in the group.

Key Takeaway (Batch Costing)

It saves time because costs are tracked for the group, not individually. It’s ideal for products that are often ordered in bulk, but where setup costs apply only once per batch.

5. Costing Applications in Service Businesses

The syllabus requires you to apply these principles not just to manufacturing (where you make physical goods) but also to service businesses.

Don’t panic! The principles remain the same; only the names of the "units" change.

The Challenge for Service Businesses

• They produce intangible output (services).
• Direct Material is often minimal (e.g., paper used by a consultant) or non-existent.
• Direct Labour (the time of the professional, like a lawyer or accountant) is usually the most significant direct cost.

How Costing Methods Apply to Services

We simply replace the "product unit" with a "service unit."

a) Service Job Costing

Used for unique client mandates or projects.

• Job Unit: The specific client engagement or case.
  Example: An accountant preparing a client's tax return.
• Costing Focus: Recording the hours spent by professional staff (direct labour) and absorbing office overheads (rent, utilities) based on those hours.

b) Service Unit Costing (Operating Costing)

Used for standardized services that occur continuously.

• Unit: A standardized measure of output.
  Examples:
  • Transport company: Cost per passenger-kilometre or tonne-kilometre.
  • Hotel: Cost per occupied room-night.
  • Hospital: Cost per patient-day.

In all cases, the primary goal is the same: determine the Full Cost (Direct Costs + Absorbed Overheads) to ensure the service is priced profitably.

6. Summary: Key Takeaways on Costing Applications

Knowing which method to use is often the first step in solving a costing problem.

Mastering these applications gives you the foundation needed to understand the more detailed calculations involved in Absorption Costing and Marginal Costing in the sections that follow. Keep practicing the preparation of these costing statements!