In direct or variable cost, only variable manufacturing costs are charged to inventory. Fixed manufacturing costs are charged as expenses in the period in which they are incurred.
This method has some advantages and some disadvantages for internal reporting. However, it does not provide an adequate allocation of cost, because current fixed costs associated with inventory production are charged to expenses, regardless of whether or not production is sold during the period. For this reason, direct costs are generally not acceptable for external reporting.
Cost per absorption
Cost per absorption, also called total cost, is a traditional method where all manufacturing costs, variable and fixed, are charged to inventory and converted to assets.
This means that these costs do not become expenses until the inventory is sold. In this way, the assignment is closer to reality.
However, all selling and administrative costs are charged to expenses. Technically, an absorption cost is required for external reporting. The absorption method is also frequently used for internal reporting.
Activity-based cost
It is a relatively new type of procedure that can be used as an inventory valuation method. The technique was developed to provide more accurate product costs. This increased accuracy is achieved by tracking product costs across activities.
Costs are assigned to activities (activity costs) and then, in a second stage, they are assigned to outputs that use those activities. That is, activities consume money and products consume activities.
Basically, it seeks to treat all costs as variables, recognizing that all costs vary with something, either with volume of production or with some phenomenon not related to the volume of production.
Manufacturing costs as well as selling and administrative costs are allocated to products.
Difference with traditional cost systems
In traditional absorption cost and direct cost systems, manufacturing overhead is assigned to products based on a measurement related to production volume, such as direct labor hours used.
Therefore, the fundamental differences between traditional systems and activity-based systems are:
- How indirect costs are allocated . Activity-based cost uses both production volume and non-production-volume bases.
- What costs are assigned to the products. Activity-based costing attempts to allocate all costs to products, including marketing, distribution, and administration costs.
Types
Calculation of costs by work order
Work order costing is a costing system that accumulates manufacturing costs separately for each job. It is appropriate for companies that are dedicated to the production of unique products and special orders.
Costs accrue for jobs, orders, contracts, or lots. The key is that the work is done to the customer's specifications. As a result, each job tends to be different.
For example, work order cost calculation is used for construction projects, government contracts, shipbuilding, auto repair, job printing, textbooks, toys, wooden furniture, office machines, caskets, tools and Baggage.
The accumulation of the cost of professional services (eg, lawyers, doctors) also falls into this category.
Calculation of costs per process
The calculation of costs per process is defined as the cost calculation method applicable when products or services result from a sequence of operations or continuous or repetitive processes. The costs are averaged over the units produced during the period.
It is a cost system that tracks and accumulates manufacturing costs separately, for each process. Determine the cost of a product in each manufacturing process or stage.
It is appropriate for products whose production is a process that involves different departments and costs flow from one department to another. For industries that produce large quantities of homogeneous products and where production is a continuous flow.
The process costing accumulates the direct costs and allocates the indirect costs of a manufacturing process. Costs are allocated to products, usually in a large batch, which can include an entire month's production. Finally, costs must be assigned to individual units of the product.
For example, it is the cost system used by oil refineries , chemical or cement producers, etc.
Hybrid or mixed cost calculation
There are situations in which a company uses a combination of the cost-per-job and cost-per-process features in what is called a hybrid costing system.
Hybrid or mixed systems are used in situations where more than one cost accumulation method is required.
For example, in some cases you use process costing for direct materials and you use cost per job calculation for conversion costs (that is, direct labor and factory overhead).
In other cases, the work order cost calculation can be used for direct materials, and the cost per process for conversion costs. Different departments or operations within a company may require different methods of cost accumulation.
For this reason, mixed or hybrid cost accrual methods are sometimes referred to as operating cost methods.
