The costing method definition refers to a systematic process companies use to determine the expenses related to manufacturing goods, including both direct and indirect costs. Depending on the business type, production process, and cost structure, companies may choose methods such as activity-based costing, process costing, or job order costing. Ultimately, an effective costing method not only enhances financial decision-making but also boosts operational efficiency and accurately determines the true cost of production.
Costing Methods
- First In, First Out (FIFO): FIFO is a method where the oldest inventory is sold first and newer stock remains. It’s useful for products with a shelf life, like food or pharmaceuticals. In times of rising prices, FIFO leads to a lower cost of goods sold, a higher inventory value, and typically higher profits and taxes.
- Last In, First Out (LIFO): LIFO is an inventory method where the most recent purchases are sold first and older inventory stays in stock. It’s often used in industries with rising costs to reduce taxable income.
- Weighted Average Cost (WAC): The weighted average cost method calculates the cost of goods sold and ending inventory by averaging the cost of all units available during the period. It’s used for homogeneous, interchangeable items, with each unit’s cost based on the total inventory cost divided by the total units available.
- Specific Indication Cost: The Specific Identification method assigns the actual cost to each unique unit of inventory, typically used for expensive or custom items. It tracks and assigns the exact cost to each unit sold, providing precise cost matching, but is only practical for items that can be individually identified and tracked.
Types of Costing Method
Different types of costs require specific costing methods for accurate allocation and management. This method helps businesses understand how much revenue is available to cover fixed costs and generate profit.
1. Standard Costing
Companies use standard costing to compare standard costs to actual costs incurred during production. It helps evaluate performance by identifying variances between expected and actual costs and setting “standard” costs for materials, labor, and overhead. Typically used in manufacturing environments, standard costing aids businesses with budgeting and cost control.
Key Benefits of Standard Costing:
- Cost Management
- Decision-Making
- Operational Efficiency
2. Job Costing
This method tracks costs associated with specific jobs or projects by treating each job as a unique cost unit, including all costs such as materials and labor. It is commonly used in industries like construction, consulting, and custom manufacturing.
Key Benefits of Job Costing:
- Provides detailed cost tracking for each job
- Enables accurate pricing for customized projects
- Helps identify job-specific profitability
3. Process Costing
This is used in industries that produce large quantities of homogeneous products. These could include food, chemicals, or textiles. Here, the costs are accumulated by the process over a period of time and then averaged over all units produced during that period. Process costing is ideal for businesses that mass produce.
Key Benefits of Process Costing:
- Simplifies cost tracking for mass production
- Suitable for industries with continuous production processes
- Facilitates cost averaging across large volumes of units
4. Direct Costing
In direct costing, companies assign only variable costs to products while treating fixed overhead costs as period costs, not allocated to individual products. This method is mainly used for internal decision-making and short-term pricing decisions. By distinguishing between variable and fixed costs, direct costing helps businesses understand how production volume affects costs and profitability.
Key Benefits of Direct Costing:
- Helps in short-term pricing and decision-making
- Provides clear insight into how variable costs impact profitability
- Useful for breakeven and contribution margin analysis
5. Target Costing
Target costing is a pricing strategy that is used in very competitive markets. It refers to the difference between competitive market price and desired profit margin. The company determines the desired profit margin and target cost based on a competitive selling price. The goal of target costing is the reduction of costs without compromising product quality.
Key Benefits of Target Costing:
- Focuses on cost reduction to maintain profitability in competitive markets
- Helps set realistic cost goals based on market conditions
- Encourages innovation in cost management
6. Activity-Based-Costing (ABC)
Activity-Based Costing (ABC) assigns overhead costs to products based on the activities that drive those costs. Unlike traditional costing methods, ABC identifies specific activities—such as machine setup, maintenance, or inspections—and allocates costs based on each product’s actual usage of those activities. As a result, this method provides more accurate cost information, particularly in complex or multi-product environments.
Key Benefits of ABC:
- Offers more accurate cost allocation by linking costs to specific activities
- Helps identify non-value-added activities and areas for cost reduction
- Improves pricing and profitability analysis, especially in complex production processes