Manufacturing Accounting Overview: Methods of Costing

Manufacturing Accounting Overview: Methods of Costing

Manufacturing accounting can be a complex subject. Manufacturers use several different production accounting methods to organize costs and evaluate performance. Direct materials include the cost of any material that goes directly into the finished product. For example, the wood used to shape toothpicks is a natural material.


Job Order Costing

Job order costing is a preferred accounting method for manufacturers who produce unique products or services. Its advantages include allowing for accurate cost allocation for individual projects and enabling informed pricing decisions. Its limitations include the complexity of tracking costs for each task and inaccuracies when estimating overhead expenses.

The company must track direct materials and labor costs to calculate job order costs. The company then pools the total costs associated with the project to determine a manufacturing overhead cost allocation base, which can be calculated using a predetermined overhead rate or activity-based costing. This overhead cost allocation base is then applied to each job in the production process. Once the project is completed, the total job costs are recorded as the cost of goods sold.

Companies that use job order costing must prepare journal entries with the aid of manufacturing accountants to record costs in the system and prepare schedules of the cost of goods manufactured and the cost of goods sold. After that, profit and loss reports and other financial statements can be created using those journals. A robust inventory management system is required to track each project’s costs accurately. For example, the system must identify which raw materials are used in each product and follow the quantity of each item. It also needs to be able to calculate the actual cost of each finished product.

Process Costing

In process costing, manufacturers use a standard accounting method for tracking costs as units pass through the production process. It works best for companies that mass-produce identical products, such as oil or food processing companies that make millions of gallons of fuel or boxes of snack foods. The goal is to determine a department’s finished goods and work-in-process quantities at the end of each month and compare them to projected manufacturing budgets. The first step in process costing is identifying the direct materials, indirect labor, and factory overhead costs that go into each unit. These are called “cost pools” and can be tracked with an inventory valuation system, such as the weighted average or FIFO methods discussed in the preceding section.

Once the direct and indirect costs are tracked, they can be assigned to the production units based on their proportion of the total resource usage. This information helps managers set prices based on production costs, assess profit margin by product, and isolate problem products before they become significant issues. The next step is to prepare a departmental production report for each month. It includes a list of all the units started and completed in the department. Then, the total cost per unit is calculated by dividing the direct expenditure by the number of units produced in that department. The entire unit cost and the total cost of work in progress are then compared to the budgeted manufacturing costs for the month to assess the effectiveness of the department’s operations.

Activity-Based Costing

Activity-based costing is a system of more precisely allocating overhead costs. It involves identifying and categorizing your business’s various activities, then calculating a per-unit cost driver rate by dividing the total amount of overhead spent on each activity by its primary cost driver (e.g., electric bill, number of labor hours). The cost drivers are then apportioned to products to determine their unit product costs. Tracing untraceable indirect costs to individual products offers benefits, including more accurate production-cost determination, improved pricing decisions, and identifying areas where costly inefficiencies are caused by process waste.

The most significant obstacle to implementing activity-based costing is the need for detailed data to classify business activities into their respective cost pools. This information may not be readily available to some businesses, mainly if they use outdated accounting systems or production equipment that does not record process steps or other activity details.

This method differs from traditional absorption costing, which divides total manufacturing costs into period and product costs. The latter include direct materials and factory overhead. The former typically includes direct and indirect costs such as depreciation and utility charges. Traditional absorption costing allocates overhead costs to all products at an average overhead rate based on attributes such as direct labor dollars/hours or machine hours, whereas activity-based costing traces overhead expenses directly to product production.

Inventory Management

Choosing the correct inventory management method is essential for accurate cost analysis. It facilitates the price-setting process for enhanced profitability and ensures businesses meet their profit goals and tax obligations. It also helps them manage inventory levels and prevents stockouts that cost a company money. In addition, manufacturing accounting methods help them identify the production costs for their products and services. In today’s world of advanced technology, SMEs can use ERP software programs to streamline their accounting operations, track purchasing and sales transactions, monitor extra costs, and get real-time reporting.

Direct materials are the raw materials that a manufacturer transforms into finished goods. They include anything visible or identifiable as going into a unit, such as wood and table screws. Inventory is the total amount of these raw materials and partially completed units that have yet to be sold. Manufacturers must track these items, which can be difficult if they have several different manufacturing methods. Popular inventory valuation methods are first-in, first-out (FIFO), last-in, first-out (LIFO), and average cost. The FIFO and LIFO methodologies impact how indirect costs are allocated. The average cost method utilizes a weighted average of inventory for calculation purposes. Regardless of the method, a company should minimize the number of cost pools to reduce manual allocation work.

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