Introduction to costing

Welcome to the World of Costing!

In your accounting journey so far, you have looked at how businesses record transactions and prepare financial statements. But have you ever wondered how a business decides what price to charge for a product? Or how they know if a specific factory department is too expensive? This is where Costing comes in!

Costing is the "internal" side of accounting. It helps managers understand exactly where every penny is being spent so they can make smart decisions. Don't worry if it seems like a lot of numbers at first—we will break it down piece by piece!

Section 1: Valuation of Inventory

Inventory (or stock) represents the goods a business has waiting to be sold. Since prices change over time, we need a system to decide which cost to assign to the items we sell and the items left in the warehouse.

Methods of Valuation

The syllabus focuses on three main ways to value inventory:

1. FIFO (First In, First Out): This assumes that the oldest items are sold first. Think of a milk aisle in a supermarket—they sell the oldest milk first so it doesn't expire.
2. LIFO (Last In, First Out): This assumes the newest items are sold first. Think of a pile of coal—you naturally take from the top (the newest addition) first.
3. NRV (Net Realisable Value): This is the estimated selling price minus any costs needed to complete or sell the item. Prudence tells us we must value inventory at the lower of its original cost or its NRV.

Perpetual vs. Periodic

Business can track these values in two ways:

• Perpetual: Inventory is updated after every single transaction.
• Periodic: Inventory is only calculated at the end of a period (like a month or year).

The Effect on Profit

When prices are rising (inflation):

• FIFO results in a higher profit because it uses older, cheaper costs for the "Cost of Goods Sold."
• LIFO results in a lower profit because it uses newer, more expensive costs first.

Quick Review Box:
FIFO = Fresh In, First Out (Higher profit when prices rise).
LIFO = Latest In, First Out (Lower profit when prices rise).
Common Mistake: Forgetting that LIFO is actually not allowed by International Accounting Standards (IAS 2) for financial statements, but we study it here to understand different management perspectives!

Section 2: Labour Costs

Labor isn't just about paying wages; it's about understanding how much value workers bring to the business.

Labour Productivity

This measures how efficient the workforce is. The formula is:
\( \text{Productivity} = \frac{\text{Total Output}}{\text{Total Input (e.g., Hours Worked)}} \)

Remuneration Methods (How workers get paid)

1. Day Work: Paid based on time (e.g., $10 per hour). It is simple but doesn't always motivate fast work.
2. Piecework: Paid based on how many items are made (e.g., $2 per shirt). This rewards fast workers but might hurt quality.
3. Individual Bonus: A reward given to one person for hitting a target.
4. Group Bonus: A reward shared by a team. Great for teamwork, but "lazy" members might benefit from the hard work of others.

Employer Cost vs. Employee Earnings

It is important to remember that what an employee "takes home" (earnings) is less than what the employer actually pays (cost).
Employer Cost = Gross Wage + Employer's Pension Contributions + Employer's National Insurance.
Employee Earnings (Gross) = Basic Pay + Overtime + Bonuses.

Key Takeaway: High productivity is the goal! It means you are getting more products made for every dollar spent on wages.

Section 3: Overhead Costs

Overheads are the "hidden" costs of running a business—things like rent, electricity, and the manager's salary. They aren't directly tied to a single product, so we have to "share" them out.

Cost Behaviour

Costs behave differently as you produce more:

• Fixed Costs: Do not change with output (e.g., Rent).
• Variable Costs: Change directly with output (e.g., Raw materials).
• Semi-Variable: Have both a fixed and variable part (e.g., A phone bill with a fixed monthly fee plus a charge per minute).
• Semi-Fixed (Step Costs): Stay the same for a while, then "jump" up (e.g., Renting a second warehouse when the first one is full).

The Three A's: Allocation, Apportionment, and Absorption

How do we get overheads into the price of a product? Follow these steps:

1. Allocation: If a cost belongs to one specific department (e.g., a machine's insurance), we give it all to that department.
2. Apportionment: If a cost is shared (e.g., Rent for the whole factory), we split it using a fair ratio like floor area or number of employees.
3. Absorption: Finally, we "charge" the overhead to the individual products using an Overhead Absorption Rate (OAR).

Calculating OAR

Usually based on Labour Hours (if work is done by hand) or Machine Hours (if work is done by robots):
\( \text{OAR} = \frac{\text{Budgeted Overheads}}{\text{Budgeted Activity (Hours)}} \)

Over and Under Absorption

Because we calculate the OAR at the start of the year using estimates, we might charge too much or too little.
- Over-absorbed: We charged more to the products than we actually spent.
- Under-absorbed: We spent more on overheads than we charged to the products (this hurts profit!).

Did you know? Using the wrong OAR can be a disaster. If you "under-absorb," you might set your selling price too low and lose money on every sale!

Section 4: Job Costing

Job costing is used when a business does "unique" work for a customer. Think of a wedding photographer, a plumber, or a bakery making a custom birthday cake.

Characteristics of Job Costing

• Every job is different and has its own Job Cost Sheet.
• Costs are tracked specifically for that one job.
• Batch Costing: This is a variation where a group of identical items are made together (e.g., a batch of 500 identical cupcakes). We find the cost of the whole batch and then divide by 500 to find the cost per unit.

How to calculate a Job Price:

1. Direct Materials (The wood for the table)
2. Direct Labour (The carpenter's time)
3. Direct Expenses (Special tool hire)
4. Add Overheads (Using the OAR we calculated earlier)
5. Add Profit Margin (The extra bit for the owner)
= Final Price to Customer

Key Takeaway: Job costing ensures that even unique "one-off" tasks are profitable by accounting for every single cost involved.

Final Quick Review

Don't worry if this seems tricky at first! Costing is just a puzzle where you are trying to fit costs into the right boxes. Remember these three pillars:
1. Inventory: FIFO vs. LIFO.
2. Labour: Efficiency and Pay.
3. Overheads: Sharing the "hidden" costs fairly.
Master these, and you'll be a costing expert in no time!