Costing
Why Costing Is One of the Most Complex Topics for Business Owners
Costing is one of the most complex subjects I deal with when discussing operations with business owners. There are several ways to cost a product or a service, but one principle must always remain consistent: the way overhead costs are applied.
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Identifying direct materials and direct labour is usually straightforward. If raw materials are transformed into a product, they are considered direct materials. If labour is used to transform those materials into a finished product, it is direct labour.
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The complexity begins when we ask a critical question: What happens to everything else?
Management salaries, tools, depreciation, utilities, rent, and materials that cannot be directly traced to a single product are often ignored. Yet these costs do not disappear—they must be absorbed somewhere. This is where costing becomes challenging: how do we fairly and consistently apply indirect costs (overhead) to a product or service?
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At its core, costing is about choosing the appropriate method to allocate these overheads.
The Four Main Costing Methods
1) Actual Costing
Under actual costing, you assign the actual cost of direct materials and direct labour to a product or service. Overhead costs are not applied to individual products; instead, they are expensed through cost of goods sold.
The major drawback is timing. You only discover the true cost of a product or service at year-end, once all overheads are known. This leaves management effectively blind throughout the year. Despite this limitation, many companies use this method simply because they are unfamiliar with overhead allocation or lack the systems to apply it properly.
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2) Standard Costing
Standard costing is used when a company has sufficient historical data and some control over material and labour costs. A standard (expected) cost is assigned to each product or service before production begins. At year-end—or during production—you compare actual costs and quantities to standard costs and quantities. Any differences are analyzed as variances, which must be explained.
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This method works best when management has real purchasing power and operational control. I often see companies adopt standard costing without having influence over supplier pricing or labour efficiency. As a result, they spend an excessive amount of time explaining variances instead of managing operations. The real objective of standard costing is accountability and predictability.
For example, if building a chair normally requires $4 of raw materials and 30 minutes of labour, any deviation—such as paying $4.50 for materials or taking 35 minutes to assemble—creates an immediate variance. This forces investigation and corrective action, whether that means finding a better supplier, improving efficiency, or documenting legitimate operational constraints.
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3) Rational Costing
Rational costing combines elements of actual and standard costing. Direct materials and direct labour are recorded at actual cost, while overheads are applied using predetermined rates (similar to standard costing).
This approach provides a more complete and timely view of product or service cost without waiting until year-end. The main limitation is that the final cost is only known once production or service delivery is completed, whereas standard costing provides the cost upfront.
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For most small and medium-sized businesses, this is often the simplest and most practical method to determine accurate product or service costs without excessive administrative burden.
4) Activity-Based Costing (ABC)
Scenario
A small manufacturing company produces 200 unit of Product A and 350 unit Product B.
Total raw material for Product A $34,000
Total raw material for Product B $26,000
Total annual overhead costs = $100,000.
Instead of spreading overhead evenly, the company uses ABC to assign costs based on activities.
Step 1: Identify activities & cost pools
Activity Overhead Cost Cost Driver
Machine setup $40,000 Number of setups
Quality inspections $30,000 Number of inspections
Machine processing $30,000 Machine hours
Total $100,000
Step 2: Measure activity usage
Product # of Setups # of Inspections Machine Hours
Product A 10 20 500
Product B 30 10 1,500
Total 40 30 2,000
Step 3: Calculate activity rates
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Setup rate: $40,000 ÷ 40 = $1,000 per setup
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Inspection rate: $30,000 ÷ 30 = $1,000 per inspection
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Machine rate: $30,000 ÷ 2,000 = $15 per machine hour
Step 4: Assign overhead using ABC
Product A
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Raw material $34,000
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Setups: 10 × $1,000 = $10,000
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Inspections: 20 × $1,000 = $20,000
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Machine hours: 500 × $15 = $7,500
👉 Total cost = $71,500
👉 71,500/200 = $357.50 per unit
Product B
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Raw material $26,000
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Setups: 30 × $1,000 = $30,000
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Inspections: 10 × $1,000 = $10,000
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Machine hours: 1,500 × $15 = $22,500
👉 Total cost = $88,500
👉 88,500/350 = $252.86 per unit
Why ABC matters?
ABC shows that Product B consumes far more setup and machine time, so it should absorb more overhead, even if unit volumes are similar.
Why Costing Gives You a Competitive Advantage
How you cost your product or service directly impacts pricing, profitability, and strategic decisions. Accurate costing allows you to:
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Adjust pricing confidently
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Identify inefficiencies
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Decide whether to outsource production
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Protect margins during cost increases