I would say costing is one of the most complex subject I had to deal with when discussing with business owners. There are different ways of costing a product or a service, but one thing should be consistent and it's the way you apply overheads.
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It's easy to determine the direct material or labor, there is nothing to it. If you transform the raw material into a product, then it is considered being applied directly to the product. If you transform that product using labor then it's direct labor, but what happens to the tools, the mangers salary, depreciation and the material you can't directly attribute to the final product? These are all cost left aside if you don't incorporate them, right? Right, this is where it get's complicated, how do we apply these indirect costs or overhead to the final product? The basics of applying overhead is to determine the type of costing you will use.
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In reality there are 4 main ways of costing:
1) Actual costing: you consider the actual cost of the direct material and the labor when costing a product or service. You leave the overheads to the cost of good sold. Then when you sell your product or service, you will see how much a product or service actual cost only at year end leaving you blind until you have completed the entire year. This is what most companies will use as they are unaware of the overheads or how to apply overhead to a product.
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2) Standard costing: when you have enough historical data and you can influence the cost of raw material or labour, you can apply a generalized cost to every product or service. Then at the end of the year you compare the actual cost and quantity vs your standard cost and quantity used. You just have to explain the variances when a production is done so you know why you weren't in line with your standard costing. It is important to point out to use this method you have to have an influence over the purchase of you materials. I see a lot of companies apply this method, but don't have any influence over their purchase power, therefore stuck explaining every variance there is wasting enormous amount of time. The goal of this method is to determine the cost of a product right away and also standardize the cost so you make people accountable for the purchase of the material and accountable for the labor applied to the product or service. As an example, let's say you are building a chair, you know it's cost you $4 of raw material and it takes 30 minutes to complete the chair. If you buy raw material at $4.50 from a different supplier and the staff takes 35 minutes to assemble the chair, you will immediately see a variance and require an explanation for the variance. If the staff doesn't want to be stuck explaining the variance, they will find a supplier that sells the raw material at 4$ or less and take less or equal to 30 minutes to build the chair, unless the current supplier can't supply the material as he is out of stock or the employee just can't find the same deal else where and the staff had to change a blade on a saw to increase efficiency, for example.
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3) Rational costing: This is when you only take the cost of raw material and direct labor the same as the actual cost method, but then add the overheads cost following the standard method as previously explained. So in reality, you get a full view of how much a product or service actually cost without waiting until the end of the year to figure how much a product or service cost. The only down side of this method is you can't see how much it cost until the product or service is completed. While the standard method give you the cost before even the production starts. For most company, I would recommend this method as it is the simples way to determine the cost of a product or service.
4) ABC costing: this is the most complex and expensive way to apply costing to a product, but the most accurate of all the costing methods. ABC stands for activity based costing. So how it works is, you apply the cost to a product at every level of production. As an example, let's say you build a chair. At the first stage, you have raw materials, the wood, transformed by employees into parts to make a chair. At this level you would apply the wood, the labor and overhead of this process to the chair. At the next stage, you will have employees assembling the parts to become a chair, consequently, we would apply the direct cost of labor and the overhead of this process to the chair. Finally, the last step, is to sand and paint the chair. The labor, the material and the overheads are then finally applied to the product. To follow this method you need a strong accounting system and you have to make sure all the systems talk to each other properly. This is why it get's expensive as to manage these systems you need an ERP and ERPs are really expensive. This method also allow you to determine the cost of a service at every level it is being performed. So, you get a feel of how every activity cost making it easier to make changes or apply new methods to bring down cost at every level of activity.
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The way you cost your product or service will give you a competitive advantage because this is how you base your pricing on. If you see your product or your service is too expensive to make, you will have the opportunity to increase your price or have your product outsourced by a supplier as an example. If you are blind to the cost of a product or service you will probably follow the competition pricing model and loose what ever advantage you have compared to your competition as he is probably increasing price as it cost more for him/her to make his/her product or service than you.