SLC | S21W3 | Costs for Entrepreneurs - Costing Methods

For any business aiming to accurately calculate their cost in order for them to set a fair price, it would need a costing method that provides the systematic approach.

In this post, we’ll be sharing more insights on costing methods, their importance and different types of costing methods. We’ll also be backing it up with relevant examples for easy understanding.

Before we dive into it, let me invite @bonaventure24, @sahmie and @ninapenda to join us in this challenge.

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Costing method are systematic approaches businesses use to add up all the money they have spent in producing a product or services. With this method, you can easily track down all associated costs including direct and indirect cost in order to give a fair price to customers.

For instance, you’re a baker, and a birthday celebrant orders your service to make a cake. You would take into consideration the cost of eggs, flour, butter, sugar, etc. (direct cost) and water, electricity and oven (indirect cost). The cost method adds up all this expenses systematically.

Importance of costing method

• Like I mentioned earlier, with a proper costing method, you can set a fair price for your product that will cover both expenses and give room to make profit.
• The costing method points out where you are spending excessively in order for you to make some adjustments to save money.
• Costing method will show business the perfect price to tag your product, so that you will never sell below break even point.
• The cost method gives an insight to business on whether they should improve a particular process or if a price adjustment is needed.

• Job Order Costing

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In my previous example in question 1, I made mention of a baker who makes a birthday cake for a celebrant. Let’s assume he also gets another order from a couple to do a wedding cake. You will agree with me that each cake is unique with its own design and taste base on the customer specifications.

In job order costing, the baker would track down the cost of each cake separately since each order is based on the customer’s specifications, and it requires different resources.

Businesses who render one-of-a-kind goods or services are the ones who used this method. Example customize clothes and cars, interior decorations etc

• Process Costing

Imagine a furniture company given a contract to produce hundreds of the same chair and table for a school. Each of the chair and table goes through different processes like cutting, assembly and painting, but they are all the same.

Unlike job order costing, where the person has to track the cost, in process costing, the manufacturer doesn’t need to do that because the products are all identical. All he only needs to do is calculate the total cost of the different processes (cutting, assembly and painting) it went through and divide the cost among all the finished products.

For those who are into business that produce large quantities of identical goods like clothes and food items, will use this method of costing.

• Activity-Based Costing

Like the name implies, it’s a system of cost accounting that is based on “activities”. It tracks down the cost of any task/activity that goes into manufacturing a product. Let’s say a fashion designer is contracted to make a dress. To produce the cloth a certain level of activity is carried out such as pattern cutting, ironing, sewing, weaving and embroidering designs.

In activity-based costing, you try to find out how much each of these activities will cost. For example, ironing cost a certain amount of money, sewing has its own cost, weaving has its own costs etc. once you are done, you assign these activities cost to each cloth you have made.

Businesses with many activities will find this costing method very useful to them because it will help them to identify which part of the activity is the most expensive. That way, it will be easier for them to set a fair price for a product and look for other measures to reduce costs.

• Standard cost.

Standard cost involves setting targets of cost for each element of production (like labor, materials, overhead) and then compare actual cost to these set targets to see if it exceeds it or the business is staying within the allocated budget. However, this comparison should be done regularly to reflect real time costs, or else it won’t be accurate.

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I got an order to make a wedding cake and base on the size of the cake it will actually take me 12 hours to make the desired cake for the customer. The customer has given me a day to come up with my price.

To figure out the right price, I’ll look at my direct cost (what I spent on buying everything that produced the cake) and indirect cost (expenses that keep the business running)

First stage: Direct cost

Things just for the specific cake order:

Ingredients: sugar, butter, flour, decoration, fondant. They all cost $200.

Labor : 12 hours will be exhausted in doing the baking and decoration of the cake. Let’s say I charge $35/hr for my workmanship.

Labor = $20 x 12hrs = $240

So, to get a total of our direct cost; we will add up materials and labor cost.

$200 + $240 = $440

Step 2: Indirect Costs

Things Needed for successfully running of your Business like fuel for my generator, electricity bills, equipment maintenance. This isn’t for just a cake, it’s spread out across all the cake I have made so far. Let’s assume I spent $800 for a month

Cost per cake : if I make 30 cakes per month, I will spread that $800 over all the cakes.

$840 / 30 cakes = $28.

In order words, for each cake, we’re adding $28

Step 3: Adding up everything for the wedding cake.

Direct cost : $440
Indirect cost: $28

The total cost is 440 + 28 = $468

So, what this means is that, the least I can charge my customer for their wedding cake is $468 to cover all my expenses and to break even. I can, as well, add an extra $32 as my profit to make it $500