cost-plus pricing and product profitability analysis are extensively used by organizations. Cost-plus pricing requires that costs are assigned to each product to ascertain the product cost for adding a profit margin to determine the selling price” With product profitability analysis we need to assign costs to products to distinguish between profitable and unprofitable products in order to ensure that only profitable products are sold.
costs must also be assigned to products for internal and external profit measurement and inventory valuation. Profit measurement requires that the costs incurred for a period should be allocated between cost of goods sold and
inventories, The cost of goods sold that is deducted from sales revenues to compute the profit for the period is derived by summing the manufacturing costs that have been assigned to all those individual products that have been
sold during the period the inventory (stock) valuation is derived from the sum of the costs assigned to all of the partly completed products (i.e. work in progress) and unsold finished products, Inventory valuation, however, is not an issue for many service organizations.
They do not carry inventories and therefore a costing system is required mainly for providing relevant decision-making information for cost-plus pricing and for distinguishing between profitable and unprofitable activities.
Types of costing systems
- Direct costing system
Direct costing vs Absorption costing
It merely involves the implementation of suitable data processing procedures that identify and record those resources that can be specifically and exclusively identified with a particular cost object.
With absorption costing systems, both direct and indirect costs are assigned to cost objects indirect costs (also known as overheads) cannot be directly traced to a cost object because they are usually common to several cost objects. indirect costs are
therefore assigned to cost objects using cost allocations. A cost allocation is the process of assigning costs when a direct measure does not exist for the quantity of resources consumed by a particular cost object Cost allocations involve the use of surrogate rather
than direct measures to estimate the amount of indirect costs that are assigned to cost objects The proponents of absorption costing argue that costs assigned to products (or other cost objects) should represent the estimated sum of all those resources that are
committed to a product in the long run. In other words, cost assignment should represent an attempt to allocate a share of all costs to products to ensure that all costs are covered in the cost base.
objects. Direct costs can be accurately assigned to cost objects but indirect costs rely on cost allocations, some of which may be on an arbitrary basis Where direct costs represent a very large proportion of an organization’s cost structure there are strong arguments for adopting direct costing systems because most of an organization’s costs will be assigned to cost objects.
Absorption costing systems, however, are likely to be preferable where indirect costs are a large proportion of total costs You should also note that external financial accounting requirements require that both direct and indirect manufacturing costs should be assigned to products for profit measurement and inventory valuation requirements. Therefore manufacturing companies must use absorption costing for inventory valuations.
Which costing system
A survey of 153 UK manufacturing and non-manufacturing companies by Al-Omiri and Drury (2007) reported that 23 per cent of respondents used direct costing systems and the remainder used absorption costing systems. In the remainder of this chapter we shall examine the cost assignment process for an absorption costing system.