Product Costing System | 4 mins read

6 Product Costing Systems for Businesses

6 product costing systems for businesses
Mary Kate Morrow

By Mary Kate Morrow

Product costing and cost-accounting are commonly utilized to assist with determining production process financial requirements. Both costing methods are valuable for a range of business activities, from generating accurate financial statements to making pricing decisions for finished products.

Challenges of Product Costing

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Product costing is defined as the accounting process used to calculate business costs incurred during the production process. Costs associated with the production process range from direct labor to manufacturing overhead fees.

Costing methods are facing increased challenges as a result of modernization. For example, previously required components of the production process such as inventory space for holding products are becoming increasingly obsolete due to lightning fast delivery speeds.

The ability for businesses to create and deliver products to customers so swiftly has changed the production process completely. As a result, calculating short term product cost and long term projections are more difficult than ever before.

One potential solution to product costing challenges is the use of the cost accounting method. Due to its focus on separate production phases, cost accounting does not need to amend long term projections in response to modern manufacturing challenges.

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3 Different Product Cost Types

There are 3 primary types of product costs that all business professionals should be aware of. Calculating these product costs is necessary for achieving optimal accuracy for financial statements and inventories.

These product cost categories include-

1. Direct Labor

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Direct labor costs consist of both employee wages and any additional costs associated with their benefits. Direct labor costs are only calculated for employees that work within the manufacturing and production process such as assembly line workers.

2. Direct Material

Raw materials and component costs are referred to as direct material costs. For example, a pottery company would classify their direct material costs by factoring in any clay and glaze used during the production process.

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3. Manufacturing Overhead

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There are both direct costs and indirect costs included when calculating manufacturing overhead costs. Indirect costs incurred during the production process range from the labor costs of factory security guards to any cleaning supplies used by the janitor.

Although indirect labor and materials contribute to the production process, they are not classified as direct labor or direct material costs and must be accounted for separately. Alternatively, direct costs associated with manufacturing overhead range from machinery operating costs to direct materials purchased.

6 Different Product Costing Systems

The 6 product costing systems are job order costing, process costing, hybrid costing, standard costing, backflush costing, and activity-based costing. These 6 different process costing methods are crucial for businesses to become familiar with-

1. Job Order Costing

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The job order costing method is especially useful for businesses that have a customized production process or smaller product quantity. A cost per unit figure is determined by factoring in labor, overhead, and material fees.

In the job order costing system, orders are commonly referred to as jobs, lots, or batches. A job order cost sheet will clearly list labor, material, and overhead costs for easy future reference.

2. Process Costing

As opposed to the job order costing method, the process costing system does not determine costs by batches. Instead, process costing calculates the costs associated with each separate production process or department.

The process costing method is widely used by companies that undertake mass production initiatives. This method is also very useful for businesses that have very limited product customization options available.

3. Hybrid Costing

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Hybrid costing occurs when businesses use a combination of process costing and job order costing methods. For example, while an enterprise may utilize process costing for overhead fees, they may alternatively use job-order costing for raw materials procured.

Hybrid costing is a great way to receive the benefits of both costing methods or for businesses that have both mass production and customization initiatives occurring simultaneously.

4. Backflush Costing

Backflush costing is a great costing method option for businesses that use the just-in-time inventory system. The just-in-time inventory system consists of keeping a low to nonexistent inventory.

Instead of spending money on costs associated with maintaining inventory, some companies prefer to order raw materials strictly based on immediate production process needs. As a result, backflush costing does not need to incorporate the many costs incurred by inventory management.

5. Standard Costing

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The standard costing process calculates costs using projected estimates. As a result, cost estimates must be revised when actual costs incurred are made available.

Alternative costing methods are generally used in tandem with the standard costing process.

6. Activity-Based Costing

The activity-based costing process utilizes cost drivers, also referred to as bases, in order to calculate costs per activity performed. Activities that are factored into this costing process range from ordering raw materials to packaging finished goods.

While standard costing uses only one basis, the alternative costing method incorporates several cost drivers.

Key Takeaways

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  • Cost accounting and product costing help businesses determine their financial requirements and production processes.
  • The 3 primary product cost types are direct labor, direct material, and manufacturing overhead.
  • Different product costing systems range from job order costing to activity-based costing.

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