All companies have costs associated with their business activities. Costing allocation methods allow a company to attribute a portion of these costs to produced goods and services. The three most basic methods include job order, process, and operations costing. Inside of these frameworks, a company can then use a specific method for identifying production costs. Properly allocating these costs is important because it ensures the company produces inexpensive products that maintain profit goals.
Job order costing assigns production costs to individual items or projects. Companies use this method when they can easily identify the materials, labor, and overhead associated with a particular job. Multiple jobs may be going on at one time, requiring the use of order sheets to track costs. Each order sheet has a number that relates to a job and the cost of items needed to complete the goods or project. In some cases, one job may be profitable, while another may not, depending on the company’s efficient use of goods.
Process costing does not account for costs used on individual goods; instead, it focuses on production processes. Companies using this method often have a continuous production process associated with homogeneous goods. Managerial accountants track all costs needed to run a single process in the production system. For example, processes may include mixing, refining, and packaging. The cost from each process is allocated to the batch of goods run through at one time.
Operations costing represents a mixture of the two previous systems. Many companies use operations costing because they produce multiple goods that fall under the different requirements. Companies need to separate costs by job orders and then by batch. A clothing manufacturer, for example, may produce standard red shirts in a process production system. A special order for yellow shirts requires costs allocated by the specific job and then by the actual processes need to produce the shirts.
Costing variations can exist under each of these methods. Variations are necessary to allocate manufacturing overhead, the costs for all items needed for multiple products. Activity-based accounting identifies activities and cost drivers to allocate overhead costs. Standard costing uses a historical predetermined overhead rate for this allocation. Differences between actual and standard costs require an adjusting entry to remove from the accounting ledger.
Cost accounting methods do not typically fall under national accounting principles. This allows a company to select whichever method best allocates costs to products. Companies can also refine and switch methods to adjust for changes in their production environment.