Production Costing Systems

All costs associated with production, direct materials and labor and both fixed and variable portions of overhead, are contributed to inventory costs when employing the full costing method. The inventory account, or cost of product, absorbs all costs, resulting in full costing often being referred to as absorption costing. All production costs within the value chain, such as R&D or marketing, are considered period costs, thus recorded and expensed in the period in which these costs are incurred. Used for external reporting, production costs are reported within the period they occurred and matched with the revenues they generated. The absorption costing income statement will not differentiate between variable and fixed costs as those are both allocated to COGS (CTU Online, 2008 and Horngren, Datar, & Foster, 2006).

The rationale for allowing fixed overhead costs to be contributed to inventory as a product costs, relies on the realization that the consumption of these resources result in products that have future economic benefit for the organization, therefore defining those costs as assets (Value Based Management, 2008). When an organization using the full costing method sells inventory, both the fixed and variable costs associated with the production of that inventory are deducted on the income statement as COGS. The unsold units still carrying all fixed and variable overhead and production costs remain on, or are capitalized, on the balance sheet as inventory (Garrison, Noreen, & Brewer, 2008).

Because absorption costing is the required inventory valuation method for external reporting, a significant portion of companies use absorption costing internally as well. Less confusion and greater cost effectiveness is an inherent benefit of absorption costing for that reason. The fact that long-term decisions require all variable and fixed cost data makes absorption costing beneficial for implementation into the decision making process as the quantitative data produced accounts for all costs that were or will be incurred with production (Horngren, Datar, & Foster, 2006 and Ramig, 2008).

Negative implications associated with full or absorption costing include the provision for misrepresentation of actual profit/loss data for the period as inventory data can be manipulated and increases in manufacturing activity, regardless of the sales that activity generates, can produce a profitable figure that is misleading (Value Based Management, 2008). The lack of detail relative to the actual resource consumption of each product makes accurate calculation of additional production units and the breakeven point impossible. Further, costs that are inappropriately classified will result in increases on actual costs of production and provide misleading financial information for internal planning and cost control, as well as external users of this financial information (Ramig, 2008). It is a given that the manufacturing organization will implement the full costing method for external reporting purposes due to requirements, however for more accurate internal decision making relative to actual cost and resource consumption per product, more detailed and specific costing methods such as ABC or life-cycle costing might be preferred.

Full costing and variable costing are the most common methods used for valuing inventory and COGS for manufacturing organizations. They differ in that variable costing commits only those varying costs associated with product output are classified as product costs and inventory values and COGS are valued using only those variable production costs. These two methods will produce different operating incomes because the COGS under absorption costing is going to be higher than the COGS as figured using variable costing. The variance is also present on the balance sheet. Whereas fixed manufacturing overhead is expensed for the period on a statement where variable costing is employed, those funds are reflected in the inventory account on the balance sheet for the company using the absorption method. Any fixed manufacturing overhead remaining in unsold units is deferred to the period in which those units are sold when using full/absorption costing, and is often referred to as "fixed manufacturing overhead cost deferred in inventory". Thus, in absorption costing, as inventory increases, some of the full production costs will be represented on the balance sheet as inventory, and the remaining reported on the income statement as COGS (Garrison, et al.).

Another notable difference between variable and full costing is the distinction between variable and fixed costs as represented on the income statement. Due to the allocation of fixed costs on a per unit basis, changes in volume will have impact on the operating income in a full costing income statement but not the variable costing income statement. If production is equal to sales, the variable and full costing income statements will reflect the same operating income. However when production is greater than sales, the income on the variable costing statement is less than that of the absorption statement. Likewise, if sales are greater than production, the variable costing income statement will reflect a higher operating income than that of the income statement developed using the full costing method (Horngren, et al.). The lack of distinction between these costs on an income statement reflecting absorption costing can make financial analysis difficult, or inaccurate without a method to determine the portion of production costs that might be contributed to fixed overhead costs. This provides for increased accuracy and easier analysis for the user when viewing an income statement reflecting the variable costing method as all fixed and variable cost components are clearly identified (Garrison, et al.).

Target costing stems from research used to determine a target price for which a company will sell its goods. From that target price, the desired profit margin is deducted, providing a target cost figure (CTU Online, 2008). Figuring or estimating a target price by which to base cost information requires an understanding of the customer base and industry and/or market competitors. This understanding is important to successful cost strategy because some competitors may provide a comparable product at a lower price, placing limitations on pricing possibilities and some products become obsolete more quickly than others, leaving less time and opportunity to recover from any target pricing and costing mistakes. Customers have also progressively become more knowledgeable and demanding of high quality products and reasonable prices, placing focus on quality, cost control, and competitive awareness; all requiring resource consumption (Horngren, et al.). The target costing method was developed as organizations began to realize with increased competition that they have less control over the costs they will incur than they would prefer and that a significant portion of a product's cost is determined during the product design stage. With the greatest opportunity for cost control lying within the design stage, dependent upon consumer preferences, the target costing approach provides management with realistic limitations and a guide for decision making as those costs cannot be easily recovered or adjusted once the product has been designed and is in the stage of production. The market is a more influential cost determinant, and external, uncontrollable elements such as this must be taken into consideration when planning costs and pricing (Garrison, et al.).

The target cost assumes a full cost approach, as all production costs are represented, however this figure is an estimate or assumption, and can also prove inaccurate as it merely provides a number representing maximum cost limitations, not the actual costs incurred with manufacturing individual products. In contrast, the full costing method uses an actual full cost amount, derived from actual cost information associated with the different material, labor and overhead elements of production. Not realizing the actual cost associated with production of individual items, target costing does not lend to effective planning, budgeting, or cost control strategies within the organization.

The life-cycle costing method also makes use of "full" cost accounting, only this method encompasses all costs, from product development and planning, to product decline and abandonment, as costs applicable to production; not just those costs incurred during the production process. Due to the recognition of the actual total of costs incurred with a specific product throughout its entire life-cycle makes life-cycle costing most effective as a product planning tool. Unlike the periodic tracking and recording of production costs as experienced in full costing, life-cycle costing tracks, records, and accumulates cost information throughout the entire value chain of production, and attributes those costs to their respective products. Budgeting and costing of specific products become activities that span numerous reporting years and result in information that is applied to strategic product costing and pricing evaluation (Horngren, et al.) Costs will occur unevenly and not completely relative to generated sales, allowing an organization to realize the impact of the product on future resources and financial statements before the product even makes it through the development and planning stage.

Pricing strategies of products valued through their entire life-cycle will consider total costs from conception of the product through its obsolescence, providing a means of cost control applicable throughout the product lifetime and realization of the impact of the different stages of the product's life on the organization's financial statements (Ramig, 2008). This systematic accrual of product costs is assumed to fulfill the principle of matching costs and revenues, providing the most accurate per product profit and loss information (Atkinson, Kaplan, & Young, 2005).

Activity based costing, or ABC, was designed to produce a more accurate picture of how product, customer, and other cost object demands make an impact on overhead resources. Traditionally, only those costs associated with manufacturing a product are assigned to and classified as product costs. Instead of spreading all the manufacturing costs among the different products manufactured based on budgeted activity, ABC does not assign manufacturing overhead totally unrelated to and unaffected by specific products, or the costs associated with unused or idle capacity. The ABC method is more of a "bottom up" approach to accurate pricing and costing information, determining the level of resources anticipated through the use of cost and time driver analysis (Soenen, 2006).

This approach to costing differs from the absorption method as it seeks to absorb all manufacturing costs, both fixed and variable, into its inventory. Implementation of the ABC method provides more stable and accurate product cost data as costs are related directly and only to the resources consumed by each (Garrison, et al.). This is capable through accounting for changes in internal and external influences on the product costs. Full costing can provide accurate historical cost data that is relevant to planning, however it does not and cannot account for changes that are inevitable in resource consumption and in the market. Improved accuracy and flexibility over the absorption costing method allows the organization employing the ABC method greater insight into the actual costs they will incur per product as both controlled and uncontrollable changes occur within the production cycle. This feature enhances ABC when implemented as a tool for decision making as informational results allow for the most accurate and customized financial data for planning, pricing and cost control (Soenen, 2006).

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