Week 2: Costing

Week 2: Costing Methods

“Costing Methods…Cost Allocation…Break-Even Analysis…Pricing…”


  • 2.1 Costing Methods
  • 2.2 Cost Allocation
  • 2.3 Break-Even Analysis
  • 2.4 Pricing

2.1 Costing Methods

  • Interesting to have an entire module dedicated to costing.
  • There’s a lot of different ways that we can determine a cost.
  • Like I said, there’s a lot of subjectivity to it, in the end costs are costs, and costs need to be accounted for.
  • So we’re going to look at the three main costing methods known as process costing, standard costing and job order costing.
  • Now process costing is used to cost a situation where everything manufactured or everything produced is basically the same, right? So you’re, you’re producing a lot of the same thing.
  • You’ll look at the direct costs that, that unit incurred.
  • Then you take the overhead costs of that particular department and you subtract, or you divide those overhead costs by the number of units produced.
  • That’s process costing, okay? Then there’s standard costing.
  • So standard costing says rather then apply the cost of the direct material, the direct labor, the direct costs that are incurred, what we’re going to do is we’re going to use pretty much an average cost.
  • So a pizzeria is going to use the average cost of mozzarella, right? And that’s the cost we’re going to put into each pizza.
  • We’re going to use an average standard cost for simplicity’s sake.
  • Job order costing is a lot like process costing, except job order costing is used when a factory or a service organization produces different things that are going to incur different costs.
  • If somebody is making custom furniture for you, well if you have them make a chair well there, there’s a cost involved in that.
  • You have them make a table, there can be completely different costs involved, right? And if you have him make just a standard square table maybe you’re, you’re paying for or using a cheaper laborer.
  • So in this case we can’t use process costing because you’re making things either individually or in small batches and then you’re changing it and making something else that has a whole different costing profile.
  • So we do what’s called job order costing, and basically we do process costing, okay? We’re going to apply direct cost.
  • We’re going to do it for individual units or small batches, okay? And in, in, in, in a general sense that’s all job order costing is, okay? Making sure that we’re costing the actual unit that’s being used every time that, or that’s being manufactured or, being performed every time that unit eh, changes.

2.2 Cost Allocation

  • Direct costing means that I’m going to apply the only the actual direct costs used in making that product.
  • So in direct costing of the pizza, I’m going to put in the, the price of the, of the flour, the price of the water, the yeast, the tomato sauce, the cheese, any toppings I put on.
  • Because if we were sitting there at my pizza restaurant and nobody walked in, I’d still have to pay that guy, right? So, the direct cost is the cost actually used in just making that pizza, that’s only incurred when that pizza is made.
  • A lot of times we can call direct costs variable costs.
  • The next two are absorption costing because the one after that is full costing, and full costing is absorption costing.
  • Many people call full costing absorption costing.
  • Because absorption costing says that I’m going to absorb some or all of my non-direct costs. So I’m going to take some or all of those costs and apply them to the pizza.
  • I will take their salaries and apply them that, their salaries will be absorbed into the cost of the pizza.
  • If I take all of my costs, every single one, direct and indirect, and I divide those all up amongst my pizzas.
  • So full costing is absorption costing, but you’re absorbing everything.
  • Because sometimes we absorb some indirect cost and sometimes we absorb all of our indirect costs.

2.3 Break-Even Analysis

  • Now I’m going to show you one of the primary uses for cost allocation.
  • In calculating Break-Even, we’re going to use the direct costs associated with producing an item.
  • What we want to know in calculating Break-Even is, let’s go back to the pizza example.
  • How many pizzas do I need to sell in a calendar month, for example, to neither make money nor lose money? Where is my Break-Even? And this is vitally important to us, as you can imagine, for a, for a number of reasons.
  • What are you going to have to do and is that realistic? If I do my calculations and find that I need to sell 25,000 pizzas a month in order to Break-Even, probably not a very good business idea.
  • How am I going to sell 25,000 pizzas a month? Can I even produce 25,000 pizzas a month? So, we’re going to do Break-Even.
  • In Break-Even, we’re going to look at fixed costs and variable costs, and we’re going to divide these up.
  • A lot of times you can take a cost that’s variable, and throw it into fixed, coz, it’s easier that way.
  • There’s not a cost out there that’s hidden, that’s not entering into your formula.
  • Do I want to label this as fixed or variable? Is this a cost that I just kind of have to pay a flat fee, month after month after month, or is this something that’s really going to change a lot with each pizza that’s ordered? Now, if we look at something, look at my gas bill.
  • Well the more pizzas I bake, the more gas I’m likely to utilize.
  • So my gas bill is really a variable cost to associate with the number of pizzas I produce.
  • That’s going to be an easier way to categorize that cost.
  • I’m going to look at my fixed costs and the first thing I need to do is I need to calculate my contribution of each item.
  • So what do I mean by contribution? Well, I sell pizzas, and let’s say I sell my pizzas for ten dollars.
  • So I sell my pizzas for ten dollars, and each pizza costs me three dollars and 60 cents.
  • Okay that’s the variable cost for the pizza, that’s what I pay for the dough the cheese the pizza sauce the toppings.
  • So the contribution of the pizza is $6.40.
  • So now I just take my fixed costs which were all the other costs that were not labeled variable. Right? Because for each pizza I’m selling, $6.40 gets contributed to my, to my fixed costs.
  • My variable costs are already covered because I’ve subtracted that to get my contribution.
  • When I sell 626 pizzas, I have finally made $6.40 in profit.
  • For each pizza after that contribution becomes my profit.
  • Now it’s very important for me to know the number of pizzas I need.
  • I need to bill 600, $6,250 a month in pizza sales.

2.4 Pricing

  • We’ve been speaking about costing and how we determine the cost of what we do, so that we can feed that cost into our financial equation.
  • Now costing is important because costing helps us strategize prices, and prices, right? Revenue equals Price times Volume, so what can I sell something at? And understanding the different ways that I can cost something.
  • Then I also want to know what are all the costs associated with what I do? What is my full costing? So that depending on the business environment, depending on the competition, I can set my prices at different levels.
  • I really want to know what’s, what’s my direct cost? Because if I get if I get somebody wanting a bid from me, and I want to bid this job, well man, right now times are hard, I need every extra dollar in my company that I can bring in.
  • So I’m going to use the lowest bid I can give, but I got to make sure it’s not going to cost me any money, right? So, that’s when I’m probably want to just look at, what are my direct costs, and if I can sell something and bring a little bit of money in, fine, it’ll help cover my rent this month.
  • So when things are going well maybe I want to really make sure that I use Full Costing on that, and price at or above Full Costing for a job.

Return to Summaries.

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