April 3, 2018
By Angie Walters
As a manufacturer, you want to achieve or exceed your set profit margin. Once you determine the best product mix, how should you price your products accordingly? With material and labor costs both essential parts of the equation, it is critical to determine the right costing method to help you achieve profitability.
Direct costs – those tied directly to production – are important considerations for short-term pricing decisions. When it comes to long-term pricing, you’ll also want to factor in indirect costs that are tied to both administrative and manufacturing overhead, such as plant maintenance, rent, supplies, and utilities.
What type of products does your business produce? How difficult is it to analyze your costs? How many people need to be involved? What is your desired rate of return? The answers to these questions weigh heavily in determining the best costing methodologies to adopt.
Inventory Valuation Costing Methods
To determine how to price purchased materials and made-to-order stock, many companies employ one of the following inventory costing methodologies: FIFO (first-In, first-out); LIFO (last-in, last-out; Average (or weighted) Cost and Specific identification.
Details on each of these methods are further explained in our previous blog on inventory valuation. In most cases, manufacturers use FIFO because it corresponds well with the material costs associated with a sale.
Production Costing Methods
If you are like many manufacturers, you likely employ this costing method on a regular basis. By establishing standard rates for material and labor used in production or inventory costing, your product managers determine the expected labor and duration rates and materials needed to produce a single unit. At the same time, cost accounting determines overhead rates of absorption.
It’s beneficial to have set standards against which variances can be monitored and analyzed. This costing method makes it easy to watch for trends and make necessary adjustments to deliver accurate pricing. Standard costing is best for manufacturers that make similar products on a regular basis or large quantities of a particular product. However, it does take time and money to determine and maintain standards. And what if your standard becomes obsolete?
Also known as variable costing, job costing works well for made-to-order manufacturers. Its advantage is that it will enable your organization to track the exact cost to build a product and then allow you to apply a markup to achieve your desired profit margin. If your company has good control on your variable and overhead costs, this method will work well for you.
The downside is that it can take a significant amount of transaction level activity to track each of the different costs. You will also need to have sophisticated software applications that can accurately update productions costs.
ABC Costing (Activity-Based Costing)
Unlike job costing, this costing method incorporates more indirect costs into direct production activities to make pricing decisions. It does this by taking a company’s activities and resources and aligning them with the company’s products (or services) as they relate to cost consumption. ABC costing is beneficial in helping you key in on which products are profitable and spot opportunities to drive better results for existing products. ABC costing may be more expensive because it takes more time to obtain such a clear picture of costs. It may not be as efficient for you if you make just a few products. However, as your product mix becomes more complex, the payoff of using ABC costing might be worth the investment.
When you only want to examine variable costs – those that increase/decrease proportionally with production output – direct costing can be a good tool for helping management analyze these costs to make short-term price adjustments. Keep in mind that this costing method is best used for short-term decision making rather than long-term pricing decisions affecting overall profitability. When you want to understand overhead cost, you will be better off using one of the other costing methodologies.
Now that you understand the pros and cons of the primary costing methods, which is best for your manufacturing operation? Like many questions, it depends. If you only make a small number of products or those that are made-to-order, it might be best to use job costing or direct costing. If you make many products, ABC costing may be the way to go.
Working with an accounting professional, you will need to determine the cost-benefit relationship. In other words, which method will best situate your company for achieving your profit margin goals?
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.