CA Foundation /Accounting

Costing methods

Corporate & Cost Accounting · free study notes · Updated

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Costing Methods – CA Foundation (Accounting)

Costing methods help a business determine how to allocate costs to products or services.
They are critical for pricing, budgeting, performance evaluation and decision‑making.

Simple Explanation

Method What it does When it is used
Absorption (Full) Costing Allocates all manufacturing costs (direct + indirect) to each unit. Required for external reporting (GAAP/IAS).
Variable (Direct) Costing Allocates only variable manufacturing costs to each unit; fixed overheads are treated as period costs. Useful for internal decision‑making, break‑even analysis.
Direct Costing Similar to variable costing but excludes all indirect costs (both variable & fixed). Rarely used; mainly for short‑term decisions.
Activity‑Based Costing (ABC) Assigns overheads based on activities that drive costs. Complex, high‑accuracy costing for multi‑product firms.
Standard Costing Uses pre‑established “standard” costs for materials, labor, overhead. For variance analysis, budgeting, control.

Key Points

Feature Absorption Variable Direct ABC Standard
Cost types included Direct + all indirect (fixed & variable) Direct + variable indirect Direct only Direct + all indirect (allocated by activity) Direct + indirect (planned)
Fixed overhead treatment Allocated to units Period cost (expense) Period cost Allocated by activity Allocated to units (planned)
Effect on profit Profit increases with inventory build‑up (since fixed overhead is deferred). Profit independent of inventory changes. Profit independent of inventory. Profit depends on activity drivers. Profit based on standard cost vs. actual.
Reporting Mandatory for external statements. Not allowed for external reporting. Not allowed. Not standard. Allowed.
Decision use Pricing, external reporting. Break‑even, cost control. Short‑term pricing. Product mix, process improvement. Budgeting, variance analysis.

Sub‑topics

1. Absorption Costing (Full Costing)

  • Formula
    [ \text{Unit Cost}_{\text{absorption}} = \frac{\text{Direct Materials} + \text{Direct Labour} + \text{Variable Overhead} + \text{Fixed Overhead}}{\text{Units Produced}} ]
  • Inventory valuation: All manufacturing costs stay in inventory until sold.
  • Pros
    • Meets accounting standards.
    • Reflects true cost of production.
  • Cons
    • Can distort profitability when inventory levels change.
    • Fixed overheads can be “hidden” in inventory.

2. Variable Costing (Direct Costing)

  • Formula
    [ \text{Unit Cost}_{\text{variable}} = \frac{\text{Direct Materials} + \text{Direct Labour} + \text{Variable Overhead}}{\text{Units Produced}} ]
  • Fixed overheads are charged to the period in which they are incurred.
  • Pros
    • Clear contribution margin (sales – variable cost).
    • Good for short‑term decisions (pricing, make‑or‑buy).
  • Cons
    • Not compliant with GAAP/IAS for external reporting.

3. Direct Costing

  • Same as Variable Costing but excludes all indirect costs (even variable overhead).
  • Rare in practice; mainly a conceptual tool.

4. Activity‑Based Costing (ABC)

  • Steps
    1. Identify activities.
    2. Determine cost drivers.
    3. Assign indirect costs to activities.
    4. Allocate activity costs to products based on usage of drivers.
  • Benefit – Provides more accurate cost per product, especially with diverse product lines.

5. Standard Costing

  • Standard cost = Expected cost under normal conditions.
  • Variance analysis:
    • Material variance = (Actual – Standard) × Actual Qty.
    • Labour variance = (Actual – Standard) × Actual Hours.
    • Overhead variance = (Actual – Standard) × Actual Hours (or units).
  • Used for budgeting, controlling, and performance evaluation.

Worked Example – Product X

Cost element Absorption Costing Variable Costing
Direct Materials ₹30,000 ₹30,000
Direct Labour ₹20,000 ₹20,000
Variable Overhead ₹10,000 ₹10,000
Fixed Overhead ₹15,000 –
Units Produced 1,000 1,000
Units Sold 800 800

Step‑by‑Step

  1. Compute unit cost

    • Absorption:
      [ \frac{30,000 + 20,000 + 10,000 + 15,000}{1,000} = ₹75 ]
    • Variable:
      [ \frac{30,000 + 20,000 + 10,000}{1,000} = ₹60 ]

  2. Inventory valuation

    • Ending inventory (200 units)
      • Absorption: 200 × ₹75 = ₹15,000
      • Variable: 200 × ₹60 = ₹12,000

  3. Cost of Goods Sold (COGS)

    • COGS = (Units Sold × Unit Cost) + Opening inventory – Ending inventory
    • Assuming opening inventory = ₹0:

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