In accounting, there are a lot of costing methods, and it may be overwhelming to know how they relate to each other. In this article, we discuss various costing methods: job costing, process costing, standard costing, absorption costing, variable costing, throughput costing, activity-based costing, target costing, and kaizen costing.

1. Types of costing methods in accounting

We briefly talk about various costing methods.  It is important to note that the methods described below are not mutually exclusive, on one hand, and that they may not relate to the same concept, on the other hand.  Instead, the list below is a summary of several different - related or unrelated - costing methods utilized in accounting.

• Job costing is a type of management and cost accounting that allows the accumulation of costs (and revenues) for individual customer projects or jobs.  This method of accounting for costs is used for management (internal) reporting purposes.  Job costing allows management to see how much revenue, costs, and profit a specific job or customer generate.  Overhead costs may or may not be allocated to jobs or customers.  Job costing is utilized by companies that sell unique, customized products or services.  Examples of companies utilizing job costing include service companies (e.g., accounting, advertising, IT consulting, marketing), manufacturers of unique and, usually, large items (e.g., ship-building shops, airplane manufacturers), and construction companies. For example, an accounting company may utilize job costing to track revenues and expenses for services it provides to customers and see profitability of such jobs and customers.  If an accounting firm has 100 customers and each customer has one engagement with the firm, then the company will track costs and revenues associated with 100 customer jobs.  The revenues and expenses attributed to specific jobs may include direct labor, vendor expenses, and sometimes, allocated overhead.
• Process costing is another type of management and cost accounting that is applied in situations when companies produces large quantities (think, mass production) of homogeneous products.  The goal of process costing, similar to job costing, is to allow proper cost accumulation and allocation to products.  However, in process costing, product costs are accumulated for large batches of produced units, typically over a period of time, and then allocated to units produced.  Because all units are the same, the accumulated costs are equally spread over all produced units.  This costing method is used by companies producing cereals, coffee, chemicals, and so on.  For example, in a company producing a specific liquid chemical, the production process may be uninterrupted (does not stop at any point of a day or night).  So, all manufacturing costs for a large batch of this chemical are added together.  Then the number of units produced is determined and, finally, all accumulated costs are allocated to units.  If the company has $100,000 of costs for a particular liquid chemical for a month and during the month, the company produced 50,000 gallons of the product, then the cost of one gallon is: $100,000 ÷ 50,000 = $2. Note, when using process costing companies often cannot use physical units to determine the cost of a product and instead use equivalent units to properly value the cost of items manufactured (completed) vs those that are work-in-process (i.e., not completed). Another note, process costing is usually used by companies that mass produce one homogenous product (e.g., one brand of a chemical cleaner). Those that mass produce multiple types of homogenous products (e.g., multiple brands of a chemical cleaner) usually use operations costing that combines cost accumulation tools from both job order and process costing (e.g., track materials by job and process costs by department).
• Standard costing is an accounting method that uses an estimate of costs instead of actual costs for recording inventory costs in manufacturing companies.  When actual costing is utilized, accountants record raw material purchases, their movements to work-in-process when manufacturing starts, and subsequently, finished goods when manufacturing is completed, using actual costs of materials, labor, and overhead.  In many instances, due to the large volume of purchases of goods, payroll records, and accumulation of various overhead costs, using actuals is not feasible or possible without delaying month end accounting tasks and financial reports. In other words, actual accounting information is often not readily available for some costs or not easily traceable in real time and waiting for such information delays management decision making (e.g., pricing products or services). So instead, accountants use estimates of such costs to record transactions.  Such estimates are determined using historical actual costs, budgets, etc.  For example, if a unit of a raw material was usually purchased for about $40/lb in the past, the company will use the $40/lb as an estimated (standard) cost for it.  After the standard costs have been established for the year, the actual cost may vary; let’s say, the actual cost paid for this raw material increased to $41/lb during the year.  The difference between the actual cost and standard called is called a variance.  Such variances are analyzed and appropriately recorded in the financial records on a monthly or quarterly basis. Note, standard costing is usually useful in processes that can be standardized (e.g., repetitive tasks). For processes that cannot be standardized (e.g., creative activities), using standard costing can provide misleading information as variances cannot be reliably interpreted in those cases.
• Absorption costing (full costing) is required to be used for external financial reporting (US GAAP) and assumes that any inventory related (manufacturing) costs, both variable and fixed, shall be included in the cost of inventory. In other words, manufacturing costs regardless of their cost behavior are first recorded as an asset on the Balance Sheet (i.e., Raw Materials Inventory, Work-in-Process Inventory, Finished Goods Inventory) and are reported as an expense on the Income Statement (Cost of Goods Sold) when inventory is sold.  Any non-product (not manufacturing) costs such as administrative and selling costs are expensed when they are incurred.  Absorption costing treats any product (manufacturing) related costs as inventory costs; this includes fixed overhead which is allocated to the inventory costs and is then expensed as the cost of goods sold when inventory is sold.
• Variable costing (direct costing) is different from absorption (full) costing in that all variable costs are treated as inventory (cost of goods sold) costs while all fixed costs are treated as period costs (i.e., expenses as incurred).  So the major difference between variable and absorption costing is the treatment of fixed manufacturing costs.  When the cost of goods sold is determined under the variable costing, it only includes variable manufacturing costs: direct labor, direct materials, and variable manufacturing overhead.  Fixed overhead is treated as a period cost (i.e., expensed in the period incurred).  Under this costing method, companies use contribution margin rather than gross margin.  Any variable non-inventory costs are considered part of the contribution margin calculation. Variable costing is not permitted for external financial reporting so it is only used for internal management reporting.
• Throughput costing is yet another variation of inventory costing which assumes that any direct material costs are considered part of inventory costs and all other costs (including direct labor, manufacturing overhead) are considered period costs and expensed as incurred.  Throughput costing is not allowed for external financial reporting and is only used for internal management reporting.
• Activity-based costing (ABC) is centered on the idea that indirect and support activity costs (overhead costs) can be allocated to units of accounting (individual products and services) using more precise measures resulting in more accurate product or service cost data.  ABC starts with calculating all costs associated with separate activities (activity centers).  For example, a purchasing department may be considered an activity center.  Let’s assume it has a total annual cost (payroll for employees, travel expenses, office and computer equipment) of $500,000.  Next, cost drivers for activity centers are determined by interviewing managers and employers as well as performing observations.  In our example of the purchasing department, cost drivers may include: evaluations of bids for goods or services, negotiations with vendors and signing legal paperwork, and issuance of purchase orders.  The $500,000 total cost is allocated to the cost drivers.  Based on interviews with managers and employees of the purchasing department, 35% ($175,000) of resources (costs) consumed by the department is for evaluations of bids, 45% ($225,000) is for negotiations and legal paperwork, and finally, 20% ($100,000) is for the issuance of purchase orders.  If the purchasing department performs 200 evaluations of bids, then the cost of one evaluation is: $100,000 ÷ 200 = $500.  And if a particular product or service required 20 evaluations, then the product or service cost will be assigned a cost of: $500 x 20 = $10,000.
• Target costing turns costing and pricing upside-down in a sense that determination of the selling price is done first before costs are calculated.  In target costing, a company performs a marketing analysis for a future product or service and estimates what selling price (target price) will provide the best return on investment.  This analysis is performed with great involvement of the marketing department.  Then the company deducts desired profit (target profit) from the estimated selling price leaving a balance available for costs.  Then manufacturing, R&D, engineering, etc. departments work together to figure out a way to manufacture the product (service) within the established maximum cost “allowance” (target cost).  For example, a company is evaluating a new product.  The marketing department performed a study which determined the maximum selling price for the product is $100.  The company also needs to secure a required profit margin of 20% or $20.  The target cost in this case will be: $100 target price - $20 target profit = $80.
• Kaizen costing is a process of continuous cost management and reduction via better business activities.  One of the ideas of kaizen costing is elimination or reduction of non-value-related activities.  Kaizen costing is applied to products that have moved to the production stage.  Before the production stage, target costing can be utilized to establish and manage costs.  The overall idea is that after cost targets have been established, activities are undertaken to gradually improve (reduce) costs while maintaining quality of products or services.

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