Operation Costing Method | Cost and Management Accounting for CA Intermediate PDF Download

Introduction

Inventory accountants frequently analyze product costs to support budgeting and order processing within their organizations. One approach they utilize for this purpose is operation costing. Familiarizing yourself with this method and its mechanics can enhance your ability to manage various expenses effectively and optimize profits for your company. In this article, we delve into the concept of operation costing, its significance, calculation methods, the advantages of comprehension, and provide an illustrative example to illustrate its application.

What is operation costing?

Professionals employ operation costing as an accounting technique to determine product costs by considering process and job-related expenses, such as material costs, labor expenses, and facility maintenance. While process costing is commonly applied to straightforward production models where products undergo identical processes consistently, operation costing is valuable for businesses with more intricate production models. For instance, a company specializing in personalized shirts may opt for operation costing to account for diverse expenses accurately.

Why is operation costing important?

Operation costing aids businesses in comprehensively tracking the cost of each operation, enabling accounting professionals to gain better insights into and manage costs effectively. Companies frequently strive to optimize operating costs to achieve optimal profitability while ensuring consistent and efficient production. Excessive operating costs could prompt a company to set product prices above market value to offset them, making this method instrumental in maximizing profits. Its value is particularly evident in scenarios where products undergo a blend of distinct and standardized production processes, benefiting companies that manufacture both mass-produced and personalized goods.

How to calculate operation costing

The method of calculating costs for a product can vary depending on the complexity of its production variables. For instance, a furniture company offering customization options like various materials, colors, and styles would have more operation steps to consider compared to a company offering limited style choices. Below are some fundamental steps to follow when calculating operation costing:

Evaluate process costing

To initiate operation costing calculations, the initial step involves evaluating the cost incurred by a company for mass-producing its goods. Cost considerations may encompass the standard material prices, the weighted average of inventory, or the sequence in which the company conducts its buying and selling transactions. Depending on the nature of the company's product offerings and its operational procedures, it may utilize one or a combination of these approaches. This preparation enables the company to adapt effectively to shifts in its sales and distribution procedures.

Determine job costing

The next phase in operation costing involves identifying the costs associated with manufacturing a product. These costs encompass overheads, labor charges, and material expenditures. For instance, a company specializing in umbrella sales would factor in costs related to metals and fabric, labor hours, facility expenses, and equipment maintenance. This step enables businesses to manage more intricate processes, especially when offering customized product variants. For instance, labor costs might escalate for personalized items due to the engagement of specialized professionals to implement individualized modifications.

Find the sum of all operation costs

After determining the job and process costing for production, the next step involves aggregating these expenses for each operation and incorporating any unique processes, such as customizations. It's also beneficial to maintain a comprehensive record of factors that may undergo changes in future calculations. For instance, a flower company might experience an increase in specialized orders during specific holidays, prompting them to track how their calculations fluctuate between holiday periods and standard cycles.

Assess totals for each process

Once you have the totals for each operation, you can analyze the expenditure associated with each process. This involves examining profit margins, cost fluctuations, and any anomalies to identify areas where operational adjustments can be made. For instance, if you observe that a company allocates more resources to one department compared to others, you can evaluate whether there are any expenses that can be reduced or eliminated. This analysis helps the company gain insights into the actual costs of processes and explore opportunities to optimize operational funding.

Benefits of understanding operation costing

Understanding operation costing offers several additional benefits:

• Expense Control: Operation costing enables professionals to evaluate expenditure at each production step, aiding in identifying areas where cost reduction is possible. For instance, if an accounting professional notes excessive spending on rent for a low-volume shipping facility, they may opt to close that facility and reallocate inventory to save costs.
• Management Assessment: Through operation costing, companies can assess the performance of different management segments within the production process. This analysis helps identify areas for improvement, allowing managers to undergo additional training or adjust practices to enhance outcomes.
• Efficiency Enhancement: Operation costing facilitates the identification of process improvement opportunities. For instance, an accounting professional may pinpoint delays in the inventory distribution due to inefficient ordering processes and recommend updating ordering software for smoother operations.
• Enhanced Accuracy: By incorporating operation costs into overall budgeting, companies gain a clearer understanding of total expenses, aiding in better fund allocation.
• Preparedness for Market Changes: Understanding historical operation costs helps companies anticipate and plan for fluctuations in expenses and profits due to market changes in goods prices, labor costs, and facility upkeep expenses.

Example of Operation Costing

Here's an example of how a business can calculate its operation costing:

A company that sells plumbing equipment wants to calculate its operations costs for the month. First, the accounting professional at that company evaluates the process costing. Because the company sells windows in batches, the professional starts with the standard cost of wood and glass, which is $50,000 that month. Costs for labor, including manufacturing and shipping, total $35,000. Finally, the overhead cost, including facility rent and equipment fees, total $100,000. This means the total process cost is $185,000.

Next, the accounting professional calculates job costs for the rest of the company's production processes. This includes salaries for the carpenters who build customer order windows and add additional sealants, which totals $80,000, and materials for these special orders are $20,000. Adding these makes the total job cost $100,000. The professionals combine process and job expenses to get $285,000 as the total operation cost for the month.