Costing systems and budgeting
To set prices and control costs, businesses must assign costs to products. Budgets then turn plans into numbers.
Job order and process costing
Job order costing tracks costs for each distinct job or batch, suiting custom work such as construction projects, law cases, or printing orders. Process costing averages costs over large volumes of identical products moving through processes, such as oil refining, soft drinks, or cereal production.
Applying overhead
Overhead cannot be traced directly to products, so it is applied using a predetermined overhead rate = estimated total overhead / estimated total allocation base (such as direct labour hours or machine hours). If overhead is estimated at 400,000 dollars and machine hours at 20,000, the rate is 20 dollars per machine hour.
Activity-based costing
Activity-based costing (ABC) assigns overhead using multiple activities and cost drivers, such as machine setups, inspections, and orders, rather than one broad base. ABC often reveals that low-volume, complex products cost more to make than traditional costing suggests, improving pricing and product decisions.
The master budget
A master budget is a comprehensive plan for a period. It starts with the sales budget, which drives the production budget, direct materials, direct labour, and overhead budgets, selling and administrative budgets, the cash budget, and budgeted financial statements. Accurate sales forecasts are critical because everything depends on them.
The cash budget
The cash budget forecasts cash receipts and payments, showing when the business will need to borrow or will have surplus cash to invest. Profitable businesses can still run short of cash if customers pay slowly or large purchases come due, so cash budgets are essential.
Static and flexible budgets
A static budget is prepared for one planned level of activity. A flexible budget adjusts to the actual level of activity, letting managers compare actual costs with what costs should have been at that volume. This separates the effect of volume changes from efficiency and spending differences.
Behavioural aspects of budgeting
Budgets affect motivation. Participative budgeting, involving managers who will be held to the budget, improves buy-in but may encourage budgetary slack (padding estimates to make targets easier). Budgets that are too tight discourage effort; those too loose waste resources. Some organisations use rolling budgets updated each quarter.
Worked example
A firm's static budget assumed 10,000 units with variable costs of 5 dollars per unit (50,000) and fixed costs of 30,000. It actually produced 12,000 units with costs of 92,000. The flexible budget for 12,000 units is 12,000 x 5 + 30,000 = 90,000. Actual costs exceeded the flexible budget by 2,000, a real overspend, even though they look 12,000 over the static budget mainly due to higher volume.
Key takeaways
Job order costing tracks distinct jobs; process costing averages costs over identical units. Overhead is applied with a predetermined rate based on an allocation base. ABC uses multiple cost drivers for more accurate product costs. The master budget flows from the sales budget to production, cash, and budgeted statements. The cash budget prevents shortfalls. Flexible budgets adjust to actual activity for fair comparisons. Budgeting affects behaviour, including budgetary slack.
Flashcard
Costs tracked per job
Check your understanding
Estimated overhead is 300,000 dollars and estimated direct labour hours are 15,000. What is the predetermined overhead rate?