top of page

Approaches to Costing

Business Studies Notes and

Related Essays

Approaches to Costing

 A Level/AS Level/O Level

Your Burning Questions Answered!

Critically evaluate the advantages and disadvantages of the absorption costing and variable costing approaches.

Discuss the role of activity-based costing in improving cost management and decision-making.

Compare and contrast the advantages and limitations of using target costing versus traditional costing methods.

Explain how cost-plus pricing and marginal costing can impact a company's profitability and decision-making.

Analyze the strategic implications of different costing approaches for businesses in changing market environments.

Approaches to Costing: How Businesses Track Their Money

Imagine you're running a lemonade stand. You need to know how much it costs to make each cup of lemonade so you can decide how much to sell it for and make a profit. That's essentially what businesses do with "costing." It's figuring out how much it costs to produce their products or services. Here are some common approaches:

1. Absorption Costing (Full Costing)

-What is it?: Absorption costing tracks all costs associated with producing a product, including direct costs (materials, labor) AND indirect costs (rent, utilities, marketing).

-Think of it like: It's like including the cost of everything that's needed to make and sell a product in the price.

-Example: Imagine making a pizza. Absorption costing would include the cost of flour, cheese, tomatoes (direct costs), as well as the cost of the oven, rent for the pizzeria, and the pizza chef's salary (indirect costs).

-Benefits:

  • Comprehensive: Includes all costs, giving a complete picture of profitability.
  • Required for financial reporting: Often mandated for financial statements.

-Drawbacks:

  • Less flexible: Can be less helpful for short-term decision-making.
  • Can make products seem more expensive: Including all overhead costs can inflate the cost per unit.

2. Variable Costing (Direct Costing)

-What is it?: Variable costing only tracks the costs that change with the number of units produced. This means it only includes direct costs (materials, labor).

-Think of it like: It's like focusing on the cost of ingredients (flour, cheese, tomatoes) for each pizza, ignoring the oven, rent, and salaries.

-Example: Using our pizza example, variable costing would only consider the cost of the ingredients in each pizza. It wouldn't include the cost of the oven, rent, or pizza chef's salary.

-Benefits:

  • Simple and clear: Easier to understand and track.
  • Great for short-term decision-making: Helps businesses make decisions on pricing and production levels.

-Drawbacks:

  • Incomplete picture: Doesn't include all costs, potentially leading to misleading profitability assessments.
  • Not suitable for financial reporting: Not typically used for financial statements.

3. Activity-Based Costing (ABC)

-What is it?: Activity-based costing (ABC) goes a step further than absorption costing. It tries to pinpoint the real cost of each activity involved in producing a product.

-Think of it like: It's like breaking down the cost of making a pizza into smaller pieces: the cost of kneading the dough, the cost of spreading sauce, the cost of adding toppings, etc.

-Example: Instead of just including the overall rent for the pizzeria, ABC would figure out how much rent is actually used for each pizza made, based on the time the oven is used, the space the pizza dough takes up, etc.

-Benefits:

  • More accurate costs: Provides a more precise picture of the costs associated with specific activities.
  • Improved efficiency: Helps identify areas where activities are inefficient and costly.

-Drawbacks:

  • Complex and time-consuming: Requires detailed data collection and analysis.
  • Expensive to implement: May require specialized software and training.

Real-World Examples:

-Absorption Costing: A car manufacturer would use absorption costing to calculate the total cost of producing a car, including the cost of materials, labor, factory rent, and marketing expenses.

-Variable Costing: A bakery might use variable costing to figure out the cost of making a specific type of cake. They would only consider the cost of ingredients and direct labor for that specific cake.

-Activity-Based Costing: A software company might use activity-based costing to analyze the cost of implementing a new software feature. They would consider the time spent by developers, the cost of testing, and the cost of training users.

Key Takeaway:

Choosing the right costing approach depends on the business and its goals. For example, small companies might use variable costing for quick decision-making, while large corporations may use absorption costing for financial reporting purposes. Activity-based costing is often used by companies looking for a more detailed and accurate cost analysis to improve efficiency.

bottom of page