How do you handle overhead costs and cost drivers in product costing?

2 Activity-based costing

Activity-based costing (ABC) is a more refined and accurate method of product costing that allocates overhead costs based on multiple cost drivers that reflect the different activities and processes involved in producing a product or service. This method recognizes that different products or services consume different amounts and types of overhead resources depending on the activities they require. For example, a low-volume, complex product may require more design, engineering, testing, and quality control activities than a high-volume, simple product, and thus consume more overhead costs related to those activities. ABC assigns overhead costs to each activity based on the resources they consume, and then assigns the activity costs to each product or service based on the amount of activity they use.

3 Variable costing

Variable costing is a method of product costing that only assigns variable costs to the products or services, and treats fixed costs as period costs that are expensed in the income statement. Variable costs are the costs that change in proportion to the level of production or sales, such as direct materials, direct labor, and variable overhead. Fixed costs are the costs that remain constant regardless of the level of production or sales, such as rent, depreciation, and fixed overhead. This method emphasizes the contribution margin of each product or service, which is the difference between the selling price and the variable cost per unit. Variable costing can be useful for decision making, planning, and performance evaluation, as it shows how changes in sales volume affect profitability.

4 Absorption costing

Absorption costing is a method of product costing that assigns both variable and fixed costs to the products or services, and treats them as inventoriable costs that are expensed when the products or services are sold. This method reflects the full cost of production, which includes both the variable and fixed overhead costs. Absorption costing can be useful for external reporting, as it complies with the generally accepted accounting principles (GAAP) and the international financial reporting standards (IFRS). However, absorption costing can also distort profitability and performance measures, as it can result in under- or over-absorption of overhead costs due to changes in production volume or capacity.

5 Choosing a method

Choosing a method of product costing depends on several factors, such as the purpose, the audience, the complexity, and the accuracy of the costing information. For example, if you want to report your financial results to external stakeholders, you may use absorption costing to follow the accounting standards. If you want to analyze your internal operations and efficiency, you may use activity-based costing to capture the true cost of your activities and processes. If you want to make short-term decisions or evaluate your managers' performance, you may use variable costing to focus on the contribution margin and the impact of sales volume. There is no one best method of product costing, but rather different methods that suit different situations and objectives.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?