Full costing and variable costing – a comparison of methods

November 2012 | Przegląd Piekarski i Cukierniczy (Baking and Confectionery Review)

Technical Cost of Manufacture – when is it worth determining it systematically?

At present, when bread is sold with a minimal margin, and the demands of trade as regards the terms of accepting returns and payment deadlines are constantly growing, the importance of a proper calculation of production costs increases. The basic method of estimating production costs, universal for all industries, is the Technical Cost of Manufacture (TKW), being the sum of the direct costs connected with production and of that part of the indirect costs which is linked to maintaining that production.

By keeping full cost accounting and warehouse records, it is possible to calculate the Technical Cost of Manufacture on the basis of the accounting entries. Unfortunately, despite possessing reliable information about the majority of costs, the application of many simplifications and compromises is unavoidable. These simplifications mean that the process of calculating the Technical Cost of Manufacture is labour-intensive, and the result itself is not very precise.

Example. The calculation of the Technical Cost of Manufacture is particularly useful in analysing the profitability of products manufactured in short production runs, because it is there that questions about profitability most often arise. In a certain large bakery, full cost accounting and warehouse management are in place. The management decided that there was a need to calculate the TKW for its niche product – the poppy-seed roll. The costs of raw materials and of labour were precisely determined on the basis of the recipe and of the records kept. Electrical energy was calculated on the basis of the working time of the equipment. Because the analysed product is manufactured in a short production run, it is particularly difficult here to calculate the amount of the indirect production costs. It turned out that it was necessary to introduce allocation keys for the indirect costs and for the direct costs connected with the changeover of machines (no records of maintenance work were kept). Because of the arbitrary character of the allocation keys adopted, the calculation of the TKW began to be unreliable. Adopting the assumption that the share of departmental costs amounts to 0.01% for manufacturing a batch of poppy-seed rolls makes the product very profitable; adopting the assumption that the said indirect cost amounts to 0.03% makes manufacturing this product completely unprofitable. In addition, someone noticed that the energy costs calculated on the basis of the time variable are also not precise, because they depended to an enormous degree on whether, at the moment production began, the ovens were hot or whether they had to be heated up. So if the ovens were hot, another production run bore the start-up costs – should the cost of starting up the oven therefore not be divided between the individual production runs?

2012-11

The estimated production costs of the poppy-seed roll turned out to be so unreliable that further calculations were abandoned. The TKW is too important a piece of information for it to be calculated occasionally and without adopting a specific, coherent calculation method.

If the monitoring of the TKW is to be an indispensable element of cost control, then its calculation should be meticulously thought through and designed from beginning to end. The records of the manufacturing process should be organised in such a way that every piece of information about the cost incurred raises no doubts whatsoever. Only then is frequent estimation of the TKW possible without incurring great outlays of work.

In a bakery many products are manufactured in small production runs and are most often sold at the limit of profitability. In order to be certain whether a product is sold at a profit or at a loss, one must be sure of the correctness of the calculated Technical Cost of Manufacture. As can be seen on the basis of the example, despite the warehouse records kept, and even full cost accounting, the calculated TKW was too unreliable to constitute a basis for taking decisions.

Preparation

It is said that the result of an equation is only as reliable as the components of that equation are reliable. In order for the calculation of the TKW to be easy and certain, one must first prepare a system of records collecting the data indispensable for the calculations.

At the outset it is worth pointing out that the starting point for this undertaking is the keeping of warehouse management and of management accounting. Management accounting, in contrast to typical full fiscal accounting, records – alongside the arrangement of costs by type – also the costs according to the places where they arise and according to the kinds of activity.

For example, in ordinary accounting there is one cost of electrical energy, which, in the best case, may be divided between cost centres (e.g. the office meter, the warehouse meter). In management accounting, alongside cost centres (MPK, Miejsca Powstawania Kosztów), kinds of activity appear (e.g. production: short pastry, wholemeal breads, whole breads). Moreover, management accounting contains one of two divisions of costs: it either divides costs into fixed and variable, or into indirect and direct production costs.

In the first case we speak of variable costing, in the second of full costing.

Variable costing

Management accounting, conducted in the variable cost arrangement, makes it possible to carry out division costing. This costing is based on the division of costs into fixed and variable. On this basis, successive margins covering the fixed costs are estimated. The classic indicator connected with this method is the BEP (Break-Even Point), showing how many units of products have to be sold in order for the revenues from that sale to cover the fixed costs and the variable costs connected with manufacturing those products.

Division costing is easy to understand and thanks to this it is often used also at a low level of management. Variable costing works particularly well in conditions of incomplete use of production capacity. Thanks to being based on sales, it illustrates changes in costs over a short time much better (e.g. in day to day analyses).

This method also has its drawbacks, among which one may count the difficulties in dividing between variable costs and fixed costs, in the case where these costs are only partially fixed in character (e.g. when certain fixed costs begin to be incurred at an appropriate scale of production – the earlier cited example of heating the oven when producing the poppy-seed roll). A further significant drawback of division costing is its lack of usefulness in financial accounting. The division arrangement cannot be reflected in the traditional calculative or in the comparative arrangement of the profit and loss account. Usually the accounting department is forced to issue many kinds of profit and loss accounts, depending on who the addressee of the report is. This is probably the main reason why this kind of division of costs is relatively rarely encountered in companies.

Variable costing works well in analyses of the profitability of sales, because the main element of the statements is the unit cost compared with the unit revenue. It also works excellently in the control of areas of activity, where it makes it possible to focus on the variable costs, over which managers have a direct influence.

In variable costing, four methods of valuing production costs are applied.

• Simple completed costing – this method may be applied in homogeneous production, e.g. the baking of bread, where there is no unfinished production.
• Simple uncompleted costing – where, in simple production, part of the production remains in the form of semi-finished products, e.g. part of the dough is deep-frozen for later baking off.
• Costing with coefficients – this method is applied to estimating the production costs of different products from the same raw material and with the application of the same technology and the same equipment. This method may therefore serve, for example, to determine the manufacturing costs of different varieties of rolls (with sunflower seed, with pumpkin, dietetic). The costing algorithm is based on the percentage share of the use of resources and means of production in successive production runs.
• Process costing – applied to determining the costs of production composed of many processes, where there are many semi-finished products subjected to successive phases of processing (e.g. in layer cakes), and in production without semi-finished products, where the starting material is subjected to successive phases of production (e.g. in the complicated processing of meat connected with maturing and thermal treatment).

Full costing

Management accounting conducted according to full costs, and the add-on costing linked with it, is the most frequently encountered form of recording and calculating production costs. In contrast to the variable costing described earlier, this method works well in long-term analyses.

Add-on costing gives a better possibility of calculating the TKW, and it is also more widely known among analysts and financial experts. This method is not, however, as comprehensible and simple as division costing. In full costing there is also a greater need to use allocation keys, which, as we know, may considerably distort the results. Because of the (often artificial) allocation of indirect production costs, the influence of individual cost centres and cost pools in add-on costing may undergo significant deformations.

When using the accounts of full costing, the following methods of estimating production costs may be applied.

• Job-order costing – applied to estimating the production costs of unrepeatable short runs of product ranges. This method will therefore rather not be useful, because apart from rare occasional orders the majority of confectionery and bakery production is repeatable in character.
• Product-range costing – applied in medium- and multi-run production. This method works well in food production using shared manufacturing resources and the same raw materials.
• ABC costing – is the most advanced way of calculating production costs, applied mainly in complex and costly production processes. The idea of this method is the identification of the basic activities in the production process and the finding of the variables which have an influence on the costs of those activities. Finally, the determination of the sum of the costs of all the activities making up the manufacturing process. In my opinion this method is too complex and labour-intensive to apply it to the manufacturing processes in a bakery.

Regardless of which kind of management accounting we adopt when designing the chart of accounts, great weight should be attached to an appropriate level of detail in the records. Greater detail results in greater precision in calculating the TKW; at the same time, the meticulous registration of events increases the labour-intensiveness of the process of collecting and posting the data.

Is it worth it?

As I have shown in the example, calculating the TKW without proper preparation is very labour-intensive, and the result, by reason of the arbitrariness of the allocation keys, is unreliable, that is to say useless.

What, then, must be the scale of production for which it is worth undertaking the effort of continuous, systematic determination of the TKW?

In the majority of medium-sized and large bakeries supplying the surrounding region, the Pareto phenomenon occurs: usually 70% of operating revenues comes from the sale of one or a few basic kinds – in this case bread – and 30% from the remaining bakery and confectionery production. However, maintaining this broad offer is often indispensable for preserving the high standard of the company shops and for attracting more demanding customers.

It is possible to calculate to what degree the peripheral offer influences the growth in sales of the basic offer. These calculations always lead to the necessity of calculating the TKW for the individual products.

The need for precise estimation of the Technical Cost of Manufacture depends to a large degree on the structure of production. If production is homogeneous in character (a form often encountered in small local bakeries) – the TKW will be able to be estimated easily, and the result will be reliable. With the great fragmentation of production encountered especially in bakeries producing a range with an extended shelf life, a precise calculation of the TKW will be possible after the meticulous design of the calculation algorithm and the preparation of methods of collecting data. In such a situation it is worth the process of calculating the TKW being continuous in character. So that it constitutes an indispensable element of the bakery’s controlling system.

Wojciech Moszczyński

Wojciech Moszczyński — graduate of the Department of Econometrics and Statistics of Nicolaus Copernicus University in Toruń; specialist in econometrics, finance, data science, and management accounting. He specializes in the optimization of production and logistics processes. He conducts research in the area of the development and application of artificial intelligence. For years he has been engaged in the popularization of machine learning and data science in business environments.