Meaning of Operation Costing
Operation costing refers to the method of assigning costs to the products of an entity with the same conversion process that differs in their usage of raw materials. In some cases, certain product-specific characteristics may also be added after the completion of the initial process of production. This method of costing is basically a union of job costing and process costing. Thus, giving it another name known as hybrid product costing.
In job costing, costs are allocated to specific jobs separately, i.e., the various units of production such as materials, labor, and overhead. Similarly, in operation costing, costs are assigned to materials through job orders or batches. On the other hand, process costing utilizes the method of charging processes or operations instead of specific jobs. Finally, the total cost of the entire process is divided between the total produced units. Operation costing borrows this element by charging labor and overheads together as a process for various products.
Calculation of Cost Per Unit
To calculate the average cost of a product, the different elements of an operation are to be ascertained for cost allocation. The following steps may be followed.
- Cost of Materials- The raw materials obtained to create a differentiated product are to be allocated costs independently. An individual cost sheet is to be prepared for this job. These costs may differ based on the quality of the material, the cost of acquisition, and the quantity acquired. Most products generally utilize more than one type of material. Therefore, the process of job costing is to be applied for computing the various groups of materials.
- Costs of Conversion Process- Now, to convert the raw material into the final sellable product, a business employs several processes. The yield of each process becomes the input of the next process. Each process has its distinct requirements of labor. These processes also have their own set of overheads such as rent, electricity bills, maintenance costs, etc. The final process costs are to be totaled but they must not include any material costs.
- Cost of Product-Specific Process- During the preliminary stage of manufacturing, the processes may be homogenous for every product. Eventually, a product-specific process may be employed to give it diverse traits. For instance, a garment manufacturer may produce shirts using the same method initially. In the final stage of production, different designs may be added to cater to diverse needs. This difference in design may add up to the cost of the process of a more complexly designed shirt as compared to a minimally designed shirt.
- Summation and Cost per Unit- The material costs and the cost of product-specific processes are to be attributed only to the particular product that applied it. These costs are then divided by the units of that particular product. The conversion process costs are divided by the total units manufactured by the entity, irrespective of the difference in the final products.
Adding up these divided amounts for each unit will result in the final cost per unit.
Use of Operation Costing
Operation costing is most suitable for entities that employ the same conversion process for their varied range of products. These products include minor changes in their quality or design. In these industries, the conversion process is extremely straightforward. There is no requirement for specialized variations in the basic process of building the product. For instance, the process of making paper out of pulp is the same across the board. However, the quality of the paper and the design of those papers vary.
Another industry where operation costing may be beneficial is when raw materials undergo multiple processes to transform into the end product. For example, similar electronic appliances such as washing machines need a similar process of conversion. However, manufacturing and assembling any electronic equipment is a complicated task and requires multiple levels of operations.
Example of Operation Costing
Suppose Company X is a chocolate manufacturer. They want to produce a similar line of chocolates with slight changes in the ingredients. For example, they want to produce fruit & nut chocolates, orange zest chocolates, coffee-flavored chocolates, and plain chocolates. The process of mixing, molding, and freezing stays the same for each variety. The only difference lies in the additional ingredients used in the mix. The conversion cost of the chocolates shall remain standard for each chocolate.
For the fruit & nut chocolate, the cost of the fruits and the nuts shall be added separately based on where these materials were sourced from and what the cost of acquisition was. Along with that, the cost of drying and crushing them into smaller pieces is also to be taken into account to arrive at the final cost.
The same process is to be followed for the other variations by taking into consideration their special requirements and processing costs. Therefore, these additional costs of the raw materials shall be added to the conversion cost to finally allot varied prices to the chocolates.