Operation costing method: definition; components; characteristics; applicability; classification; advantages and disadvantages

Definition-1; Operation costing is a methodology of collecting cost data which is more appropriate when it comes to production of goods or services involving continuous production process or operation. All cost associated to a certain process is charged therein before further spreading the total cost to the items produced thereof.


Definition-2: Operation costing method is the approach a manufacturer use to compute or calculate the total cost of a product where a process and job costs are applicable such as material cost, labor cost and overheads.

Components of operation costing method

From these definitions, it is clear that operations costing entails;

  1. Production process which is a continuous one.
  2. Identification of the specific cost elements associated to that specific process or stage.
  3. Confirming if the cost elements, namely; direct material cost, direct labor cost, direct expenses and overhead costs are traced and attached to that specific stage or process level.
  4. Cumulating or summing up all the monetary values of those production inputs (i.e., cost) to establish the actual cost of the specific process level once it is complete.

NB2: That operation costing method is one of the two key or mainstream classification of costing methods (the other one is job costing method) which is based on the unit or output costing criteria.

Characteristics of operation costing method

Operation costing method is a costing approach which is dominated by the following characteristics which in return distinguishes it from other costing methods. These characteristics are, and not limited to;

1). The assignment is specific. In other words, the operation to be undertaken is on the basis of strict guidelines. There are terms of reference from the customer or client.

2). It is possible to trace exactly the cost elements associated to that job.

3). Jobs undertaken are different one from the other. This is because the manufacturer may be dealing with different customers or the same customer/client but with different nature of jobs.

4). Overhead cost allocation/apportionment is based on the appropriate criteria.

Steps for operation costing method

The following steps are the most suitable stages to follow if you are to efficiently determine the total cost that is associated with the completed assignment.

STEP-1: Process costing evaluation stage.

The starting point is to assess the total cost associated with the mass production of the products in question. To achieve this objective, the manufacture needs to focus on the standard price of the materials, weighted value of the inventory or the order made by the client.

STEP-2: Identify all direct material costs associated with the specific job and accumulate it accordingly.

STEP-3: Identify all direct labor costs associated with the specific job and accumulate it accordingly.

STEP-4: Identify all direct expenses associated with the specific job and accumulate it accordingly.

STEP-5: Allocate or apportion the overhead processing cost as per the chosen appropriate basis

STEP-6: Sum up the total costs as per all operation cost breakdown you have used. That is establish the total cost of each operation.

STEP-7: Assess profitability of each level of production process

After Summing up the total costs as per all operation cost breakdown you have used, further establish the profit margins thereof.

Applicability of operation costing

Operation costing is applicable or suitable where;

1). Industries dealing with uniform products

Operation costing method focus on producers of homogenous products such as sweets and biscuits etc.

2).Industrialists using several departments in production

Organizations which produce output through several departments such that each department has an assignment to undertake on one product. For example, if a firm produces women clothes, one department will do the material cutting, another department will saw the materials together, another department will iron the final cloth output and another department will do packaging of the final products.

3). Industries with Diverse Product Characteristics

A firm can be dealing with production of various products but in mass form. In this case, the producer will produce in much more output where by each department will play its part to realize the final product.

4.)Industries adopting innovative approach

For innovative firms, there is need of using operation costing method in determining an appropriate price for a new type of product without knowing how much the product will cost to

manufacture overall.

Classification of operation costing method

Operation costing is also referred to as unit costing method. Examples of operation costing are;

  • Service Costing
  • Process Costing

Advantages of operation costing method

1). Cost control

This method of costing enables the management to identify the cost spending trends in every process level and suggest corrective measures thereof. For example, if a facility is not commonly used in production or it is used to process only a by-product (i.e., minor product) the management will close it down if its contribution is dismal.

2). Assessment of the management performance.

Since each stage or level of production is managed or supervised by a responsible official, it is possible to assess the efficiency of the firm personnel and see ways of improving if low performance is noted.

3). Increased accuracy

Operation costing method enables the management to establish the exact cost of production and hence be in a position to increase accuracy of budgeting processes. For instance, in the process activities, areas of delay can be easily identified and then corrections done to avoid further errors.

4). Flexibility to market changes

Operation costing method guide the management to understand the historical operation cost trends and can then rely on that past history to plan for the market changes that may arise in the future.

5). Fostering of resource allocation of fund or other firm economic resources.

Operation costing method help in improving the way resources are assigned to different production activities which in turn avoids wastages.

6). Less clerical work required:

It is simple to undertake and it is not complicated. This is evident by the fact that less clerical work is factored in.

7). Application of standard costing system

This can be of much help to the organization for comparison purposes to avoid previously committed errors in resource allocation.

Disadvantages of operation costing method

1). Historical cost

Basically, operational costing method is made up of sunk cost associated to each process level(s). This data may be of no use for future decision-making purposes.

2). Inaccuracies cost computation

The operation costing method is faced with challenges of estimates of costs most of the times and this may lead to wrong or misleading cost reports.

3). Work in Progress is difficulty to compute

A times some materials are partly processed and the determination of the equivalent units may be inaccurate for it depends on personal judgement of the degree of completion.

About the Author - Dr Geoffrey Mbuva(PhD-Finance) is a lecturer of Finance and Accountancy at Kenyatta University, Kenya. He is an enthusiast of teaching and making accounting & research tutorials for his readers.