What is Operation Costing?

Operation costing is a mix of job costing and process costing. It may be used when a product initially uses different raw materials, and is then finished using a common process that is the same for a group of products. Or, it may be used when a product initially has identical processing for a group of products, and is then finished using more product-specific procedures.

In both cases, a mix of job costing and process costing is used to compile the cost of a product; this mixed costing environment is called operation costing. The job costing element is based on the concept that costs can be assigned to specific products, which is the case when something is produced in units of one or in very small quantities. The process costing element is based on the concept that the cost of producing a large group of products is allocated equally to all the products in that group, since they are manufactured in an identical manner.

In short, operation costing is most applicable to the more complex manufacturing environments that require a mix of different types of production processes in order to create goods.

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Examples of Operation Costing

A company manufactures watches in lots of 1,000. The watch casings and workings for all 1,000 units are identical, so the company simply adds up the cost of the production run and divides by 1,000 units to arrive at the per-unit cost. In addition, watch bands are custom-made for the wrist size of the customer, and use a variety of unique materials. These costs are compiled for each individual watch. Thus, we have process costing for one portion of the production process (the watch casings and workings) and job costing for another portion (the watch bands). When combined, this is operational costing.

An example of the reverse situation is when a product initially has unique raw materials, but is then finished using a common process. For example, a company builds unique, custom-designed race cars. It uses job costing to compile the cost of each car. However, all cars are then run through a paint shop, which is essentially a fixed cost. The cost of the paint booth is allocated equally to all of the cars run through it, which is process costing. Thus, we use job costing for the first part of the production process and process costing for the second part. Again, this is an example of operation costing.

Advantages of Operation Costing

There are several advantages to setting up and running an operation costing system, which are as follows:

Reasonably high accuracy level. It is a reasonably accurate way to assign costs to products. This means that management can use it to gain an understanding of how much products and production processes are costing, which may lead to cost-analysis projects to reduce costs in selected areas.
Good for determining performance. Operation costing information can be used to assess the performance of the managers assigned to each functional area of a production process.
Good basis for budgeting. Having a better grasp of costs makes it easier to devise cost budgets that are reasonably accurate, and which can be used as the basis for ongoing planning activities.
Good for price setting. Operation costing is useful for setting prices for special deals demanded by customers; with a good knowledge of costs, it is easier to set prices that will still produce a profit for the business.
Adaptable to different situations. Operation costing can be adapted to different types of production environments, which makes it usable across a broad range of production environments.