Costing formula

What it means

A costing formula is a fixed order and breakdown of cost items that a company uses to build the costing of a product, service or job. It usually starts with direct costs, which can be assigned to a specific product, and continues with indirect costs, which are allocated.

The classic formula comprises direct materials, direct labour including contributions, other direct costs and production overhead, giving the production cost, then administrative overhead, giving the cost of output, and selling overhead, giving the full cost. Adding profit or margin gives the price.

Overheads are allocated to products through an overhead rate, for example as a percentage of direct wages or per machine hour. The choice of allocation base strongly affects which products look profitable and which do not.

How it works in practice

We recommend a costing formula to companies that quote for jobs or make several products. It ensures every quote includes the same items and does not forget overheads, which are the most often omitted when estimating “by eye”.

The formula should be linked to the accounts: job costing or cost centres show actual costs, which are then compared with the preliminary costing. The differences show where estimates go wrong and allow overhead rates to be adjusted.

Costing by formula is also used to value work in progress and finished goods in the balance sheet at cost. For accounting valuation, however, only production costs are included, not administrative or selling overheads, which must be borne in mind when designing the formula.

What to watch out for

The most common mistake is an outdated overhead rate. If overheads are allocated using a percentage set years ago, then as rent, energy or administration costs rise the company systematically underestimates costs and sells below its real cost. Rates should be recalculated at least once a year.

The second mistake is one rate for everything. A product that uses a lot of machine time and one with a high share of manual work consume overheads differently. With a varied range, several allocation bases or activity-based costing make sense.