Product Costing Systems - Essay Example

Product costing system The aim of any business is to make profit out of its activities in satisfying a need in the market1. This means that for a business to make profit it must get more benefit than the expenditures it has incurred in availing such a good. Therefore, a company must cost its products prudently in order to ensure that it remains profitable. Cost refers to a resource which is foregone in order to attain a certain objective. The most prudent way of understanding how costs are incurred in a company is to analyse them as part of the value chain of the company. This is a set of related processes and activities that create value in a product. This includes both the primary activities and the supporting services. The primary activities may include research and development, design, supply, operations, marketing, distribution and customer services. On the other hand, supporting services include human resources, financial accounting, general management and information system among others. Cost incurrence is said to occur whenever a resource is used up or sacrificed. Costing system requires costs to be recorded only when incurred. A good costing system makes an estimation of the cost of a cost object which may be services, activities, products, a customer or a supplier. This is done in two stages. The first stage accumulates the cost by collecting data related to cost in an organised manner through an accounting system. This is achieved through cost data classification into cost pools such as labour, materials and advertising among others. The second stage is cost assignment which involves assigning costs to cost objects. The purpose of a costing system at this point is to trace accumulated direct costs to a cost object and allocate the accumulated indirect costs to a cost object. Therefore, managers should take appropriate actions to increase the value of products and increase cost efficiencies. In order to achieve this goal they must have a clear understanding of the real causes of costs. Product costing system requires cost and revenue information but emphasis is placed on costs. There is no business that does not incur costs hence the need to plan and control the costs. Data related to costs are readily available and the business is only required to understand the causes of costs. However, the benefit derived from the utilisation of cost information should outweigh the costs of obtaining this information. Cost information is required for decision making. Specific reasons for establishing costs include: Determination of the areas of business or certain items that are most profitable for the business. This helps the business to focus on those areas or items that will maximize its profit. Cost control: knowledge of the exact cost incurred in a particular cost object will help the management to control the cost of that cost centre. For instance if the actual amount incurred in a particular department is more than was budgeted then the management will put measures to control the costs in that department. Determination of costs will help the management to decide on whether to outsource a particular function. For instance, LifeStyle Furniture can evaluate its distribution costs and compare it with the distribution fee from an outsourcing company. if the fee from outsourcing is less then the company should consider outsourcing its distribution function. Determination of costs aids in pricing decisions2. In order for the company to continue growing it must make profit. The profit will be determined by the difference between its selling price for its products and the cost incurred in producing that product. Therefore, LifeStyle should first determine the cost of producing its furniture before deciding on the selling price. The selling price will be determined by adding a profit margin on the cost incurred in producing the furniture. Cost of goods manufactured LifeStyle Furniture Schedule of Cost of Goods Manufactured April XXX Direct materials: Raw materials inventory, beginning $2,100 Raw material purchases 14,600 Total raw materials available $16,700 Raw materials inventory, ending 3,200 Raw materials used in production $13,500 Direct labour 21,900 Total manufacturing costs $35,400 Beginning work in process inventory 1,670 $37,070 Ending work in process inventory 1,110 Cost of goods manufactured $38,180 LifeStyle Furniture Cost of Goods Sold January XXX Finished goods inventory, beginning $46,980 Add cost of goods manufactured $38,110 Cost of goods available for sale $85,090 Deduct: finished goods inventory, ending 44,410 unadjusted Cost of goods sold 40,680 add: under-applied overhead 15,600 Adjusted Cost of goods sold 56,280 T-Accounts Dr. work in process Cr. 01 April Bal B/d 4,500 April C.O.G.M 4,500 Dr. Raw materials Cr. 01 April Bal B/d 12,000 manufacturing cost 13,500 purchases 4,700 Bal C/d 3,200 16,700 16,700 Dr. Manufacturing Overhead Cr. 30 April Actual cost for April 14,800 April C.O.G.S 14,800 Dr. Cost of goods sold Cr. April Finished goods 56,280 April Profit and loss 56,280 Dr. Finished Goods Cr. 01 April Bal B/d 11,000 30 April Bal C/d 16,000 Cost of Goods sold 5,000 Dr. Accounts Payable Cr. April Bank 40,000 01 April Bal B/d 6,000 30 April Bal C/d 8,000 c.ii) raw material purchased in April = $4,700 c.iii) Overhead applied in April Predetermined absorption rate = $180,000/ 60,000 = $3 per direct labour hour Therefore, overhead applied in April = predetermined absorption rate * actual labour hours = $3 *5,200 = $15,600 c.iv) cost of goods sold in April = $56,280 c. v.) raw material used in April = $13,500 c.vi) Under or over applied overhead in April This is found by subtracting applied overhead from actual overhead Actual overhead in April = actual rate * actual direct labour hours = $6 * 5,200 = $31,200 Therefore, under applied overhead in April = $31,200 - $15,600 = $15,600 Overheads Overheads refer to the indirect expenses in the company. Overhead absorption is the process through which overheads are included in the total cost of the product3. It is a means of attributing overheads to a product or service based on direct labour hours or machine hours among other bases of absorption. Overhead absorption is particularly important when dissimilar products are made which require different production processes or for jobs which although using identical facilities occupy the facilities for varying length of time. Using predetermined rates, overheads are absorbed into the actual production throughout the accounting period. Because the predetermined rates are based on the estimated production and estimated overheads, it is unlikely that the estimated overheads equal actual overheads incurred for the period. If the overheads absorbed are greater than actual overheads then the overheads are said to be over applied. On the other hand, if the overheads absorbed are less than actual overheads then the overheads are said to be under applied. Over or under application of overheads can be dealt with by using marginal costing technique. By using this technique over or under application is almost entirely avoided. This is because the common reasons for over or under absorption is the inclusion of fixed costs into overhead absorption rates and the level of activity being different to what the company had budgeted for. Marginal costing distinguishes between variable costs and fixed costs as conventionally classified. Under this method, the marginal cost of a product is its variable cost. Marginal costing does not include fixed costs in determining the absorption rate hence dealing with over or under application of overheads. ABC costing system In an ABC system, the organisational processes are broken down into activities4. An activity can be any event which causes a cost to be incurred. LifeStyle Furniture can break its process of producing furniture into maintenance, process setups, receiving goods, engineering, purchasing, and handling materials activities. The costs assigned to these activities are then allocated to products or services on the basis of cost drivers appropriate to these activities. For instance, the best cost driver for maintenance activity is the number of hours taken by maintenance workers. The steps applied are outlined below: 1. Identify major activities. 2. Identify appropriate cost drivers 3. Collect costs into pools based upon the activities. 4. Charge costs to units of production based on cost driver volume. According to Fess and Warren (2004), ABC first categorizes indirect costs according to discrete business activities that are responsible for consuming resources and then uses cost drivers to estimate the resources attributable to the cost objects. Product cost differences between simple costing system and ABC system arise because of the manner of treating the indirect costs. As noted in Hilton (2004), the objective of ABC is not to attempt to allocate all indirect costs. Rather, the objective is to accurately allocate indirect costs where it is relevant. Some costs will have no relevant or applicable basis to allocate to cost objects. Conclusion This report has shown that a company aims at making profit. The profit is achievable if the company can sell its products at a margin. The cost of producing a product is important since it will guide the company in deciding how much to sell its products. These costs may be fixed while others may be variable. These costs can never be similar from one company to another. Therefore, LifeStyle Furniture should price its products independently of other market players. Direct labour is a major cost for products but these costs varies because human labour is dynamic and is priced differently from different companies. Pricing decisions can be a competitive tool for a company. If the company is cost efficient then it can reduce the product cost hence can price its product competitively. Therefore, instead of LifeStyle Furniture pricing its product dependent on the price charged by the market leaders, it is recommended that it becomes cost efficient to allow it to lower its selling price. This will allow the company to maximize revenue and in the process command a large market share for furniture. Bibliography Atrill, McLaney. Management accounting for decision makers. 7th ed. Harlow, England: Pearson education ltd, 2012. Fess Warren. Accounting principles. Canada: Southwestern Company, 2004. Guilding, Caleb. Accounting Essentials for Hospitality Managers. (2nd ed.). Oxford: Butterworth Heinemann, 2009. McCrary, Stuart. Mastering Corporate Finance Essentials: The Critical Quantitative Methods and Tools in Finance. New York: John Wiley & Sons, Inc., 2010. Read More