Product Costing System: Estimating And Calculating Product Cost

Product Costing System

Questions:

Prepare a report for Frank Burgess that addresses the following:

a) The purpose of a product costing system.

b) Preparation of a Schedule of Cost of Goods Manufactured and Cost of Goods Sold. (The schedules may be in the appendix). Explain why some items have been excluded from the schedules.

c) Complete the Tâ€Âaccounts and determine the following:

i. Work in Process at the end of April;

ii. Raw materials purchased in April;

iii. Overhead applied in April;

iv. Cost of Goods sold in April;

v. Raw materials used in April; and,

vi. Overâ€Â or underâ€Âapplied overhead in April.

d) Discuss how overheads can be overâ€Â or underâ€Âapplied and how the company should deal with the overâ€Â or underâ€Âapplication.

e) Evaluate whether ABC should be introduc.
 

The report is prepared by the New Age Caravan Company. The company has been undergoing stringent technical constraints where the accidental fire affected the accounting data of the company. The company does not have a professional accountant and the report is intended for the cost information of the company. The report focuses on estimating and calculating the product cost and the cost per unit at each process. The incomplete ledger accounts are prepared for the company and the evaluation of activity based costing is done as an alternative to traditional costing method.

Product costing system is a combination of techniques that evaluates the cost of product of the organisation and provides timely data about the cost per unit of products for effective pricing and planning strategies employed by the company. It assists in a valuation of stock and helps in controlling production activities and lends notable help for preparing a financial statement. The purpose of product costing system is to provide a bird’s eye view and strategic analysis of products of the organisation

Product costing system underlines the complete procedure that is required during production activities. It underlines the study and evaluates the complete list of the data relating to the cost of a product and undertakes to deal with new and extra costing features. It provides in-depth study of billing and routine procedures of the materials. It creates the comprehensive understanding of the costing procedure of a product. It creates simulated cost and also deals with obsolete and frozen cost (Figge and Hahn 2013).

Product Costing helps in computation and analysis of the cost of goods manufactured and the cost of goods sold for every unit of a product. It holds key importance since it sheds critical light about the operational activity of the organisation.

It provides vital knowledge for a process called as roll up of cost. Product costing undertakes the breaking down of the cost to provide additional and cohesive knowledge about the cost of a product and the value added at each step of the production activity. It allows the user of such information to understand how the cost of a product is changing at each level and how organisations are operating, which causes the changes of cost at each level (Dai and Zhi 2015).

Benefits of Product Costing System

The process of product costing helps in achieving the understanding of the optimum level of cost. Over production and under production are extreme cases for any organisation, which casts its evil on the production through adverse conditions leading to a decline of profitability. It allows the cost of goods manufactured to be optimum by employing costing on a comparative basis. This synchronisation is possible through “product cost controlling” and the information system existing in the organisation.

Product costing is an effective analytical tool for profit evaluation and update on pricing equilibrium. It undertakes to highlight the efficiency of the production process and points the advantage, which the organisation possesses regarding production process. It, however, also depicts the shortcoming in the production process and raises the potential red flags for the organisation regarding production process (Bjørnenak 2013).

i) Schedule of goods manufactured

Opening balance of raw materials	12000
less: losing the balance of raw material	(12000)
Material transferred to production		180000
Direct Labour				182000
Manufacturing overhead
Depreciation of factory building	8000
Depreciation of factory equipment	16000
Factory Insurance			14000
Repairs and Maintenance		8000
Land tax				4500
Indirect labour			118000	156000
total Manufacturing cost			518000
Add: opening work in progress	4500
Less: Closing Work in Progress		(33500)
Cost of goods manufactured			489000

Notes: Predetermined overhead rate = Annual overhead costs/ Annual direct labour hour

= 1,800,000/ 60,000

= 30/ unit

Direct labour hour for April = 5200 hours.

Applied overhead = 5200* 30= 156,000

Actual overhead = 168,500

ii) Schedule of cost of goods sold

Particulars				Amount	Amount
Opening balance of finished goods inventory	11,000
Add: Cost of goods manufactured		489000
Less: Closing balance of finished goods inventory	16000
Cost of goods sold					484000

Certain items have been excluded from the schedule. The company’s account section suffered because of the fire and certain information was not traceable. However, on completion of the schedule, it can be observed that the company follows the under application of overhead, where the manufacturing overhead is lower than the actual overhead. The cost of goods manufactured was fixed at 489,000.

					Raw materials a/c
Particulars		Amount				Particulars			Amount
To balance b/f		12000				By cost of goods manufactured	a/c	180000
To creditors a/c		180000				By balance c/d			12000
			192000								192000

					Accounts Payable a/c
Date	Particulars		Amount	Date	Particulars		Amount
1-Apr	To balance b/f		12000		By purchases a/c		184000
	To bank a/c			180000	30-Apr	By balance c/d		8000

	Manufacturing overhead a/c
Amount	Date	Particulars		Amount
168500		By Applied overhead	156000
		By Cost of Goods Sold	12500
168500				168500

	Finished goods a/c
Amount	Date	Amount
11000		484000
489000	30-Apr	16000
500000		500000

					WIP a/c
Date	Particulars		Amount		Date	Particulars		Amount
1-Apr	To balance b/f		4500			By Finished Stock of Goods	460000
	To Cost of Good Manufactured	489000		30-Apr	By balance c/d		33500
				493500						493500

					Cost of goods sold a/c
Date	Particulars		Amount	Date	Particulars		Amount
	To cost of goods manufactured	489000		By goods available for sale	460000
	To manufacturing overhead	12500	30-Apr	By finished goods c/d	33500
	To opening balance of finished goods	11000	30-Apr	By balance c/d		0
				512500					512500

Over applied and under applied overhead arises due to the process of standard costing approach. Over applied and under applied overhead arises when organisations employ the rates of overhead on the estimation basis. This could lead to a curbed figure of the overhead figure. In the case of under applied overhead, the applied overhead value is lower than the actual value of the overhead that the company incurs during the operational process. The difference between the over and under application overhead is the under application overhead. Many organisations employ the under application of overhead, to curb and deflate the cost figure. This leads to a hike of profitability for the organization. The predetermination of the overhead rates is the sole cause of such deviation, which the company employ during the production process (DRURY 2013).

On the other hand, many organizations employ over application of overhead. In this case, the actual value of the overhead is lower than the applied value of the overhead of the organization. The deviation between the two overhead is the value of the over application of the organization during the accounting year. This practice is undertaken by organizations to curb the profitability of the organization and show an inflated figure of the cost of the organizations. This method is employed to avoid taxes by showing deflated figure of profits. It also functions on the lines of predetermined rates of overhead and the estimation of the overhead rates causes the deviation between the actual value of the overhead and the applied value of the overhead. Either case of the overhead does not depict the true image of the overhead employed by the company (Clinton and White 2012). It’s a case of extremities on the part of the company, where in one case the overhead is allocated excessively and the other case depicts the allocation inadequately. Spending on overhead cost needs proper control procedure and competency of accountants and personnel. Lack of competency and control on the part of the personnel lead to a situation where over an application and under application of overheads take place. Another reason of how under and over application of overhead takes place is because the overhead includes a certain portion of fixed cost, which does not increase in the same proportion as the variable cost of the direct labour or machine hours.

Cost per Unit at Each Process

There are certain points, which an organization needs to follow in case of over applied and under applied overhead. Theoretically, it can be inferred that the over-application and under application are caused due to the predetermination of rates. Therefore, the overhead application amount should apply to each item of the account, instead of the total account balance. But in practice, this is not followed. The application is carried out on the complete account balance. When the amount of application is insignificant, then the company offsets the amount with the cost of goods sold. In the case of significant application of overhead, the amount can be diffused among work in progress inventory, finished goods inventory and the cost of goods sold (Figge and Hahn 2013).

The company can employ alternative measures like theoretical capacity measures, where the utmost capacity of an activity is measured against a standard time. It includes the future and historical data of production and cyclical trend in the economy. It ignores a factor like a machine breakdown and other factors leading to hindrances in operation. It produces results that cause the actual and budget cost to be near to each other. This leads to product cost being less deviate from the actual cost. This causes less deviation in the under and over application of overheads. This measure lends much more accuracy and in the product costing methodology and reduces the chance of risk and deviations (Messner 2015). 

More and more companies are approaching towards the adoption of Activity Based Costing technique. Many advantages and benefits are inferred from this costing technique. It is a method, which allocates the indirect cost and the total overhead cost based on the actual resources it consumes. This leads to the approximate evaluation of the overhead cost by the company. The company in the case study suffers from various issues of over and under application of overhead, which does not reflect the correct cost of the product and the profit in the financial statement of the company. The company in the case study has suffered significant losses due to fire and during the evaluation of the cost methodology, it was inferred that the under and over application of overhead had caused a significant problem for the company, which was needed to be dealt with it. This requires a customized environment of production, which assesses the indirect costs according to the resources and consumed and then the true cost is depicted. It however, can be a challenging task for the company to employ this cost technique as it suffers from various benefits and demerits (Van der Stede 2016).

The benefit of activity based costing can be traced from the fact that it improves the processes used in costing. It underlines and thoroughly detects all the processes that have an impact on costing and critically analyses it. In the longer run the overall processes can be evaluated and seen to be working effectively (Quinn 2014).

Activity based costing calculates the costing of each overhead item by the actual resources it consumes. In such circumstances, it reflects the true and fair image of the cost of each item of overhead account. It assists the company in reducing and eliminating waste in costing process of overheads, which might give an inflated or deflated picture of the costing of the company. Activity is Based Costing technique initially removes waste from each item of the overhead process and then ultimately remove it from the business altogether (Messner 2015).

Activity Based Costing vs Traditional Costing Method

Activity based costing is useful in identifying the true and approximate cost of each unit in the production process. This allows the company to identify the actual cost of the product and effectively apply price strategy in the sales procedure of the company. Price strategy of a company is a useful aspect to consider since it allows the company to understand cost and price strategy and the level of profit margin it can attain. It allows the company to employ better pricing strategies and marketing strategies, which is needed for the company (Leauby and Wentzel 2012).

The activity based costing technique effectively allows the company to evaluate the cost and benefit between the cost techniques that the company uses. The concept of cost and benefit is an important aspect for the company to assess before applying any costing technique.

Activity based costing allows the company to improve it business and overcome the loopholes of every facet of the operational activity. It helps in the functioning of the company and also improves the image of the company with working methodologies and principles, higher profitability and minimization of risks and wastes by the company (Parker 2012).

The Activity base costing does suffer from certain shortcomings and loopholes. The company needs to evaluate these demerits as well to form a proper idea of the effectiveness of the costing technique.

Activity Based Costing heavily depends on data and thus data is collected from many departments of the organization. The heavily reliance on data makes the technique heavily susceptible to deviations in case of untrue and misrepresented data. This is one of the shortcomings of the technique (Soin and Collier 2013)

The period involved in activity based costing is long and therefore it involves a length period in the evaluation of cost as it carries an in depth analysis of the production process, employee action and also every aspect of the business (Parker 2012).

The implementation and the cost of employing this technique is high. Therefore, the company has low wastage and therefore the high implementation cost might make it not prospective to employ thus costing technique.

The activity based costing technique is not very effective if the over and under application of overheads is very high and very low. This leaves the business in a disadvantageous position.

Therefore, it can be concluded that activity based costing requires careful and strategic evaluation before employing this technique. 

Conclusion

On concluding the report it can be observed that the company has suffered a major technical hassle due to the fire, which caused the loss of accounts of the company. Certain information was traceable and the T account has been created using the schedule of goods manufactured and schedule of goods sold. The company follows the under application of overhead and the company follows standard costing method. Activity Based Costing has been the future plan of action as it holds certain benefits to the company. The purpose of product costing has highlighted the effective product costing process and the necessity to employ price strategy.   

Reference list

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e) Evaluation of Activity Based Costing

Reference