Product Costing System: Understanding And Advantages

Product Costing System

1. Frank does not realise the important of full time accountants and the use of a good product costing system in a company. He thinks that summing up all the revenues and deducting the expenses is all that he needs to do. He thinks there is no relevance of ascertaining the cost of the product as it will not be of any help. So, to make him understand the product costing system, different systems under it and the purpose of  various product costing system the following information is provided (Alex, 2012).

There are various ways through which a company can keep a record of the expenses that it has incurred in the course of production. It is a process through which a company can maintain a track of the expenditures that it has incurred to convert the raw material to finished goods and make it available for sale. These costs include both direct and indirect expenses related to the product. Some examples of the costs that are included are raw material cost, wages paid to the labours, transportation cost etc. It is not enough to set the prices based on the standards set up by the competitor, it is equally important to analyse all the expenses and plan it accordingly (Ball, 1984).

All these expenses are summarised and a cost sheet is prepared which helped us to know the cost per unit of a product. It helps us to answer many questions such as-

• Whether the product line is efficient or not?
• What is the proportion of overhead in the total cost?
• Has there been any increase in the cost of the product? What is the reason behind it?
• What will be the impact on the unit cost of the product if we increase the output?

There are various methods under product costing system which a company may adopt. They are-

• Job order costing – The cost sheet prepared is of a particular job. Such a cost sheet reflects accumulated cost. This type of method is used by manufacturing concerns where limited quantities of products are produced. In such concerns, the products are unique and prepared on the basis of order (Berman, Knight, & Case, 2013).
• Standard costing – Standard costing is not used independently. It is either used with job costing or process costing. In this method, an estimate of the cost of the product is made and when the actual figures are available the estimated figures are adjusted accordingly (Berman, Knight, Case, & Berman, 2008).
• Process costing – The cost of the product or cost per unit is ascertained right after the completion of a process.  This method is adopted where there is a huge volume of production. Unlike job costing, these types of concerns manufacture same kind of product (Bragg, n.d.)..
• Hybrid costing- There are some companies that use job costing and process costing simultaneously. For example, a company may use process costing for overheads whereas it may use job costing for materials.
• Activity based costing- A single overhead rate is computed and cost is accumulated on the basis of such activity. Then there is an allocation of cost that is based on different cost drivers such as number of orders, floor space, light points, etc.

All the above are used by different manufacturing concerns but the system to be followed is dependent on the basis of nature, size and working procedure of the business (Cafferky, & Wentworth, 2010)..

There are various advantages of using an efficient product costing system. Some of them are-

• Accuracy- It helps to accurately measure the business expenses and also to ascertain the values of opening stock and closing stock correctly.
• Decision making- It helps to take intellectual decisions which will be beneficial for a company’s working and results in earning higher profits.
• Project development – An efficient product costing system helps to design a new product line and to make some changes in the old products by adding some new features to it (Financial management, n.d.)..
• Project tracking- project tracking helps us to analyse the gross cash inflows and cash outflows related to the job along with its success and failure.
  Schedule showing preparation of cost of goods manufactured and cost of goods sold:-

Particulars	Amount
Opening stock of raw materials	12000
Add: Purchases of raw materials	180000
Less: closing stock of raw materials	12000
Direct wages	182000
Prime cost	362000
Add: Factory overhead
Insurance	14000
Repairs and maintenance	8000
Land tax	4500
Factory building depreciation	8000
Factory equipment depreciation	16000
Work cost incurred	412500
Add: Opening work in process	4500
Less: closing work in process	33500
Works cost	383500
Add: Administrative overhead
Administrative salaries	24000
Indirect labour cost	118000
General liability insurance	2400
Depreciation on office equipment	1800
Cost of goods manufactured	529700
Add: Opening stock of finished goods	11000
Less: Closing stock of finished goods	16000
Cost of goods sold	524700
Add: Selling and distribution expense
Advertisement expense	12000
Sales salaries	90000
Travel and entertainment expense	14100
Cost of sales.	640800

A cost sheet is a statement that shows all the cost that is related to a particular job or a particular product. It also tells about the margin earned on that product or the job. A company can keep records of its expenses properly which will further help them to control cost. In order to ascertain cost of goods sold, cost of goods manufactured and cost of sales we can prepare a schedule known as the cost sheet (Fischer, Cheng, & Taylor, 2002). Cost of goods manufactured is the cost incurred to convert the raw material into finished goods. The cost of goods manufactured includes direct material that has been used, the direct wages and also the manufacturing overhead that has been assigned.

Cost of goods sold can be determined by two ways. First way to calculate cost of goods sold is by deducting gross profit from the sales value (Garrison, & Noreen, 2003). When the information regarding sales or gross profit is missing we should adopt second method. The second method to calculate cost of goods sold is by adding opening inventory to the cost of goods manufactured and deducting the closing inventory (Gitman, 1985)..

1. c) The following are the accounts that were required in the question to give proper information to the creditors and for other purposes:

Cost Sheet and the Breakdown of Costs

WIP
Particulars	Amount	Particulars	Amount
To bal b/d	4,500	By Finished Goods	3,33,000
To Raw Material	1,80,000	By Bal c/d	33500

Raw Material
Particulars	Amount	Particulars	Amount
To bal b/d	12,000	By WIP	1,80,000
To Accounts Payable	1,80,000	By Bal c/d	12000

COGS
Particulars	Amount	Particulars	Amount
To Finished Goods	4,84,000	By Bank	4,84,000

Accounts Payable
Particulars	Amount	Particulars	Amount
To Bank	1,84,000	By Bal b/d	12,000
To bal c/d	8,000	By Raw Material	1,80,000

Finished Goods
Particulars	Amount
To bal b/d	11,000
To Overheads	1,56,000
To WIP	3,33,000

1. d) Overhead are the costs that are not directly attributable to the product. These are a kind of indirect cost. These cannot be easily identified and measured in the finished product produced. Overhead is charged to the customer at a pre-determined rate known as overhead rate. This overhead rate is estimation and not on the basis of actual overhead incurred (Goyal, 2012). When the production process is completed and the actual value of overhead is ascertained we come to know the actual overhead rate. This overhead rate is on the basis of direct material, labour hours or machine hours.

On comparison, when the overhead recovered is more than the overhead incurred then there is a situation of over absorption whereas when the overhead recovered is less than overhead incurred then it is known as under absorption (Narayanaswamy, 2014). There are several reasons behind the under and over absorption such as extraordinary expenses that was not expected to arise, incorrect absorption method used, any kind of unexpected changes such as replacement of machinery and recruitment of new labours, increase in level of capacity, etc.

The treatment of over and under absorption should be as follows-

• The situation of over absorption is when the company recovers more that what is incurred and earns profit. Such profit is credited to the profit and loss account (Pandey, 2015).
• Under absorption is an expense to the company which reduces the profit and therefore it is charged to profit and loss account.
• If there is under or over absorption due to price level then the treatment for goods sold and the treatment to deal with goods still in stock is different.
• In respect of the goods that are sold, the overhead under or over absorbed is charged to profit and loss account. But in respect of goods that is still lying in the stock a supplementary rate is calculated and charged to customers (Pratt, 2006).
• If the situation of under or over absorption arises because of seasonal variation then it must be carried forward to the subsequent years. Such amount should be transferred to overhead suspense account whose treatment shall be done in the next year.

Over absorption cost increases the cost of the product for the customers which may affect the sales of the company because a customer is highly influenced by the price of the product. Under absorption has an adverse effect on the company as the company is not able to recover the extent to which it has spend. Therefore, both under and over recovery is not considered to be good. These should be treated properly in otherwise it may have adverse impact on the company (Ramsey, & Ramsey, 2003).

1. e) Frank should know about all the merits and limitations of the ABC analysis before introducing it in his company. He can evaluate whether it will be beneficial or not when he has a complete knowledge about it. He can draw a conclusion and adopt ABC analysis once he has acquired the relevant information.

The ABC analysis is a technique which helps a company to manage its material and keep a control over it. This technique is also popularly known as “Selective inventory control”. The materials are basically divided into three categories A, B and C. The materials in category A or of higher values and do there is a strict control over it. The materials in category B have a less control when compared to the materials in category A. In case of category C, the control and record both are minimal(Tulsian, 2006).

ABC should be recommended and introduced in the company because it suggests that all inventories do not have an equal value.  This analysis helps to identify the important impacts that material control can have on the overall cost of the inventories.

ABC analysis should be recommended and introduced because of the following advantages-

• Strict control – Material in category are of high values and therefore it enables to keep a strict control over it.
• Minimum storage cost- The quantity of materials purchased are as per the requirements. Therefore, there is a minimum storage cost involved.
• Economical – this method of material control is very reasonable and economical.
• Savings in time – The category A goods of higher values are managed properly so not much time has to be devoted to the other category of goods.
• Reduction in investment – The management always tries to agree with a shorter delivery period. Therefore, the investment requirement is reduced.
• Boosting efficiency – The company is able to run more efficiently and its effectiveness also increases (Hoyle, Schaefer and Doupnik, 2015).

However, there are some limitations of using ABC analysis. Some of the limitations are-

• The materials present in the store must be standardised only then this method can be applied.
• All the factors other than the price of the product is ignored in the concept of ABC analysis.
• ABC analysis is a time consuming method.

As we can see that there are a lot of advantages over the disadvantages Frank can adopt ABC analysis for material control (Ehrhardt and Brigham, 2011).

Conclusion

It is concluded that only calculating revenues and deducting expenses is not enough. A company needs to adopt a proper product costing system and should choose the product costing system which will be most useful to the company. The efficiency in product costing system will help the company to recover cost from the customers. If the accounting system is inefficient then there is a very less chance that a company will be able to estimate the recovery rate correctly. Overhead has a large proportion in the total cost of the product and therefore it is necessary to maintain proper records. Cost control and cost reduction both are the main targets of cost accounting. Material control is also equally important because it is the main component required to produce any kind of finished goods. This record which is required cannot be maintained without proper knowledge of it. If a company maintains records properly it is also easy to provide information to the creditors and the debtors.

References

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