Product Costing And Profit Analysis

Calculating Product Cost under Traditional Costing

Statement of Cost- Traditional Approach Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper
Particulars	Basic Model	Advance Model
Units produced and sold Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper	1,600	1,500
Direct Material cost per unit	325	560
Direct Labour cost per unit	150	260
Total Material Cost (1600*325)+(1500*560)	5,20,000	8,40,000
Total Labour cost (1600*150)+(1500*260)	2,40,000	3,90,000
Total Allocated Overhead cost	1,43,750	1,06,250
Total Cost	9,03,750	13,36,250
Cost Price Per unit	565	891

Total cost:

• Basic Model= 520000+240000+143750=903750

Total units= 1600 unit

Cost per unit =564.84

• Advance Model=840000+390000+106250=1336250

Total units= 1500 unit

Cost per unit = 891

Allocation of Overhead-Traditional approach
Particulars	Amount
Inspection	20,000
Assembly	90,000
Production Scheduling	1,05,000
Machine set-up	35,000
Total Overhead to be allocated	2,50,000
Total Machine Hours consumed	8,000
Overhead per Machine Hour	31.25
– Overhead Allocated to Basic Model (4600*31.25)	1,43,750
– Overhead Allocated to Advance Model (3400*31.25)	1,06,250

Total Overhead to be Allocated=20000+90000+105000+35000= $250000

Total Machine Hour Consumed= 4600+3400= 8000 hours

Overhead allocation per machine hour= 250000/8000= $ 31.25

Statement of Cost- ABC approach
Particulars	Basic Model	Advance Model
Units produced and sold	1,600	1,500
Direct Material cost per unit	325	560
Direct Labour cost per unit	150	260
Total Material Cost (1600*325)+(1500*560)	5,20,000	8,40,000
Total Labour cost (1600*150)+(1500*260)	2,40,000	3,90,000
Total Allocated Overhead cost	75,506	1,74,494
Total Cost	8,35,506	14,04,494
Cost Price Per unit	522	936

Total cost:

• Basic Model= 520000+240000+75506=835506

Total units= 1600 unit

Cost per unit = $522

• Advance Model=840000+390000+174494=1404494

Total units= 1500 unit

Cost per unit = $936

Allocation of Overhead-ABC Approach
Particulars	Inspection	Assembly	Production Scheduling	Machine set-up	Total Cost
Cost	20,000	90,000	1,05,000	35,000	2,50,000
Units	950	8,000	550	350
Cost per unit	21	11	191	100
Units for Basic Model	200	4,600	50	100
Units for Advance Model	750	3,400	500	250
Total Overhead for Basic Model	4,211	51,750	9,545	10,000	75,506
Total Overhead for Advance Model	15,789	38,250	95,455	25,000	1,74,494

Statement of Profit and Loss- Tradition Approach
Particulars	Basic Model	Advance Model
Sales	10,84,500	16,03,500
Less:
Total Material Cost	5,20,000	8,40,000
Total Labour cost	2,40,000	3,90,000
Total Allocated Overhead cost	1,43,750	1,06,250
Other Operating Expenses for Advance model
– Selling and Administration expenses	–	1,40,600
– Interest Expense	–	25,200
– Office Rent	–	35,900
Profit	1,80,750	65,550
Basic Model: Total Sales = 1600*678=1084500 Total Cost = 520000+240000+143750=903750 Profit = 1084500-903750= 180750 Advance Model: Total Sales = 1500*1069=1603500 Total Cost=840000+390000+106250+140600+25200+35900=1537950 Profit = 1603500-1537950= 307590
Calculation of Sales Price Per unit- Tradition Approach
Particulars	Basic Model	Advance Model
Cost per unit	565	891
Add: profit margin 20%	113	178
Sale Price Per unit	678	1,069

Statement of Profit and Loss- ABC Approach
Particulars	Basic Model	Advance Model
Sales	10,02,607	16,85,393
Less:
Total Material Cost	5,20,000	8,40,000
Total Labour cost	2,40,000	3,90,000
Total Allocated Overhead cost	75,506	1,74,494
Other Operating Expenses for Advance model
– Selling and Administration expenses	–	1,40,600
– Interest Expense	–	25,200
– Office Rent	–	35,900
Profit	1,67,101	79,199
Basic Model: Total Sales = 1600*624=998178 Total Cost = 520000+240000+75506=835506 Profit = 998178-835506= 167101 Advance Model: Total Sales = 1500*1124=1685393 Total Cost=840000+390000+174494+140600+25200+35900=1606194 Profit = 1685393-1606194=79199
Calculation of Sales Price Per unit- ABC Approach
Particulars	Basic Model	Advance Model
Cost per unit	522	936
Add: profit margin 20%	104	187
Sale Price Per unit	627	1,124

In the given case we see that the overseas buyer is interested in buying only the advance model and not the basic model of the sewing machines. Also, that the company has been currently using traditional costing practices. From the table above we can see that the price which the company would have offered to the overseas buyer would have been $1069 per unit. The company uses traditional costing system because of which indirect overheads have been allocated based only on consumption of machine hours (Atkinson, 2012). This is not a practical costing approach since costs are not apportioned on the basis of actual usage of resources. If the company had opted for ABC costing the price of the advance model would increase to $1124. The overseas buyer is aware of the fact that due to usage of traditional costing system, costs have been wrongly charged more to basic model and less to the advance model. Therefore, the overseas buyer sees the advantage of lesser price due to wrong costing practices and wants to buy only the advance model since it is priced lower and not the basic model, which has been priced higher than the usual market price.

Overhead expenses are the expenses which are not directly attributable to the product. The costs incurred in connection with activities which assist the production activities are classified as overhead expenses (Berry, 2009). Since these expenses cannot be directly traced to a particular product, there are different ways which help allocate the expenses among various products.                                                                                         

The most popularly used methods for overhead allocation are traditional approach of overhead allocation and activity based costing. (Boyd, 2013)

Under the traditional approach of overhead allocation all the overhead costs are summed up together a then using a single attribute these costs are allocated among various products. The process of calculation of unit cost is relevant for the companies, so that they can set a selling price for the product (Dash, 2016). But the expenses can be calculated once they are actually incurred. Therefore in order to predetermine the rate of cost allocation, the companies make a budget.

The budget helps companies calculate the level of costs which are likely to incur given the target sales and profit of the company. While preparing the budget, the management estimates the expenses and the level of output (Datar M. S., 2015). Theses estimated costs also include overhead expenses. In order to determine the unit cost these budgeted costs are divided by the budgeted number of units produced. This helps calculate the budgeted unit cost and further helps in setting the price of the product. These are just budgeted figures. The actual expenses which are incurred once the actual production takes place might be higher or lower than the budgeted. This creates variance. The overhead recovered from the customers are based on the budgeted rate and not on actual which leads to over and under application of overheads.

Calculating Product Cost under Activity-Based Costing

Let us take a practical example to understand this concept. Following table shows budgeted and actual expense and units for a product:

Particulars	Budgeted	Expenses per unit
No of units produced	2,000
Direct Material	5,000	2.50
Direct Labour	2,500	1.25
Direct Expenses	2,500	1.25
Overhead Expenses	3,000	1.50
Particulars	Actual	Expenses per unit
No of units produced	1,900
Direct Material	5,200	2.74
Direct Labour	2,600	1.37
Direct Expenses	2,500	1.32
Overhead Expenses	3,200	1.68

Now, when we priced the product, we used the budgeted expenses to recover the amount form the customers. In the scenario above we charged the customers $1.50 for overhead on every unit, when the actual expenses incurred was $1.68. This is the case of under absorption.

There is only one situation under which both the actual and applied overhead rates can be same. This is the situation when both the actual and budgeted overhead amounts are same (Datar S. , 2016). This is very unlikely to happen since the market tends to move irregularly.  

When a company comes across a situation of under or over absorption, it is required to treat them in the books of accounts. There are various ways by which they can be treated:

• Carrying forward the amount of under/over absorption: under this system, any amounts of expenses which have been under or over applied are carried forward to the next year. This amount is expected to be adjusted in the next year and any further over/under absorptions for that year are then carried forward.(Girard, 2014)
• Writing off the said amount in the costing profit and loss account: this is the most commonly used method for treatment of under and over absorption. The said amount is directly taken to the costing PL amount and written off in the same year.(Holtzman, 2013)
• Adjusting the under/over applied amount from the products in the current year: this is one of the most complex treatments. Under this system the amount which has been under or over applied are adjusted to the existing units.(Horngren, 2012)

Therefore we see that absorption costing requires a lot of adjustments to be made in order to account for correct costs of the products. (McLaney & Adril, 2016) Companies may opt for any technique of costing which is most suitable for them. This system of costing establishes the relationship between the product and its expenses. This type of costing though is very helpful; it is difficult for some expense for distribution.

Activity based costing is the costing technique under which the cost are allocated amongst the products on the basis of resources used by them. ABC is the modern costing technique which helps in allocation of costs in an appropriate manner (Menifield, 2014). This costing method helps to establish the relationship between the cost and product.  Under this system of cost allocation, sometimes it is difficult to allocate few costs such as administrative expenses. Since costs can be allocated properly in the factory area, this type of cost allocation is more suitable for the manufacturing industries.

The main advantages of activity based costing are stated below:

• Accuracy in the calculation of product cost: since the activity based costing helps allocate cost on the basis of actual usage of services, actual and real cost for a product can be calculated. There are some manufacturing industries in which overhead expenses make a huge part of the cost of the product(Noreen, 2015). It is important that cost is allocated in a proper manner. ABC helps in proper allocation and to determine the correct cost of the product manufactured.
• Helps in controlling costs: since the system of ABC established clear relationship between an activity and product, the mangers can easily identify the fixed overhead related to the activity. They can then take appropriate measures to control these costs.
• Helps in tracing activities: the method involves evaluation of consumption of each activity so that proper allocation is made. This helps the manger trace activities which are even not related to factory. Therefore, ensuring all costs is included in valuation of the product.
• Enhances decision making: since the data from ABC method is more reliable, the managers can use this data in further decision making (Seal, 2012). This helps in setting proper selling price for the product and even helps control cost as discussed above.
• Helps in capacity utilisation: the ABC approach pools up the data on costs and production. This helps the mangers understand the cost behaviour, and how maximum utilisation of the said expense can be made(Siciliano, 2015). The managers can this way put to application the unused capacity.

These were few of the advantages of ABC approach of costing. But this method has few limitations also, these have been listed below:

• Expensive and complex method for application: this system of costing requires pooling the data at one place so that they can be properly allocated (Taillard, 2013). This process of collection of data and counting the units of usage is very tiring and complex. This makes it difficult for application.
• Not suitable for small enterprises: Since ABC costing includes a lot of manual work and collection of data, this tends to become costly form small firms. Hence, it becomes impractical from application in smaller firms.
• Difficulties in measurement: the expenses which are incurred can be easily calculated. But to determine the consumption of resources by the products becomes very difficult (White, 2009). This is s tedious work and also need too much attention. Any wrong data may lead to incorrect results.
• Not very suitable for service industry: as discussed above, sometimes it becomes difficult to appropriate some costs amongst the products. Also, for service industry which does not involve any unit, division of costs and utilities amongst them becomes very difficult. ABC is not very helpful in the service industry.

Therefore, we see that that the process of activity based costing is very useful for the manufactures but it also has a few drawbacks. Companies should check there requirements and then opt of the best suitable costing technique.

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