Product costing is defined as the process that is responsible for the assigning of costs to production and inventory based on the expenses that a company incurs in the purchase and production of the inventory. The process is essential to manufacturers and there are different methods that can be used for costing. Process costing is used because of the benefits that are associated with the system. The benefits include:
Accuracy is the efficiency with which a business can be able to track all expenses that are incurred by a business. There are different costs that are incurred before a product becomes a complete product. In most business settings, companies suffer loss because of underpricing, or under costing. If the costs are undervalued, then the company will set a margin that will be aimed at covering the underestimated costs. In that case, the company will suffer loss and that will be a cause of failure to a business (Eldenburg, 2004). In the same case, if a business undervalues its costs, then they will set a relatively lower price causing a reduction in the revenue of the business. That implies that a business has to come up with a system that will ensure that costing is done in an accurate manner to ensure such irregularities in the operations of a business.
The use of a product costing system will increase the accuracy that is associated with variable costing methods. Under variable costing, the costs of a product that are incorporated in the final price are the variable costs only and the fixed costs are apportioned to various expense accounts. The use of a product costing method will ensure that there is matching of costs and revenue and that creates value for the business operations.
Product costing involves the division of the product based on its level of completion. There are raw materials that advance to work in progress then the final complete product. A company will be able to assign costs to the various stages that are found in the project and hence help the company in making various decisions. The decisions will be on budgeting, and how to cut on costs on various stages. A business will be able to determine the stage in the business operations whereby the processes can be innovated to ensure that there is cost reduction or incremental efficiency in the operations. The use of a product costing system ensures that the costs of a business are tracked efficiently and the analysis of cash flows done. This will help in determining the level of success of a project. The use of costing methods helps in the separation of the broad company cost to different departments and teams and that leads to incremental accuracy in business operations.
Decisions that are made in a business are meant to increase the return that the shareholders get form the business operations. In that case, a company should have the correct information that will enable the managers involved to make the correct business decisions. Managers have to make the pricing decision and at the same time make a decision on the return that should be awarded to the shareholders of the company. In that case, the management will have to rely on information that they get from the costs of the business. The costs are essential in setting prices and at the end determining the revenue that will be received by the company. The product costing system will be influential in helping the company to arise at the accurate costs that will be used in decision-making.
The issue of project development refers to the creation of new products. When designing new products, a company should determine the costs that would accrue with the new costs. In that case, a company should be able to plan on ways of cutting costs and determine the anticipated costs. A product costing system helps in allocation of costs to revenues and that will help management in making a decisions as to whether they should develop a new product or they should remain with their old products.
The cost of good manufactured (COGM) comprise of all the expenses that are incurred in the production process. The costs incurred in the factory are assumed to be for the production process. In that case, any depreciation to factory equipment is recorded as a COGM. The COGM comprise of the opening WIP, direct labor, direct materials, factory overheads, and the closing WIP are deducted from the total. The factory overheads include the costs that are incurred in the factory including depreciation. The costs are not directly connected to the materials that are used in the production process but they are indirectly used in the production process. Below is the COGM schedule for New Age Canvas Company:
|Cost of goods manufactured schedule|
|Less ending WIP||(33,500.00)|
|Cost of goods manufactured||373,500.00|
The cost of goods sold (COGS) comprise of the total cost of the finished goods that ate taken from the production process. The cost includes the opening finished goods cost, the cost of goods that are manufacture and the closing finished goods amount is deducted from the total. The costs of goods manufactured are assumed competed goods and are transferred to the finished goods category for selling. The COGS schedule for New Age Canvas Company is as below:
|Cost of goods sold schedule|
|Beginning balance of finished goods||11,000.00|
|cost of goods manufactured||383,500.00|
|less closing finished goods||(16,000.00)|
|Cost of goods sold||378,500.00|
Items not involved in the calculation
In a manufacturing set up, there are direct costs and administrative cost. The direct costs are the costs that are directly associated with the operations of the company while the administrative costs are the supporting costs that are incurred by a company in the course of its production process. In that case, administrative salaries are not included in any of the above schedules. The administrative costs are deducted from the gross profit of the company. A company usually adds a market to its cost so that it can cater for such expenses. The company in catering for the needs of the support employees who include finance department, and people in management incurs the administrative salaries.
The advertising cost is also a supporting cost in any manufacturing set up. The cost is incurred in selling the brand of the company. Advertising costs are crucial in a business set up because they are the only costs that bring revenue to a business in terms of sales. The depreciation of the office equipment is also not included in the above schedules. The office equipment is assumed to be used for administrative roles and not directly involved in the manufacturing process of the company products. The indirect labor costs are also not included in the schedule. A company can incur various labor costs but not all are apportioned to the production process.
The production process caters for the costs that are incurred directly by the company hence the reason for leaving the costs in the calculations. Sales salaries are costs that are incurred in the selling prices and not in production of goods. The cost is incidental to the production process hence used when calculating the total costs of the company. The travel and entertainment costs of the company are also incurred in the selling process and not involved in the production process.
In the production process, the cost account has to prepare financial accounts that will help in the costing process. In the process of preparing the financial accounts, various ledger items are included. In the case of New age Canvas in April, the below accounts were prepared:
|Opening overheads||4500||Transferred goods||489000|
|Cost of goods sold|
|Cost of goods manufactured||489000|
The over or under absorbed overheads are determined by comparing the actual overheads and the budgeted overheads. New age canvas has a policy of absorbing 1,800,000 in overheads. The costs are allocated on an equal basis over the year. That implies that the budgeted overhead for April was 150,000. However, the labor costs that were incurred in that month were equal to 182,000. That is an indication that the company had under absorbed by 32,000. This is an under absorption because the actual overheads are more than the budgeted overheads. That means that the company’s costing system is not accurate and that will cut on the company profits.
Budgeted overheads= 1800,000 per year
Per month =1,800,000/12= 150,000
In April = (5200*35) = 182,500
Under absorbed overheads= 182,000- 150,000= 32,000
In an instance whereby a company makes use of standard costing, there are standard costs that are derived from the overhead costs of the company operations. The costs have to be reflected in the books of account of the company. The costs are allocated to cost objects (Hitt, 2005).The cost objects in most situations are usually the finished products of a company. There are costs that cannot be directly be attached to a certain item or cost. That means that the costs have to be absorbed in cost objects. Over or under absorbing occurs when the standard cost is either more or lower than the absorbed cost. In the case of under absorbing, then the actual overheads are more than the budgeted costs. The difference is expenses in the financial stamenst of the company as opposed to showing it as a cost of production. The profit of the stated accounting period will reduce. The expenses that are absorbed in the cost of production are used in setting the selling price. In that case, the company will be able to factor all the operation costs other than costs incurred for administration. That implies that under absorption reduces the profit levels of a company.
Over absorbing occurs when the overhead costs are less than the budgeted costs. That implies that there were more costs that were apportioned to the cost objects of the company as should have been the case. The profit levels of a company will increase in such an instance. Several situations lead to over or under absorption of costs. The factors include the incurred overhead not been the same as the expected costs. Usually a budget is set for the production costs. The budget usually sets aside different costs for the various cost objects of a company. If the budgeting was not done in accurate manner, then there will be either over or under absorption (Rasmussen, 2004).
Over or under absorbing will also happen when the overhead cost that is applied is different from the expected amount. This occurs when the budgeted cost objects such as labor hours or machine hours are not as expected. For any task, there is an allocated resource base. If the costs do not tally as the earlier projected, then there will be over or under absorbing. The other cause of difference in absorption will be caused by timing differences. The planned costs must be apportioned in the expected period as opposed to pushing forward the costs. The timing differences will lead to differences for costs that are absorbed in the final product. An error in allocation will also happen when the basis that was used in the allocation was wrong. That means that there has to be an accurate costing system that will ensure that all costs are as expected.
The issue of over or under costing cannot be totally be avoided in a business setting irrespective of the systems that are put in place. The over or under absorbed costs have to be dealt with to ensure that the issue is solved. The difference in the absorbed cost can be charged as cost of goods or applied to the different cost objects. The charging of the difference to the cost of goods is done easily but it is usually associated with inconsistency and inaccuracy. To totally avoid such issues, the just in time costing system should be used in a company. This is because the inventory that is held by a company will be less and the costs will be precisely allocated and that will be advantageous to all stakeholders in the organization.
In the above scenario at New age canvas company, the company under absorbed its overheads by 32,000. That shows that the company will have a reduction in its profits by the 32,000. This is because the amount that was not apportioned will be listed under expenses category in the financial stamenst of the company and that will be deducted from the gross profit of the company.
Activity based costing (ABC) is a method in costing that is essential in identifying various activities in an organization and assigning costs to the activities. The indirect costs are assigned to activities and the resources of all services and products based on level of consumption. Compared to traditional costing methods, the ABC method is associated with assigning costs that are more indirect to direct costs. The approach is able to monitor the various activities that are involved in the consumption of company resources.
New age Caravans should be able to make use of ABC system. The company should take up the system because of the advantages that are associated with this costing method. The advantages include the ability of New Age Canvas Company been able to estimate the costs that are associated with crucial company services. That means that the various products that are produced in the company will be priced accurately. The method will help in identifying any products that do not yield to profits to the company and the management can make a decision as to drop or retain the product.
The other factor that the company should determine when using ABC will be the fact that it makes use of a pricing system that is scientific and it makes it easier for the company to cut on costs. The company will also be able to provide t pip services to its existing services and that will help in the elimination of any product lines that are not adding value to the operations of the company. The method is able to determine the cause of waste in company operations. That means that with time the wastes that are associated with a company will be reduced or totally eradicated.
From the above calculations for the costing done by new age canvas for April, the company undervalued its overheads and that led to a decline its expected profits. If the company were using ABC method, there would be a more accurate outcome in the calculations and allocations. ABC method is now widely used but it has its shortfalls.
One of the shortfall that is associated with the method is the fact that it is associated with a high initial capital (Horngren, 2005). The system is expensive to put in place and it involved an additional cost of training employees. That implies that companies that do not have a good cash flow will opt to use the traditional costing methods that are vulnerable to errors.
The other shortfall of the method is that the figures that are given the system require a person who has knowledge on finance and hence not all people can understand the figure issued. That means that a company would have to incur an incremental cost of staff training of the hiring of a knowledgeable person who will help the organization in the costing system.
The costs of a company are determinants of the profit level of a company and other factors. The costs will determine if a company should change its assets of drop a product line. The system that is used in costing should be effective enough to offer the management with solutions to any problems that they may be having. In that case, new age canvas should consider shifting from the traditional costing method to the ABC system. The costs will be high at first but the company will enjoy the benefits that come with the system.
Eldenburg, L. (2004). Cost Management: Measuring, Monitoring, and Motivating Performance. John Wiley & Sons.
Hitt, M. (2005). Management. Prentice Hall.
Horngren, C. (2005). Introduction to Management Accounting. Prentice Hall.
Rasmussen, N. (2004). Budgeting: Technology, Trends, Software Selections, and Implementation. John Wiley & Sons.