Systems and methods of product costing

THEME 6. Systems and methods of product costing 
 
 

4.1 Product costing and its systems.

4.2 The process of product costing.

4.3 Allocating indirect costs.

4.3.1 Primary allocation of indirect costs to analysis centers.

4.3.2 Secondary allocating of indirect costs to products.

4.4 Calculating a predetermined overhead rate. 

4.1 Product costing and its systems  

      Product costing is a tool for planning costs and establishing prices for materials. It is used to calculate the costs of goods manufactured and the costs of goods sold for each product unit.

      Product costing is a process of identifying the cost of a specific cost object. A cost object is a product, an operation, a responsibility center, a service for which a separate cost measurement and management is required.

      The two most important product costing systems are job-order costing and process costing.

      In job order costing, costs are accumulated by jobs, orders, contracts, or lots. The key is that the work is done to the customer's specifications. As a result, each job tends to be different. For example, job order costing is used for construction projects, government contracts, shipbuilding, automobile repair, job printing, textbooks, toys, wood furniture, office machines, caskets, machine tools, and luggage.

      So, job-order costing is used when:

• Many different products are produced each period.
• Products are manufactured to order.
• The unique nature of each order requires tracing or allocating costs to each job, and maintaining cost records for each job.

      In process costing, costs are accumulated by departments, operations, or processes. Unit costs are then computed on an average basis. The work performed on each unit is standardized, or uniform where a continuous mass production or assembly operation is involved. Industries that use process costing systems are for example: chemical processing, oil refining, pharmaceuticals, plastics, brick and tile manufacturing, semiconductor chips, beverages and breakfast cereals.

      So, process costing is used when:

• A company produces many units of a single product.
• One unit of product is indistinguishable from other units of product.
• The identical nature of each unit of product enables assigning the same average cost per unit.

      The difference between job costing and process costing is the extent of averaging used to compute unit costs of product and services. The cost object in job costing is a job that constitutes a distinctly identifiable product or service. The quantity of manufacturing resources is different in any job. It would be incorrect to cost each job at the same average manufacturing cost. So, when like or similar units are mass produced, process costing averages manufacturing costs over all units produced. 

      4.2 The process of product costing

      The process of product costing involves six broad steps (Exhibit 4.1).

      The first step is aimed at selecting a cost object. Let's remember that the cost object is a product, an operation, a responsibility center, a service for which separate cost measurement and management is required. The identifying of the cost object depends on the product costing objective. For the purposes of price setting and internal reporting, cost objects are products (goods, services). For evaluating the performance of managers as well as planning and control, cost objects are divisions, geographical regions, etc. 
 
 
 

 
 
 
 
 
 
 
 

  
 

 

     Exhibit 4.1 - Steps to calculate the product cost 

     The second step implies the selection of job-order costing or process costing and establishing a cost accounting system taking into account the following factors:

• Organization and production factors such as: the state of the market, the sphere of activity, forms of specialization, production type, organization structure.
• Accounting and organization factors such as: inventory accounting methods (LIFO, FIFO or weighted average), an accepted cost accounting method, etc.
• Technological aspects. 

      The third step is connected with splitting manufacturing costs to direct and  indirect costs.

      The fourth step assumes tracing direct costs to specific products. The calculation is carried out by multiplying actual costs items by their purchasing price. 

     The fifth step is connected with allocating indirect costs to specific products. Exhibit 4.2 shows us the process of allocating direct and indirect costs to products.

  

 
 
 
 
 

  
 
 

Exhibit 4.2 - The process of product costing 

      Before allocating indirect costs to products, it is necessary to trace and allocate them to analysis centers and only then to the product cost. An analysis center is an analytical accounting object which accumulates overhead costs before their assigning to products.  Analysis centers must correspond to a company's responsibility centers structure.

      There are two types of analysis centers:

1. Structural analysis centers. Their activity cannot be expressed in physical terms, their costs are measured in monetary terms (e.g. marketing, administration, human resources, etc.). The costs of these centers are regarded as period costs and not allocated to the product cost.
2. Operational analysis centers
1. Basic operational analysis centers. They correspond to basic manufacturing shops as they are called in Russian terminology (in foreign sources this type of analysis centers are called manufacturing departments). They are assembly, mechanical departments etc. Costs of these analysis centers are directly allocated to  products produced at these departments.
2. Supporting operational analysis centers (in foreign sources this type of analysis centers are called service departments) which activity is aimed at supporting the activity of manufacturing centers, (e.g. transport center, equipment maintenance, instrumental department, energetic department etc.). The costs of supporting operational analysis centers cannot be directly allocated to the product cost. Their costs are allocated to basic operational analysis centers and become the part of costs of basic operational analysis centers which are apportioned later to the product cost.

     Thus, the process of allocating indirect costs to products consists of the following two stages (Exhibit 4.3): 

1. Primary assigning indirect costs to basic operational analysis centers.
2. Secondary assigning own and allocated indirect costs of basic operational analysis centers to products.

 

4.3 Allocating indirect costs.

   4.3.1 Primary allocation of indirect costs to basic operational analysis centers.  

     At the first step the allocation of indirect costs is carried out in the following way. Costs which are directly related to analysis centers but indirect to products and services may be traced (included) to all the types of analysis centers (e.g. staff costs are included on the basis of payroll sheets; materials costs – on the basis of invoices; gas, water and electricity – according to meter measurements). The costs of supporting operational and structural analysis centers may be allocated among each other in case of rendering mutual services. Later the costs of supporting operational analysis centers are assigned to basic operational centers according to the chosen allocation base (Table 4.1). Allocation base is the measure of activity such as direct labor-hours or machine-hours that is used to assign costs to cost objects. The costs of structural analysis centers are regarded as period costs and that is why they are not apportioned to basic operational centers.  

   Table 4.1 - Examples of allocation bases

 

     There are 4 methods of primary allocation of indirect costs:

• Direct method
• Step-down method

• Reciprocal method

• Interaction allocation method

     In this lecture we will study the first three methods.  

     Example:

     Virginia Inc. has two manufacturing departments (Mechanical and Assembly) and three service departments (Maintenance, Warehouse and Transport). Basic information about these departments’ activities is given in Table 4.2. 

     Table 4.2 - Initial information for allocating costs of service departments

 

     Using the above data services of service departments may be allocated in the following way.  

     Table 4.3 - Allocating services of service departments

 

     The Direct Method

     The direct method is the most widely-used method. This method allocates each service department total costs directly to the production departments, and ignores the fact that service departments may also provide services to other service departments.

     Table 4.4 - Direct allocation of costs of service departments

 

     The costs of the Transport department are to be allocated as follows: 30/80 of costs are apportioned to the Mechanical Department and 50/80 - to the Assembly Department. Such proportion may be explained by the fact that 80% of total costs of the Transport is apportioned to departments, in particular 30% is allocated to the Mechanical Department and 50%- to the Assembly Department.

Maintenance Department costs should be allocated in the same way.

     The Step-Down Method

     Unlike the direct method, the step method provides for allocation of a service department's costs to other service departments, as well as to operating departments.The step method is sequential. The sequence typically begins with the department that provides the greatest amount of service to other service departments. After its costs have been allocated, the process continues, step by step, ending with the department that provides the least amount of services to other service departments. 

     Table 4.5 - Allocation of costs of service departments