PRODUCT COSTING
Chapter Contents:
- Some Useful Definitions
- Overview of Product Costing
- Cost Objects
- Direct Costs
- Overhead Costs
- Cost Allocation Bases
- Overhead Rates
- ZFN Apparel Company, Example of Actual Costing
Some Useful Definitions:
Cost object: A cost object is anything that we want to know the cost of. We might want to know the cost of making one unit of product, or a batch of product, or all of Tuesday’s production, in which case the cost objects are one unit of product, a batch of product, or Tuesday’s production, respectively. We might want to know the cost of operating a department or a factory, in which case the cost object is the department or factory. In a service sector company, we might want to know the cost of treating a patient in a hospital, or the cost of conducting an audit, in which case the cost object is the patient or the audit client. In a government setting, a cost object might be a program such as “Meals on Wheels.”
Product costs: A product cost is any cost that is associated with units of product for a particular purpose. Hence, the identification of product costs depends on the purpose for which it is done. For example, the factory manager is interested in manufacturing costs, whereas the merchandising manager might be interested in both manufacturing and nonmanufacturing costs, including research and development, marketing, and advertising costs.
Inventoriable costs: These are costs that are debited to inventory for either external or internal reporting purposes. For manufacturing firms, all inventoriable costs are manufacturing costs, but the reverse is not necessarily true. In other words, inventoriable costs are either the complete set or a subset of manufacturing costs, and non-manufacturing costs are never included as inventoriable costs. For merchandising firms, inventoriable cost is usually the purchase price of inventory.
Period costs: These are costs that are expensed when incurred, usually because they are not associated with the manufacture of products. Examples include advertising costs and research and development costs. Period costs are distinguished from inventoriable costs.
Direct costs and overhead costs: In relation to a given cost object, all costs are either direct costs or overhead costs. Direct costs can be traced to the cost object in an economically feasible way. Overhead costs (also called indirect costs) are associated with the cost object, but cannot be traced to the cost object in an economically feasible way. These terms apply to companies in all sectors of the economy and to all types of organizations.
Cost driver: A cost driver is any factor that affects costs. A change in the cost driver will cause a change in the total cost of a related cost object. Any one cost object almost always has numerous cost drivers. This term applies to companies in all sectors of the economy and to all types of organizations.
Cost allocation: The assignment of overhead costs to the cost object. This term applies to companies in all sectors of the economy and to all types of organizations.
Cost allocation base: A quantitative characteristic shared by multiple cost objects that is used to allocate overhead costs among the cost objects. A cost allocation base can be a financial measure (such as the raw material cost of each unit of product) or a nonfinancial measure (such as direct labor hours incurred in the manufacture of each unit of product). The simplest cost allocation base is simply the number of cost objects (e.g., the number of units produced by the factory during a period of time).
The distinction between a cost driver and a cost allocation base can be summarized as follows. A cost driver is an economic concept; it relates to the economic reality of the business. A cost allocation base is an accounting choice that is made by accountants and managers. Usually, the best choice for a cost allocation base is a cost driver.
Conversion costs: All manufacturing costs other than direct materials.
Overview of Product Costing:
Product costing follows these steps:
1. Identify the cost object;
2. Identify the direct costs associated with the cost object;
3. Identify the overhead costs;
4. Select the cost allocation base to use in assigning overhead costs to the cost object;
5. Develop the overhead rate for allocating overhead to the cost object.
The cost accounting system “builds up” the cost of product (or other cost object) by recording to a job cost sheet, a work-in-process account, or some other appropriate ledger, the direct costs that can be traced to the product, and a share of the overhead costs, which are allocated to the product by multiplying the overhead rate by the amount of the allocation base identified with the cost object.
Cost Objects:
Recall that a cost object is anything that we want to know the cost of, such as a product or service.
There is a common convention that can be confusing. We often talk about the cost object (the thing we want to know the cost of) as one unit of product, because factory managers and product managers speak in terms of unit costs. These managers want to know the unit cost for product pricing, product sourcing, and performance evaluation purposes. They do not want to talk about the cost of making 620 units, even if that is the batch size. However, in most batch processes, there would be very little benefit and enormous additional expense in determining the cost of each unit of product individually. Rather, the accounting system treats the batch as the cost object, and to derive a unit cost, we divide the cost of the batch by the number of units in the batch. Hence, loosely speaking, we talk as if a unit of product is the cost object, but more precisely, it is the batch (or the production run in an assembly-line process, or perhaps one day’s production in a continuous manufacturing process) that constitutes the cost object.
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