Know What is Product Costing and what are the factors to be considered while product costing with a practical simple example( Part 1)

 

Product costing is the process of determining the total cost involved in manufacturing a particular product. It involves identifying and quantifying all the expenses incurred in producing the product, including both direct costs (those directly attributable to the production of the product) and indirect costs (those that are not directly linked to the production process but are still necessary for the overall operation of the business).Product costing can be based on specific purpose as well. Example of product costing under different purpose may be 

1. Pricing of open Market Selling.

2. Product Mix decisions and rating of customers

3. Selling Products through Government Contracts

4. Reporting in Financial Statement

5. Market Penetration Pricing

6. Inter unit transfer

7. Valuing stock/Inventory for Insurance

8. Buy vs. Make Decision

Every purpose serves a different costing aspect. For example in Market penetration pricing management is not concerned with the fixed overhead cost allocation. They are eager to raise sale via charging only variable cost to the product making product more price competitive. In inter unit transfer relevant costing comes in picture. However these are broad concepts and we need to cover it in different blogs. For time being we are taking a simple example for calculating total product cost ignoring other purposes.   

Let's take the example of shoes to understand the factors involved in calculating product costing:

 

1.      Direct Materials: These are the raw materials that are directly used in the production of shoes, such as leather, fabric, sole materials, and accessories like laces, buckles, and zippers. The cost of each material needs to be determined based on the quantity used and their unit prices.

 

2.      Direct Labor: This includes the cost of the labor required to manufacture the shoes. It involves wages or salaries of workers directly involved in the production process, such as the cutting, stitching, and assembly of shoes.

 

3.      Overhead Costs: These are the indirect costs associated with the production process. They include expenses like factory rent, utilities, maintenance costs, depreciation of machinery, administrative expenses, and other costs that are not directly attributable to a specific shoe but are necessary for the overall production.

 

4.      Manufacturing and Operating Expenses: This includes expenses related to the manufacturing process, such as machinery and equipment maintenance, quality control, packaging, and transportation costs.

 

5.      Research and Development Costs: If the shoes are a new product or involve innovative features, research and development costs should be considered. These costs cover the expenses incurred in designing and developing the shoes.

 

6.      Marketing and Distribution Costs: These costs include expenses related to advertising, promotion, packaging design, branding, and distribution of the shoes to retail stores or customers.

 

7.      Overhead Allocation: When calculating the product costing, it is necessary to allocate the indirect costs to individual units of the product. This can be done using various methods like activity-based costing or traditional costing approaches.

 

By considering these factors and accurately calculating the costs associated with each, a comprehensive product costing analysis can be carried out. This analysis helps businesses determine the profitability of their products, set appropriate pricing strategies, and make informed decisions regarding production, cost reduction, and resource allocation.

 

 

Let’s have a practical example

1.      Direct Materials:

For manufacturing a pair of shoes, ShoeTech uses the following direct materials and their respective costs in INR:

·        Leather: ₹1,500

·        Fabric: ₹400

·        Sole materials: ₹800

·        Laces, buckles, and zippers: ₹100

 

2.      Direct Labor:

The total labor cost for manufacturing a pair of shoes is ₹1,000.

 

3.      Overhead Costs:

ShoeTech incurs various indirect costs related to production. These costs include:

 

·        Factory rent: ₹50,000 per month

·        Utilities (electricity, water, etc.): ₹10,000 per month

·        Maintenance costs: ₹5,000 per month

·        Depreciation of machinery: ₹8,000 per month

·        Administrative expenses: ₹20,000 per month

·        Manufacturing and Operating Expenses:

·        Additional expenses directly associated with the manufacturing process include:

·        Machinery and equipment maintenance: ₹2,000 per month

·        Quality control: ₹1,000 per month

·        Packaging: ₹100 per pair of shoes

·        Transportation costs: ₹10 per pair of shoes

To allocate the machinery and equipment maintenance and quality control expenses over the number of pairs produced, we need to estimate the number of pairs produced. Let's assume ShoeTech produces 1,000 pairs of shoes.

 

Now, let's calculate the cost per pair of shoes, considering the allocation of overhead costs:

 

Direct Materials:

Leather (₹1,500) + Fabric (₹400) + Sole materials (₹800) + Accessories (₹100) = ₹2,800

 

Direct Labor: ₹1,000

 

Overhead Costs Allocation per Pair:

Factory rent: ₹50,000 per month

Utilities: ₹10,000 per month

Maintenance costs: ₹5,000 per month

Depreciation of machinery: ₹8,000 per month

Administrative expenses: ₹20,000 per month

 

Total Monthly Overhead Costs = Factory rent + Utilities + Maintenance costs + Depreciation of machinery + Administrative expenses

Total Monthly Overhead Costs = ₹50,000 + ₹10,000 + ₹5,000 + ₹8,000 + ₹20,000 = ₹93,000

 

Machinery and Equipment Maintenance Allocation per Pair = Machinery and equipment maintenance / Number of pairs produced

Machinery and Equipment Maintenance Allocation per Pair = ₹2,000 / 1,000 pairs = ₹2

 

Quality Control Allocation per Pair = Quality control / Number of pairs produced

Quality Control Allocation per Pair = ₹1,000 / 1,000 pairs = ₹1

 

Manufacturing and Operating Expenses Allocation per Pair:

Machinery and equipment maintenance (₹2 per pair) + Quality control (₹1 per pair) + Packaging (₹100 per pair) + Transportation costs (₹10 per pair) = ₹113

 

Total cost per pair of shoes = Direct Materials + Direct Labor + Overhead Costs Allocation per Pair + Manufacturing and Operating Expenses Allocation per Pair

 

= ₹2,800 + ₹1,000 + ₹93 + ₹113

 

= ₹4,006

 

Therefore, the cost per pair of shoes manufactured by ShoeTech, correctly allocating the overhead costs and the expenses over the estimated number of pairs produced, is ₹4,006.

 Now let's talk about what are factors that needs to be in mind while calculating product costing

When calculating product costing, there are several factors to consider. Here are some key factors to keep in mind:

 

1.      Direct Materials: Identify and quantify the costs of the raw materials directly used in the production of the product.

 

2.      Direct Labor: Determine the labor costs associated with the production process, including wages, benefits, and any additional labor-related expenses.

 

3.      Overhead Costs: Consider all indirect costs associated with the production process, such as factory rent, utilities, maintenance, depreciation, administrative expenses, and other overheads.

 

4.      Manufacturing and Operating Expenses: Account for additional expenses directly related to manufacturing, including machinery maintenance, quality control, packaging, and transportation costs.

 

5.      Research and Development Costs: Include any costs incurred for research, development, and innovation of the product.

 

6.      Marketing and Distribution Costs: Take into account expenses related to marketing, advertising, packaging design, branding, and distribution of the product.

 

7.      Volume and Scale: Consider the production volume and scale of operations, as costs may vary depending on the quantity produced.

 

8.      Cost Allocation Methods: Determine the most appropriate method for allocating overhead costs to the product, such as traditional costing, activity-based costing, or other suitable approaches.

 

9.      Costing Period: Ensure that the costs are allocated correctly for the specific period under consideration.

 

When calculating product costing, it's essential to be aware of potential errors that cost accountants may make. Here are a few common errors to watch out for:

 

1.      Incorrect Cost Classification: Misclassifying costs as direct or indirect, leading to inaccurate allocation and incorrect product costing.

 

2.      Incomplete Cost Consideration: Overlooking certain costs or not considering all the relevant factors that contribute to the overall cost of production.

 

3.      Overlooking Cost Drivers: Failing to identify the key cost drivers that influence the cost of production, resulting in inaccurate cost allocation.

 

4.      Over- or Under-Absorption of Overhead Costs: Improper allocation of overhead costs can lead to distorted product costs, affecting pricing decisions and profitability analysis.

 

5.      Inaccurate Volume Assumptions: Using incorrect or outdated volume assumptions can lead to inaccurate cost per unit calculations.

 

6.      Failure to Update Cost Data: Not updating cost data regularly can result in outdated and inaccurate product costing information.

 

7.      Ignoring Variable and Fixed Costs: Neglecting to distinguish between variable costs (those that vary with production volume) and fixed costs (those that remain constant regardless of volume), leading to inaccurate cost analysis.

 

8.      Lack of Standardization: Failing to establish standardized cost calculation methods and consistently applying them across products, resulting in inconsistent and unreliable product costing.

 

To ensure accurate product costing, it's important to carefully review the calculations, consider all relevant costs, update cost data regularly, and implement appropriate cost allocation methods while avoiding the common errors outlined above.