How to Deal with Product Costing


Product costing is needed at the time of producing goods or services, the calculation of product costing will be used as the basic information and to find out the cost of production or cost of goods manufactured. Improper of product costing will effect on  cost of goods sold, selling price and failure in business competition. To avoid these errors we need to understand how to deal with product costing and what the elements of product costing are that we should understand.

Direct materials 

Direct materials are those materials that are traceable to the goods or services being produced. By using physical observation on all of materials can be directly charged to products and the quantity consumed by each product can be measured. Some several kinds of direct materials such as steel in automobile industry, wood in furniture, anesthesia for an surgery operation, food on an airline, etc.

Direct materials that form an “ insignificant part of the final product “ are lumped into overhead category as INDIRECT MATERIAL because the cost of tracing is greater than the benefit of increased accuracy. The glue used in furniture industry or toys is an example of indirect material.

Direct labor

Direct labor is the labor that is traceable to the goods or services being produced. Physical observation can be used to measure the quantity of labor used to produce a product or service. Employees who convert raw materials into a product or who provide a service to customer are classified as direct labor. Some examples of direct labor such as workers on assembly line at a plant, a chef in a restaurant, a pilot, etc.

The cost of overtime for direct labor is assigned to overhead category as INDIRECT MANUFACTURING COST because no particular production run can be identified as the cause of the overtime. For example if workers are paid at regular rate $50 and $25 for overtime, then only $25 overtime is assigned to overhead. The $50 still regarded as a direct labor cost. However if a special order is taken when production is at 100% capacity, in these cases it is appropriate to treat overtime as a direct labor cost.

Overhead

All about production costs other than direct materials and direct labor called overhead. Overhead is also known as factory burden or manufacturing overhead. It contains a wide variety of items. There are many inputs other than direct material and direct labor are needed to produce products or services. Samples of overhead costs such as depreciation on building and equipment, maintenance costs, supplies, supervision, material handling, power, etc.

Those materials necessary for production that do not become part of the finished product or which do not used in providing a service, called “ Supplies “. Dishwasher detergent in a fast food restaurant and oil for production equipment are examples of supplies.

Other than direct materials, direct labor and overhead ; Selling or marketing costs and administrative costs are categories of non production costs. They are noninventoriable or period costs because selling or marketing costs and administrative costs are expensed in the period in which they are incurred. None of these costs can be assigned to products or appear as part of inventories on the balance sheet.

In a manufacturing organization, these costs can be significant because these costs often run greater than 25% of sales revenue. Controlling on these costs may bring greater cost savings results than the same effort exercised in controlling production costs.

Salaries and commissions of sales personnel, advertising, warehousing, shipping or freight out, customer service, royalties paid and rent are examples of selling or marketing costs.

Administrative costs are costs that cannot be reasonably assigned to either marketing or production. Top executive salaries, office salaries, loss from bad debts, legal fees, printing and annual report, general accounting, R&D with designing and developing of the new products, are examples of administrative costs.

Another term used in product costing is the Prime cost and Conversion cost. Prime cost is the sum of direct materials cost and direct labor cost while conversion cost is the sum of direct labor cost and overhead cost. For a manufacturing firm, conversion cost can be interpreted as the cost of converting raw materials into a final product. To meet external reporting requirements, costs must be classified according to its function. In preparing an income statement production costs, selling and administrative costs are viewed as period costs. Thus, production costs attached to the products sold are recognized as an expense called “ COST OF SALES “ on the income statement.

Production costs that are attached to products that are not sold are reported as inventory on the balace sheet. Selling and administrative expenses as costs of the period must be deducted as expenses and not appear on the balance sheet.

Income stament of a manufacturing company

After reading those information element of production costs, we have to prepare an income statement for a manufacturing company on end of each year as steps below

Step 1

Beginning inventory of Direct materials add with Purchases of direct materials to get Direct materials available for use.

Diret materials available for use deducted with Ending inventory of direct materials to get Direct materials used.

Step 2

Direct labor.

Step 3

The sum of Manufacturing overhead or Factory overhead ; Such as indirect labor, power and light, heat, insurance, tool expenses, supplies, machine and factory building depreciation, rent, utilities, property taxes, repairs and maintenance, etc

Step 4

Get a Total manufacturing cost by summing Direct materials used in step 1 with Direct labor in step 2 plus the sum of Manufacturing overhead or Factory overhead in step 3

Step 5

Total manufacturing costs as result of step 4 plus Beginning inventory of work in process, then deducted with Ending inventory of work in process to find the Cost of goods manufactured

Step 6

The Cost of goods manufactured in step 5 plus Beginning inventory of finished goods to find Cost of goods available for sale

Step 7 

Deducted the Cost of goods available for sale in step 6 with Ending inventory of finished goods to find Cost of goods sold

Step 8

To find Gross profit, deducted Sales with Cost of goods sold in step 7

Step 9

To know Net income before taxes, deducted Gross profit in step 8 with the sum of Operating expenses. Operating expenses consist of marketing expenses and administrative expenses.

Income statement of a service organization

An income statement for a service firm is computed differently with a manufactured firm. In a service organization, there are no beginning or ending finished goods inventories. The service firm has no finished goods inventories because it is not possible to store services. However it is still possible to have work in process for services, for example an architect may have drawing in process. Cost of services sold in a service organization would correspond to Cost of goods manufactured in a manufacturing company. Cost of services sold in a service organization consist of

* Direct materials plus direct labor and overhead or manufacturing overhead

* Add: Beginning of work in process

* Less: Ending of work in process

 To find Gross profit, deducted Sales with Cost of services sold

To know Net income before taxes, deducted Gross profit with the sum of Operating expenses. Operating expenses consist of marketing expenses and administrative expenses.

An income statement provides information on how sales are generated, gross profit and net income before taxes. Through the income statement, we may know how much the cost of goods manufactured, cost of goods sold and operating expenses. All information submitted by the income statement can be used as a basis to determine what corrective action should be undertaken by management because there are direct materials, direct labor and overhead component as a determinant of total manufacturing costs.

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