Cost Measurement

Product costing is the process of tracking and studying all the various costs that are incurred by the firm on its products or we can say what it costs to make the product. To determine the total cost of a product you need to calculate both the direct and indirect costs. The total cost is the sum of all costs associated with a particular unit or process or department or batch. It comprises of cost of production, selling and distribution expenses. It is also called cost of sales.Product costs are traceable to the product and include direct material, direct labour and overheads. As already mentioned that for the purpose of formulating various strategies and policy matters, the total cost of the product must be ascertained. This means allocating the direct materials cost, direct labour cost, other direct expenses and allocation / apportionment of burden of manufacturing overheads, Office overheads and Selling and Distribution overheads to the product.

How product costing is accomplished in any manufacturing unit becomes easy if we understand what types of departments do we generally have in any organization. In a manufacturing concern there are generally two types of departments

i) Production Departments and
ii) Service Departments.

A production department is one that is engaged in the actual manufacture of the product by changing the shape, form or nature of material worked upon or by assembling the parts into finished product.. In a dairy plant or dairy factory, the departments which are manufacturing ghee, butter, ice cream, flavoured milk,lassi, milk of different grades like skim milk, double toned milk, toned milk,
standardized milk, full cream milk are production departments A service department, on the other hand, is one, which is rendering a service to production departments. It contributes in an indirect manner to the manufacture of the product but it does not itself change the shape, form or nature of material that is converted into the finished product. To process milk or make butter and other dairy products we require steam, chilled water, refrigeration system,maintenance of machinery and equipments. The departments, which are providing these services, are known as service departments. Service departments provide services to production departments and some service departments in addition to it also provide services to other service departments.

Assignment of Direct Costs to Departments and Products

The direct costs of accomplishing an activity or producing or distributing a product generally are routinely charged to that activity or product by the company’s accounting system. For example, direct labour would be charged to a product if only single product is produced. However if more products are manufactured in a department, the time spent in manufacturing a particular product and its quantity produced is ascertained to work out direct labour cost. The process of estimating direct labour cost becomes easy if time cards for doing the job or activity are kept in the department. If no records of this type are maintained, time studies can be conducted and used to determine the average time that a unit or sub unit takes to process the product. Direct material costs also may be routinely charged to products.Where a department processes only one product, the average product direct cost can be determined by dividing the total amount of direct cost of the department by the number of units produced (adjusted for work- in- process)

Allocation and Apportionment of Overhead (Primary Distribution)

The major problem arises when we are to decide how overheads ought to be allocated or apportioned among products in a multi-product firm or when joint products are produced what method should be adopted? This necessity arises as we are to consider the indirect costs’ share that should go to the product in its manufacturing. In addition there is the problem of joint costs involved in some
processes. How to account for such costs are some of the other relevant points.The theory of cost accounting suggests that the basis of the apportionment of overheads to the cost center should be on equitable basis. The procedure adopted for the distribution of overheads involves the following steps.

(i) Classification and collection of overhead.

(ii) Allocation and apportionment of overhead to production departments and service

(iii) Re-apportionment of service department costs to production departments.

(iv) Absorption of overhead of each production department in cost units.

(i) Classification and Collection of Overhead

overheads need to be collected from various sources like i)Invoice ii)Stores requisitions iii)Wages Analysis Sheet and iv)Journal entries and classifying them where they are occurring.

(ii) Allocation and Apportionment of Overhead (Primary Distribution)

There are certain expenses which can be allocated directly to different departments or cost centers or products since these costs can easily be identified and allocated to a cost centers. But some expenses cannot be allocated to a particular department. Such expenses require division and apportionment over two or more cost centers or cost units.Different products pass through a number of departments and receive benefits from them in varying degrees. A Product must bear an equitable portion of expenses relating to it. These expenses might have been incurred in various production and service departments. The process of assigning the expenses to departments is known as departmentalisation.

Principles of Apportionment

Apportionment of overhead to various production and service departments is based on the following principles:

1. Service or use. This is the most common principle of apportionment of overhead costs. It is based on the theory that greater the amount of service or benefit received by a department/product, the larger should be the share of the cost to be borne by that department/ product.

2. Survey method. This method is used for those overhead costs that are not directly related to departments and survey may be conducted to find out the share of overheads to the cost centre.

3. Ability-to-pay method. This is based on canon of taxation, which holds that those who have the largest income should bear the highest proportion of the tax burden.

(iii) Re-apportionment of Service Department Costs to Production Departments

Not all items of the factory overhead are amenable to direct allocation. While some items can wholly be allocated to specific departments of cost centers, there are certain expenses, which need to be apportioned amongst different departments on an equitable basis. Costs of service cost centers (Service departments) are apportioned to productive cost-centers (Production departments) on equitable basis The effort related transfer price method assigns service costs to a department or product according to the amount of effort incurred.

Bases of Apportionment

The following bases are most commonly employed for apportioning items of overheads expenses among production/service departments.

(iv) Absorption of Overheads of Each Production Department in cost Units.Absorption is the allotment of overhead to cost units, may be a product, or process or an activity. It is the charging of overhead to individual product or units.The amount of overhead allocated and apportioned to the production department is to be borne by all cost units pertaining to that department. This is known as overhead absorption. Terms such as ‘recovery’, ‘application’ are also used. For the purpose of absorption of overhead to individual jobs, process or products,overhead absorption rates are applied. The term ‘overhead rate’ refers to the rate at which the overheads are to be charged to different cost units. It may be in the form of a percentage or a rate per unit.It may be based on actual cost or on the basis of estimated cost. or a pre-determined overhead rate or a blanket overhead rate for the entire factory. The blanket rate is computed as follows

Blanket rate = (Total overheads for the factory)/Base for the factory

Blanket overhead rate should not be used except when output is uniform.Otherwise it will result in over-costing or under-costing of certain cost units.Multiple Rates also may be applied for each department, cost center etc. For instance, separate rates may be calculated for each of the these Production department, Service department, cost center , product, fixed overhead and variable overhead.

The following formula is used to calculate the multiple rates:

Overhead rate = (Overhead of department or cos t center)/Corresponding base

A good absorption rate possesses the following characteristics

1. It is convenient to use and involves minimum of paper work

2. It should be according to the nature of the product.

3. It is stable so that comparisons can be made and also be flexible enough to take note of changing conditions

4. It does not bring much difference between recovered overheads and actual overheads

Methods Of Absorption of Manufacturing Overhead

There are various methods of absorbing manufacturing overhead. These methods have their own merits and demerits.

The more common of these are:

1. Percentage of direct materials cost.

2. Percentage of direct labour cost.

3. Percentage of prime cost.

4. Direct labour hour rate.

5. Machine hour rate.

6. Combined machine hour and labour hour rate.

(i) Percentage of Direct Materials Cost:

In this method the cost of direct materials used in the manufacture of a product is used as the base in absorption of factory overheads. The overhead rate is calculated on the basis of the following formula:

Overhead rate = ((Factory overheads)/(Direct material cos t))× 100

(ii) Percentage of Direct Labour Cost:
In this method, overheads are charged as a percentage of the direct wages incurred on jobs. The formula for computing the percentage is as under:

Overhead rate =(Factory overheads)/(Direct wages or labour cost))× 100

For example, when factory overheads are Rs.200000 and Direct Labour Cost is Rs.100000

The percentage overhead rate = ((1000000)/(200000))× 100 = 20%

(iii) Percentage of Prime Cost:

Here direct material cost, direct labour cost and other direct expenses,being all the constituents of prime cost are taken for calculation of the percentage.

The formula is:

Percentage on prime cost =((Factory overheads/Pr ime cost))× 100

For example if factory overheads amount to Rs.200000 and the prime cost is Rs.2000000,

Prime cost percentage comes to =(200000/2000000)× 100 = 10%

(iv) Direct Labour Hour Rate

In this method, the overheads are charged to production on the basis of number of labour hours spent on every job. The formula is

Direct labour hour rate = (Factory overheads/Direct labour hours used for the period)

Thus if total manufacturing overheads for a period are Rs.400000 and number of direct labour hours is 10000, then the labour hour rate works out to be Rs.4/- (400000/10000=Rs4/-). If a job takes 50 hours, then overheads applied will be 50 ́4=Rs.200/-

(v) Machine Hour Rate. It is the cost of running a machine per hour

Machine hour rate =(Factoryoverheads/ Machinehours duringa given period)×100

(vi) Combined Machine Hour and Direct Labour Hour Rate

A combination of machine hour rate and direct labour rate (called as dual hour rate) could also be used in those departments where work is done both manually and on the machine.

Joint Costs: In dairy industry or a dairy factory joint products and by products are obtained from the same raw material. In such cases Joint Costs of facilities or services employed in the output of two or more simultaneously produced commodities are involved . These Joint Costs are Common Costs till the point of split off when joint products and by products are obtained. The methods of apportionment of Joint Costs are based on the following bases

(i) Market Value Bases: under this method joint cost allocations are made on the basis of sale prices of the products provided the products can readily be sold in the markets without further processing. However, if further processing is required to bring the product into saleable form, value additions during further processing are to be assessed and deducted from the sale value to arrive at the basis for the apportionment of joint cost among the products.

(ii) Physical Unit Bases: under this method the joint costs are allocated to individual products on some physical basis, viz weight, volume, or some other common unit used to measure output.

Methods of Absorption of Administrative Overheads
In comparison to production overheads, administrative overheads relatively constitute a small portion of the total cost. There is a popular view that these overheads should not be treated as part of the cost of production because these are the period costs and should be debited to the Cost of Sales Account wholly.The other viewpoint is that it should be apportioned between production and sales departments. In such a case administrative overheads get merged with production and selling and distribution overheads. For the purpose of absorption of these overheads a single overhead rate is computed by any of the following methods

1. Percentage of Works Cost: Administration overhead is generally absorbed as a percentage of works cost. It is computed as follows

Overhead rate =(Admn. Overhead/Works Cost)× 100

2. Percentage of Sales: In this method, Administration overheads are absorbed as a percentage of sales which can be worked out as under

Overhead rate =(Admn Overhead/Sales)×100

3. As a percentage of Conversion cost: This method is not common and is rarely used

Overhead rate = (Admn. Overhead/Conversion cos t )× 100

Methods of Absorption of Selling and Distribution Overhead 

Selling and Distribution overheads may be allocated directly where they can be  identified with specific products. Where they cannot be identified with particular products, they have to be apportioned on some suitable basis, which may be one of the following.

1. Rate per article: Under this method, the total costs are estimated and are divided by the quantity of sales. It gives the rate per article.
Rate per article =(Total sellingand distributi costs/Numberof units sold)

2. A Percentage on Sales: In this method on the basis of the previous year’sfigures, a percentage of selling and distribution overhead to the total sales is calculated and the same rate is applied to recover the overheads from the selling price.

3. A Percentage of Works Cost: A percentage of selling and distribution overheads to works cost is arrived at from past records. This percentage rate is applied for the absorption of selling and distribution overheads

Overhead rate =(Selling and distributi on overheads/Works Cost)× 100

An improvement in cost measurement has been made by introduction of Activity-Based Costing (ABC). It is generally used as a tool for planning and control.

ABC is an approach to solve the problems of traditional cost management systems.Traditionally cost accountants had arbitrarily added a broad percentage on to the direct costs to allow for the indirect costs. Direct labour and materials are relatively easy to trace directly to products, but it is more difficult to directly allocate indirect costs to products However as the percentages of overhead costs has risen, this technique became increasingly inaccurate because the indirect costs were not caused equally by all the products.

As a result these traditional costing systems are often unable to determine accurately the actual costs of production and the costs of related services. Consequently managers were making decisions based on inaccurate data especially where there are multiple products.
Activity-Based Costing (ABC) is a method allocating costs to products and services on more scientific basis. Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause and effect relationships to objectively assign costs. Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity. In this way ABC often identifies areas of high overhead costs per unit and so directs attention to finding ways to reduce the costs or to charge more for costly products.

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