Product Costing Methods: Strengths and Weaknesses

Today’s competitive environment requires manufacturers to know their costs for competing globally. A top notch costing system is one of the most powerful information tools a management can have; especially which provide a clear picture of the activities that are driving costs and the ways individual products and processes consumes resource. We can use costs in distinct ways. Product costing is used for strategic decision making.

1 – PRODUCT COSTING

Product costing system is a set of procedures that accounts for an organization’s product costs and provides timely and accurate unit cost information for pricing, planning and control, inventory valuation and financial statement preparation. An organization should be concerned about product costing and their firm’s product costing system. Use of an appropriate product costing system helps allocation of indirect costs and helps to use resources in a productive way. It is used to determine the market profit margins and also focus on sales function, customers markets and setting prices.

1. A – The most common systems of product costing are:

Job order costing

Job order costing allocates costs to products that are readily identified by individual units or batches of which requires varying degrees of attention and skill. It is extensively used in service industries, hospitals, law firms, movie studio, accounting firms, etc.

It is more complex when companies sell many different products and services.

Process costing

Process costing allocates costs to products by averaging costs over large number of nearly identical products. Since every unit is essentially the same, each unit receives the same manufacturing input as every other unit. Refineries, paper mills and food processing companies use process costing.

A complication arising in process costing is that manufacturing of not all units may be completed at the balance sheet date.

1. B – Strengths of Product Costing

• Useful for making judgments about management related profitability and performance, which often leads to decisions about resource allocation, shifting money from unrewarding activities to profitable activities and improve products’ cost performance.
• Helps for valuation of inventories for financial reporting purposes. Stock can be valued at the lower of cost or net realizable value under the prudence principle and the problems of allocating overheads to products for financial reporting do not arise.
• Plays an important role in complex pricing decision process and cost control. Cost based pricing is particularly true for customized products which do not have readily available market price.
• Managers often use product cost for planning and controlling the costs. For this purpose managers mainly focus on the product cost, although the scope of the analysis can be extended to include product costs from other areas of the value chain.
• Helps the organizations to find out the cost associated to each product .That enables to selling profitable products.
• This will help to avoid the use of non profitable products, and maximize profits.
• It gives an understanding of each product’s contribution to the bottom line.

1. C – Weaknesses of Product Costing

There are few limitations faced by the organizations by using the product costing systems they are:

• This costing system was developed during a period when 80% cost were related to labour, so it focused on direct labour cost.
• It is related to the benefits of a change in process or method reduction in direct labour.
• Only limited service organizations used full product costs for pricing decisions. In service organizations inventory valuation is not a major issue because there is not much to store.
• Planning and controlling of service organizations done through responsibility centers linked to functional activities rather than product or services.
• It assumed that the factory is an isolated entity and provide no indication of the impact of change in the factory on the rest of the organization.

2 – Conventional costing

Conventional costing produces inventory values which consist of variable costs and such fixed costs which commensurate with the level of production at which the inventories are produced. Conventional cost can aid in controlling cost as efficiently as direct costing. When conventional cost is employed on the books, the variable and fixed costs must be assembled and arranged to fit the analysis made out side the records.

A limitation for conventional system is that conventional costs develop under absorbed or over absorbed manufacturing expenses which are not understood by management.

(Convertibility of Direct and Conventional Costing; Joseph A. Mauriello; National Association of Cost Accountants. NACA Bulletin (pre-1986); Mar 1954; 35.7)

3 – Traditional Costing

Traditional costing is among the oldest used methods of costing systems. In traditional costing, the manager or the management assigns direct labour, direct material and overheads to each unit of production. In this case, the overheads are not broken down by activity but based on certain volume related factors such as direct machine hours, direct labour hour etc.

(At what overhead level does activity based costing pay off? Robert J Vokurka; Rhonda R Lummus

Production and Inventory Management Journal; First Quarter 2001; 42, 1; ABI/INFORM Global pg. 40)

3. A – Going against the odds

Although the introduction of ABC was supposed to be the remedy for the short-comings of Traditional Costing, the Japanese managers still use traditional costing measures and are able to reduce costs and increase their market share. Traditional costing uses a very powerful set of tools and methods and may be much mightier than written deficient by the simplistic textbooks.

(Why the Japanese can do without ABC Patel, Ashok, Russell, David. Certified Accountant. Cork: Nov 1994. pg. 64)

3. B – Advantages of Traditional costing system

• Easy to understand and it is widely used
• In a firm with only one product line, the final cost will be the same as if ABC were used
• It is a convenient base for the assignment of manufacturing overheads (with direct labour as a significant portion of the product cost)
• Easy to depict a diagram representing the flow of product cost

(ABC: Revisiting the Basics)

3. C – Disadvantages of Traditional Costing

In most of today’s business scenario, the information that a management needs for decision making are not being satisfactorily provided

The averaging of the overall costs to the entire product line may result in some products carrying a major proportion of the overheads than it actually should. This in turn will affect the decision making related the product such as marketing emphasis, pricing, cost control etc

Since being a volume driven cost allocation, the entire process of costing is based on the manufacturing cost while the other factors of costs (performance driven) such as Research and Development, marketing etc are averaged across all the products.

(ABC: Revisiting the Basics)

4 – Activity Based Costing

Activity-based costing was introduced about 15 years ago and implemented initially by large manufacturing companies since it is proven to show as more beneficial in larger firms that have a diverse mix of products or services.

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ABC is a system for assigning costs to products based on the activities they require. These activities are those regular actions performed inside a company. Eg: asking a customer invoice related questions. In this way an organization can establish the true cost of its individual products and services for the purposes of identifying and eliminating those which are unprofitable and lowering the prices of those which are overpriced. It is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing and identification and measurement of process improvement initiatives. Cost centre, cost allocation, fixed cost, variable cost, cost drivers are the methodologies used in activity based costing.

4. A – Strengths

• It helps to identify costs of individual activities, based on their use of resources
• Identify most and least profitable customers, products and channels through its methodologies.
• It helps to control the cost at individual level as well as on departmental levels.
• The cost of all activities associated with a product or service can be accurately determined before it is launched, so it helps in pricing, future product planning etc.
• Expands the cost of producing and selling a product so that better decision making information is available.
• Uses the technologies available to track costs in today’s manufacturing environment.

4. B – Limitations

• Some overhead cost is difficult to assign to products and customers, such as the chief executive’s salary.
• ABC is time consuming, if all activities are to be costed.
• It may be difficult to set up and establish ABC if an organization is using more traditional accounting methodologies.
• ABC identifies product costing better in the long run, but may not be too helpful in day-to-day decision-making.

5 – Conclusion

Product costing suffers from some set backs but overall it is an effective tool that helps organization in predicting and minimising costs involved in manufacturing a product as well as in providing management with relevant information for strategic decision making process that have a long term impact on the profitability of the firm. And though many experts suggest the use of marginal costing in decision making the modern organization concentrate on product costs. Traditional costing systems fail to meet the management’s decision making requirements in the modern organization. But the introduction of ABC had taken out this shortcoming to a minimum level and has made it much easier for the cost control and help managers take wise decisions based on their numbers. This is where product costing systems make an impact and prove to be useful and more importantly a necessity.