• Product Costing is the mechanism adopted to determine the cost of products. It forms the basis of product pricing. When the cost incurred on a product is ascertained then the profit it yields is known and helps in the decision making process.
• The direct costs attributable to a product can be apportioned to the product directly, whereas the factory overhead includes indirect costs which cannot be apportioned to the product directly, hence require allotment.
• Factory overheads can be allocated in the following three methods:
• Single Plant wide Rate Method
• Multiple Production Department Rate Method
• Activity Based Costing Method
• In traditional costing approach the entire factory overhead is allocated to the products based on a fixed rate; for example labor hours, machine hours, the entire cost is allocated to the products based upon the machine hours and labor hours worked upon.
• In Activity Based Costing, Activities undergone during the production process of the product are recognized and the budgeted cost on the activity is ascertained; an activity rate is computed basing upon the expenditure incurred and the activity undergone.
• Activity Based Costing system allocates cost basing upon the activities undergone, hence the cost ascertained denotes the accurate picture of the cost of production of the product, unlike the Traditional Based Costing System where the cost allocated is in excess of the actual cost incurred by the product.
• The Shifting from Traditional Costing System to Activity Based Costing results in better pricing of products and better results. Thus the decision of the controller is correct.
• The inventory valuation as per Activity Based Costing results in higher profits as the cost of products are allocated basing upon activities and results in apportionment of cost only to the extent of activities undergone in the production process of the product.
• Since, the controller's action is correct, it is wise enough to continue Activity Based Costing.
Accuracy of Product Costs
Product costs comprise of (i) direct costs and (ii) indirect costs. Materials and labor are direct costs which can be readily computed. Factory overhead involves indirect costs which must be allocated to the product. The method employed for allocating costs to products affects the final product cost.
It is necessary for managers to choose a method which accurately reflects product costs.
This is because managers use product costing to make strategic decisions on
(a) Fixing competitive product prices
(b) Selecting the appropriate product mix for maximizing profits
(c) Introducing a new product
(d) Discontinuing an existing product or service.
Single Plant wide overhead allocation:
• Total fabrication department's factory overheads = $560,000
• No. of machine hours consumed by sprockets = 5,150.
• Total No. of Machine Hours = 8,000.
Now to calculate the amount of factory overheads allocated to sprockets using machine hours as allocation base:
Therefore from the above calculation,
Amount allocated to sprockets is $360,500.
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