Quiz 3: Product Costing and Cost Accumulation in a Batch Production Environment
Product costing: Product costing is the process of tracking and studying all the various expenses that are accrued in the production and sale of a product, from raw materials purchases to expenses associated with transporting the final product to retail establishments. It is widely regarded as an extremely important component in evaluating and planning overall business strategies. A product-costing system accumulates the costs incurred in a production process and assigns those costs to the organization's final products. Products costs are needed for a variety of purposes which are explained as follows: a) Use in financial accounting b) Use in managerial accounting c) Use in cost management d) Use in reporting to interested organizations a). Use in financial accounting: In financial accounting, product costs are needed to value inventory on the balance sheet and to compute cost of goods sold expense on the income statement. Under generally accepted accounting principles, inventory is valued at its cost until it is sold. Then the cost of inventory becomes as expense of the period in which it is sold. If the inventory is properly valued, the financial statements do not reflect true and fairness of the affairs of the firm for the reporting period. b). Use in managerial accounting: In managerial accounting, product costs are needed to help managers with planning and to provide them with data for decision making. Decisions about product prices, the mix of products to be produced, and the quantity of output to be manufactured are among those for which product cost information is needed. c). Use in cost management: In order to manage the cost control and to implement cost reduction measures, it is essential to know actual costs being incurred and to analyze where ever it is possible to reduce wastages etc. Hence in cost management of a product the product costs play a very key role. d). Use in reporting to interested organizations: apart from uses of product cost information by the internal agencies, various outside agencies are also interested in the product costs. For example, public utility organizations such as electricity, gas companies, record product costs to justify rate increases that must be approved by the State Regulatory Authorities. Hospitals keep track of costs of medicals procedures in order to get reimbursement of expenses from the insurance companies or by the federal government under the Medical Program. Product costs are also very essential where a contract is awarded on cost plus basis. In such situation the company has to produce cost data in order to settle claim of sale invoices raised on the customer.
Before discussing about the differences between both costing systems, we may examine the similarities for better understanding. Similarities between job order and process costing systems can be summarized as follows. 1. Both systems have the same basic purposes-to assign material, labor, and overhead costs to products and to provide mechanism for computing unit product cost. 2. Both systems use the same basic manufacturing accountants, including manufacturing overhead, Raw materials, Work in process, and Finished Good. 3. The flow of costs through the manufacturing accounts is basically the same in both systems. Differences between Job Order Costing and Process Costing: The differences between job order costing and process costing arise from two factors. The first is that the flow of units in a process costing system is more or less continuous, and the second is that these units are indistinguishable from one another. Under process costing it makes no sense to try to identify materials, labor, and overhead costs with a particular order from a customer ( as we do with job order costing ), since each order is just one of many that are filled from a continuous flow of virtually identical units from the production line. Under process costing, we accumulate costs by department rather than by order, assign these costs uniformly to all units that pass through the department during a period. A further difference between the two costing systems is that the job cost sheet is not used in process costing, since the focal point of process costing is on departments. Instead of using job cost sheet a production report is prepared for each department in which work is done on products. The production report serves several functions. It provides a summary of number of units moving through a department during a period, and it also provides a computation of unit costs. In addition it shows what costs were charged to the department and what disposition was made on these costs. The department production report is a key document in a process costing system. These differences are summarized below:
Concept of Product Costing: Conventional wisdom and empirical evidence suggest that in manufacturing businesses product costs are used for various purposes, including inventory valuation, product pricing and mix decisions and for management planning and control. In the service sector inventory valuation is not a major issue, as the inherent perishability of their services means that they cannot be stored. Second, service organizations uses full product costs for pricing decisions. Third, in many service organizations costs are planned and controlled via responsibility centers linked to functional activities. A closer alignment of a service organization's responsibility centers with its value chain might be a source of competitive advantage. Application of product costing concept to services: Many service providing industries like Banks, insurance companies, hotels, airlines, law firms, hospitals, and city governments all record the costs of producing various services for the purpose of planning, cost control, and decision making. For example, in making decision about adding a flight, the management needs information about cost of flying the proposed route. Similarly in a banking industry to make a decision to open a new branch, the bank may like to know the cost of maintaining a new branch as well as expected revenue in flow. A local government may decide as to whether a new drug counseling program should begin or not if cost of similar existing program is known.