Product Costs

8/9/2019 Product Costs

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Product costs: A product cost is any cost that is associated with units of product for a particular purpose. Hence, the identification of product costs depends on the purpose for which it is done.

For example, the factory manager is interested in manufacturing costs, whereas themerchandising manager might be interested in both manufacturing and nonmanufacturing costs,including research and development, marketing, and advertising costs.

Overview of Product Costing:Product costing follows these steps:

1. Identify the cost object ;2. Identify the direct costs associated with the cost object;3. Identify the overhead costs ;4. Select the cost allocation base to use in assigning overhead costs to the cost object;

5. Develop the overhead rate for allocating overhead to the cost object.

The cost accounting system builds up the cost of product (or other cost object) by recording toa job cost sheet, a work-in-process account, or some other appropriate ledger, the direct costs thatcan be traced to the product, and a share of the overhead costs, which are allocated to the

product by multiplying the overhead rate by the amount of the allocation base identified with thecost object.

Cost Objects:Recall that a cost object is anything that we want to know the cost of, such as a product or service.

There is a common convention that can be confusing. We often talk about the cost object (thething we want to know the cost of) as one unit of product, because factory managers and productmanagers speak in terms of unit costs. These managers want to know the unit cost for product

pricing, product sourcing, and performance evaluation purposes. They do not want to talk aboutthe cost of making 620 units, even if that is the batch size. However, in most batch processes,there would be very little benefit and enormous additional expense in determining the cost of each unit of product individually. Rather, the accounting system treats the batch as the costobject, and to derive a unit cost, we divide the cost of the batch by the number of units in the

batch. Hence, loosely speaking, we talk as if a unit of product is the cost object, but more

precisely, it is the batch (or the production run in an assembly-line process, or perhaps one days production in a continuous manufacturing process) that constitutes the cost object.

Direct Costs:Management accounting classifies product costs as either direct costs or overhead costs (indirectcosts). This distinction is important because costing systems handle these two types of costs verydifferently. The distinction is sometimes subtle, because whether a cost is direct or overhead is a


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function of the cost object, and also partly a matter of choice on the part of managers andaccountants.

Following are three definitions of direct costs from different accounting textbooks:

Direct costs of a cost object are costs that are related to the cost object and can be tracedto it in an economically feasible way.

Direct costs are costs that can be directly attached to the unit under consideration.

Direct costs are costs that can be traced easily to specific products.

Direct costs are also called prime costs . For manufacturing companies, direct costs usually can be categorized as either materials or labor.

Direct materials: materials that become part of the finished product and that can beconveniently and economically traced to specific units (or batches) or product.

Example of direct materials for an apparel manufacturer: fabric. All other materials, such asthread and zippers, are probably indirect.

Direct labor: costs for labor that can be conveniently and economically traced to a unit (or batch) of product. The following examples show how the determination of whether a cost isdirect or overhead depends on the identification of the cost object:


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Examples of direct labor for an apparel manufacturer:

1) If the cost object is a single pair of pants, in a batch of several dozen pairs:

Probably no labor is direct.

2) If the cost object is a batch of several dozen pairs of pants:

Probably, sewing operators wages are direct.

3) If the cost object is a production line in the factory, add:

The line managers salary, and possibly wages incurred in the cutting room (where rollsof fabric are cut into panels and pieces that are then sewn together).

4) If the cost object is the entire factory, add:

The factory managers salary, wages of maintenance and janitorial workers, and salariesof front office personnel.

Even though probably no labor is direct with respect to a single pair of pants, if labor is directwith respect to a batch of 50 or 100 units, cost accountants would usually (and loosely) call labor a direct cost with respect to units of product, and divide the direct labor cost for the batch by thenumber of units per batch to derive the direct labor cost per unit.

Overhead Costs:

Overhead costs are costs that are related to the cost object, but cannot be traced to the cost objectin an economically feasible way. Overhead costs are not directly traceable to specific units of production. Examples of overhead costs incurred at an apparel manufacturer, when the costobject is a batch of product, probably include the following:

- Electricity- Factory office salaries- Building and machine maintenance- Factory depreciation

The distinction between direct costs and overhead costs relate, in some measure, to the way the

accounting system treats the cost. For example, one apparel manufacturer might track threadusing the same methods that are used to track fabric, thus treating thread as a direct material.Another apparel manufacturer might decide that the cost of thread is immaterial, and does notwarrant the cost and effort to track it as a direct cost. For this company, thread is an overheadcost. Therefore, whether some costs are direct or overhead depend on a choice made by themanager and the cost accountant.


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There are three ways overhead costs can be treated in any decision-making context: (1) they can be ignored, (2) they can be treated as a lump-sum, or (3) they can be allocated to the productsand services (i.e., to the cost objects) to which they relate. Each of these three alternatives isappropriate, depending on the circumstances and the purpose for which the accounting is done.However, in this chapter and throughout much of this book, we are concerned with the third

alternative: how to allocate overhead costs to products and services.

Cost Allocation BasesThe allocation base is the link that is used to attach overhead costs to the cost object. In amanufacturing setting, the simplest allocation base is the number of units produced. For example,if the factory makes 15,000 units, the accounting system can simply spread the overhead costsevenly over all 15,000 units. The problem with using units as an allocation base, however, is thatif the factory makes a range of different products, those products might differ significantly intheir resource utilization. A deluxe widget might require twice as much labor and 20% morematerials than a standard widget, and one might infer that the deluxe widget also requires more

resources that are represented by overhead costs.

Whatever cost allocation base is chosen, it must be a common denominator across all costobjects. For example, a furniture factory could allocate overhead costs across all products usingdirect labor hours, because direct labor is incurred by all products made at the factory. However,it would not seem appropriate to allocate factory overhead based on the quantity of wood used ineach unit, if the factory makes both wood furniture and a line of plastic-molded, because nooverhead would be allocated to the plastic chairs.

Overhead Rates:The overhead rate is the ratio of cost pool overhead dollars in the numerator, and the totalquantity of the allocation base in the denominator:

Overhead rate Overhead costs in the cost pool

=Total quantity of the allocationbase

The result represents dollars of overhead per unit of the allocation base. For example, if anapparel factory allocates overhead based on direct labor hours, the overhead rate representsdollars of overhead per direct labor hour. Assume the overhead rate is $20 per direct labor hour.Then for every hour that a sewing operator spends working on product, $20 will be allocated tothe products that the sewing operator assembles during that hour.


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ZFN Apparel Company, Example of Actual Costing:The ZFN apparel company in Albuquerque, New Mexico makes jeans and premium chinos.Each product line has its own assembly line on the factory floor. Overhead costs for the factoryfor 2005 were $3,300,000. 500,000 jeans and 400,000 chinos were produced during the year.500,000 direct labor hours were used: 200,000 for jeans, and 300,000 for chinos. The average

direct labor wage rate was the same on both assembly lines, and was $14 per hour. Denim fabricis used to make jeans, and chinos are made from a cotton twill fabric. Overhead is allocatedusing direct labor hours.

The following journal entries and T-accounts illustrate how the accounting system records themanufacturing activities of the factory in order to derive product cost information for jeans andchinos. Journal entry (6) to debit overhead to work-in-process is based on an overhead ratecalculated as follows.

$3,300,000 500,000 direct labor hours = $6.60 per direct labor hour.

In practice, the factory would track costs by batch, or perhaps weekly, but to simplify our example, we record only one journal entry for each type of transaction. We also make theunrealistic assumption that there is no work-in-process at the end of the period. To focus the

presentation on inventory-related accounts, T-accounts for some non-inventory accounts, and theentry to debit accounts receivable and credit revenue, are omitted.


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(1) Raw Materials: denim fabric $3,000,000Raw Materials: cotton twill 2,250,000

Accounts Payable $5,250,000

(To record the purchase of 600,000 yards of denim fabric at $5.00 per

yard, and 500,000 yards of cotton twill fabric at $4.50 per yard.)

(2) Work-in-process: Jeans $2,500,000Raw Materials: denim fabric $2,500,000

(To record materials requisitions for 500,000 yards, for the movement of denim from the receiving department to the cutting room.)

(3) Work-in-process: Chinos $2,160,000

Raw Materials: cotton twill $2,160,000(To record materials requisitions for 480,000 yards, for the movement of cotton twill from the receiving department to the cutting room.)

(4) Work-in-process: Jeans $2,800,000Work-in-process: Chinos 4,200,000

Accrued Sewing Operator Wages $7,000,000

(To record sewing operator wages for the year: 200,000 hours for jeans,and 300,000 hours for chinos, at $14 per hour.)

(5) Factory Overhead $3,300,000Accounts Payable $1,800,000Accrued Wages for Indirect Labor 900,000Accumulated Depreciation 600,000

(To record overhead costs incurred during the year, including utilities,depreciation, repairs and maintenance, and indirect wages and salaries.)

(6) Work-in-process: Jeans $1,320,000Work-in-process: Chinos 1,980,000

Factory Overhead $3,300,000

(To allocate factory overhead to production, using an overhead rate of $6.60 per direct labor hour.)


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(9) Cost of Goods Sold: Jeans $5,296,000Cost of Goods Sold: Chinos $7,297,500

Finished Goods: Jeans $5,296,000Finished Goods: Chinos $7,297,500

(To record the sale of 400,000 jeans and 350,000 chinos.)

Raw Materials:Denim Fabric

Raw Materials:Cotton Twill

(1) $3,000,000

$ 500,000

$2,500,000 (2) (1) $2,250,000

$ 90,000

$2

Accrued SewingOperator Wages Factory Overhead

$7,000,000 (4) (5) $3,300,000

$0

$3

Work-in-Process: Jeans Work-in-Process: Chin

(2)(4)(6)

$2,500,0002,800,0001,320,000

$0

$6,620,000 (7) (3)(4)(6)

$2,160,0004,200,0001,980,000

$0

$8

Finished Goods: Jeans Finished Goods: Chin

(7) $6,620,000

$1,324,000

$5,296,000 (9) (8) $8,340,000

$1,042,500

$7

Cost of Goods Sold: Jeans Cost of Goods Sold: Ch

(9) $5,296,000 (9) $7,297,500


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Accounts Payable

$5,250,0001,800,000

(1)(5)

The per-unit inventory cost is calculated as follows:

Jeans: $6,620,000 500,000 pairs = $13.24 per pair Chinos: $8,340,000 400,000 pairs = $20.85 per pair

These amounts, which are used in journal entry (9), can be detailed as follows:

Input Jeans ChinosFabric

DirectlaborOverheadTotal

1 yard per jean x $5 per yard =

$5.000.4 hours per jean x $14 per hour= $5.60

0.4 hours per jean x $6.60 per hour= $2.64$13.24

1.2 yards per chino x $4.50 per yard =

$5.400.75 hours per chino x $14 per hour =$10.50

0.75 hours per chino x $6.60 per hour =$4.95

$20.85

In the above table, the direct labor hours per jean and per chino appear in the lines for both the per-unit direct labor cost and the per-unit overhead cost, because overhead is allocated based ondirect labor hours. If the allocation base had been something else, such as machine hours, the

hours per unit would only appear in the calculation of the direct labor cost.More overhead is allocated to each pair of chinos than to each pair of pants ($4.95 versus $2.64)

because direct labor hours has been chosen as the allocation base, and each chino requires moredirect labor time than each pair of jeans (0.75 hours versus 0.40 hours). Changing the allocation

base cannot change the total amount of overhead incurred, but it will usually shift costs fromsome products to others. For example, if the allocation base were units of production instead of direct labor hours, the overhead rate would be:

$3,300,000 900,000 units = $3.67 per unit.

In this case, the total cost per pair of jeans would increase from $13.24 to $14.27, and the totalcost per pair of chinos would decrease from $20.85 to $19.57.

Because the choice of allocation base determines how overhead is allocated across products, product managers usually have preferences over this choice (because a lower reported productcost results in higher reported product profitability). However, the companys choice of allocation base should be guided, if possible, by the cause-and-effect relationship betweenactivity on the factory floor and the incurrence of overhead resources. For example, direct labor


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hours is a sensible allocation base if the significant components of overhead increase as directlabor hours increase. More direct labor implies more indirect labor by human resources andaccounting personnel, janitorial staff and other support staff. Also, more direct labor impliesmore machine time, which implies more electricity usage, and more repairs and maintenanceexpense. For these reasons, direct labor hours is probably a better choice of allocation base than

units of product.

The textile industry generally concentrates on designing or manufacturing of clothes and also the task of distribution and use of the manufactured textile.

The textile industry has changed continuously in the last few years. It looks at carrying out their businessin systematic way. For this reason ERP can be used and it plays an important role. As we know ERPstands for enterprise resource planning. Therefore the major goal is plan out the resources used andkeeping a proper data in software.

It is software for a business; which can be customized according to the needs of the enterprise. The ERPsoftware is the latest high end solution for performing the business efficiently. The software aims atkeeping a track of data and making internal procedure flow smoothly.

ERP has helped in increasing the quality and efficiency of the manufacturing process. The manufacturing processesexperiences some problems quiet often because of miscommunication and lack of communication. ERPprovides a solution by enhancing coordination by keeping

an eye on the supply chain, warehouse and logistic.

It also helps greatly in the function of tracking theprogress made in the manufacturing of the product. If anytechnical problem occurs it can be tracked down easily.The customer can be answered easily with the statisticsin hand and his queries can be easily answered with thedetails of the status of the product. Long chains of communication are shortened and the details can beshared through internet also, thus avoiding anymiscommunication.

For both textile and garment sector strategic planning is important and ERP system is designed tosupport this through resource planning. It facilitates report generation which has to be updated every timea progress takes place. This report can be distributed among employees so that they also know whicharea has to be given more attention for the completion of the task. The textile and garment industry isever-changing and thus it is important to know the customers need and record it.

It helps reduce operating cost because it integrates processes of the business across departments onto a


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single information system. The problem of low inventory or reduced operating cost is ruled out. Whenever resource is needed it is available on time because everything has already been planned. The day to daymanagement becomes easy because it keeps a track of the warehouse also. Everything going into thedata warehouse is recorded thus planning for a specific day can be easily done. Due to the fact that everyactivity is recorded the actual cost can be calculated easily. The unwanted ambiguity is ruled out whichmakes the database user friendly.

Since the product is being managed so well its quality remains intact what the world gets is a reliableproduct. Every small detail can be easily taken care of and smooth flow of activity takes place.

About the Author:

He writes on alternative health and has contributed lot of articles on natural cures, ayurveda, massage,yoga and home remedies. He is founder and CEO of Elite Informatics, an Internet Advertising Company

The textile industry generally concentrates on designing or manufacturing of clothesand also the task of distribution and use of the manufactured textile.

The textile industry has changed continuously in the last few years. It looks atcarrying out their business in systematic way. For this reason ERP can be used andit plays an important role. As we know ERP stands for enterprise resource planning.Therefore the major goal is plan out the resources used and keeping a proper datain software.

It is software for a business; which can be customized according to the needs of theenterprise. The ERP software is the latest high end solution for performing thebusiness efficiently. The software aims at keeping a track of data and makinginternal procedure flow smoothly.

ERP has helped in increasing the quality and efficiency of the manufacturingprocess. The manufacturing processes experiences some problems quiet oftenbecause of miscommunication and lack of communication. ERP provides a solution

by enhancing coordination by keeping an eye on the supply chain, warehouse andlogistic.

It also helps greatly in the function of tracking the progress made in themanufacturing of the product. If any technical problem occurs it can be trackeddown easily. The customer can be answered easily with the statistics in hand andhis queries can be easily answered with the details of the status of the product.Long chains of communication are shortened and the details can be shared through


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internet also, thus avoiding any miscommunication.

For both textile and garment sector strategic planning is important and ERP systemis designed to support this through resource planning. It facilitates reportgeneration which has to be updated every time a progress takes place. This reportcan be distributed among employees so that they also know which area has to begiven more attention for the completion of the task. The textile and garmentindustry is ever-changing and thus it is important to know the customers need andrecord it.

It helps reduce operating cost because it integrates processes of the businessacross departments onto a single information system. The problem of low inventoryor reduced operating cost is ruled out. Whenever resource is needed it is availableon time because everything has already been planned. The day to day managementbecomes easy because it keeps a track of the warehouse also. Everything goinginto the data warehouse is recorded thus planning for a specific day can be easilydone. Due to the fact that every activity is recorded the actual cost can be

calculated easily. The unwanted ambiguity is ruled out which makes the databaseuser friendly.

Since the product is being managed so well its quality remains intact what theworld gets is a reliable product. Every small detail can be easily taken care of andsmooth flow of activity takes place.

Why ERP Works

Enterprise resource planning or ERP is the way to go for optimal usage of resources. Heres what

ERP is all aboutText by Manish Dalal While selecting an Enterprise Resource Plan (ERP) for the apparel sector, one must consider anessential factor should you go for a General Purpose ERP that will be customised for the apparelsector, or should you go for an Apparel pecific ERP? Both have a far-reaching impact on theimplementation and effectiveness of the ERP on the organisation. Being able to respond quickly to the sales pattern at our various EBOs is a great advantage of implementing the ERP - Bobby Arora, One distinct feature that distinguishes an Apparel Specified ERP from a General Purpose ERP isthat in apparel, the users need to deal with various sizes for the same product style and colour combination. This means that in the apparel sector users are accustomed to viewing reports, aswell as input data with sizes appearing across the page rather than one below the other as wouldhappen when a General Purpose ERP is implemented. To illustrate, the order booking form in anApparel Specific ERP would look something like this:


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On the other hand, the order form in a General Purpose ERP, unless it has been specificallyconfigured to be in the format above, looks like the following:

The basic advantage in having a horizontal structure as in the General Purpose ERP is that youcan have various sizes till any number and of any description, and all can be easily fitted into theERP. But in the Garment specific ERPs, the number and types of sizes may be restricted in

number, if not in type. Normally, up to 3 sizes can be accommodated in the Header columnwithout causing any confusion. However, if the types of size numbers increase, then specificsizes need to be indicated against each style. With the ERP in place, we are able to quickly know of the events occuring in our companywithout any additional effort- Kamal Limbad, Director Roop Designs Pvt. Ltd.

For an apparel brand which also has manufacturing as a part of its core activities, either throughin-house facilities or through supporting job workers, a typical ERP should have all the basicfunctions that the company has to deal with in respect to planning for the season, procurement of fabric and trims, issuing for cutting and stitching and then tracking its movement till it isreceived in the finished warehouse. Then onwards, the orders received from customers need to

be tracked for deliveries and realisation of monies, issue of credit notes for sales return etc. Atypical Apparel ERP can be diagrammatically represented as follows:

Flow Chart for the ERP Software at the head office


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Management As seen in the diagram, an Apparel ERP can be broadly divided into 4 modules:

Planning Procurement and production Sales and distribution Accounts

The diagram distinctly reveals the various broad functions of the manufacturer i.e. the PlanningModule wherein the styles that are to be launched are defined. Then the Sales and DistributionModule comes into play wherein the orders received are matched with available stocks and thenthe goods are dispatched and invoiced. Finally, there is the Accounts Module wherein thefinancial entries get recorded. The dark lines joining Product Definition with Garment Purchase, Orders Received, EBO Ordersand Cutting Issue indicate that these activities can be started independent of each other as soon asthe Product is defined. In our next issue we shall take an in-depth look into how each of these modules works. Theimplementation of an ERP in the apparel sector has its own peculiar features and dynamics thatneed to be taken into account while selecting an ERP. A well designed ERP is one that reflectsthe actual occurrence of events in the physical form on to the computers. So watch out for further details on the process of formulating and executing an effective ERP in the apparel industry.

definition -

ERP (enterprise resource planning) is an industry term for the broad set of activities that helps a business manage the important parts of its business. The information made available through anERP system provides visibility for key performance indicators (KPIs) required for meetingcorporate objectives. ERP software applications can be used to manage product planning, parts

purchasing, inventories, interacting with suppliers, providing customer service, and trackingorders. ERP can also include application modules for the finance and human resources aspects of a business. Typically, an ERP system uses or is integrated with a relational database system.

Leveraging Your ERP System for ContinuousBusiness Improvement
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by Dave Litzenberg | View all posts by Dave Litzenberg

So, youre an owner of a small to mid-market manufacturing or distribution company. Your business is making a nice profit and youre pleased with your personal earnings from theventure. Even so, its not time to rest on your laurels and be satisfied with the status quo.

Every day, theres someone out there who wants to eat your lunch. It could be an existingcompetitor who wants to get the upper hand, or it could be someone with a new idea to turn your industry upside down. Whatever the source of the threat, it is real, and it is coming.

Thus, it is imperative to make on-going adjustments in your business for purposes of continuous

improvement unless you want to wake up some day to be the person wondering, What hit me?

There are so many manufacturing and distribution businesses we walk into where thats just theway we do things around here is a widely-used term. For example:

We always buy substantially more product than we need at the time because we get anadditional discount from our supplier.

We always have three people sequentially check the same order and its pricing before itis billed so our customers always receive a clean invoice.

We couldnt possibly require the receiving people to record lot numbers because it willhurt their productivity.

We allow our customer to buy a full container of product and pay us for it over a twelvemonth period, even though the customer sells all of the associated product in six monthsand is using us as their bank for interest-free money for the last six months.

We arent interested in going out and finding any new customers; we have more thanenough business from the two big customers were already working with.

These are but five of the countless statements weve heard over the past several years about why businesses do quirky things just because, thats the way its done here.

Every day in business is a new opportunity to change old ways and to make improvements thatcan lead to improved operational efficiencies and customer service. No one can afford waste in

their businesses. Customers are unwilling to pay a premium for your products to absorb your excess costs because youre doing things the way theyve always been done.

Youre encouraged to challenge the norm by setting up continuous improvement teams andrewarding your personnel to cut waste and streamline business processes. And, assuming youhave a high-quality manufacturing or distribution software system in place like Enterprise 21 inwhich data and metrics are available for ease of access and analysis through fully-integrateddecision support and workbench technologies and are working with a software vendor like
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Technology Group International who is seen as a strategic partner to many customers bringing best-practice experience from working with a myriad of small to mid-market manufacturing anddistribution customers, your ERP system can be a key enabler for your companys continuousimprovement efforts.

Technology Group International is such a strong believer in continuous improvement that we perform return on investment (ROI) workshops with our customers some six to twelve monthsafter their initial Go Live with TGIs Enterprise 21 ERP software . During an ROI workshop, thecustomer reviews key business practices from across their enterprise and how theyre usingEnterprise 21 in those situations. While there are numerous recommendations as to how themanufacturer or distributor can take better advantage of the software theyve already bought,some 3-5 key elements tend to emerge for improvement out of the workshop that can help thegiven manufacturer or distributor derive substantial incremental ROI with the software theyvealready installed.
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