Product Costing New Age Caravans
This report tries to address the costing issue which is currently being faced by the manufacturing division of New Age Caravans, a manufacturer of a rugged, but the luxury range of caravans. We have tried to explain the concept of product costing and its purpose. We have also tried to work out the cost of goods manufactured and cost of goods sold and also drawn up the T accounts for some of the key accounts. This report also attempts to explain the concepts of over/under absorption of overheads and also Activity-Based Costing (ABC) and whether it will be useful for the business and in what way.
II. Product Costing System
Product costs are costs incurred for manufacturing a particular product. This includes Direct Material, Direct Labour, Factory Overheads, consumable production supplies & Utilities. Product costing is used for the following:
• Compute the cost of goods manufactured and cost of goods sold for each product
• To ascertain the valued added in each stage of production so that the cost break for each item produced can be determined
• To help in controlling the product cost and also facilitate to compare the actual product cost with product cost controlling information system
• Useful in decision making such as make or buy decision
• Helps monitoring and controlling overheads cost
• Helps in pricing decisions
• Helps in margin analysis
• Gives inputs on the decision whether to produce more or fewer volumes
III. Cost of Goods Manufactured and Cost of Goods Sold
The cost of goods manufactured is the cost incurred purely for manufacturing the goods. This is computed based on the RM consumed in production, the differential of stock of WIP and all direct cost and manufacturing overheads. The cost of goods sold is computed by adjusting the under/over absorption of overheads and the differential in FG stock to the cost of goods manufactured.
For the purpose of computation of cost of goods manufactured and cost of goods sold, the costs other than factory costs should not be considered. These include Administrative salaries, Advertising expenses, and all other administrative and selling and distribution expenses. For the purpose of computation of the cost of goods manufactured, the actual manufacturing overheads are not applied. Overheads are first absorbed based on a standard overhead absorption rate. Later, while computing the cost of goods sold, the over/under absorption of overhead is adjusted to the cost of goods sold.
By applying the above basis and assumptions, the cost of goods manufactured has been computed as $ 489,000 and the Cost of goods sold as $ 496,500. The workings are available in the Appendix.
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IV. Overhead absorption
Over or underapplied overhead is defined as the difference between the manufacturing overheads actually incurred by the company and the theoretical overhead amount arrived based on the predetermined overhead absorption rate. When the actual overhead is more than the applied overhead value, there it is under-absorption. On the other hand, if the actual overhead is less than the applied overhead value, there is over-absorption. This is a normal feature in any manufacturing business.
The predetermined rate usually arrives at the beginning of the period based on the assumption and past trend. These assumptions and trends may differ when the actual expenses are incurred. However, in order to ensure uniformity of reporting, the applied overhead method is effective from a cost control point of view. Any such under/over absorptions are adjusted in the cost of goods sold by adjusting to the value of the Finished good. Alternatively, this difference can also be adjusted to Work in progress account also. Both methods are acceptable and are applied based on priority and convenience.
V. Activity-Based Costing (ABC)
Activity-Based Costing (ABC) is a new concept of cost accounting. In this method, the entire production process is classified into different activities. These activities are called cost pools. For every such activity or cost pool, a cost driver is defined. All costs are assigned to the activities or cost pools based on these cost drivers. This process ensures better accuracy of the cost assignment and computation as every cost is assigned based on the most relevant cost driver with respect to each and every respective activity. This also includes non-manufacturing expenses as well. This method is however more complicated than the traditional costing method.
Traditional costing methods, on the other hand, are much simpler. This method mostly uses only a single cost driver such as labor hours or machine hours base on which the cost allocation is done. The biggest disadvantage under this method is that there is usually no nexus between the cost and the cost driver.
This business which is into the manufacture of New Age Caravans will be more benefited by ABC. The manufacturing process will be capable of being classified into different activities. ABC method can be more effectively applied in a business that is more into assembling of parts. However, the business has to carefully evaluate whether it will be able to switch to the ABC process. ABC process usually requires a large amount of data at all stages. There should be a well-defined data capturing mechanism which gives reliable data with respect to each of the cost drivers. The data should also be available on a timely basis and should be easily retrievable. The management should also envisage the possibility of having stable and permanent staffing for carrying out the above change. If the benefits are able to justify the additional costs involved, then the management should definitely go ahead and implement the ABC method.
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