Product Costing (Leaving Cert Accounting): Revision Notes

Product Costing

Introduction to product costing

Product costing is a fundamental aspect of management accounting that involves calculating the total cost of producing goods or services. Understanding how to classify and allocate costs helps businesses determine selling prices, value stock, and make informed decisions about production.

Cost classification

Costs can be organised in several different ways depending on their characteristics and how they behave within the business.

Manufacturing vs non-manufacturing costs

Manufacturing costs are expenses directly related to the production process. These costs form part of the manufacturing account, which has three main components:

• Raw materials - the basic inputs used to create products
• Direct costs - expenses that can be directly traced to specific products
• Factory overheads - indirect costs related to the production process

Non-manufacturing costs appear in the profit and loss account as operating expenses. These include administration costs like office rent, selling expenses such as advertising, and distribution costs like delivery van expenses.

Direct vs indirect costs

Direct costs can be specifically identified with a particular product or department. Examples include:

• Raw materials used in production
• Wages paid to workers directly involved in manufacturing
• Special equipment hired for specific jobs

Indirect costs (also called overheads) cannot be directly traced to individual products but must be shared across all production. These include:

• Supervisor salaries
• Factory rent and rates
• Depreciation of machinery
• Light, heat, and power costs

Fixed, variable and mixed costs

Fixed costs remain constant regardless of production levels. Examples include rent, insurance premiums, and management salaries. Even if production stops completely, these costs continue.

Variable costs change in direct proportion to production volume. As output increases or decreases, these costs rise or fall accordingly. Direct materials and direct labour are typical variable costs.

Mixed costs contain both fixed and variable elements. A telephone bill demonstrates this - it includes a fixed line rental charge plus variable call charges based on usage.

Step-fixed costs remain constant up to a certain activity level, then jump to a higher fixed amount. For example, once factory capacity is reached, additional premises may be needed, causing a step increase in fixed costs.

Controllable vs uncontrollable costs

Controllable costs are expenses that managers can influence through their decisions. Department managers have responsibility for these costs and can be held accountable for any variances. For instance, a sales manager can control the commission paid to the sales team and decides how much to spend on promotional activities.

Uncontrollable costs are beyond a manager's direct influence. Even though these costs affect their department, managers cannot control them. A sales manager, for example, cannot control the rates charged on business premises as these are set by the local authority.

Stock valuation

Stock must always be valued at the lower of cost or net realisable value. Since cost is typically lower than selling price, stock is usually valued at cost.

FIFO (First in first out)

The FIFO method assumes that stock received first is the first to be issued for sale or production. This approach is straightforward and reflects the natural flow of goods in most businesses. When calculating the value of closing stock, FIFO uses the most recent purchase prices, making it particularly useful when stock has been purchased at different prices throughout the period.

Absorption costing

Absorption costing (also called full costing) includes both direct costs and indirect costs (overheads) in the total cost of a product. This comprehensive approach ensures that all production-related expenses are captured in the product cost.

The absorption costing process follows four distinct steps:

1. Allocation

Direct costs are allocated to the correct department or production job. This is straightforward as these costs can be directly traced to specific areas.

2. Apportionment

Indirect costs and overheads are divided among various departments using an appropriate basis. The choice of basis depends on what most fairly represents how each department uses the resource.

3. Reapportionment

Service department costs need to be redistributed to production departments. Service departments (like maintenance or administration) support production but don't directly manufacture products, so their costs must be absorbed by the departments that actually make goods.

4. Absorption

An absorption rate is calculated for each production department using an appropriate basis such as machine hours or labour hours. This rate is then applied to individual jobs to determine their share of overhead costs.

Overhead absorption rates

Absorption rates can be calculated per labour hour, per machine hour, or per unit. The rate chosen depends on the dominant activity of the department.

The calculated absorption rates are then used to absorb budgeted overheads into specific jobs based on the actual labour hours or machine hours used.

Over-absorption and under-absorption of costs

Overhead absorption rates are based on budgeted costs rather than actual costs because businesses need to calculate selling prices before knowing the final actual costs for the year.

Over-absorption of costs

This occurs when too much cost has been charged to products or departments. Actual costs turn out to be lower than budgeted costs, meaning profits will be greater than expected. Over-absorption might happen due to reduced rent or rates, falls in heating and lighting costs, or lower insurance premiums.

Under-absorption of costs

This occurs when too little cost has been charged to products or departments. Actual costs exceed budgeted costs, meaning profits will be lower than expected. Under-absorption might result from rent or rate increases, higher heating and lighting costs, or increased insurance premiums.

Reasons for product costing

Businesses need accurate product costing for several important reasons:

• Calculate selling prices - Without knowing production costs, businesses cannot determine appropriate selling prices to ensure profitability
• Determine stock values - Product costs are needed to value closing stock for the trading account and balance sheet
• Control costs - Comparing budgeted costs to actual costs helps identify areas where costs are getting out of control
• Planning and decision-making - Accurate cost information supports management decisions about which products to promote, discontinue, or modify