Product cost measurement is a critical component of cost accounting, allowing businesses to track and allocate expenses efficiently. Understanding different cost measurement methods helps in setting product prices, improving cost control, and making informed business decisions.
I extend my sincere gratitude and acknowledgment to Dr. Farman Afzal, from the Institute of Business & Management (IB&M), UET Lahore, for his invaluable assistance and insights in shaping this knowledge. His expertise in Financial and Managerial Accounting has greatly enriched the content, making it more relevant to contemporary financial practices. This acknowledgment also highlights his continuous contributions to promoting awareness and fostering meaningful discourse on Corporate Social Responsibility (CSR), benefiting both the student and professional community.
For detail pl review the post
- https://solbiztech.com/blog/sbt-blog-1/cost-classifications-explained-direct-indirect-fixed-and-variable-costs-in-managerial-accounting-17
- https://solbiztech.com/blog/sbt-blog-1/the-flow-of-costs-in-manufacturing-processes-documents-and-accounting-entries-19>
1. What is Product Cost?
Product cost refers to the total expenses incurred to manufacture a product or deliver a service. It consists of three key components:
- Direct Materials: Raw materials directly used in production.
- Direct Labor: Wages paid to workers involved in production.
- Overhead Costs: Indirect expenses such as utilities, depreciation, and rent.
The accurate measurement of product cost is essential for financial reporting, pricing strategy, and profitability analysis.
2. Product Cost Measurement Methods
Various methods are used to measure product costs, depending on the nature of production and the cost accounting system in use. The primary product costing methods include:
A. Job Order Costing
Definition:
Job Order Costing is used for unique, customized, or made-to-order products where costs are assigned to specific jobs.
Characteristics:
- Costs are traced to a specific job.
- Used in industries like construction, custom manufacturing, and consulting services.
- Each job has a Job Order Cost Card detailing material, labor, and overhead costs.
Example: A company produces a custom-built machine for a client. The job order cost includes:
- Direct materials: 8,000
- Direct labor: 5,000
- Overhead (120% of labor cost): 6,000
- Total job cost: 19,000
Unit cost = 19,000 / 1 machine = 19,000 per unit
B. Process Costing
Definition: Process Costing is used in industries with continuous production of identical or similar products.
Characteristics:
- Costs are assigned to a process or department rather than individual jobs.
- Used in industries like chemicals, oil refineries, food production, and paper manufacturing.
- Work in process (WIP) accounts track costs as products move through production stages.
Example: A factory produces 10,000 liters of paint in a batch. Costs incurred:
- Direct materials: 25,000
- Direct labor: 10,000
- Overhead costs: 15,000
- Total cost: 50,000
Unit cost = 50,000 / 10,000 liters = 5 per liter
C. Hybrid Costing (Operations Costing)
A mix of Job Order Costing and Process Costing, used when products have both standardized and customized components. Example:
- An automobile company uses process costing for mass production of cars but job order costing for customized features like sunroofs and premium interiors.
D. Activity-Based Costing (ABC)
Definition: ABC assigns costs to products based on activities that consume resources, rather than just labor or machine hours.
Characteristics:
- More precise than traditional costing methods.
- Identifies cost drivers (e.g., number of machine setups, inspection hours).
- Suitable for complex manufacturing environments.
Example: A company manufactures two types of products: Standard and Premium. Instead of allocating overhead based only on labor hours, the company identifies cost drivers:
- Machine setup costs: 50,000
- Quality inspection: 30,000
- Packaging: 20,000
- Total Overhead = 100,000
By using ABC, costs are assigned to products based on how much they use each activity, providing better cost accuracy.
3. Computation of Product Unit Cost
Once costs are assigned, the next step is computing the unit cost:
Unit Cost=Total Production Cost / Total Units Produced
Example Calculation A company produces 1,000 chairs with the following costs:
- Direct materials: 50,000
- Direct labor: 30,000
- Overhead: 20,000
- Total Cost: 100,000
Unit Cost = 100,000 / 1,000 = 100 per chair
4. Choosing the Right Costing System
| Factor | Job Order Costing | Process Costing | Activity-Based Costing |
|---|---|---|---|
| Type of Product | Custom-made | Mass production | Complex, multi-step production |
| Cost Assignment | Per job | Per process | Based on activities |
| Industry | Construction, Printing, Consulting | Chemicals, Oil, Food | Electronics, Automotive |
| Cost Accuracy | Moderate | Lower | Higher |
5. Conclusion
Measuring product cost accurately is essential for setting prices, controlling costs, and improving business decisions. Different costing methods serve different industries, and advanced techniques like Activity-Based Costing (ABC) provide better insights into cost drivers.
Author:
Mohsin Yaseen
On behalf of the SolBizTech Team
https://www.linkedin.com/in/rmyasin