Tutorial -2

PRODUCT COSTING
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 the
merchandising 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.

Challenges of product costing

The pricing of products depends notably on the competition in the market. In a weakly competed
market, such as a closed market, the sales price can be calculated as follows:
Sale price = cost + profit
Since the competition is not strong, the changes in the company costs and profit targets can be
incorporated into the sales price. In modern open markets, competition is very strong and the
pricing equation changes to
Cost = sales price profit

Example 1
The cost of production allows a company to determine how much cost goes into a product before
sales. Cost of production is the total cost of producing all inventories for the year. This is made
up of both direct and indirect costs, such as labour and overhead costs. Firms use cost of
production to determine how efficiently they are producing their products. If a firm is efficient
and keeps a low cost of production, they will increase their profit from each sale. If a firm is
inefficient and has a higher cost of production, the firm will decrease their profit from each sale.
In addition, by knowing the cost of producing a specific product, the firm will be better capable
of determining a selling price for that product.

Solutions:
1. Add together all costs during the year associated with production. This includes fixed
costs, such as rental space used to produce the product, and total variable costs, such as
raw material costs. For example, Firm A spent $50000 for rent on a production facility,
$4000 for raw materials, $25000 on labour costs to produce their product, and $10000 of
various overhead costs, such as electricity while producing 40000 widgets.

Total cost= $50000 + $4000 + $25000 + $10000 = $89000

The total cost to produce for the year equals $89000.

2. Determine the total number of units produced during the year. This is equal to total
inventory sold during the year plus the difference between ending inventory and
beginning inventory. For example, Firm A used the costs mentioned in Step 1 to produce
40000 widgets.
Divide the cost of production of the total units to get the average cost to produce one unit.
In our example, divide $89000 by 40000 units, which equals to:

$89000/40000 units = $2.225 per unit produced.

Example 2

A company produces 4 types of product K, L, M and N.

Production cost data are as follows:

COST-BENEFIT ANALYSIS (CBA)

Cost-benefit Analysis (CBA) or can be called as Benefit-Cost Analysis (BCA) estimates and
totals up the equivalent money value of the benefits and costs to the community of projects to
establish whether they are worthwhile. This analysis considers the changes in benefits and costs
that would be caused by a potential improvement to the status quo facility. These projects may
be dams and highways or can be training programs and health care systems. In highway
decision-making, CBA may be used to help determine the following:
1. Whether or not a project should be undertaken at all, take an example whether the
project's life-cycle benefits will exceed its costs.
2. When a project should be undertaken.CBA may reveal that the project does not pass
economic muster now, but would be worth pursuing 10 years from now due to projected
regional traffic growth. If so, it would be prudent to take steps now to preserve the future
project's right-of-way.
3. Which among many competing alternatives and projects should be funded given a limited
budget? CBA can be used to select from among design alternatives that yield different
benefits (e.g., reconstruct a roadway with additional lanes versus no additional lanes);
unrelated highway projects (a widened road versus an interchange on another road); and
unrelated transportation projects in different transportation modes.
CBA problem have three basic types of goals:
1. To maximize the benefit for any given set of costs (or budget)
2. To maximize the net benefit when both benefits and cost vary
3. To minimize costs in order to achieve any given level of benefits

Example Cost-benefit Analysis 1:

Two mutually exclusive proposals for improvement to a water distribution utility station are
under consideration. One proposal is to upgrade the existing facility at a much lower cost and
lower overall benefit. The second more costly proposal potentially more beneficial alternative is
to build an entirely new facility. The new facility will incorporate many cost savings including
more efficient machinery, economy of scale, and automation to reduce manpower. The
disbenefits associated with the new facility include use of additional land, the need for more
roads, and the disruption of traffic and transportation. The costs and benefits are outlined in
Table 1
Using the information provided in Table 1, determine which alternatives to recommend using
B/C analysis using conventional methods. Assume a 6% interest rate.
Table 1: Benefits and costs for two alternatives
Alternative A (x1000)

Alternative B (x1000)

Initial Construction Costs

40000

4000

Annual Maintenance Costs

1500

150

Annual Public Benefit

6500

650

Annual Public Disbenefit

1500

Service Years

30

12

Solution steps using conventional B/C analysis:

The B/C may be computed using present values (P), future values (F) or uniform series annual
worth values (AW). It is straightforward to transform the present value construction cost to an
annual worth (AW) using the tabulated A/P factor. The calculations are as follows:
In conventional B/C analysis:
B/C = (B D) / C

Assume all value in a Million.

Alternative A:
Cost AWA = (Annual Maintenance Cost) + (Ins. Construction Cost) (A/P, 6%, 30)
(

Cost AWA = (1.5M) + (40M) (0.07265) = $ 4.406M

B/CA = (B D) / C = (6.5M 1.5M) / 4.406M = 1.14 > 1 (Alternative A is justified.)

Alternative B:
Cost AWB = (Annual Maintenance Cost) + (Ins. Construction Cost) (A/P, 6%, 12)
(

Cost AWA = (0.15M) + (4M) (0.11928) = $ 0.627M

B/CA = (B D) / C = (0.65M 0.15M) / 0.627M = 1.04 > 1 (Alternative B is justified.)

Therefore, both alternatives are justified. Alternative A have slightly advantage compare to
Alternative B.

Example Cost-benefit Analysis 2:

As the Production Manager, you are proposing the purchase of a $1 Million stamping machine to
increase output. Before you can present the proposal to the Vice President, you know you need
some facts to support your suggestion, so you decide to run the numbers and do a cost benefit
analysis.
Cost Benefit Analysis - Purchase of New Stamping Machine
(Costs shown are per month and amortized over four years)
1.

Purchase of Machine includes interest and taxes

-$20,000

2.

Installation of Machine including screens & removal of -$3,125

existing stampers

3.

Increased Revenue net value of an additional 100 units per $27,520

hour, 1 shift/day, 5 days/week

4.

Quality Increase Revenue calculated at 75% of current reject $358

rate

5.

Reduced material costs purchase of bulk supply reduces cost $1,128

by $0.82 per hundred

6.

Reduced Labor Costs 3 operators salary plus labor o/h

$18,585

7.

New Operator salary plus overhead. Includes training

-$8,321

8.

Utilities power consumption increase for new machine

-$250

9.

Insurance premiums increase

-$180

10.

Square footage no additional floor space is required

Total Net Savings per Month $15,715

The cost benefit analysis clearly shows the purchase of the stamping machine is justified. The
machine will save the company over $15,000 per month, almost $190,000 a year.

Example

1. The balance sheet dated December 31, 2003, has a balance in the Finished Goods Inventory
account of $26,200. The December 31, 2004, balance sheet has a balance in the Finished Goods
Inventory account of $24,000. Work in Process Inventory account has a beginning balance of
$20,000 and an ending balance of $30,000. If the cost of goods manufactured is $340,000, how
much is the cost of goods sold?

Beginning FG inventory

RM 26,200

+ CGM

340,000

= Available

366,200

- Ending FG inventory

(24,000)

= Cost of goods sold

RM 342,200

3. If a company has a reliable bill of materials, the accountant can simply take the total
material cost from it as an estimate of product cost. The following example illustrates a
bill of materials for a paint sprayer. As this example shows, the bill of materials lists all
the materials and purchased components that make up the product, their quantities, and
the unit cost for each one. The summation of the material cost for each piece gives the
total material cost for the finished product. Accountants usually refer to this cost as
the unit variable cost. The accountant will estimate the unit production cost for the paint
sprayer at $310 because this equals the materials cost for the product.

Bill of Materials for a Paint Sprayer

Extended

Description

Quantity Unit Cost

Head casting

RM54.23 RM54.23

Block casting

81.25

81.25

Head bolts

0.12

0.72

Head gasket

0.15

0.15

Bushings

0.85

3.40

Piston casting

35.00

35.00

Piston connection assy. 1

5.14

5.14

Crankshaft

45.32

45.32

Base casting

24.13

24.13

Gaskets

0.08

0.40

Check valve assembly

5.64

5.64

Intake valve assembly

12.45

12.45

Output valve assembly 1

15.14

15.14

Hose--18 inches

1.25

1.25

Hose--five feet

3.24

3.24

Metal frame

1.13

1.13

Wheels

1.85

3.70

Mounting platform

3.25

3.25

Label set

12.45

12.45

Packing materials

0.75

0.75

Packing box

1.26

1.26

Total material cost

Cost

RM310.00

To estimate the increase in company cost from producing another 100 paint sprayers, the
accountant merely multiplies the unit cost of RM310 by the 100 units to arrive at a total cost
increase of RM31,000. If the accountant or manager expects any of the materials costs to change
because of this order, he or she can just incorporate the new materials cost into the bill of
materials to compute a new unit cost.

COST BENEFIT ANALYSIS

Cost benefit analysis is the systematic process for calculating and comparing benefits and cost in
order to determine if the investment is good or not and how to see how it compares with alternate
projects. It is used to evaluate if the benefits exceeds the costs.
Equation,
B/C = (Benefits Disbenefits) to the public
(Costs) to sponsoring agency
It is a step to compare the cost and its benefits of a product. The purpose of CBA is to lead the
decision of company to produce any proposed products. If the benefit outweighs the cost, the
company can proceed to produce their particular product and vice versa. Hence, by considering
CBA for any product that is going to be produced, it can help to justify the feasibility of product
in market.

Example
1. Cost Benefit Analysis - Purchase of New Stamping Machine
(Costs shown are per month and amortized over four years)
1. Purchase of Machine .................... -RM20,000
includes interest and taxes
2. Installation of Machine ..................... -3,125
including screens & removal of existing stampers
3. Increased Revenue .......................... 27,520
net value of additional 100 units per hour, 1 shift/day, 5 days/week
4. Quality Increase Revenue ..................... 358
calculated at 75% of current reject rate
5. Reduced material costs ...................... 1,128
purchase of bulk supply reduces cost by RM0.82 per hundred
6. Reduced Labor Costs ....................... 18,585
3 operators salary plus labor o/h
7. New Operator ................................. -8,321
salary plus overhead. Includes training
8. Utilities ............................................ -250
power consumption increase for new machine
9. Insurance ......................................... -180
premiums increase
10. Square footage ...................................... 0
no additional floor space is required
Net Savings per Month ........................... RM15,715
Your cost benefit analysis clearly shows the purchase of the stamping machine is justified. The
machine will save your company over RM15,000 per month, almost RM190,000 a year.

2. A commercial director is deciding whether or not to invest in a new computer-based

customer service system. The sales department currently has only a handful of
computers, and the customer service operatives are not especially computer literate,
but he can see the potential value of being able to reach a significantly larger number
of customers and provide more efficient customer services, and feels that the new
system would enable this to happen. The director carries out a cost benefit analysis,
with the results shown below. It can be seen from these figures that (providing the
estimates are accurate, of course) the system would pay for itself within the first year
of operation - within the first eight months, in fact.

Example 3

The table below shows its set of data of all cost and benefits involved in production in Syarikat Tenaga
Bersih Sdn Bhd
Type of cost
Purchase of Machine (includes interest and
taxes)
Installation of Machines (including the screen
and the removal of existing stampers)
Increase revenue (the net value of add. 100
unit/hr , 1 shift /day, 5 days/week)
Quality increase revenue (calculated at 75% of
current reject rate)
Reduce material cost (purchase of bulk supply
reduces cost by 0.82 $ per hundred
Reduce labour costs (3 operators salary + labour
o/h)
New operator (salary + overhead includes
training)
Utilities (power consumption increase for new
machines)
Insurance (premium increase)
Square ft (no additional flow space is required)
Net savings

Cost
-RM 20,000
-RM 3,125
+RM 27,520
+RM 358
+RM 1,128
+RM 18,585
- RM 8321
- RM 250
- RM 180
-nilRM 15,715

Based on the table above, + (plus) sign shows the benefits acquired during production while (negative)
sign shows the cost that are incurred by the company. The net savings are RM 15,715 which shows the
health benefits of the product.