Page |1

UTILISATION OF PRODUCT COSTING SYSTEMS IN THE MANUFACTURING INDUSTRY

Page |2

Table of Contents
1.0: INTRODUCTION4 1.1: 1.2: 1.3: Component of Product Costing4 Method to Calculation of Product Cost Method......5 Types of Product Costing System6 1.3.1: Job Order Costing........6 1.3.2: Process Costing7 2.0: UTILISATION OF PRODUCT COSTING SYSTEM IN MANUFACTURING 2.1: 2.2: 3.0: Activity in Job Order Costing Systems7 Activity in Process Costing Systems........8

INDUSTRY.7

JOB ORDER AND PROCESS COSTING COMPARISION.........8 3.1: 3.2: 3.3: 3.4: 3.5: 3.6: The Similarities .......8 The Differences ...9 The Strength and Weakness of Job Order Costing.......9 The Strength and Weakness of Process Costing.........10 Flow of Activity in Job Order Costing Systems.11 Flow of Activity in Process Costing Systems.12

4.0: 5.0: 6.0:

THE EVALUATION ..13 CONCLUSION 15 REFERENCES ...16

1.0:

INTRODUCTION

Page |3

A manufacturing industry/organisation is an organisation that processes raw materials into finished goods. Each manufacturing industry must have its price determined to ensure that the estimated returns can be achieved. One such important information that is always used is information is concerning cost. Product cost as indicated in BBAP2103 Management Accountings module for Open University Malaysia, is the cost that is provided directly to the product and Product costing involves measuring, recording and reporting of product cost. 1.1: Component of Product Costing

In term of manufacturing, direct raw material, direct labour & factory/manufacturing overhead cost is product cost. Product cost is the cost that is provided directly to the product . Add all of the direct costs associated with production. Direct costs are costs that are specifically and solely related to the product. These costs may include items such as salaries, supplies and advertising. To calculate the cost of product we have to add all the Direct Materials, Direct Labor and Manufacturing overhead ( PC =DM+DL+Mfg OH). For example, if a certain employee's job is to oversee the production of the one specific product being studied, that worker's salary would be a direct cost. This cost is absorbed into the product unit and at the point of sale and the change into an expense that is known as the cost of goods sold and is not considered an expense immediately . In commercial firm is known as purchase cost of the traded good. The components of product cost in manufacturing industry are summarized in Figure 1.1(a):-

DIRECT MATERIAL materials used in making finished goods. Example: flour and sugar for making biscuits, leather

Page |4

PRODUCT COST

DIRECT LABOUR Cost of lalbour directly involved in making finished goods. Example: the baker and the shoe maker

FACTORY OVERHEAD All manufacturing cost involved in making the product other than direct materials and direct labour. Example: electricity, water, rent

Figure 1.1: Summary of product cost involving manufacturing industry 1.2: Method to Calculate Product Costing

They are two method to calculate the product costinga) Absorption Costing System

Any cost that is directly involved with production is considered as a product cost without taking consideration whether they are variable costs or fixed cost. It also known as as full costing. Examples:Direct Material Direct Labour Variable Manufacturing Overhead Cost Fixed Manufacturing Cost = = = = = RM RM RM RM RM 22.00 14.00 6.00 9.00 51.00#

b) Marginal Costing

Page |5

It also known as variable costing or direct costing because it only takes into account the variable manufacturing overhead as a part of the product cost and considers the fixed manufacturing overhead as a period cost. Examples:Direct Material Direct Labour Variable Manufacturing Overhead Cost = = = = 1.3: Types of Product Costing System RM RM RM RM 22.00 14.00 6.00 42.00#

Product costing is required in all types of organization involves measuring, recording and reporting of product cost. There are two types of product costing systems used in manufacturing industry, job order costing and process costing. These two systems is used to calculate and present the total production cost. 1.3.1: Job Order Costing Job order costing is suitable to be used to allocates costs to products that are readily identified by individual units or batches, each of which requires varying degrees of attention and skill. The products that are on special order from customers, as an example tailoring shop where the tailor produces various types of shirts an uniforms at any one time. In other words, manufacturing costs are assigned to specific jobs: specific customers, specific orders, specific projects, specific contracts, etc. Job costing is often used by small- and medium-sized firms. The job order costing is used to record all cost allocated to produced the shirts that required by customers. 1.3.2: Process Costing Process costing is a method of allocating manufacturing cost to products to determine an average cost per unit. It is used by companies which mass produce

Page |6

identical or similar products. Since every unit is essentially the same, each unit receives the same manufacturing input as every other unit. Refineries, paper mills, and food processing companies are examples of businesses which use process costing and often used in the following industries: textiles, food processing, automobile manufacturing, electronics, drugs, paper, paint, oil refining, chemicals, service companies offering homogenous services, etc. 2.0: UTILISATION OF PRODUCT COSTING SYSTEM IN MANUFACTURING

INDUSTRY. 2.1: Job Order Costing Systems

All activities of completing to finished goods is based on job. As an example making biscuit, usually custom made. All manufacturing costs are assigned to specific jobs: specific customers, with specific orders and specific periods. Each product is made according to a customers specifications and the price quoted is closely tied to estimated cost. The cost incurred in manufacturing a particular job must therefore be matched to the goods produced. The diagram below presents a general flow of costs in a job order costing system where more than one job order is involved: Direct Direct Labour Mfg OH Direct Direct Labour Mfg OH Direct Work In Progress JOB 1 Work In Progress JOB 2 Finished Goods JOB 1 Finished Goods JOB 1 Finished Goods JOB 1

Work In Progress Direct Labour 2.2: Flow of Activity in Process Costing Systems JOB 3 Mfg OH

Process costing is a method of allocating manufacturing cost to products to determine an average cost per unit. It is used by companies which mass produce identical or similar

Page |7

products. Since every unit is essentially the same, each unit receives the same manufacturing input as every other unit. Refineries, paper mills, and food processing companies are examples of businesses which use process costing. The diagram below presents a general flow of costs in a process costing system: Direct Direct Labour Mfg OH Direct Direct Labour Mfg OH Direct Direct Labour Mfg OH

PROCESS A

PROCESS B

PROCESS C

Finished Goods

3.0:

JOB ORDER AND PROCESS COSTING COMPARISION 3.1: The Similarities

The similarities between job-order and process costing can be summarized as follows: a) Both systems have the same basic purposesto assign material, labor, and manufacturing overhead costs to products and to provide a mechanism for computing unit product costs. b) Both systems use the same basic manufacturing accounts, including Manufacturing Overhead, Raw Materials, Work in Process, and Finished Goods. c) The flow of costs through the manufacturing accounts is basically the same.

3.2:

The Differences

There are three differences between job-order and process costing. Table 3.2(a) summarizes the differences just described.

Page |8

Job Order Costing Environment Materials Involves small quantity products and is based on customer orders. Materials required for job varies from order to order Skilled labour varies according to changing specification

Process Costing Involves production on a large scale and in large quantities Materials needed are same for every order leading to bulk purchases opportunity Unskilled workers who carry out specific tasks repeatedly which form small part of the production process Big quantities are produced leading to longer production runs Remains the same for all orders and costs are accumulated by departments.

Direct Labour

Production Runs

Each production run is relatively short as the production is carried out for specific orders Varies from order to order and Costs are accumulated by individual job.

Cost Per Unit

Table 3.2(a): Differences between Job-Order and Process Costing 3.3: Strengths and Weaknesses of Job Order Costing

Strengths It provides detailed analysis of cost which enable the management to determine the operating efficiency of the different factors of production. It helps in comparing the two set of works and hence it is of great use while deciding on the efficiency of the departments within an organization.

Weaknesses It is very expensive as more clerical work is involved in identifying each element of cost with specific department and/or jobs. The cost are ascertained, even compiled promptly, are historical as they are compiled after incidence.

Page |9

Since precise order is to be completed by the company can allocate the resource according to order and hence there is no chances of any spoilage and hence it saves lot of money for the company. Company can know precisely how much profit it made from the completion of the order immediately after completing it. It lays down the standard for future similar contacts so that company can follow those standards and complete the next similar jobs effectively and efficiently.

The cost represent the cost incurred under actual conditions of operation. The system does not have any specific basis to indicate what the cost should have been, unless standard costing is employed. With the increase in clerical processes, chances of errors are enhanced. In case of inflation, comparison of cost of a job for one period with that of another becames meaningless. Distortion of cost occurs even when the batch quantities are different.

3.4:

Strengths and Weaknesses of Process Costing Strengths Weaknesses Process costing is ideally suited for homogeneous products, and fails to provide an accurate estimate of product costs when a single process produces many items or different versions of a same item.

The primary advantage of process costing is the ease and simplicity of accounting.

Process Costing is a simple and direct method of cost ascertainment that collects the overall costs from each department and ignores costs related to specific jobs within a department.

It also remains suitable only for bulk process works and not for customized orders.

This reduces the volume of data, and makes data collection easy and quick.

Apportionment of joint costs to diverse products may lead to irrational pricing decisions in such cases.

P a g e | 10

The analysis is likewise simple and straightforward, and does not require any specialized skills other than normal accounting skills.

While process costing enables budgeting standard costs, the costs obtained are historic and not current, and their use for managerial decision-making remains limited.

The uses of process costing extend to help establish effective control over the production process

Process costing makes evaluation of the efficiency of individual processes or productivity of an individual worker difficult.

3.5:

Flow of Activity in Job Order Costing A job order costing system is used when a job or batch is significantly different from other jobs or batches. Cost accounting is usually fairly simple in these systems. Labor and materials are entered on a job ticket. Overhead is usually added to the amount the customer will be charged for labor and materials. All activity of completing to FG is based on job. In the job is making biscuit.usually custom made and involves small quantity products and is based on customer orders. Diagram 4.1(a): JOB 1 Ordering of Chocolate Biscuit from Customer A

Direct Labour:Mixer Chocholate Biscuits Baker Making: Direct Material:Flour Maxing Sugar Moulding Margerine baking Chocolate Powder Direct Labour:cooling Chocolate cips Mixer packing Mfg OH:Baker RentDiagram 4.1(b): JOB 2 Ordering of Almond Biscuit from Customer B Oven Direct Material:Chocholate Biscuits Rent Mixer Flour Making: Utilities Sugar Margerine Almond Powder Almond Mfg OH:Rent Oven Rent Mixer Utilities Maxing Moulding baking cooling packing

FINISHED GOODS:CHOCOLATE BISCUIT

P a g e | 11

FINISHED GOODS:ALMOND BISCUIT

3.6:

Flow of Activity in Process Costing The process costing methodology suits homogeneous products and continuous flow production situations and finds widespread application in manufacturing industries such as a large amount of product that are similar remains the same for all orders. Diagram 4.2(a): Organisation that Produce One Type of Butter Cream Biscuit Direct Labour Mixer, Baker Direct Material Flour, Sugar, Butter, Cream Mfg OH - Rent Oven, Rent Mixer, Utilities

MAXIN G

MOULDI NG

BAKI NG

COOLIN G

PACKIN G

FINISHED GOODS:BUTTER CREAM BISCUIT

4.0:

EVALUATION In accounting, a standard costing system is a tool for planning budgets, managing and controlling costs, and evaluating cost management performance. A standard costing system involves estimating the required costs of a production process.

P a g e | 12

Before the start of the accounting period, standards are determined and set regarding the amount and cost of direct materials required for the production process and the amount and pay rate of direct labor required for the production process. These standards are used to plan a budget for the production process. At the end of the accounting period, the actual amounts and costs of direct material used and the actual amounts and pay rates of direct labor utilized are compared to the previously set standards. Comparing the actual costs to the standard costs and examining the variances between them allows managers to look for ways to improve cost control, cost management, and operational efficiency. An accurate product costing system will help managers come up with better product profitability analysis and product pricing decisions. However the organization often face problems in making decisions in what production method has to be used. In decision making, cost in an important factor that has to be considered. The cost of each alternative should be compared as one of the steps in decision making. Below are the example for the discussion on the decision making process for a special order from customer. Example 4.1: Syarikat Pemanis Sdn. Bhd. produces butter cream biscuits. The practical production of the company is 15,000 packet per year. Recently they received a special order for 500 packets from Encik Ahmad and requested modification to the biscuit with additional ingredients. The modification will incur and additional cost of RM1.00 per packet. The company also has to pay a special baker and that will incur a total cost of RM 1,000.00. Other than two machines will have to be rented to fill the special order with a total rental cost of RM 600.00. Encik Ahmad agree with the price of RM13.00 per packet. Normally,

P a g e | 13

the selling price of the ready-made biscuits produced by Syarikat Pemanis Sdn. Bhd. is RM 15.00 per packet. The cost for one packet of ready-made biscuits are:Direct Materials Direct Labour Variable Manufacturing Overhead Cost Fixed Manufacturing Overhead Cost Cost per packet : : : : = RM 1.50 RM 2.00 RM 2.50 RM 4.00 RM10.00#

Syarikat Pemanis Sdn. Bhd. should identify the relevant cost and benefits such as the production of the company per year and what are the price of the special order. The differences or increase in the operation is shown in Table 4.1:One Packet Increase in revenue Increase in cost:Direct materials Direct Labour Variable manufacturing OH Modification Machine Rental Total increase in cost RM 1.50 RM 2.00 RM 2.50 RM 1.00 RM 750.00 RM 1,000.00 RM 1,200.00 RM RM 500.00 600.00 RM 13.00 Total RM 6,500.00

RM 4,050.00

Increasse in Operating Income RM 2,450.00 The above calculations shows that the special order will brings a profit of RM 2,450.00 even though the price of the special order RM 13.00, is lower than the normal price RM 15.00 per packet. The fixed overhead cost is not taken into account in the analysis because the total fixed overhead cost will not increase if the special order is accepted or not. From the result of the analysis, suggest that the manager should accepted the special order from Encik Ahmad because it will brings a profit to the company. 5.0: CONCLUSION

P a g e | 14

Every organization needs to have a range of options in distributing its cost of products. There are two primary ends for the said spectrums which are th process costing and the job order costing. Based on the analysis, the organization that uses the job order costing is one which makes the unique and special order products. Thus, it is consider being a customer order in the specific number that specially designed for the product which is made to order. It measures the cost every complete unit. Thus, while product are manufactured, the direct labour and the direct materials are being transferred to the account of process inventory control. On the other side, the organization that uses the process costing is the one that produce the large similar of products which has the continuous product flow. In this regard, at the system of process costing, the direct labour, direct materials and the manufacturing overhead are traced primarily in the work cells and to the process but assigned to the produced products by the work cell or to the process. Generally, some of the companies are need of the process costing whereas the products are produced to the continuous basis. This methodology of tracking and capturing the costs associated to the form of process manufacturing is greatly different from the methodology needed in the discrete process of manufacturing. Process Cost management is an approach that is used to determine the costs of existing processes by which goods and services are designed, procured, delivered, and supported. It can be done for benchmarking, activity cost analysis, or product costing. It is also used to simulate resource consumption levels for future process and product configurations based on cost driver relationships derived from product attributes and process parameters. Managers perform these simulations to be able to deploy and align resources with anticipated activity demands as well as respond to new business opportunities. (2,600 words)

P a g e | 15

References Noor Asma Jamaludin et. al (2011). Open University Malaysia:BBAP2103: Management Accounting. Kuala Lumpur. Meteor Doc Sdn Bhd.

Lessner, John A. (1991) "Traps to Avoid in Product Costing." Journal of Accountancy.

Abdul Rahman Hamzah (1998), Perakaunan Perniagaan. Shah Alam. Piramid Perdana Sdn. Bhd.

Jafri Mohd Rohani, dan K. Y. Wong. 2000. Productivity Improvement in an V-Shape Manual Assembly Cel.. Jurnal Teknologi, 32(A).