Product Costing

Professor Gil Sadka

Agenda: Basics of Product Costing
General mechanics of product costing

Actual and normal costing

Firm practice
Five-step Approach to Product Costing
1. Identify cost object
2. Identify direct cost categories (DM, DL)
3. Lump together all OH (indirect) costs
4. Choose an OH allocation base
5. Calculate OH rate:
total costs in OH pool
OH cost rate =
total units of allocat. base
Direct vs. Overhead (Indirect) Cost

Direct cost Cost tracing (Step 2)

(dir. labor and
materials)
Cost
object
(Step 1)

Overhead Cost
(OH) pool

Cost allocation (Steps 3-5)

Example: Apparel
1. Cost objects: 1,000,000 pants and 500,000 shirts manufactured in a plant
2. Direct cost:
Pants Shirts
Fabric (DM) $3,500,000 2,000,000
Sewing labor (DL) 1,300,000 500,000

[… at an hourly sewing wage of $20 / DLH, where DLH = DL hours]

Example [cont.]
3. OH costs:
– Factory rent $2,400,000
– Utilities 800,000
– Management 550,000
– Staff 450,000
Total: $4,200,000
All OH cost are collected in one cost pool
Example [cont.]
4. Allocation base: direct labor hours.
ØIn this case: 90,000 DLH (total DL cost of $1.8m divided by hourly wage of $20)

5. OH cost rate:

total OH cost
OH cost rate =
total # of DLH
$4,200,000
= = 46.667 $/DLH
90,000 DLH
Example [cont.]
Deriving per-unit cost for each pair of pants:
$/unit

– DM [$3.5m/1m units] 3.50

– DL [$1.3m/1m units] 1.30
– OH [($46.667 per DLH)*(0.065 DLH/unit)] 3.03
Total: $7.83
[where 0.065 = $1,300,000 / (1,000,000 units * ($20 / DLH))]
Example [cont.]
Deriving per-unit cost for each shirt:
$

– DM 2,000,000
– DL 500,000
– OH [($46.667 per DLH)*(500,000/20 DLH)]
1,166,667
Total: $3,666,667
[per unit cost is 3,666,667 / 500,000 = $7.33]
Should We Allocate Fixed Overhead Costs?
The Economist’s Perspective
A fixed cost is a sunk cost so it should be ignored always
There is no economic role for allocating fixed cost
The Economist’s Also Tell Us
Efficient/optimal practices are the ones that will continue and persist
Given this, how should we interpret the following?
Almost Every Business We Observe Allocates Overhead Costs In
Determining Performance
Banks
(who we believe are quite sophisticated)
Consulting Firms
(who often tell clients not to allocate fixed overhead costs)
Service Companies
Manufacturing Companies
High Tech Companies
The Managerial Accountant’s Perspective
In the long run if you are unable to cover fixed costs, the business is not viable.
One role of cost allocation may be that it provides an indicator of whether the
business will survive.
The Managerial Accountant’s Perspective
What is a Fixed Cost?

Overhead Cost
Sales Volume

In Order To Be A Truly “Fixed

Cost”, The Cost Should Not
Increase As Volume Increases
Time
The Managerial Accountant’s Perspective
But In Many Companies We Observe The Following:
Variable Costs Are Those Which
Increase With Sales Volume, But Maybe
At a Lower Rate

Time
In Many Companies, Overhead Cost is
Growing Faster Than Sales. These Costs
Could Be Considered “Super Variable”
Overhead Cost
Sales Volume
Time
Summary: Pros and Cons of Cost Allocation
CON: Used incorrectly, allocated fixed costs might lead you to wrong business decisions

PRO: Need to cover fixed cost in order to be viable

PRO: What is a “fixed” cost
PRO: Cost Allocation is a common business practice and needs to be understood

We may not have any perfect solutions, but that doesn’t

mean we should ignore the problems