The strengths and weaknesses of product costing systems in modern organisations

Product Costing System is a management tool that identifies the actual cost of producing each product.
Identifying profit or loss on each product, companies can identify and promote profitable products while
dropping, redesigning, or repricing unprofitable products.

It is the process of identifying and allocating all the relevant expenses that are accrued in the production and sale
of a product, from procurement of raw materials to transportation of final product to retail establishments. As
John A. Lessner indicated in the Journal of Accountancy, "In today's hotly competitive business environment,
accurate product costing has become critically important to a business's survival."

In older days the manufacturing processes were less automated than what it is today. In those days the costs
were allocated only on the basis of material, labour & overheads, however in today’s world the production of a
product has so many components and has an extremely automated production lines that there is little or no need
to maintain component inventories; thus, the old costing formulas, which are still being used by many industries,
are no longer applicable. In modern world the focus while manufacturing is quality, flexibility and meeting
customer’s needs. This further complicates the old costing methods.

Now we will discuss the 3 methods which are primarily used under product costing methods:

Process Costing Method: This method of costing is used where the output results from a continuous or
repetitive operations or processes and products are identical and cannot be segregated. This method is also used
where a number of production processes are involved and the output of one process is the input to a later
process, this continuing until the final product is completed. Examples of industries where process costing might
be applied are food processing, chemicals and brewing.

The advantage of this system is that it is easier to use in comparison with the other cost allocation methods. As
in today’s dynamic world, most of the companies have to be flexible when it comes to production, and a lot of
processes are either added or deleted, the process costing helps the management accountants to track and
allocate the costs accordingly. This process helps a company to determine selling price/unit by adding profit
margin to profits. This method also enables a company to increase efficiency by pointing out the processes
where cost is higher than budgeted.

The disadvantages of this system are that by accruing all costs and dividing such costs on an average, it becomes
difficult to determine the actual cost accrued to manufacture a specific variant. This method may cause
unreasonable pricing decisions at times as it does not takes customization into account for individual orders.
This system reflects historical costs instead of current costs, thus limiting the purpose of managerial decision
making in modern organisations.
Job Costing Method: This method is used where goods and services are produced upon receipt of a customer
order, according to customer specifications, or in separate batches. In this process as each job is treated as a
unique job, the material & labour can be easily traced and allocated to the job. The overheads are allocated on
the basis of allocation rate. This method is used not only by manufacturing companies, but also by service
industry like hospitals, law firms, etc. This system is a complex one that is prone to error, but it does yield good
information about production-specific costs.

The advantages of this system are that it provides the management team with ready access to all the costs
incurred pertaining to each completed job. This helps the management in doing a detailed analysis of costs to
find why was the cost incurred and how can the cost be controlled to attain maximum profits. This method also
provides ongoing results for each job which enables to management to take preventive measures in case of any
unnecessary costs being incurred, instead of an identification post the job is over.

The disadvantages of this system are that overhead is usually allocated on rates that change almost annually,
however at times fluctuations can cause over and under allocation of overhead costs to jobs during that period,
which might misguide the managements decision. This method also requires a lot of data entry work, and as it is
done by human intervention, any single mistake can result in ineffective results. This method has little relevance
in some environments. For example, the soft ware industry has high development costs but almost zero direct
costs associated with the sale of its products.

Activity Based Costing Method: This method attempts to divide production into its core activities, define the
costs for those activities, and then allocate those costs to products based on how much of a particular activity is
needed to produce a product. In this method the costs are assigned to specific activities such as planning,
research, or production—and then the activities are linked to relevant products or services. This enables the
management to analyse which products or services are profitable or visa-versa.

The advantages of this method are that it gives a more accurate and reliable costing of different activities. This
method is easier to understand and gives a better understanding of overheads. This method utilizes the unit cost,
rather than just the total cost. Thus method enables costing of processes, supply chains, and value streams, and
makes visible waste and non value added activities.

The disadvantages of this process are that the implementation of this method requires significant amount of
resources. Reports generated by using this method do not confirm to GAAP (generally accepted accounting
principles). At times this method becomes a hindrance in the process as overly detailed information if not
connected well to the actions creates problems. The data obtained from this method can be easily incorrectly
interpreted and must be used with care in the decision making process. Costs assigned to products, customers
and other cost objects are only potentially relevant. Before making any significant decision using the data
obtained from this method, managers must identify which costs are really relevant for the decisions at hand.
The product costing system is primarily used for manufacturing businesses; however it also has applications in
non manufacturing industries. Above we discussed the 3 different methods of product costing systems being
used in the modern organisations. Each method has its pros and cons, and it is advisable that he management
accountants of the company carefully choose the method which best suits their business and will help the
managers to take effective decisions pertaining to the business.

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Refrences:

http://www.futureaccountant.com/process-costing/study-notes/characteristics-features-application-industry.php

http://www.accountingformanagement.com/process_costing_system.htm

http://www.download-it.org/free_files/file1Pages%20from%209%20Process%20Costing.pdf

http://www.principlesofaccounting.com/chapter%2020.htm

http://www.brighthub.com/office/finance/articles/100024.aspx

http://www.referenceforbusiness.com/small/Op-Qu/Product-Costing.html

http://www.referenceforbusiness.com/small/A-Bo/Activity-Based-Costing.html