Product costing methods may be grouped under the following three main categories: 1. Specific Order Costing 2. Continuous Operation/Process Costing 3. Service/Function Costing.
Method # 1. Specific Order Costing:
Specific order costing method is the basic costing method applicable where work consists of separate contracts, jobs, or batches, each of which is authorized by a special order or contract.
Thus, specific order costing refers to costing methods that are used by organizations whose products are identified as individual units (jobs or contracts or projects) or batches. Batch costing and Contract costing methods are included in this broad category.
A. Job Costing or Job Order Costing Method:
Features of Job Order Costing:
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Job order costing is that form of specific order costing that applies where work is undertaken to customer-specific requirements and each order is of comparatively short duration (compared with those to which contract costing applies).
The work is usually carried out within a factory or workshop and moves through processes and operations as a continuously identifiable unit. The term may also be applied to work such as property repairs and the method may be used in the costing of internal capital expenditure jobs.
Organizations that commonly use job costing system are engaged in manufacturing general engineering products, e.g., high-capacity pumps, compressors and pressure vessels, steel structures, and shipbuilding. Consulting firms and firms offering IT-enabled services use job costing method.
The distinguishing features of a situation where use of the job costing method is appropriate are as follows:
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(a) The product is not meant for a mass market.
(b) The job is for a specific customer and is of the ‘one off’ type. The job is not exactly the same as anything produced before and may never be produced again.
(c) The job can be identified at each stage of production, from start to finish. There is no predetermined flow line for the job and, therefore, careful routing and scheduling is essential for successful completion of the job.
(d) The production cycle is short as compared to that of long-term contracts, which often span over multiple accounting periods. The production cycle usually ranges between 6 and 18 months.
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Issue of the production order lays the foundation for collection and monitoring of costs, as the job proceeds through various stages of production. Each production order bears the unique job number allotted to job. If a production order covers more than one unit, each unit is identified by a serial number.
E.g., the first unit of Job No. 1503 may be identified by Job No. 1503/1 and similarly, second and third units may be identified by 1503/2 and 1503/3, respectively.
The production order contains all the relevant information, which includes particulars of the job or product, the quantity or units to be manufactured, scheduled delivery date, details of materials required as per ‘bill of materials’, and operations in different workstations.
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As the job proceeds, the cost accounting department, on receipt of the production order, opens a job cost card or job sheet to record costs.
It is essential to compare actual costs with estimates used for preparing the quotation. The analysis brings out variances in material quantity and price, labour hour for each cost centre, and in overheads.
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Job cost cards or Job sheets are maintained for each job. They do not relate to specific periods but maintained for each job, and all costs incurred on the job are recorded therein.
The job cost card bears the job number, customer name and order number, and scheduled delivery date, date of commencement, and completion of the job. To facilitate comparison, the job sheet shows the final cost estimates.
Collection of Costs:
i. Material Costs:
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Most materials required for a particular job are specifically purchased for the particular job and others (usually termed as ‘stock items’) are drawn from the regular stock. Materials specifically purchased are priced using specific identification method and materials drawn from stock are valued on weighted average price or any other method (LIFO, FIFO, etc.) adopted for pricing material issues.
Waste is discarded material having no value.
Wastage of materials may be normal to a specific job or normal to the process. If it is normal to the process, i.e., common to all jobs, the cost of the wastage should be treated as overhead. If it is normal to a specific job, the same should be booked to the job.
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Costs of abnormal wastage should not be charged to the job or the process. It should be charged to the Costing Profit and Loss Account. It is important to highlight abnormal wastage so that remedial actions can be taken to correct the conditions, which may have resulted in abnormal wastage and the incorrect decisions can be avoided.
Scrap is the discarded (residual) material having some recovery value. Scrap does not refer to a job rejected after processing up to a certain stage.
No distinction is made between normal and abnormal scrap because no cost is assigned to scrap. Accounting for scrap depends on its sale value. If the sale value is immaterial, scrap sale is recognized as other income in the Profit and Loss Account. If, the sale value is material, scrap sale is reduced from manufacturing overheads. If the sale value is material and the scrap can be traced to a particular job, scrap sale is adjusted against the cost of the job.
Labour costs are booked to particular jobs on the basis of the ‘Time ticket’ or any other document which is used for time booking. Labour hours booked against the job are valued by applying the hourly rate established by the cost accounting department.
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Direct expenses other than direct material and labour such as subcontracting expenses and hire charges of special machinery, should be shown separately.
Overheads are charged to the job by applying predetermined rates. E.g., if factory overheads are absorbed at a pre-determined rate per labour hour, the amount to be charged is calculated by multiplying the actual labour hours booked on the job by the predetermined hourly rate.
Spoilage is a fully or partly completed unit of production that does not meet the product specification. It is discarded or sold at reduced prices.
Spoilage is classified as normal spoilage and abnormal spoilage. Normal spoilage arises even under efficient operating conditions. Abnormal spoilage would not arise under efficient operating conditions.
Normal spoilage common to all jobs is accounted for as manufacturing overhead. Normal spoilage specific to a particular hob is charged to the job. Let us take an example. A firm manufactures steel castings. At the machining stage, the last in the sequence of operations in manufacturing castings, 10% spoilage is considered normal.
Assume that during the period under consideration 100 units had been machined and 10 units were spoiled. The cost at the point of inspection was CU 10,000 per unit. The spoiled units are expected to realize CU 1,000 per unit. Therefore, spoiled units will be taken in stock at CU 1,000 per unit.
If the spoilage is common to all jobs, the loss, i.e., the cost to the point of inspection less the realizable value, is considered as manufacturing overhead. In this example, (CU 10,000 × 1,000) × 10 or CU 90,000 should be included in the manufacturing overhead.
If the spoilage is specific to the job, the realizable value of (CU 1,000 × 10) should be reduced from the cost of the job. The net cost of the 90 good units up to the point of inspection is (CU 10,000 × 100 – CU 1,000 × 10) or CU 990,000.
Cost of abnormal spoilage does not form part of the cost of good units produced. It is charged to Costing Profit and Loss Account.
Rework is units of production that do not meet the product specification and subsequently repaired and sold as good finished units.
Accounting for rework cost depends on whether the rework is normal or abnormal. Cost of abnormal rework is charged to the Costing Profit and Loss Account. Cost of normal rework common to all jobs is accounted for as manufacturing overhead. Cost of normal rework specific to a particular job is charged directly to the job.
Bookkeeping is most appropriate for job cost bookkeeping. Double entry principles are applied in recording transactions. Firms have options to use either separate books for cost accounting and financial accounting with interlocking systems or the same set of books both for cost accounting and financial accounting. Under both these methods, accounting flow synchronizes with production flow.
B. Back Flush Costing:
Under job costing method inventory accounting synchronizes with purchase and production flow. Accounting entries for purchases are made immediately on receipt of material. Immediately on issue of materials and consumption of other resources, entries are made in work-in-progress accounts.
As the job moves through different work-stations and as production progresses, the job account in work-in-progress ledger is debited with costs of direct materials, direct labour costs and bought out services consumed at each stage of production, and also with a fair share of overheads pertaining to different work-stations through which it is routed. This method provides detailed cost information and audit trails but requires elaborate and correct documentation.
Firms that follow JIT manufacturing philosophy and management philosophies, which advocate minimizing use of accounting information for control, are now questioning the need for such an elaborate method. These firms prefer to use simple methods that may not track down costs at each stage of production, yet provide the results that do not differ materially from those being generated by conventional job costing method. Back flush costing is one such simple method, which has earned favour with cost accountants.
Back flush costing is defined as ‘Cost accounting system, which focuses on the output of an organization and turns back to attribute costs to stock and cost of sales’. Under this method, accounting entries are made on the completion of the job. In extreme cases, accounting is delayed until the manufactured produce is sold. Evidently, WIP account is dispensed with and costs are assigned to units only on competition. Often, budgeted or standard costs are used to assign costs to finished units.
This method is also known as delayed costing, end costing, or post-deducts costing. There are three versions of back flush costing method.
We shall use the following data to illustrate the accounting under each of these three versions:
There are no opening stocks of raw materials, work-in-progress, or finished goods. It is assumed that there are no direct material variances for the period.
In this version a combined direct materials inventory and work-in-progress account is maintained to record purchase and consumption by units completed. Consumption is calculated using budgeted or standard rates. A single conversion cost control account is maintained to record actual labour costs and overheads. Alternatively, separate accounts are maintained to record labour costs and overhead. The account(s) is credited by the amount assigned to completed units using budgeted standard rates.
Finished goods control account is maintained to record the cost of completed units and cost of goods sold account is maintained to record the cost of units sold. Completed units are valued by using budgeted or standard costs.
Over- or under-absorbed conversion costs are transferred to cost of goods sold account on monthly basis. Unlike in job costing methods, the amount is not prorated between WIP, finished goods, and cost of goods sold.
This method is known as ‘super-variable costing’ or ‘throughput costing’. In this method, a combined direct raw material, work-in-progress and finished goods inventory is maintained to record purchase and consumption by units sold. The account is titled as ‘Inventory control A/c’ and the cost of direct materials consumed is calculated by using budgeted or standard rates.
A single conversion cost control account is maintained to record labour costs and overheads. The account is credited by the amount assigned to units sold by using budgeted or standard costs.
Cost of goods sold account is maintained to record the cost of units sold. Cost is determined by using budgeted or standard rates. Over or under-absorbed conversion costs are transferred to cost of goods sold account on monthly basis. The net effect of this method is that conversion costs are treated as period costs and not inventoriable costs.
The difference between Versions 1 and 2 is that for accounting purposes in Version 1, the physical sequences are taken as complete on completion of the manufacturing of units of output while in Version 2 physical sequences are taken as complete only when units of output are sold.
This method is a radical shift from the conventional job costing method and is the simplest of the three versions. Under the method no entry is made for purchases of materials. The first entry for inventory is passed for recording cost of finished goods.
This method is suitable only for those firms that use JIT philosophy and hold almost NIL direct material inventories.
Conditions Suitable for Back Flush Method:
The following three conditions must be satisfied for adopting back flush costing method:
(a) Control systems in the firm do not use cost information and therefore management does not feel the necessity of detailed tracking of costs;
(b) It is feasible to set budgeted or standard costs for each product; and
(c) Back flush costing method generates approximately the same operating income and inventory valuation as are generated by conventional job costing method.
This is likely to happen only if the firm has implemented JIT systems or there is an almost NIL fluctuation in inventory levels.
Difficulties in back flush costing:
(a) It does not strictly adhere to the accounting standards for external reporting.
(b) In this method, it is difficult to create audit trails.
(c) It is feasible only in those situations where JIT is fully implemented.
(d) It fails to provide accounting information for control.
Under contract costing each contract is designated as a cost unit. It is used where work is undertaken to customer’s special requirements and each order is of long duration (compared to those to which job costing applies).
Usually contract costing is used to determine cost of contracts entered into for the design, manufacture, or construction of a single substantial asset or the provision of a service (or of a combination of assets or services that together constitute a single project) where the time taken substantially to complete the contract is such that the contract activity falls into different accounting periods.
E.g., contract costing is used to determine cost of a contract for shipbuilding or a contract for construction of a flyover.
In general the method is similar to job costing.
Method # 2. Process Costing:
Features and Uses:
Process costing method is used to ascertain the cost of the product at each process, operation, or stage of a manufacturing process, which involves a sequence of continuous or repetitive operations and processes.
In a continuous manufacturing process/operation, plant and machinery are so arranged that production of a standard product continues for a long period without interruption. The process/operation is interrupted only when the plant or machinery is shut down for repair or if a change in production technique or product specification is proposed.
It is common that a single process/operation produces more than one product simultaneously. Each can be identified separately, only when they emerge as finished products. Depending on the importance (in terms of value) of a product jointly produced with other products, it is designated either as a joint-product or as a by-product.
All joint products are considered main products. By-products are considered incidental to the process. E.g., in the petroleum industry petrol, diesel, liquid petroleum gas, and kerosene emerge as joint products. In coke oven, coke is the main product and gas is a by-product, while in gas works, gas is the main product and coke is the by-product.
If manufacture of saleable products involves more than one process/operation, output of one process/operation becomes the input for the next process/operation. The output of one process/operation is transferred to the next process/operation either at cost or at a predetermined transfer price.
As the production process is continuous, usually there is work-in-progress at the end of each accounting period. The process cost for a period is apportioned between completed output and WIP at the end of the accounting period.
Process costing method can be used in all those industries where job, batch, contract, or unit or operating costing system cannot be employed. Examples of such industries are chemicals (pharmaceutical, paint, ink, varnishing, soap, etc.), steel/rubber, distilleries, dairy, food processing, confectioneries, tanneries, paper, oil refineries, textile weaving, and spinning.
Process Loss, Scrap, and Wastage:
A loss of material due to evaporation or spoilage in process is inevitable in process industries and therefore output from the process is less than the input of material. Scrap is discarded material, which has some recovery value and which is either disposed of without further treatment (other than reclamation and handling), or reintroduced in the production process in place of raw material.
The spoilt material, which has low recovery value, is termed as scrap. Spoilt material may sometimes be reintroduced in the process after reprocessing and such spoilt material is also known as scrap. E.g., copper offcuts may be reprocessed for conversion into copper strip for reintroduction in the process.
Spoilt material, having no value is termed as waste.
Inspection Point:
An inspection point is the stage of the production cycle at which products are examined to determine whether they are acceptable or unacceptable units. Spoilage is typically assumed to occur at the stage of completion where inspection takes place. In absence of any specific mention, it is assumed that the inspection takes place at the end of the process. Therefore, it is usually assumed that scrap units are 100% complete in respect of both the material and the conversion costs.
Elements of Production Cost:
a. Material:
Usually, raw materials are introduced in the first process and after processing they are transferred to the next process or to the warehouse. Conversion of raw materials into finished products involves a single process or a sequence of processes. The previous process costs are often termed as ‘Transferred-in costs’.
Additional materials added in the second and subsequent processes do not add to the quantity of basic inputs introduced in the first process. E.g., catalysts added in the second or subsequent processes do not add to the quantity of basic inputs.
Generally, in industries for which process costing method is suitable, the cost of direct labour forms only a small part of the total production cost because those industries are mostly capital intensive. With increasing automation, the direct labour cost decreases while manufacturing overhead increases.
The task of workers is generally to keep a watch on the process or operation to identify malfunctioning of the equipment. They cannot directly influence the productivity. Therefore, time rates are used to calculate salaries and wages.
c. Direct Expenses and Overheads:
Expenses attributable to a particular process should be treated as a direct charge to the process account.
Each process account is charged with a reasonable share of general production overhead. Production overhead is assigned to different processes on some equitable basis.
Accounting of Normal Loss, Abnormal Loss, Abnormal Gains, and Scrap:
The fundamental cost accounting principle is to value completed units at ‘normal cost’ and exclude ‘abnormal costs’ from the product cost. Accordingly, to determine average cost per unit, the total cost is divided by normal output. In other words, the cost of ‘normal loss’ is absorbed by good units.
The normal product cost thus determined is applied to determine the costs of abnormal loss and abnormal gain. Abnormal loss arises when the actual output from the process is less than the normal output. Similarly, abnormal gain arises when the actual output from the process is greater than the normal output.
The spoilt material may have some recovery value. The process account is credited with the scrap value of normal loss.
Physical and Equivalent Units:
In industries, where process costing system is used, the manufacturing process is continuous. Therefore, it is not possible to identify costs incurred for specific output units. Costs for a period are accumulated against the process. The average cost per unit of output is computed by dividing the total costs accumulated in a particular period by the number of units produced.
It is possible that at the end of the period, some units are incomplete. In that situation, average cost is calculated by taking ‘equivalent units’ in the denominator. The same method is used to determine the average if some incomplete units carried forward from the previous period are processed during the period.
Equivalent units = Physical units × Work done during the period
Work done is expressed as a percentage of total work required for completing one unit of the product.
Transfer Prices:
In an industry where sequences of processes constitute the whole production process, output of one process becomes the input of the next process. Usually output of one process is transferred to the next process at normal cost.
However, a firm may use either of the following different methods for fixing the transfer price. Transfer price is a price related to goods or other services transferred from one process or department to another or from one member of a group to another. The extent to which costs and profit are covered by the price is a matter of policy.
a. Absorption Cost as Transfer Price:
Absorption cost, often known as total cost, is composed of direct material, direct wages, direct expenses, and production overhead.
This method allows the manager of the department transferring its output to recover the full cost of the output. A major disadvantage of this method is that inefficiencies in the operation may be concealed in the transfer price at a disadvantage to the transferee process.
b. Marginal Cost as Transfer Price:
Marginal cost is composed of direct materials, direct wages, direct expenses, and variable production overheads. It excludes fixed production overhead. This method is usually considered unsuitable for transfer pricing.
However, the proponents of this method argue that if contributions from all products are sufficient to leave profit after absorbing fixed overhead, there is no need to recover fixed production overhead through transfer price. As in the case of absorption cost method, a major disadvantage of this method is that it may conceal inefficiency in the operation.
c. Standard Cost as Transfer Price:
Standard cost may either be standard absorption cost or standard marginal cost. The greatest advantage of standard cost over actual cost is that inefficiencies cannot be hidden in the transfer price. Moreover, actual performance can be monitored through variance analysis, i.e. comparing the actual cost with the standard cost.
d. Cost Plus Profit as Transfer Price:
Under this method transfer price is calculated by adding a ‘mark-up’ to the cost of production. The ‘mark-up’ is usually expressed as a percentage of the cost of production. However, most firms allow managers to negotiate the transfer price.
The method of adding predetermined mark-up, expressed as a percentage of cost of production, not only conceals inefficiency, it rather allows greater profit with increase in cost. This is the reason why standard cost is preferred to this method. A variation of this method is to fix the transfer price at the current market price.
The advantage of using current market price is that it does not allow profit to the transferor process to the disadvantage of the transferee process. The most appropriate transfer price for an intermediate product that has a market is the market price.
Some firms add profit to the cost of production to calculate the transfer price. For the purpose of financial accounting, value of inventory should not include profit. Therefore, unrealized inter-process profit is eliminated from the period end inventory.
Method # 3. Service Costing:
Thus, operating or service costing is the method of determining the cost of specific services. In this method, operating costs are collected periodically and the total operating cost is divided by the quantity of service rendered during the period to arrive at the cost per unit.
The operating or service costing applies to activities that provide a service rather than a tangible product.
Examples of service organizations are transport companies (e.g. shipping, railways, airways, roadways), catering services (e.g. hotels, canteen, cafeteria), public utility services (e.g. gas, electricity, steam generation, hospitals, educational institutions), and professional services (e.g. accounting firms, management consultants, real estimate firms).
Although the types of services are diverse and each has its own peculiarities requiring different cost accounting treatment, the general principles of costing is applied in determining cost of services.
Cost Units:
The following list provides examples of the cost units for service activities:
Selection of a cost unit for the service department that provides a general non-specific service to the organization as a whole is a complex decision. Examples of such departments are the accounts, general administrations, security, building maintenance departments, etc. In most situations, it is wasteful to determine cost per unit of services rendered by those departments.
Collection of Costing Data:
Costs are accumulated under various headings suitable for cost control and for decision-making. Costs collected are usually grouped under fixed costs and variable costs. The format in which cost data is presented depends upon the nature of the industry and the need of the management.