Introduction to Product Costing

Introduction

A company that sells products must be able to make financial decisions such as:

• Do we really sell our products at a profit? Can we accept an order at a special price? Would an increase in sales actually result in increased profit?
• Would it be more profitable to buy a product rather than manufacture it ourselves, or to process the product further before selling it?
• Are our equipment and machinery cost effective? Is there wasted time, money, and effort in our processes?
• What impact will production changes have on product cost?

Costs to consider

There are different kinds of costs to consider in product costing.

• Recurring vs. Non-Recurring Costs

  Costs are either recurring or non-recurring. Recurring costs are costs that are incurred from year to year for goods and services consumed, such as staff salaries. Non-recurring costs are not likely to recur again.

  Usually, only recurring costs are included in product costing. The main exception is when apportioning an imputed cost annually for a resource with a budget life longer than one year, for example, costs for a specific machine, land, or plant.

Direct Costs vs. Indirect Costs (Overhead Costs)

Any operation involved in manufacturing or acquiring a product involves both direct costs and indirect costs. It is usually rather easy to allocate direct costs for operations and materials to the product. One of the biggest challenges in product costing is to allocate indirect costs to products.

• Direct Costs

  Direct costs are costs that can be directly identified with and traced to a particular product.

  The main categories of direct costs are:

  • Costs for raw materials or items that are part of the finished product or are used in the delivery of the product and that are charged by means of material requisition orders
  • Operations costs, that is, costs for labor (man-hours) and machine run time
  • Direct, billable expenses such as freight costs for purchased materials or materials distributed between different warehouses within the same company, costs for subcontracted work, or costs for special equipment
  • Other costs that can be traced directly to a part of the business or organization.
  • Indirect Costs

    Indirect costs are costs that cannot be directly identified with and traced to a particular product. Such costs are usually apportioned to the product, either directly or via cost centers. Since the cost of accurately measuring costs directly to products can be considerable in itself, many companies prefer to allocate these costs on a yearly basis in the form of estimates.

    Indirect costs can in turn be divided into production overhead costs (indirect costs that relate to production) and non-production overhead costs (costs that relate to administration and marketing).

    Examples of production overhead costs are:

    • Costs for tools or machinery used for various purposes
    • Depreciation on fixed assets
    • Cost of capital
    • Maintenance costs
    • Costs for supervision
    • Costs for electricity
    • Taxes.

    Examples of non-production overhead costs (usually general costs that would remain the same regardless of production output) are:

    • Salaries of sales and marketing staff
    • Advertising costs
    • Administrative costs.

• Fixed vs. Variable Costs

  Identifying which costs are fixed or variable in which circumstances is an important part of product costing.

  Fixed costs are costs that do not change when the volume of activity is changed, for example, rent for equipment. Variable costs instead do change; the cost increases when the volume of activity increases and decreases when the volume of activity decreases. An obvious example of a variable cost is the cost for materials used to manufacture a product.

  Traditionally, the cost per unit produced has depended to a high degree on variable costs. In modern manufacturing companies, fixed costs constitute an increasing part of costs due to increasing technology improvements, something which results both in a decrease of direct labor and an increase of total overhead due to depreciation on equipment, maintenance, and so on.

  However, the distinction between fixed and variable costs can sometimes be blurred. For example, if the volume produced increases above a certain level, it might be necessary to use additional equipment or hire extra staff. The fixed cost for tools or salaries then becomes partly variable. Salary costs are often partly variable with a fixed portion (the salary itself) and a variable portion (overtime).

  A lower volume of activity due to lower demand results in lower variable costs. However, since the fixed costs usually remain the same and are difficult to affect as quickly, the result is often a higher cost per unit produced. The calculated product cost might then not cover the actual cost, that is, the cost is under-absorbed. Or, in an opposite scenario, where the volume of activity is higher than normal, the calculated product cost might in effect be higher than the actual cost. The cost is over-absorbed.

  Direct costs are often variable or partly variable. Indirect costs are usually fixed or only variable to a lesser degree.

Allocation of costs

In product costing, only the resources that are required to obtain a specific benefit and that are normally connected with the business are included. How this is done depends on the costing technique and costing method selected.

Costing Techniques

Common basic methodologies (costing techniques) for product costing are:

• Full Absorption Costing

  Full absorption costing focuses on the functional nature of costs. It involves tracing all kinds of manufacturing-related costs for the product and absorbing them into the cost per product unit until the product is delivered and paid. This includes allocating both fixed and variable costs to the product. However, non-manufacturing costs such as administrative costs and selling and distribution costs are not allocated to the products and are consequently not part of the inventory value of the product; the unsold stock of products are valued at their total cost of manufacture.

  Direct costs are allocated directly to the product. Indirect costs are usually allocated first to cost centers (for example, the cost center of the manufacturing department), from where the cost then is apportioned to the product. The correct apportioning of indirect costs usually requires a continuous cost accounting.

  Some benefits of full absorption costing are:

  • Companies can more easily set product prices that result in a profit, since fixed costs are a substantial part of the total cost.
  • Companies can use the costing analyses for long-term decisions on product pricing, valuation of work in progress and finished goods as well as profit measurement.
• Variable Costing

  Variable costing focuses on how costs behave by separating costs into fixed and variable elements. Only variable costs are included in the cost of a product unit (product cost), whereas fixed manufacturing costs are treated as period costs to be written off in the period they are incurred. The variable costs are divided by the number of product units produced to retrieve the lowest price that can be assigned to the product. Inventory valuation is normally not done based on the total variable cost.

  Some benefits of variable costing are:

  • It is easier to manage.
  • Since there is no apportionment of costs, companies avoid both the common error of making misleading, arbitrary estimates on the basis of fixed costs, and the error of omitting invisible fixed costs.
  • There is almost no over-absorption or under-absorption, since those usually are incurred by fixed costs.
  • Since variable costing indicates the variable costs of the product, it is suitable for special analyses such as pricing decisions or management of short-term problems.
• Activity-Based Costing (ABC)

  In traditional product costing, costs are measured per unit of production. Indirect costs are added as a roughly estimated percentage of expenses onto the direct costs based on volume-based measures such as man hours and machine hours. That is, one assumes that there is a relation between the overhead and the volume-based measure, an assumption that not always holds true and might result in unreliable product costs.

  Activity-based costing, on the other hand, avoids this trap by focusing on the costs of each activity that leads to the final delivery of the product: You manage activities rather than costs. Examples of such activities (operations) are setting up equipment, maintaining equipment, and moving materials.

  In activity-based costing the entire business organization is regarded as a collection of activities on which product costs are based. After all, products consume activities and activities consume resources. Since the focus is on the consumption of resources in the activities undertaken to produce a product, activity-based costing puts the spotlight on the indirect costs (overhead).

  After having identified all relevant activities, the cost of each activity is allocated to the product proportionally to the extent the product uses the activity based on the number of events or transactions involved in the activity.

Costing methods

Costing methodologies (costing methods) can be applied in many different ways. Each costing method would most likely result in a different cost, so the selection of the method must be based on a thorough analysis of the company’s needs. The most widely used costing method within manufacturing companies is standard costing, where planned (budgeted, predefined) standard costs and income are compared periodically with costs actually incurred and income actually generated.

Another costing method supported by M3 is job costing, where the individual costs of performing a job are assessed. (In the case of M3, manufacturing orders and work orders.)

Some basic principles in product costing are:

• Include only the resources that are required to obtain a specific benefit and that are normally connected with the business.
• Value materials at their present value (the acquisition cost) at the time of consumption. For the sake of simplicity, a standard cost is usually applied.
• To avoid under-absorption and over-absorption, measure the normal volume of activity over a longer period of time so that the differences in calculated cost and actual cost are evened out in the long run.
• Test the accuracy of potential costing models by using historical data.

M3 product costing

M3 Product Costing combines traditional product costing with activity-based costing (ABC). All kinds of costs, direct and indirect, fixed or variable, can be retrieved to calculate the product unit cost.

• Standard Cost in Focus

  M3 Product Costing is basically about defining the standard cost of a product in a specific facility.

  A standard cost is a calculated production or operating cost of material and operations that needs to be carefully predetermined. A standard cost is set to reflect the expected cost of acquiring a product over a future number of periods. Consequently, the standard cost functions as a target cost that might or might not be attained. The standard cost is compared with the actual cost in order to measure the performance of a given costing department or operation. Unacceptable results are easier to identify for items and operations with a standard cost instead of average cost or actual cost.

  Standard costs are appropriate for items manufactured often enough so that material and labor costs are well known through repetition. Overhead is usually added as a percentage of the labor.

  The calculated standard cost is used as the booked inventory value (that is, the inventory value in the general ledger) for standard-costed items.

  In M3 you can also calculate the standard cost for manufacturing orders and work orders, provided that the product involved has a dynamic product cost (inventory accounting method 3).

• Other Costs

  Standard cost is used as one of five possible inventory accounting methods in M3, each one representing a different costing method for calculating item costs. For information about how item costs are calculated for other inventory accounting methods such as average cost and actual cost, see Calculation of Item Cost per Inventory Accounting Method.

  You can also calculate the standard cost of items that have a different inventory accounting method than standard costing. The standard cost calculated then reflects the cost of the item at the last product costing run and does not affect the inventory value of the item.

The product costing model

Definition

The key tool in product costing is the product costing model. The costing model is in practice a simplified model of the manufactured product, a model that is structured based on types of costs instead of product components (materials and operations). Therefore, the model looks different for different products. The costing model can also look different depending on the purpose of the analysis. For example, a costing model designed for pricing purposes might not be useful for profitability assessments. However, usually companies develop only a few costing models that are accurate for many items and facilities.

The product costing model does the following:

• Collects data from various parts of M3 of estimated costs that are incurred in manufacturing or handling a product whether they are direct or indirect, fixed or variable
• Displays the calculated costs online per type of cost represented in the model, thereby enabling you to trace specific costs using the drill-down functions in M3
• Identifies the cost to use as standard cost for the costed product
• Enables you to simulate and evaluate changes in costs and in the manufacturing process
• Enables you to follow up calculated costs with the actual costs incurred per order in M3 Cost Accounting.

The costing model is defined in 'Product Costing Model. Open' (PCS025).

Types of Costs Displayed

The product costing model enables you to view the calculated cost of the product broken down into the following categories:

• Material costs for purchased and distributed materials that are part of the manufactured product
• Operation costs (costs for labor time and machine time)
• Tool costs (costs for consumption of tools)
• Subcontract costs
• Other product costs

The drill-down functions in M3 then enable you to identify in detail the sources of a particular cost.

The cost is always calculated per facility, since material and labor can have different prices at different locations. That is also why product structures (see below) are defined per facility. This allows for different product costs for different production plants within the same company.

Two Display Modes

Apart from reviewing costs per category in the product costing model, you can also review these costs in two different display modes:

• Review the total cost incurred in acquiring or manufacturing semi-finished products. Costs related to manufacturing a semi-finished product on a lower level in the product structure (that is, costs for both materials and operations) are included in the cost of each semi-finished product.
• Review a total for each kind of cost separately in the form of 'exclusive' material costs, tool costs, and so on. Costs related to manufacturing a semi-finished product lower down in the product structure are not included in the material cost itself. Instead, each kind of cost is totaled for each level up to the level of the costed item in the product structure. For example, operation costs are always kept separate from the material costs.

When Used

Usually, a company would calculate the cost based on the product costing model once a year or when a new product is introduced. However, you can continuously simulate changes in the product costing model based on adjusted cost data or modified production routines.

The Cost Object

The object - a product, a product series or a product group - for which product costing is carried out is called cost object. If you want to calculate the costs for producing a table, for example, the table is your cost object. Usually the cost object in product costing is a manufactured product. For products with a dynamic product cost (inventory accounting method 3) you can also cost specific manufacturing orders or work orders, which in such a case function as cost objects.

Product is the term used in M3 for the top item in a product structure. Any items included on lower levels in the product structure are regarded as materials or material items. A material item can be a raw material or a more complex subassembly of materials that is the top item in another product structure.

Costs for Purchased and Distributed Items

Often material items are purchased from an external vendor or distributed from another facility within the same company. This purchase cost or distribution cost is calculated based on a specific type of costing model reserved for purchase costing or distribution costing. The cost can be calculated separately or automatically when you calculate the product cost. The calculated cost is then displayed in the product costing model.

A distributed item might already be associated with a product costing model with a similar structure in the delivering facility. In such a case and depending on your configuration, detailed cost data can be copied to the receiving facility.

For details, see Introduction to Purchase/Distribution Costing.

Role of the Product Structure in Product Costing

The primary base of the values in the product costing model is the product structure in 'Product Structure. Open' (PDS001).

Whereas the product costing model determines which costs to focus on and which rates to apply when calculating and displaying the cost, the product structure determines the materials and operations required to manufacture a product, thus functioning like the drawings for a construction kit. This includes a specification of the following:

• Which material items are used in manufacturing the product
• How many units of the material items are required
• Which operations are required
• The time each operation takes to carry out (for example, run time and setup time)
• The department and work center involved in each operation
• How many people and pieces of equipment are required to carry out the operation
• The planned scrap percentage and setup scrap.

The Building Blocks of the Product Costing Model

The product costing model consists of the following three types of building blocks:

• Costing Components and Cost Drivers

  Cost drivers, connected to most of the costing components, measure the cost object’s resource consumption. They define from where values are retrieved and how they are calculated.

  Costing components represent different types of costs such as labor costs and tool costs.

  Different categories of costs are each represented by a costing component. M3 provides 33 predefined costing components:

  • Costing components A01 - A03 are reserved for costs for purchased or distributed materials.
  • Costing components A04 - A05 are reserved for any material overhead and the distribution cost, that is, the cost for distributing a material from one facility to another.
  • Costing components B01 - B14 are reserved for costs for operations.
  • Costing components C01 - C02 are reserved for costs related to tools. A tool is an item that belongs to item category 4 in 'Item. Open' (MMS001/G).
  • Costing components D01 - D02 are reserved for costs related to subcontracting.
  • Costing components E01 - E10 are reserved for 'common' product costs not related to material, labor, tools, and subcontract.

  For most costing components you also select a predefined cost driver. The cost driver represents the aspect of the manufacture to focus on when you calculate the cost, for example, the number of units produced, the internal time required to set up machines used in the production, and machine time. Many cost drivers use predefined formulas to calculate the cost.

  For A, B and E costing components, cost rates can be defined manually or automatically. A cost rate is a price or a percentage that is applied to objects of your choice such as item type and warehouse. If the cost rates are defined automatically, they are based on a combination of a company budget and the number of cost driver units each cost driver retrieves.

  For more information, refer to the following documents:

  Costing Components and Cost Drivers in M3 Product Costing

  Create Costing Components and Select Cost Drivers

  Manually Entering Cost Rates for Costing Components

  Automatically Entering Cost Rates for Costing Components

• Costing Elements

  Costing elements are primarily used to represent subtotals or totals in the product costing model. However, they can also be used as complementary costing components.

  There are four types of costing elements. The most common - and required - usage is to let costing elements represent and display a subtotal or a total in the product costing model.

  One costing element, totaling the values of the preceding costing components in the model, displays the calculated standard cost of the product. For standard-costed items (items with inventory accounting method 1), this value is used as the booked inventory value. By adding costs such as sales and administrative costs after the costing element for the standard cost, those costs are not included in the standard cost.

  Costing elements can also be used for the following purposes:

  • As supplementary costing components, when required
  • To present totals of selected costing components
  • To form an overhead base.

  For more information, refer to Create Costing Elements for the Product Costing Model.

Example of Product Costing Model

A company manufactures dinner tables. The product structure defines the operations and materials required to produce a table.

In this simplified figure, circles represent operations and rectangles represent materials.

A simple product costing model for the table above could look like this:

Building Blocks	Name	Comment
Costing component A01	Direct material cost	Includes all costs for materials, regardless of level in the structure. In this case, the cost for gluing on the lower level is included in the material cost.
Costing component B01	Machine time - production	Displays the cost for running the machine for drilling.
Costing component B02	Labor time - production	Displays the cost for man hours required to assemble the table.
Costing element 1	Direct costs	Displays the subtotal of the costs for the preceding components in the model.
Costing component E01	General costs	Displays an overhead cost based on weight.
Costing element 2	Inventory value	The total of direct costs and general costs. This total will be the inventory value of the table.

Support for Activity-Based Costing

M3 supports activity-based costing in several ways:

• The product structure contains information on activity-based factors such as run time and setup time for operations.
• Several cost drivers are directly related to activities and their consumption of resources.
• You can use resource drivers (serving as additional links between resources and activities) in the product costing model to calculate the unit cost of an activity as part of closed circle budgeting.

Selecting Product Costing Model

When calculating the cost, M3 automatically searches for a product costing model selected for the product in 'Item. Connect Facility' (MMS003/F). If no model is found there, M3 uses the general product costing model that is selected in 'Settings - Product Costing' (PCS001/E). You can manually select a product costing model for simulation purposes when calculating the cost in one of the costing programs, but the costing data is then not saved in M3.

Configuring Product Costing

The configuration of product costing is in most manufacturing companies a difficult but rewarding task. For an overview of the steps involved, see Enabling M3 Product Costing.