If a firm manufactures just one product or provides a single service, determining the unit cost of production is a fairly simple exercise. It merely involves adding up all the manufacturing costs such as material cost, labor cost, rent, depreciation, and so on incurred in the period and dividing this total by the number of units produced during the period.
Most of the firms, however, manufacture multiple products which pass through different departments or processes. In such a case, the process of costing is more complex. It involves the following steps:
1. Define the cost object
2. Accumulates costs
3. Determine the direct costs
4. Allocate indirect costs
5. Calculate the total cost of production.
Define the Cost Object:
The definition of the cost object is an important first step in the costing exercise. The cost object can be almost anything. The commonly chosen cost objects are:
Cost Object Example
Product An 800cc diesel car
Service An air journey from Chennai to Delhi
Program A one-week top management executive development Program.
Department The purchase department of a company
Customer All the vehicles purchased by MSRTC from
In the rest of the discussion we will assume that the cost object is some product.
Cost accumulation refers to the collection of costs in natural categories like materials, labor, power, transport, rent, depreciation, insurance, and on. Typically, these costs are collected department wise. The departments are treated as cost centers. Some cost centers are product centers and some cost centers are services centers. A product center is a center where some work is done on a product. Examples: machining department and assembly department. A service center represents a center which renders some service but does not work directly on the product. Examples: maintenance department and security department.
Determine the Direct Costs:
Direct costs are costs that can be traced in a cost-effective manner to the cost object. Direct costs consist of direct material costs and direct labor costs. When a product passes through passes through two or more product centers, the direct costs of the product is the sum of the direct costs incurred in all the product centers.
Allocate Indirect Costs:
Indirect costs, also called manufacturing overhead, are costs that cannot be traced t the cost object economically. So, they have to be allocated to the product (cost object) in some reasonable manner. The procedure for allocating indirect costs is as follows:
* Estimate indirect costs for various product centers
* Estimate costs of various service centers.
* Transfer the estimated service center costs to product centers by a direct charge or by allocation.
* Divide the total cost accumulated in each product center by a measure of activity such as direct labor hours or machine hours or total direct cost, to get the overhead application rate.
* Apply the overhead application rate to the product passing through the product centers.
Remember that the process of accumulation and allocation of indirect costs has the following characteristics:
* The entire process is based on subjective judgment of what an equitable over head rate is. Hence, there is an inescapable element of arbitrariness in it.
* The overhead application rate is based on an overhead budget and a projected level of activity.
* The total amount of overhead application may, and often does, differ from the actual overhead expenditure incurred.
A most valuable concept in decision making is known as incremental cost defined as the additional (change in) total cost that results from a particular decision. Incremental analysis involves a comparison of changes in revenue and the associated changes in costs.