Production Finance

For any firm the major source of revenue is through sales of products. Even before fixing the price of a product it is necessary to determine the costs of the product i.e. cost incurred in producing the product. The cost of a product depends upon the pattern of production. In production Finance we will discuss.

(1) Product Costing Methods
(2) Cost Control
(3) Cost reduction

Product Costing Methods:

There are two methods of product costing

(1) Job order costing
(2) Process costing

Job order costing method is also known as specific order costing and production order costing. The job order costing method is used where the production is strictly according to the customers’ orders. For example, in a ship building industry each ship is made according to the specifications (as capacity of the ship, number of cabins etc) of the customers. The order placed by another customer for a ship may not be according to the earlier order specifications and the cost of a ship differs from order to order. Thus, in the order costing the cost of a product is determined, based on the customers’ orders.

In job costing, the quantity of production is small and unit costs are relatively high. Whereas, process costing involves large quantity of homogeneous product with relatively low unit cost. For example, a customer placed an order for 500 kg of nails. Usually the process of making nail involves a) cutting the length of rod to the nail size b) making head at one end and to sharpen the other end. Estimating the cost of each nail is not a feasible method. According to the process costing method the process cost of each department, in which the process takes place, will be accumulated and the costs of each department will be added to determine the total cost of production. This total cost of the production is linked to the total units produced during period and the unit cost of a product can be determined.

Cost Control:

Cost control can be achieved through,

(1) Decision control
(2) Operational control

Decision Controls and Operational Controls:

One of the primary objectives of an organization is to earn the maximum possible profits by providing products and services of expected quality to its customers. A firm can earn higher profits either by increasing the selling price or by reducing the manufacturing costs while the former one is not advisable in the competitive markets. Thus, the only alternative is reduction of the manufacturing costs which is achieved through cost control and cost reduction.

Decision control mainly includes make or buy decision. Because some times firms may earn higher profits by buying a part of equipment or a component or by giving a subcontract instead of producing it. For example, let us consider the example discussed in the job costing, shipping industry. In the process of making a ship, a firm needs nuts and bolts. Here the firm has to decide whether to produce the nuts and bolts or to buy these from the market or to give sub-contract to make these components. Here one has the market or to give sub-contract to make these components. Here one has to evaluate the advantage and disadvantage of each option and has to make a decision. An operational control is concerned with the extent to which the expected level of performance to be achieved in the implementation phase of any decision.

In any organization the effective way of implementing cost control is by responsible accounting in the organization. For this it is necessary to categorize the costs as costs control by me (or of department) and costs controllable by others.

Once the controllable cost of each department is identified, the actual costs of a department are compared with the expected or estimated costs and proper actions will be initiated wherever necessary.

Cost reduction:

Actual costs are costs incurred because of operations to produce a product

Standard costs are estimated costs and these costs act as benchmark which is compared with the actual costs and this helps in evaluating performance.

Cost control involves ensuring the actual costs incurred are in accordance with the standard costs. Whereas, cost reduction involves revising of the standard costs with the objective of reducing the cost of a product without affecting the quality or performance of the product in the end use for which it is intended. The cost reduction can be achieved by systematic examination of the operations involved in the process and

1) by eliminating unnecessary operations
2) by rearranging the sequence of operations
3) by modifying the process of operation
4) by eliminating the unnecessary movements of men and material
5) by minimizing the material wastage in the process of operation.