Product Costing (Encyclopedia of Small Business)
Product costing is the process of tracking and studying all the various expenses that are accrued in the production and sale of a product, from raw materials purchases to expenses associated with transporting the final product to retail establishments. It is widely regarded as an extremely important component in evaluating and planning overall business strategies. 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."
Product costing has undergone a dramatic metamorphosis in America over the past 50 years, as Textile World's Frank Wilson noted: "In the 1940s, cost estimates normally included nothing more than total manufacturing costs. In the late '50s direct costing was implemented to separate variable [cost of materials, cost of transportation] and fixed [interest payments on equipment and facilities, rent, property taxes, executive salaries] costs." Indeed, Lessner remarked that "fifty years ago, when manufacturing was far less automated than it is today, the costs of materials, labor and overhead were just about evenly divided. Now, production of a product's various components is often so synchronized on highly automated production lines that there is little or no need to maintain component inventories; thus, the old costing formulas, still used by many industries, are no longer applicable Further complicating the costing equation is the trend in manufacturing to focus more attention on quality, flexibility and responsiveness, to meet customer needs. This makes production-line cost analysis more difficult because each line requires small, but significant, changes in production techniques." As a result, today's managers and business owners have found that the limited information available through older job costing methods is inadequate for making informed decisions in the contemporary business environment.
With this in mind, companies have increasingly turned to detailed, long-range examinations that provide a more accurate representation of a product's true costs and benefits. "Companies are discovering that their competitiveness is enhanced when purchasing, manufacturing, logistics, and product design groups begin using total life cycle costing," wrote Joseph Cavinato in Chilton's Distribution. "Total life cycle cost recognizes that the purchase price of an item is only part of its total cost, just the beginning of a series of costs to be accumulated by the firm, its downstream customers, and users until the end of the product's life." This analysis is further enhanced when companies include suppliers/vendors in the process, because the costing process can help create a partnership relationship that enables both parties to move away from competitive stances on pricing, delivery dates, etc., toward cooperative initiatives that optimize the expense of creating and maintaining new products.
COSTS ASSOCIATED WITH MANUFACTURED PRODUCTS
As Chilton's Distribution observes, there are myriad potential costs associated with selling a product which may be directly or indirectly linked to the actual production process. Possible costs include:
- Developing and maintaining supplier relationships.
- Transportation costs, including carrier payment terms; special charges in the realms of packaging, handling, and loading and unloading; and loss and damage expenses.
- Sales and freight terms that define payment terms, sales, and title transfers.
- Payment termsptions here range from 15 days to as many as 90 days in some industries, and letter of credit terms provide additional options. These options, stated Cavinato, "often are not considered by managers in purchasing, traffic, and sales. Instead, most firms mandate these terms and they become 'boiler plate' in purchase orders, carrier contracts, and invoices. It can be mutually beneficial to negotiate these terms with suppliers and carriers.
- Costs to receive, process, or make ready, including unloading, counting, inspection, and inventory costs, as well as expenses associated with disposal of packaging and other product protection/transportation materials.
- Logistics expenses (warehousing, loading, unloading, handling, inventory control), which are typically lumped together under the catch-all title "Overhead," despite the fact that costs for each of these can vary significantly depending on the arrangement.
- Production costs accrued in actual manufacture of goods.
- Warranty costs.
- Quality costs, including costs associated with defective products (what percentage and how far down the production line), inspections, product returns, chargebacks, cooperage, and storage.
- Lot size costs, including inventory and cash flow costs associated with lots of varying size.
- Supplier inventory.
- Overhead costs of supplier and customer transactions, including billing, collection, payment preparation, and receiving processes.
- Product improvement and modification, including costs of correcting defects and standardization of materials and packaging.
- Regulatory/environmental costs associated with meeting federal or state laws and community expectations on environmentally friendly production and packaging processes.
PRODUCT COSTING IN MULTI-PRODUCT ENVIRONMENTS
Some manufacturers distort true product costing results by evenly distributing costs for a certain aspect of production across all product lines, even though costs might vary with each specific product. In some instances, this practice might have little or no impact on a business's well being; a company that is enjoying record growth and profits on all three of its product lines, for instance, is unlikely to be seriously harmed by accounting practices that evenly divide transportation costs three ways, even though one of the product lines may account for, say, half of the firm's transportation expenses. Huge profits mask such inequities fairly well. But relatively few companies are in such a luxurious position. Most companiesnd especially most small businesses, which typically have less margin for error than their larger cousinseed to work hard to arrive at true product costing figures. "As national and global competition increase," wrote Lessner, "even tiny costing disparities can have an over-whelming impact on whether a productr an entire company, for that matterurvives Over the longterm, product profitability analyses that use these distorted costs cause management to erroneously assume custom products generate better margins than they actually do," and top performing goods end up subsidizing other, less profitable, product lines.
PRODUCT COSTING IN NONMANUFACTURING FIRMS
Although product costing is primarily associated with manufacturing businesses, it also has applications in non-manufacturing industries. "Merchandising companies include the costs of buying and transporting merchandise in their product costs," observed Ronald W. Hilton in Managerial Accounting. "Producers of inventoriable goods, such as mining products, petroleum, and agricultural products, also record the costs of producing their goods. The role of product costs in these companies is identical to that in manufacturing firms." Business experts also note that while service-oriented companies (both service businesses and non-profit organizations) do not offer products that can be stored and sold in the manner of manufactured items, they nonetheless need to track the varied costs that they accrue in offering their services. After all, the services that they offer are in essence, their "product" line. "Banks, insurance companies, restaurants, airlines, law firms, hospitals, and city governments all record the costs of producing various services for the purposes of planning, cost control, and decision making," wrote Hilton.
Cavinato, Joseph. "Product Costs From Cradle to Grave." Chilton's Distribution. January 1992.
Hilton, Ronald W. Managerial Accounting. New York: McGraw-Hill, 1991.
"The Ins and Outs of Target Costing." Purchasing. March 12,1998.
Lessner, John A. "Traps to Avoid in Product Costing." Journal of Accountancy. July 1991.
Smith, Richard L., and Janet Kilholm Smith. Entrepreneurial Finance. John Wiley, 2000.
Wilson, Frank C. "How Modern is Your Company's Costing System?" Textile World. September 1991.
SEE ALSO: Activity-Based Costing; Overhead Costs