College of Engineering

Department of Mechanical Engineering

Process planning & product costing (MEng 5322)

L6- Product Cost Accounting Principles/Costing
Prepared by Gebre F.

September 2022
Learning objectives
Students are able to know

 Understand how the cost of a part/product

is accounted or determined
 To differentiate the kinds of cost
accounting principles.

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 Definition
➢Cost accounting- It is the determination of an actual cost
of a component after adding different expenses incurred
in various departments. /or

➢A system which systematically records all the expenditures

to determine the cost of manufactured products.

➢It begins with the preplanning stage of the product. And

➢Ends only after the whole lot of the product has been fully
manufactured.

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 Aims of cost accounting
Purpose of cost accounting;
✓ to compare the actual cost with the estimated cost
✓ to point out wastages and undesirable expenses
✓ to change selling price
✓ to locate reasons for the increase or decrease of a profit
✓ helps to decide whether to continue with the manufacture of a
product or to buy it from outside
✓ helps the enterprise to prepare its budget.
✓ helps to formulate policies and plans for the pricing of a new
job.
✓helps in regulating from time to time the production of a job.

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 Cost accounting systems
✓Job order cost system and
✓ Process cost system

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 Cost accounting systems Contd.

Job Order Costing

✓Costs are assigned to each job or batch
✓Each job or batch has its own distinguishing characteristics
and related costs
✓Objective: To compute the cost per job.

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 Cost accounting systems Contd.

Process Cost System

✓Accumulates and accounts for product-related costs for a
period of time.

✓Used when a series of connected manufacturing processes

produce a large volume of similar products.

✓Costs are accumulated by and assigned to departments or

processes.

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 Definitions
An activity- A specific task or action of work done. An activity can
be a single action or an aggregation of several actions.
Example- moving inventory, production setup…
A resource- An economic element needed or consumed in
performing activities. Example- labor and supplies to perform
manufacturing activities
A cost driver- A factor that causes or relates to a change in the
cost of an activity.
Examples- number of items in a purchase or sales order, changes
in product design, number of machine-hours to manufacture
product X, number of batches used to manufacture product Y.

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 Definitions Contd.
A cost object- is a product or department for which costs are
accumulated or measured.
Example- a product is a cost object for direct materials.

A cost pool- the amount of money spent on an activity, for

finance, customer service or manufacturing.

✓Used in an activity based costing to accurately determine

weather the money is spent rather than splitting the
overhead costs equally over all departments.

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 Product cost accounting systems

➢ Different methods for allocating indirect (overhead) costs

to products.
1. Traditional cost accounting/costing
2. Activity based cost accounting/costing

➢Estimate overhead costs related to production and then

assign these costs to products based on a cost-driver rate.

➢The differences are in the accuracy and complexity of the

two methods.

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 Product cost accounting systems Contd.
1. Traditional cost accounting/costing
➢ It is more simplistic and less accurate.
➢ Typically assigns overhead costs to products based on an
arbitrary average rate.
➢ It refers to the allocation of manufacturing overhead costs
to the products manufacturing.
➢ Allocates the factory’s indirect costs to the items
manufactured on the basis of volume such as the number of
units produced, the direct labor hours, or the production
machine hours.

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 Product cost accounting systems Contd.
➢Users of the traditional costing method make the
assumption that the volume metric is the underlying driver
of manufacturing overhead cost.
➢Under traditional costing, accountants assign
manufacturing costs only to products.
➢Fails to allocate non-manufacturing costs that also are
associated with the production of an item, such as
administrative expenses.
➢ Companies commonly use traditional accounting in
external financial reports because it provides a value for
the cost of goods sold.

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 Product cost accounting systems Contd.
✓Traditional costing allocates overhead using a single
predetermined rate.
➢Job order costing: Direct labor cost is assumed to be the
relevant activity base.
➢Process costing: Machine hours is the relevant activity base.

➢Assumptions are satisfactory when direct labor was a

major portion of total manufacturing costs.

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 Product cost accounting systems Contd.

Uses a two-stage cost assignment procedure

1. Assigns resource costs such as factory overhead costs to
activity cost pools and,

✓Then to cost objects to determine the amount of resource

costs for each of the cost objects.

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 Product cost accounting systems Contd.
2. Volume-based costing systems-assign factory overhead
costs first to plant or departmental cost pools and second to
products or services.

✓In the first stage of volume-based costing the factory

overhead costs are combined into a single plant cost pool
or several departmental cost pools.

✓In the second stage, a volume-based rate (based on units

produced or hours used in production) is then used to apply
overhead to each of the cost objects.
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 Figure 1- The volume based two stage procedure.
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 Product cost accounting systems Contd.

Advantages and Disadvantages of Traditional Product

Costing
Advantages
✓Traditional costing systems are simpler and easier to
implement than activity based costing systems.

✓Effective for implementation to companies that provide one

product).

✓It aligns with generally accepted accounting principles.

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 Product cost accounting systems Contd.
Disadvantages
✓Traditional costing systems are not as accurate as activity
based costing systems. Traditional costing systems can also
result in significant under-costing and over-costing.
✓It is an outdated costing system in many companies
because those manufacturing companies now use machines
and computers for much of their production.
✓Computers and machines make the system outdated
because it often uses direct labor hours to calculate cost.
✓Cost is not appropriately assigned because direct labor
hours is not the best cost driver to use.
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 Product cost accounting systems Contd.
❖ The preceding methods of applying overhead to products
assumed that all overhead costs incurred were related to
volume ( i.e. Volume based costing).

✓This means that all of the overhead costs incurred were

a function of how many direct labor hours or machine
hours, volume-related activities were worked.

❖ In a modern factory that produces many products, a

substantial portion of the overhead may be more a
function of the complexity of the product being made than
the number of units produced, labor hours worked, or
machine hours used.
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 Product cost accounting systems Contd.
The Need for a New Costing System
✓Tremendous change in manufacturing and service
industries.
✓Decrease in amount of direct labor usage.
✓Significant increase in total overhead costs.
✓May be inappropriate to use plant-wide predetermined
overhead rates based on direct labor or machine hours
when a lack of correlation exists.
✓Complex manufacturing processes may require multiple
allocation bases;
✓this approach is called Activity-Based Costing/accounting
(ABC).
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Product cost accounting systems Contd.
2. Activiy-Based Cost accounting/Costing
➢Is a costing approach that assigns resource costs to cost
objects such as products, services, or customers based on
activities performed for the cost objects.
➢ABC recognizes the causal or direct relationships between
resource costs, cost drivers, activities, and cost objects in
assigning costs to activities and then to cost objects.
➢ABC is more complex and more accurate than traditional
costing.

✓This method first assigns indirect costs to activities and then

assigns the costs to products based on the products’ usage
of the activities.
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Product cost accounting systems Contd.
➢A two-stage cost assignment procedure assigns resource
costs such as factory overhead costs to activity cost pools
and then to cost objects to determine the amount of resource
costs for each of the cost objects.
➢ABC systems differ from volume-based costing systems by
linking resources to activities and linking activity costs to
products, services, or customers ( Figure 2).
✓The first stage assigns factory overhead costs to activities
by using appropriate resource consumption cost drivers.
✓The second stage assigns the costs of activities to cost
objects using appropriate activity consumption cost drivers
that measure the demands cost objects have for the
activities.
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 Figure 2- The activity based two stage procedure
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Product cost accounting systems Contd.

➢By using cost drivers in both the first and second stage cost
assignments,

✓activity-based costing systems provide more accurate

measures of product or service costs for the cost of activities
that are not proportional to the volume of outputs produced.

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Product cost accounting systems Contd.
ABC differs from traditional cost accounting in two main
ways,
➢The ABC system defines cost pools as activities rather than
production plant or department cost centers.

➢The cost drivers that the ABC system uses to assign activity
costs to cost objects are drivers based on an activity or
activities performed for the cost object.
✓ The volume-based approach uses a volume-based cost
driver that often bears little or no relationship to the
consumption of resources by the cost objects.

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Product cost accounting systems Contd.
Steps in Developing ABC System
Step 1- Identify Resource Costs and Activities
✓ An activity analysis is performed to identify key activities
and the way in which the activities consume resources.
o Activity Analysis for ABC
✓Through activity analysis- a firm identifies the work it
performs to carry out its operations.
✓This process includes gathering data from existing
documents and records, as well as collecting additional
data using questionnaires, observations, or interviews of
key personnel.

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Product cost accounting systems Contd.
Sample questions include;
✓What work or activities do you do?
✓How much time do you spend performing these activities?
✓What resources are required to perform these activities?
✓What value does the activity have for the product,
service, customer, or organization?

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Product cost accounting systems Contd.
Levels of activities
➢To identify resource costs for various activities, a firm
classifies all activities according to the way in which the
activities consume resources.
1. A unit-level activity is performed on each individual
unit of product or service of the firm.
2. A batch-level activity is performed for each batch or
group of units of products or services.
✓A firm incurs a batch-level activity for each batch or
group of units of products or services scheduled to be
processed together.

✓A batch has more than one unit of a product or service.

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Product cost accounting systems Contd.
3. A product-level activity supports the production of a
specific product or service.

4. A facility-level activity supports operations in general.

These activities are not caused by products or customer
service needs and cannot be traced to individual units,
batches, or products.

✓Some firms refer to these activities as business or

infrastructure sustaining activities.

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Product cost accounting systems Contd.
Step 2- Assign Resource Costs to Activities
➢Activity-based costing uses resource consumption cost
drivers to assign resource costs to activities.

✓Because activities drive the cost of resources used in

operations, a firm should choose resource consumption cost
drivers based on cause-and-effect relationships.

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Product cost accounting systems Contd.
Typical resource consumption cost drivers include the number
of :
✓Labor hours for labor intensive activities;
✓Employees for payroll-related activities;
✓Setups for batch-related activities;
✓Moves for materials-handling activities;
✓Machine-hours for machine repair and maintenance;
✓Square feet for general maintenance and cleaning
activities
The assignment is made through either direct tracing or
estimation.
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Product cost accounting systems Contd.
Step 3- Assign Activity Costs to Cost Objects
➢Use activity consumption cost drivers, such as purchase
orders, receiving reports, parts stored, direct labor-hours,
or manufacturing cycle time to assign activity costs.

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Product cost accounting systems Contd.
Advantages and limitations of activity based cost accounting
Advantages Limitations
✓ Better profitability measures ✓ Some costs may require
due to more accurate costs allocations to departments and
✓ Identification of value added products based on arbitrary
Vs. non-value-added volume measures activities and
✓ Information for process associated costs the cost of
improvement unused capacity.
✓ Improved cost estimation ✓ Some costs that can be
✓ Helps identify and control identified with specific products
are omitted.
✓ Expensive and time consuming to
develop and implement.
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Product cost accounting systems Contd.
Applications/When Should a Company Use ABC
✓Indirect costs are significant in proportion to direct costs.
✓Goods are complex, requiring many inputs and processes.
✓Complex, low-volume products are profitable while standard, high-
volume products are not.
✓Different departments believe costs are assigned inaccurately.
✓The company loses bids it thought were low, and wins bids it thought
were high.
✓Operations have changed significantly, but the costing system has not
changed.
✓Introduction of new models result in higher sales, apparent profits
per unit, but an overall income decline.
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