Purpose of a Product Costing System

Question:

You have just been hired as an accountant by GoodStyle Furniture, a manufacturer of specialty, hand-made furniture based in South Australia. The furniture produced by Goodstyle is in two ranges, Modern and Classical. The two ranges are different in design, but both are high quality, hand-made furniture and are priced accordingly. The owner of the company, Brenton Pryce, has always believed in pricing a quality product based on how much their larger competitors are pricing theirs. His argument has been that “our product is as good, if not better, than the mass producers of furniture, so we should be charging at least as much, if not more, than what they charge”.

When you arrived at work for the first time, you learnt that the though the company has been in existence for the last twelve years, they have never had an accountant. The accounts were typically prepared by the Laura Peters , secretary of Brenton Pryce and Tom Nichols, a part-time accountant who came in once or twice a month. Tom has informed Brenton that he could no longer spare the time to come in and has suggested the need for an accountant on a full time basis, which is why you have been hired. Brenton, though, is still not convinced of the need for a full time accountant. “Look, why do I need a full-time accountant? At the end of the day, all I need to do is total up my revenues, total up my expenses and the difference is my profit. Do I really need to understand my product costs? What is the purpose of that? It’s not like I can lower my prices if my product costs are lower. I just follow the big guys like Hardly Normal and Super A-mart and price my product according to their prices. Why do I need to know what my product costs are?” asked Brenton.

Laura, who has been the secretary cum bookkeeper (of sorts) since the day the company started has prepared some information for you. Trying to be helpful, she has alphabetised the accounts. “I do not know much about accounting,” said Laura. “But Tom has said that we need a Schedule of Cost of Goods Manufactured and a Schedule of Cost of Goods Sold, whatever that means. I have last year’s accounts for you, so could you please prepare those schedules or whatever and get it to Brenton?” The alphabetised list of accounts can be found in Appendix A.

Four days into your work, there was a fire over the weekend in the main office that stored the accounts. The manufacturing facility was not affected and work could go on, however, most of the information that was for the current year’s accounts was damaged and only partial fragments were readable. Luckily your work on last year’s accounts were not affected as you had brought them home to complete and was still in process of completing them.

“You need to get me back all the information that’s now lost! My creditors want to see that information and I need you to work on it asap” said Brenton
Sifting through ashes and interviewing selected employees, you have worked up some additional information:

Preparation of Schedule of Cost of Goods Manufactured and Cost of Goods Sold

a) Laura remembers clearly that the predetermined overhead rate was based on 60,000 direct-labour hours to be worked for the year and $180,000 in overhead costs. (“Tom mentioned this before he left,” Laura said. “No idea why it is important, but if it can help you, good luck”.)

b) The work in process balance was $4,500 at 1^st April . Also the production supervisor’s cost sheets showed only one job in process on 30th Materials of $2,600 had been added to this job, and 300 direct labour hours had been expended at $6 per hour on this job.

c) The accounts payable are for raw material purchases only, according to Laura. She clearly remembers that the balance in the account on 1st April was $6,000. Checking with Brenton for his cheque stubs, payments of $40,000 were made to suppliers during April. (All materials used were direct materials.) .The balance in the Accounts Payable account was $8,000 at 30 April .

d) A charred piece of the payroll ledger shows that 5,200 direct labour hours were recorded for the month. Laura has confirmed that there were no variations in pay rate (i.e. all employees were paid $6 per hour.)

e) Records in the warehouse indicate that the finished goods inventory totalled $11,000 on 1st. Also the finished goods balance was $16,000 on 30^th April .
f) The balance in the Raw Materials account was $12,000 on 1^st April.
g)Actual Manufacturing overhead incurred during April was $14,800.

h) From another charred piece of paper, you discerned that the cost of goods manufactured for April was $89,000. 

You are now ready to and give Brenton the information he needs before you lose your job! When you went in to tell him that you can now start working on the information, Brenton tells you that he has spoken to Tom (their previous part-time accountant) and that the following information are required: “Tom says we need the following information: Work in process at the end of April, raw materials purchased in April, Overhead applied, Cost of goods sold in April, and Raw materials used in April. He also suggested that we should be looking at whether the overhead was over- or under-applied, whatever that means. “

REQUIRED:
Prepare a report (no more than 10-pages) for Brenton Pryce that addresses the following:
1. The purpose of a product costing system.
2. Preparation of a Schedule of Cost of Goods Manufactured and Cost of Goods Sold for last year. (The schedules may be in the appendix). Explain why some items have been excluded from the schedules.
3. An Income Statement for last year assuming that tax is charged at 30% on Income before tax
4. Determine the values for the following:
(a)Work in Process at the end of April;
(b) Raw materials purchased in April;
(c) Overhead applied in April;
(d) Raw materials used in April; and,
(e) Over- or under-applied overhead in April.
(f) Cost of Goods sold in April;
5. Discuss how overheads can be over- or under-applied and how the company should deal with the over- or under-application.

Income Statement

SCHEDULE  A
Last years accounts

There is a great importance of Producing Costing system in a Manufacturing Industry. Product Costing is basically to identify the Cost of the Product to the company. There are various method through which product cost can be identified some of them are standard cost, Marginal Costing Method or Actual Cost Method. (Thomas, 2012)

To Identify the Product Cost first of all we have to identify the direct cost, overhead cost, basis of cost allocation and then we have to calculate the Overhead Cost. This production manager wants per unit cost of the product in order to identify the performance and product sourcing. This helps the manager in identifying the wastage made by the worker if the cost per product is higher than the industry average. (Calpan, 2012) 

Further, if the Management knows the cost of his product than h is in better position to negotiate the price of its product with the buyer of the goods and increase its sale volume. Product Costing also helps the top management in evaluating the performance of the production Manager. It also help them to give focus on such factory which costing is high and also necessitate the top management to identify the reason for such high cost and take measures to reduce the wastages to reduce the product cost.

While calculating Cost of Goods Manufactured we will consider all the direct and indirect cost which has been incurred in the factory for manufacturing the goods along with the portion of deprecation. This is mainly the Factory Cost

However if we calculate the cost of goods sold, then we will have to also consider the opening and closing inventory of goods. All the other expenses will be consider as operating Expenses and we will form Part of Income Statement.

Overhead Cost                 =          180,000

Direct Labour                    =          60,000

Overhead Rate                  =          180,000/60,000           =          3 per hour

(b) Raw Material Purchased in April

(c) Overhead Applied in April 
Labour Hours Worked in April    =          5,200
Overhead Rate                              =          3 per hour
Total Overhead Expenses           =          5200 * 3          =          15,600 

(d) Cost of Goods Sold in April

 (e) Raw Material Used in April

(f) Over or Under Allied Overhead
Overhead Applied                  =          15,600
Actual Overhead                     =         14,800 
Overhead Over applied          =          (15600 – 14800) = 800 

(5) All the cost incurred in the factory other than Direct Material and Direct Labour is called overhead. In Standard / Marginal Costing we will predetermined the Overhead Expenses that would likely to be incurred in the given period of time. Then we will determine the appropriate cost driver to determine the recovery rate of the overhead. After determining the appropriate cost driver we will divide the overhead expenditure with the cost pool to get the recovery rate.

Overhead recovery rate is just estimation. This may differ from the Actual Expenditure. If the actual expenditure is more than the overhead applied than this is the situation of under recovery of overhead. However, if the actual expenditure is less than it is case of over recovery.

In case of Over / Under recovery of the overhead the same should be debited / credited in the profit & loss a/c so that it impact will reflect on the company balance sheet. 

Reference:

Calpan, D. (2012). Management Accounting: Concept & Technique. 10.

Thomas, J. (2012). Overview to Product Costing and Manufacturing Accounting. 8.