Related Terms: Activity-Based Costing
Product costing is a methodology associated with managerial accounting, i.e., accounting intended to serve management in an operational context rather than to measure corporate performance as such, although, of course, any kind of cost accounting, including product costing, contributes to overall results. More specifically product costing is intended accurately to determine the cost of a unit of production (or of a service delivered) by study of every resource used in its creation. The activity is only in part motivated by obtaining an accurate final cost that incorporates all contributing streams. In part it is a way of identifying cost components that can be addressed specifically in order to take cost out of the product by purchasing, redesign, reengineering, retooling, packaging, and other interventions by management at whatever stage.
Product costing evolved in an environment of mass production in the second half of the 20th century as ever more managerial attention was focused on optimizing the production function. Traditional financial accounting approaches have been—and continue to be—based on measurements of fairly rough granularity. For determining corporate profitability, it is sufficient generally to track raw materials, labor, tooling, and energy inputs and to sum these into production costs. Pricing of different products, of course, necessitated finer distinctions so that costs associated with classes of products would be available as a basis for differential pricing. Closer attention to the costs of, for instance, low-, medium-, and high-end models of a vehicle or a device then proliferated "downward." The costing of composite products required costing of their components. In turn operations on each component might vary. Some might require more or less strength and hence heavier forgings; these in turn might need more or less additional machining. Some components could be attached mechanically, others had to be welded. These operations could be measured in time, time in dollars. A systematic analysis of how a product came to be, the inputs costed as received and then the operations performed on them individually estimated, produced the final cost of production from which receipts from sale of scrap would be deducted to get a net cost. Product costing evolved further from this point by assigning an appropriate percentage of total overhead and also measuring additional costs upstream—such as packaging, warehousing, and delivery to the ultimate buyer.
The analytical resources made available by such detailed information have made product costing a routine aspect of most significantly-sized manufacturing operations. Product costing data act as feedback to designers, are used in manufacturing management to identify ideal workflow, influence the purchase of tooling, and are used in precise pricing of goods. Product costing is used in most routine production activities, including service occupations, although the level of detail sought is variable and usually determined by the size of the operation. Even in quite small businesses, some level of product costing is practiced in that managements usually know the costs associated with important functions identified with different products.
In recent years product costing has given rise to Activity Based Costing (ABC). The subject is covered in more detail elsewhere in this volume. ABC is based on the notion that costs arise in various activities. The concept is well-summarized by John Stark Associates, a management consulting group, as follows: "The Activity Based Costing paradigm is based on the principle that it is not the products that a company produces that generate costs, but rather the activities that are performed in planning, procuring and producing the products. It is the resources that are necessary to support the activities performed during the course of business that result in costs being incurred. Product costs should therefore be calculated by determining the extent to which each product makes use of the activities being performed. Products 'consume' activities and activities 'consume' costs." ABC may be a more refined method for precisely capturing inputs that, in many operations, are associated with overhead functions, such as engineering and design.
In product costing much emphasis is placed on capturing all costs, even those that do not immediately spring to mind, one of the reasons why ABC is growing in popularity: it begins with activities and thus by definition encompasses all of a corporation's many involvements. In the production process, measurement is relatively easy even if complex. A complexity arises, for instance, in assigning the capital costs of equipment to individual products that pass through it—and including the costs of cooling liquids and lubricants used in machining. But raw materials purchasing, for instance, including the costs of developing good relations with suppliers, is difficult to measure in relation to individual products. Warranty service is yet another area that does not immediately spring to mind: it is typically handled long after a sale is completed.
Just how detailed product costing should be will naturally arise in the course of operations—motivated by the types of analysis a business requires to solve its problems or to adjust its pricing. Very detailed product costing has a cost of its own—the justification for which will be the use to which such data are put.
The "product" of a sales consultancy may be a printed report to a client accompanied by a Microsoft PowerPoint presentation at the client's headquarters. Here the real cost of the product will have little relationship to the costs of the tangible "deliverables." The business is actually selling information and judgments acquired by interviews, focus groups, data searches, reading, analysis, discussions, and consultations some of which may have required extensive travel. In another operation, engaged in evaluating sites for the presence of hazardous waste dumped in the past, the deliverables may again be a report, but the work may have required extensive groundwater sampling based on geological maps of the site and extensive searches of old real estate transactions. In yet a third operation, specializing in carpet cleaning operations, the product is a visit in the course of which equipment is used and labor applied.
In most such situations, product costing takes place in advance of all work actually accomplished. And, typically, good estimating is the difference between turning a profit or booking a loss. But the principles that apply are identical. Both in the services and in the manufacturing environments, accurate costing (hence pricing) will depend on subdividing the work carefully into its many categories, measuring time and purchased materials and services. As in manufacturing some products are rejected for faults, so in service work there is wasted time, false starts, and other experiential factors that must be factored in. In both cases, overhead must be known accurately and applied in proportion to the value of the service bid and supplied.
The chief difference is that service activities almost never repeat exactly. Therefore discoveries made in comparing estimates to actual costs can rarely be applied to future jobs with the same precision and expectation of exact results.
When all is said and done, the message conveyed by product costing translates into the sage words routinely murmured by the skilled carpenter: "Measure twice, cut once."
"A Few Words About Activity Based Costing." John Stark Associates. Available from http://www.johnstark.com/fwabc.html. Retrieved on 9 May 2006.
Baxendale, Sidney J. "Activity-based Costing for the Small Business: A Primer." Business Horizons. January 2001.
Hansen, Don R. Management Accounting. Thomson SouthWestern, 2005.
Jackson, Steve, Roby Sawyers, and Greg Jenkins. Managerial Accounting: A Focus on Decision Making. Thomson South-Western, 2006.
Smith, Richard L., and Janet Kilholm Smith. Entrepreneurial Finance. John Wiley, 2000.