Cost Accounting 101: Understanding Product Costs and Pricing
Cost accounting is a systematic set of procedures manufacturers use for recording and reporting measurements of the cost of manufacturing goods and performing services. It includes methods for recognizing, classifying, allocating, aggregating and reporting such costs and comparing them with standard costs.
Cost accounting was originally developed to help manufacturers estimate the full costs of manufactured goods. “Costs” include the variable costs of the labor and raw materials needed for production, as well as the fixed costs. The total of these costs, divided by the number of units produced, represents the per-unit cost. As manufacturers increased the range of goods and services they provided and new technologies and management philosophies arose, costs became more difficult to assign.
Purpose of Cost Accounting
An effective cost accounting system is needed to determine the “true” cost of a product, which is critical for all manufacturers in order to:
• Properly assign costs to inventory items for financial statement purposes.
• Determine sales price for products.
• Identify money makers/money losers.
• Compare different options for product mix
• Locate opportunities for cost improvement or reduction.
• Assist in the preparation and actualization of a business plan that includes an economic breakeven point.
• Improve strategic decision making.
How Effective is Your Product Costing?
It’s likely that many small or mid-sized manufacturers are putting themselves at considerable risk through the use of outdated costs if products have not been updated to take into account ongoing changes in the way the Company’s products are made. Consideration needs to be given to the cost impact of new technologies or recently-added business overhead. A periodic review should be conducted where individual product costs are reevaluated and overhead application rates and costing practices are adjusted accordingly.
The first step to determining how effective your product costing is involves a determination of what your most profitable and least profitable products and customers are. Communication with management and the sales department can go far to create a more profitable product mix and provide valuable input, whereby sales prices can be properly adjusted. Product profitability analysis drives corporate profitability; a function that is entirely controllable by management.
Methods of Cost Accounting
There are several different cost accounting approaches that may be considered before implementing a cost accounting system. Traditional cost accounting is most effective for manufacturers with homogeneous products that have very few differences in the manufacturing process. This method assumes that there is a relationship between overhead and some volume-based measure, such as direct labor dollars/hours or machine hours. Advanced traditional cost accounting uses multiple factors as a base for allocating overhead and can significantly improve costing. Activity-based costing is a practical tool that can be used by manufacturing companies of all sizes to not only better determine the cost of their products, but also to better understand why those products cost what they do.
Factors for Determination of Market Price
When determining the right market price for your product, it’s important to know what your competition is doing. Maintaining a history of your competition’s pricing and price changes will assist you in anticipating their future decisions and allow you to react accordingly. Considering your customers’ feedback is another valuable source of data to use in your pricing strategy. Your sales force should be seen as a resource to provide management with information related to customer satisfaction and for reactions on product quality and value.
In summary, understanding key factors impacting product costs and pricing is a critical function for any organization and will ensure that your organization has the information it needs to maintain or improve its competitive position.
Brian W. Johnson, CPA, CFE, is an audit partner with over thirty combined years’ experience providing audit and accounting services to both private and publicly-held domestic and foreign companies. He has extensive experience in a variety of industries including manufacturing, inventory and cost accounting, construction contractors, fraud and forensic examination, audits of the controls of service organizations (SOC), internal audit outsourcing and internal controls evaluation and consulting.