Managerial accounting refers to a branch of accounting that covers the flow of information internally. This branch covers various tools and techniques that companies can use to enhance decision-making. While financial accounting covers reporting information externally, managerial accounting is for internal purposes. For most companies, it is more crucial than financial accounting as it has various critical advantages.
One area within managerial accounting is cost accounting. This area covers all the methods companies use to derive costs and control them. Consequently, companies can use various tools to achieve these benefits. Primarily, cost accounting covers the expenses incurred on developing or manufacturing a product. For service companies, these costs include the expenditure on the process of rendering services.
Cost accounting also involves analyzing various costs and reporting them using several formats. These formats, also known as costing techniques, allow companies to derive their product costs. For most companies, these costs are crucial in understanding the expenses incurred in the manufacturing process. Once companies derive these, they can use pricing tools to set the amount charged from customers.
What are Product Costs in Managerial Accounting?
Product costs contain any expenses incurred on creating or manufacturing a product. For companies providing services, these consist of costs incurred on rendering services. Usually, these costs include direct materials, direct labour and production overheads. In some cases, they may also cover consumable production supplies, also known as direct expenses. For companies, these costs are crucial in determining the value of a product or service.
Product costs also cover the cost of the labour required to deliver a service to a customer. In this case, the product cost, also known as service cost, relates to companies in the services sector. However, they may not include the same items as production companies. For example, they will usually omit direct material, direct expenses and consumable production supplies.
For service companies, these costs primarily include any expenses incurred on labour. Usually, these involve compensation paid to employees, such as salaries and wages. On top of that, it also covers payroll taxes and employee benefits. These costs are also a part of the direct labour calculated for production companies. However, they also include additional expenses, as mentioned above.
Product costs become a part of the financial statements, although not directly. Usually, they appear as the cost of sales or services in the income statement. This treatment differs from period costs, including fixed costs under selling and administrative expenses. In some cases, companies may remove overheads from the product costs. This process usually relates to short-term product and sale-price decisions. On top of that, it is a part of managerial and cost accounting.
Overall, product costs cover all expenses incurred in producing a product. It does not cover any other items which do not contribute to those products. Usually, these costs consist of direct material, direct labour, factory overheads and direct expenses. These costs allow companies to determine the value of a single unit of product or various items. Once they establish these costs, they can set the product price accordingly.
What are the Components of Product Costs in Managerial Accounting?
Product costs include various components. As mentioned above, these components include direct materials, direct labour, factory overheads and consumable supplies. Each of these components increases the product costs and play a crucial role in it. For service-based companies, it will include direct labour only. Nonetheless, an explanation of each of these components is below.
Direct material
Direct material refers to the raw material used in the production process. Companies may use various resources while manufacturing their products. However, direct material only covers those which directly contribute to the process. In other words, direct materials are an essential part of the underlying product. Other materials that do not contribute directly to the production process fall under indirect materials.
Direct materials also exclude materials that companies consume as part of the general overheads of their operations. However, there is no specific rule to what may classify under this heading. The particular materials will differ based on the underlying product and the process used to manufacture it. For example, wood is a direct material for furniture companies. However, wooden tools may fall under indirect materials for other companies.
Direct labour
Labour includes the expenses incurred on employees. Usually, these expenses include salaries, wages, taxes, benefits, etc., paid to workers. Direct labor, however, does not cover all those areas. Instead, it includes all expenses incurred on production-line employees. These include workers who contribute to the production process directly. Any other employees will not fall under this category.
Direct labor is crucial in completing a product. Usually, it includes skilled staff who complement the production process. On top of that, direct labor is the only component of product costs for service-based firms. These firms do not indulge in any manufacturing or production. Instead, they hire employees who render or produce services to the client. Direct labor examples include salaries paid to employees working in a factory.
Factory overheads
Factory overheads include costs incurred during the manufacturing process. However, these exclude direct material and labor costs. Factory overheads usually come as a fixed or total amount. Companies then allocate them to units produced during a specific period. This process occurs to divide those costs overall items. This way, factory overheads also contribute to the production costs for a company.
Factory overheads become a part of product cost when converted into finished goods. Some companies may also allot them during the work-in-progress stage for products. Usually, companies avoid allocating factory overheads to units produced under the direct costing method. However, it is critical in absorption costing. Examples of factory overheads include factory rent, supervisor salaries, equipment costs, etc.
Consumable supplies
Consumable supplies include items that directly contribute to producing a product. However, they do not classify as direct material. Similarly, these do not fall under the definition of factory overheads. In most cases, consumable supplies are a part of the direct expenses during the production process. Consumable supplies contribute to the product costs directly and are essential to them.
Consumable supplies differ from direct materials as they do not become a part of the finished product. In contrast, direct materials are essential to that product. However, consumables include supplies used in the general production process. These items also contribute to the product costs. However, they may not show in the finished product. An example of consumable supplies includes machine oil.
What is the Formula for Product Costs in Managerial Accounting?
The formula for product costs is straightforward. This formula incorporates all the components of product costs and adds them together. If one of those components is absent, companies can ignore them in the calculation. Overall, the product cost formula is as below.
Product Costs = (Total direct materials + Total direct labor + Total allocated overheads + Consumable supplies) / Total number of units produced
For example, a company produces a batch of 1,000 units of products. For these items, the total direct materials cost $100,000. Direct labour was $60,000. Similarly, the company incurred factory overheads of $80,000. The company also used consumable supplies of $10,000 during the process. Overall, the production costs for that company will be as follows.
Product Costs = (Total direct materials + Total direct labor + Total allocated overheads + Consumable supplies) / Total number of units produced
Product Costs = ($100,000 + $60,000 + $80,000 + $10,000) / 1,000 units
Product Costs = $250 per unit
Conclusion
Product costs include any expenses incurred on producing or manufacturing a product. Usually, it consists of direct material, direct labor, factory overheads, and consumable supplies. For service-based companies, these only consist of direct labor. Product costs are crucial in determining the value of a product. These costs become a part of the income statement as the cost of goods sold.
