Product Costing

Definition / Meaning

Product costing is not an absolute term having a permanent definition. The definition of product costing varies with the purpose behind costing a product. A product costing can be simply defined as the total amount of costs assigned to a particular product based on a specific PURPOSE of the management of the organization.

Costing is a concept not only applicable to for-profit organization, its applicable to all types of organization which involves in financial transactions and need financial viability. The principles of costing are applicable whether we are costing a product, service, subsidized products by government or NGOs, etc.

Example of Product Costing Under Different Purposes

Pricing for Open Market Selling

When a company does everything from scratch and sells the product by its own. The activities starting from research and development for the product, designing, manufacturing, marketing, distribution and even customer service are undertaken for a particular product or set of products. For costing of such a product, all the cost elements mentioned above should be assigned to the product.

Product Mix Decisions and Rating of Customers

With rise in choices of products offered to consumers based on colour, variance in designs, size etc. every organization has to deal with many products. Product mix has gained a lot of importance that an efficient mix can decide the bottom-line of a company. Right mix can convert a loss making company into a profit making one. For determining the product mix, it is necessary to have a correct product costing report to determine contribution and net margins of each product. This can further help in deciding the priority of product marketing efforts and rate the customers.

Product costing in case of determining the contribution would require following the marginal costing method and allocate all the variable cost to the products.

Selling Products through Government Contracts

Product costing in case of selling products under government contract is highly influenced by the guidelines issued in the contract especially in the Cost-Plus Contracts. What costs will be reimbursed is given in their agreement and therefore costing of products in this case can only allocate costs which are allowed by the government authority. Usually, expenses like marketing, distribution, customer service, R&D, etc. are either not allowed or partially allowed.

Reporting in Financial Statements

Financial reporting requires valuing the stock / inventory and most country’s accounting standards follow conservative approach towards valuing the stock. The rule of ‘cost or net realizable value’, whichever is low is followed. Product costing reports are prepared based on the same principle.

Market Penetration Pricing


Product Costing

Suppose the management decides to enter a new market or geography with its existing or new set of products and adopt a strategy of cost competitiveness. They may price the products in a way that do not even cover the all the basic costs. They are intentionally pricing too low and bear the losses to follow the decided strategy and enter the target markets. The loss in the initial period that they accrue due to this can even be capitalized as marketing spend just like advertisement. Product costing under this purpose is done with a preparedness to incur loss in selling the products initially. Once the product is accepted in the market, they may slowly increase the prices and start covering other costs which were left initially.

Inter Unit Transfers

While transferring the goods between a company’s own units as semi-finished goods or otherwise, product costing is guided by authorities levying taxes on manufactured goods for taxing purpose.

If the organization recognizes its units as a separate profit centre, the costs allocated while transferring the goods takes care of all the costs (mostly marketing cost excluded and a portion of administration cost is allocated) and an agreed margin between the two. They try to simulate a normal market situation between the units also.

Valuing Stocks / Inventory for Insurance

When valuing the stocks / inventory in case of fire where loss of inventory has occurred, the product costing is done based on the rules and regulation given by the insurance company. The insurance company will pass the claim only if the value is derived using the guidelines issued by them.

Buy vs. Make Decision

At many times, a manufacturing concern comes across decisions of buy vs. make where they need a product as an accessory, or additional product selling to same etc. They may trade the same or manufacture themselves. Under this situation, the making decision will mostly depend on the product costing in case of making vs. if it is directly bought from market. Product costing here will have many considerations like additional capacity enhancements, size of market, possibility of capacity utilization, existing underutilized capacity, economies of scale etc.

Product Costing Formula

Product costing formula cannot be a universal truth. With the change in purpose behind calculating cost of a product, the formula will also need changes. We have observed above that with different purposes, the approach significantly changes. One same product will have different costing formula for different purpose.

Last updated on : December 23rd, 2017
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