Once costs have been accumulated and measured, they are assigned to units of product manufactured or units of service delivered. Unit costs are important for a wide variety of purposes. For example, bidding is a common requirement in markets for custom homes and industrial buildings. It is virtually impossible to submit a meaningful bid without knowing the costs associated with the units to be produced. Product cost information is vital in a number of other areas as well. Decisions concerning product design and introduction of new products are affected by expected unit costs. Decisions to make or buy a product, to accept or reject a special order, or to keep or drop a product line require unit cost information.
In its simplest form, computing the unit manufacturing or service cost is easy. The unit cost is the total product cost associated with the units produced divided by the number of units produced. For example, if a toy company manufactures 100,000 tricycles and the total cost of direct materials, direct labor, and overhead for these tricycles is $1,500,000, then the cost per tricycle is $15 ($1,500,000/100,000). Although the concept is simple, the practical reality of the computation is more complex and breaks down when there are products that differ from one another or when the company needs to know the cost of the product before all of the actual costs associated with its production are known.
Importance of Unit Costs to Manufacturing Firms
Unit cost is a critical piece of information for a manufacturer. Unit costs are essential for valuing inventory, determining income, and making a number of important decisions. Disclosing the cost of inventories and determining income are financial reporting requirements that a firm faces at the end of each period. In order to report the cost of its inventories, a firm must know the number of units on hand and the unit cost. The cost of goods sold, used to determine income, also requires knowledge of the units sold and their unit cost.
Whether or not the unit cost information should include all manufacturing costs depends on the purpose for which the information is going to be used. For financial reporting, full or absorption unit cost information is required. If a firm is operating below its production capacity, however, variable cost information may be much more useful in a decision to accept or reject a special order. Simply put, unit cost information needed for external reporting may not supply the information necessary for a number of internal decisions, especially those decisions that are short run in nature. Different costs are needed for different purposes. It should be pointed out that full cost information is useful as an input for a number of important internal decisions as well as for financial reporting. In the long run, for any product to be viable, its price must cover its full cost. Decisions to introduce a new product, to continue a current product, and to analyze long-run prices are examples of important internal decisions that rely on full unit cost information.
Importance of Unit Costs to Nonmanufacturing Firms
Service and nonprofit firms also require unit cost information. Conceptually, the way companies accumulate and assign costs is the same whether or not the firm is a manufacturing firm. The service firm must first identify the service “unit” being provided. In an auto repair shop, the service unit would be the work performed on an individual customer’s car. Because each car is different in terms of the work required (an oil change versus a transmission overhaul, for example), the costs must be assigned individually to each job. A hospital would accumulate costs by patient, patient day, and type of procedure (e.g., X-ray, complete blood count test). A governmental agency must also identify the service provided. For example, city government might provide household trash collection and calculate the cost by truck run or by collection per house. Service firms use cost data in much the same way that manufacturing firms do. They use costs to determine profitability, the feasibility of introducing new services, and so on. However, because service firms do not produce physical products, they do not need to value work-in-process and finished goods inventories. Of course, they may have supplies, and the inventory of supplies is simply valued at historical cost. Nonprofit firms must track costs to be sure that they provide their services in a cost-efficient way. Governmental agencies have a fiduciary responsibility to taxpayers to use funds wisely. This requires accurate accounting for costs.
Production of Unit Cost Information
To produce unit cost information, both cost measurement and cost assignment are required. We have already considered two types of cost measurement systems, actual costing and normal costing. We have seen that normal costing is preferred because it provides information on a more timely basis. Shortly, we will address the cost assignment method of job-order costing. First, however, it is necessary to take a closer look at determining costs per unit. Direct materials and direct labor costs are simply traced to units of production. There is a clear relationship between the amount of materials and labor used and the level of production. Actual costs can be used because the actual cost of materials and labor are known reasonably well at any point in time. Overhead is applied using a predetermined rate based on budgeted overhead costs and budgeted amount of driver. Two considerations arise. One is the choice of the activitybase or driver. The other is the activity level.
There are many different measures of production activity. In assigning overhead costs, it is important to select an activity base that is correlated with overhead consumption. This will ensure that individual products receive an accurate assignment of overhead costs. In a traditional costing system, a unit-level driver is used. Five commonly used unit-level drivers are:
1. Units produced
2. Direct labor hours
3. Direct labor dollars
4. Machine hours
5. Direct materials dollars or cost
The most obvious measure of production activity is output. If there is only one product, then overhead costs are clearly incurred to produce that product. In a singleproduct setting, the overhead costs of the period are directly traceable to the period’s output. Clearly, for this case, units produced satisfies the cause-and-effect criterion. Most firms, however, produce more than one product. Since different products typically consume different amounts of overhead, this assignment method is inaccurate. At Kraft, for example, one plant produces salad dressing, ketchup, and marshmallow creme each in a range of sizes from personal application packs to 32-ounce jars. In a multiple-product setting like this, overhead costs are common to more than one product, and different products may consume overhead at different rates.
In its simplest form, computing the unit manufacturing or service cost is easy. The unit cost is the total product cost associated with the units produced divided by the number of units produced. For example, if a toy company manufactures 100,000 tricycles and the total cost of direct materials, direct labor, and overhead for these tricycles is $1,500,000, then the cost per tricycle is $15 ($1,500,000/100,000). Although the concept is simple, the practical reality of the computation is more complex and breaks down when there are products that differ from one another or when the company needs to know the cost of the product before all of the actual costs associated with its production are known.
Importance of Unit Costs to Manufacturing Firms
Unit cost is a critical piece of information for a manufacturer. Unit costs are essential for valuing inventory, determining income, and making a number of important decisions. Disclosing the cost of inventories and determining income are financial reporting requirements that a firm faces at the end of each period. In order to report the cost of its inventories, a firm must know the number of units on hand and the unit cost. The cost of goods sold, used to determine income, also requires knowledge of the units sold and their unit cost.
Whether or not the unit cost information should include all manufacturing costs depends on the purpose for which the information is going to be used. For financial reporting, full or absorption unit cost information is required. If a firm is operating below its production capacity, however, variable cost information may be much more useful in a decision to accept or reject a special order. Simply put, unit cost information needed for external reporting may not supply the information necessary for a number of internal decisions, especially those decisions that are short run in nature. Different costs are needed for different purposes. It should be pointed out that full cost information is useful as an input for a number of important internal decisions as well as for financial reporting. In the long run, for any product to be viable, its price must cover its full cost. Decisions to introduce a new product, to continue a current product, and to analyze long-run prices are examples of important internal decisions that rely on full unit cost information.
Importance of Unit Costs to Nonmanufacturing Firms
Service and nonprofit firms also require unit cost information. Conceptually, the way companies accumulate and assign costs is the same whether or not the firm is a manufacturing firm. The service firm must first identify the service “unit” being provided. In an auto repair shop, the service unit would be the work performed on an individual customer’s car. Because each car is different in terms of the work required (an oil change versus a transmission overhaul, for example), the costs must be assigned individually to each job. A hospital would accumulate costs by patient, patient day, and type of procedure (e.g., X-ray, complete blood count test). A governmental agency must also identify the service provided. For example, city government might provide household trash collection and calculate the cost by truck run or by collection per house. Service firms use cost data in much the same way that manufacturing firms do. They use costs to determine profitability, the feasibility of introducing new services, and so on. However, because service firms do not produce physical products, they do not need to value work-in-process and finished goods inventories. Of course, they may have supplies, and the inventory of supplies is simply valued at historical cost. Nonprofit firms must track costs to be sure that they provide their services in a cost-efficient way. Governmental agencies have a fiduciary responsibility to taxpayers to use funds wisely. This requires accurate accounting for costs.
Production of Unit Cost Information
To produce unit cost information, both cost measurement and cost assignment are required. We have already considered two types of cost measurement systems, actual costing and normal costing. We have seen that normal costing is preferred because it provides information on a more timely basis. Shortly, we will address the cost assignment method of job-order costing. First, however, it is necessary to take a closer look at determining costs per unit. Direct materials and direct labor costs are simply traced to units of production. There is a clear relationship between the amount of materials and labor used and the level of production. Actual costs can be used because the actual cost of materials and labor are known reasonably well at any point in time. Overhead is applied using a predetermined rate based on budgeted overhead costs and budgeted amount of driver. Two considerations arise. One is the choice of the activitybase or driver. The other is the activity level.
There are many different measures of production activity. In assigning overhead costs, it is important to select an activity base that is correlated with overhead consumption. This will ensure that individual products receive an accurate assignment of overhead costs. In a traditional costing system, a unit-level driver is used. Five commonly used unit-level drivers are:
1. Units produced
2. Direct labor hours
3. Direct labor dollars
4. Machine hours
5. Direct materials dollars or cost
The most obvious measure of production activity is output. If there is only one product, then overhead costs are clearly incurred to produce that product. In a singleproduct setting, the overhead costs of the period are directly traceable to the period’s output. Clearly, for this case, units produced satisfies the cause-and-effect criterion. Most firms, however, produce more than one product. Since different products typically consume different amounts of overhead, this assignment method is inaccurate. At Kraft, for example, one plant produces salad dressing, ketchup, and marshmallow creme each in a range of sizes from personal application packs to 32-ounce jars. In a multiple-product setting like this, overhead costs are common to more than one product, and different products may consume overhead at different rates.
As this example illustrates, activity measures other than units of product are needed when a firm has multiple products. The last four measures listed earlier (direct labor hours, direct labor dollars, machine hours, and direct materials dollars or cost) are all useful for multiple-product settings. Some may be more useful than others, depending on how well they correlate with the actual overhead consumption. As we will discuss later, it may even be appropriate to use multiple rates.
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