PRODUCTION COST MANAGEMENT

Fundamentals of Costing

In any business, especially in manufacturing, there are production and service departments (units). A Cost Center is a department or unit to which costs can be allocated. All costs incurred by production department are directly relatable to the products. However, in the case of service departments, their costs have to be mutually allocated and then finally allocated to production cost center. Thus, all costs are finally absorbed by production. This method of costing is called Absorption Costing or Full Cost Method

Absorption costing does not distinguish between Fixed Costs such as rent, salaries etc. which have to be incurred anyway, and variable costs, which vary directly in proportion to production within defined activity levels (capacity usage). The alternative to Absorption Costing is Marginal Costing or Variable Costing, which ignores all fixed costs as already incurred (‘sunk costs’) and of no relevance to product costs. Hence, Marginal Costing method only considers direct material, labor and overheads to compute product costs. Under this method, overheads can also include semi-variable costs – costs that tend to remain fixed up to a certain level of activity.

Direct Costs Vs. Indirect Costs

Cost of production [COP] of an item consists of Direct Costs and Indirect costs.

Direct Costs are those costs that can be directly identified with individual ‘cost centers’. Direct costs include direct material, labor and overheads. Direct material cost will be considered net of scrap/wastage. Direct labor includes wages of workers exclusively on the production line, but excludes ‘shared’ resources like factory maintenance staff. Direct overheads include electricity, water, equipment depreciation etc., which wouldn’t be spent if the product was not manufactured. Direct costs are variable in the sense that consumption is directly linked to production volume.

Indirect Costs may include indirect material, such as consumables, indirect labor such as supervisory costs etc. which do not have a correspondence to the quantity or volume of the end product.

Consumption of all direct materials, that are part of the Manufacturing BOM, are automatically absorbed by production units. Direct labor and overheads are absorbed at a fixed rate per quantity produced or as a standard fixed cost. Indirect costs are absorbed as a percentage of total material costs or as a percentage of overall process cost excluding materials. The choice between these two will depend on the nature of the product and the production process.

*Other methods of overhead absorption based on labor hours, machine hours etc. are also prevalent, though not offered in CREST ERP

Defining Cost Absorption Rules In CREST ERP

You must identify all costs relevant for your products and manufacturing process and define them in CREST ERP. These cost absorption rules or models are then linked to Routing Tasks, as already explained under Routing Tasks-Associated Costs

To add a new Cost Component, click the Create New Cost Component link on the Costs home screen

You must first choose the Cost Type : direct or indirect.

Direct and Indirect cost components have been discussed in detail in the following sections