Production costing and optimization involve complex algorithms and mathematical techniques which come at a great cost far beyond the reach of small-scale manufacturers. For this reason most small-scale manufacturers end up with a situation where allocation of manufacturing cost is more of heuristic than scientific. This approach can easily lead to a tragic consequence of a business shutting down even with a hefty turnover. However, accurate production costing is not optional—it is something every manufacturer, irrespective of size, must come to terms with for the health of their business.The profitability or otherwise of a manufacturing entity has everything to do with accurate costing of production resources. It does not matter whether you are manufacturing at industrial scale or from your kitchen—the result is the same: If you cannot determine what it costs you to produce a product accurately, you will, certainly, not be in a position to know how much profit or loss you are making until, perhaps, things get out of hands.
In this article, I have presented a simple computational method of costing using what I call Production Cost Ratio (PCR), which can allow small-scale manufacturers to determine their cost more accurately as well as control known cost parameters. The steps involved are simple enough to be adapted and applied by any manufacturing entity.
Production Cost Optimization
Optimization and control of production cost are some of the major goals of cost accounting. The process generally involves the collation and analyses of data to obtain relevant information that could assist the organization in the planning and allocation of resources efficiently. Various operational and mathematical techniques have been developed and implemented for production cost optimization over the years, with varying degree of accuracies and constraints. Today, production optimization is part of a discipline which belongs to a branch of mathematics called Operations Research.
The problem with most of these techniques is that they are not simple and heuristic enough to be adopted by small-scale manufacturers. Apart from their complex algorithms, their implementation costs are also prohibitive. The good news is that cost accounting methods, unlike financial accounting, are not regulated by any formal rules or standards, such as the IFRS (International Financial Reporting Standards), which compel organizations to adhere to a set of strict policies. That means any organization is free to develop and implement any technique that provides the most accurate and affordable method for minimizing and allocating its production costs, without compromising product quality.
Proper costing allows you to accurately determine the unit cost of your finished goods to provide input data for financial accounting, as you move your output from work-in-progress to inventory. In one of my previous posts, I presented a Simplified Costing and Accounting Workflow for Small- and Medium-Scale Manufacturers, which described the flow of data from cost accounting to financial accounting—along with the various steps and accounting entries involved in the process. In this article, I am going to provide you with a special method of determining and allocating production cost in a way that is more accurate and simpler using what I call Production Cost Ratio (PCR).
Allocating Cost Using Product Cost Ratio
Before we can define Production Cost Ratio, we need to take a look at some case studies. Let us assume that a manufacturer that produces one line of product incurs a total fixed non-raw materials (or Indirect) costs of $28,000 per week as shown on the table below:
Let us also assume that the total cost of raw materials required to produce 2,000 units of the finished goods is $30,000. This will result in a unit cost of $29 ($58,000/2,000) for the finished goods. This amount comprises both the fixed costs and the raw materials cost—out of which the fixed (indirect) costs constitute 43%. I believe this is simple and straight-forward enough.
Now, let us consider a situation where the manufacturer has 3 lines of product to be produced using the same pool of Labour, Overhead and other resources, but with a different set of raw materials.
Before we can take on this case, we need to define some important parameters:
Production Run (or Batch)
I will be using the terms Production Run and Production Batch interchangeably to refer to a group of similar products manufactured using the same method, raw materials, labour and other resources. Each Production Run must have a known (or estimated) quantity of the finished product expected from it. Production Runs are repetitive tasks which should be measured on weekly or monthly basis. In a multi-products production environment, each product type must have a separate production run. For example, Production Runs for the manufacture of White Bread are different from those of Wheat Bread, in terms of the raw materials used, time and the quantity of product expected per run, among other things.
This refers to the length of time (in hours) it takes to complete one Production Run. For example, the time it takes to produce White Bread may not be the same as the time it takes to produce Wheat or Burger Bread. The one that takes longer to produce will, obviously, consume more resources and incur more costs. This time variable must be taken into account when allocating cost to these products.
Production Cost Index (PCI)
Production Cost Index (PCI) is the result of multiplying the Production Run (PR) by the Production Time (PT). This parameter is important because a product with a weekly Production Run of 5 with each run lasting 2 hours, will consume fewer resources than the one with 3 Production Runs per week with each run lasting for 4 hours. The later will have a higher cost index.
The table below shows the PCI for three products based on their respective PR and PT:
Note that PCI = PR x PT
We can see that Product C has a higher cost index.
To be able to allocate cost fairly, we need to find a constant value that will act as cost multiplier for each product. That multiplier is what I call Production Cost Ratio (PCR), and can be defined as stated below.
Production Cost Ratio (PCR)
To obtain the Production Cost Ratio (PCR), we have to divide each product’s Production Cost Index (PCI) by the sum of Production Cost Index for all the products. From the table above, the sum of Production Cost Index for the three products is 44. The table below shows the Production Cost Ratio (PCR) for each of the products.
This ratio should be used as a multiplier in determining the proportion of Fixed Costs to allocate to each Production Run. PCR is necessary for accurate computation and allocation of production costs to each category of product in a multi-products manufacturing environment when both the Production Time and the Production Runs are not the same and when fixed labour, overhead and other costs are drawn from the same pool. Failure to apply this ratio could result in a skewed or unfair allocation of production costs and, ultimately, lead to misstatement of cost of sales and profit for each category of the finished goods, making it difficult to know the products that are more profitable.
We can also call this ratio Production Cost Allocation Ratio.
Let us use the data below for our next case study. This time, there are three products with different parameters as show on the table below:
With these figures, you can easily calculate the Production Cost Index (PCI = PR x PT) for each product as 6, 5, 6, with the following corresponding Production Cost Ratio (PCR) as follows:
- Product A: 0.35
- Product B: 0.29
- Product C: 0.35
Let us assume the raw materials costs for each product to be as follows:
- Product A: $30,000
- Product B: $18,000
- Product C: $20,000
The table below shows the allocation of fixed costs to each production run for the three categories of the product based on their PCR:
From this table, we can draw the following inferences:
- The fixed costs have been proportionately allocated to each production batch for each category of product based on their Production Cost Ratios. This makes it possible to determine the unit cost of the finished goods from each category fairly.
- To confirm the accuracy of this method, you can also see that the Percentage of Fixed Cost against the Total Production Cost is the same as that of the Fixed Unit Cost Recovery against the Unit Cost of the Finished Product.
You can see how the Production Cost Ratio (PCR) plays a crucial role in ensuring that the fixed cost components are proportionately allocated to the various products in a multi-products production environment, leading to accurate determination of unit cost price for the finished goods.
The PCR method of costing is applicable and accurate under the following conditions:
Production must involve multiple lines of products with varying production runs and (or) production times
- Non-raw materials costs, especially Labour cost, are fixed. That is, your weekly or monthly payroll, monthly or annual rent, etc. will remain the same irrespective of the quantity of products you produce. However, other costs, such as electricity and fuel, which are affected by production runs, should be updated whenever necessary.
- The closest alternative to the PCR method of costing (in terms of precision) is the Activity Based Costing (ABC), which allocates labour, overhead and other costs directly based on the number of units (usually in hours) consumed by each production task. However, this method of costing requires a lot of planning and documentation, and may be too expensive and difficult for small-scale manufacturers to implement.
We have successfully implemented the Production Cost Ratio algorithm as a standard module in the Professional Edition of our ABC Toolkit Financial and Business Solution for SMEs and in the special edition of Bread Production Costing and Accounting, known as BakerMITS.
I invented the Production Cost Ratio (PCR) method of costing through empirical measurements and analyses while trying to solve production costs allocation problem for bakeries. After weeks of frustrating search online and offline for a standard solution without success, I decided to collate production data and carry out manual computations, where I was able to discover this ratio. Perhaps, similar methods do exist, but I have not come across one yet. I will appreciate if you can call my attention to any such method you may have come across.