Production Cost and Selling Cost

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PRODUCTION COST Cost-of-production theory of value In economics, the cost-of-production theory of value is the theory that the price of an o !ect or condition is determined y the sum of the cost of the resources that "ent into ma#in$ it% The cost can comprise any of the factors of production &includin$ la or, capital, or land' and ta(ation% The theory ma#es the most sense under assumptions of constant returns to scale and the e(istence of !ust one non-produced factor of production% These are the assumptions of the so-called non-su stitution theorem% Under these assumptions, the lon$-run price of a commodity is e)ual to the sum of the cost of the inputs into that commodity, includin$ interest char$es% Historical development of theory[edit] *istorically, the est-#no"n proponent of such theories is pro a ly +dam Smith% Piero Sraffa, in his introduction to the first volume of the ,Collected -or#s of David Ricardo,, referred to Smith.s ,addin$-up, theory% Smith contrasted natural prices "ith mar#et price% Smith theori/ed that mar#et prices "ould tend to"ard natural prices, "here outputs "ould stand at "hat he characteri/ed as the ,level of effectual demand,% +t this level, Smith.s natural prices of commodities are the sum of the natural rates of "a$es, profits, and rent that must e paid for inputs into production% &Smith is am i$uous a out "hether rent is price determinin$ or price determined% The latter vie" is the consensus of later classical economists, "ith the Ricardo-0althus--est theory of rent%' David Ricardo mi(ed this cost-of-production theory of prices "ith the la or theory of value, as that latter theory "as understood y 1u$en von 23hm-2a"er# and others% This is the theory that prices tend to"ard proportionality to the socially necessary la or em odied in a commodity% Ricardo sets this theory at the start of the first chapter of his ,Principles of Political 1conomy and Ta(ation,% *e also refutes the la or theory of value in later sections of that chapter% This refutation leads to "hat later ecame #no"n as the transformation pro lem% 4arl 0ar( later ta#es up that theory in the first volume of Capital, "hile indicatin$ that he is )uite a"are that the theory is untrue at lo"er levels of a straction% This has led to all sorts of ar$uments over "hat oth David Ricardo and

4arl 0ar( ,really meant,% Nevertheless, it seems undenia le that all the ma!or classical economics and 0ar( e(plicitly re!ected the la or theory of price567&567'% + some"hat different theory of cost-determined prices is provided y the ,neo-Ricardian School, 587 of Piero Sraffa and his follo"ers% The Polish economist 0icha9 4alec#i 5:7 distin$uished et"een sectors "ith ,costdetermined prices, &such as manufacturin$ and services' and those "ith ,demanddetermined prices, &such as a$riculture and ra" material e(traction'% One mi$ht thin# of this theory as e)uivalent to modern theories of mar#up pricin$, fullcost pricin$, or administrative pricin$% 1ver since *all and *itch,587 economists5citation needed7 have found that the evidence $athered in surveys of usinessmen support such theories% 0ost contemporary economists accept neoclassical economics or mainstream economics% The non-su stitution theorem is presented in $raduate-level microeconomics te(t oo#s as a theorem of mainstream economics% 0any mainstream economists also elieve they can !ustify theories of full-cost pricin$ "ithin their theory% The ma!ority of mainstream economists "ould pro a ly then accept this theory as an element in their theory, "hich does not $ive ade)uate attention to issues of consumer demand and mar$inal utility% Market price[edit] Main article: Market price 0ar#et price is a familiar economic concept; it is the price that a $ood or service is offered at, or "ill fetch, in the mar#etplace% It is of interest mainly in the study of microeconomics% 0ar#et value and mar#et price are e)ual only under conditions of mar#et efficiency, e)uili rium, and rational e(pectations% In economics, returns to scale and economies of scale are related terms that descri e "hat happens as the scale of production increases% They are different, noninterchan$ea le terms% Labor theory of value[edit] Main article: Labor theory of value The la or theories of value are economic theories accordin$ to "hich the true values of commodities are related to the la or needed to produce them% There are many accounts of la or value, "ith the common element that the ,value, of an e(chan$ea le $ood or service is, or ou$ht to e, or tends to e, or can e considered as, e)ual or proportional to the amount of la or re)uired to produce it &includin$ the la or re)uired to produce the ra" materials and machinery used in production'%

Different la or theories of value prevailed amon$ classical economists throu$h the mid6<th century% This theory is especially associated "ith +dam Smith and David Ricardo% Since that time, it has een most often associated "ith 0ar(ian economics, "hile amon$ modern mainstream economists it is considered to e superseded y the mar$inal utility approach% Taxes and subsidies[edit]

+ supply and demand dia$ram illustratin$ ta(es. effect on prices% Main article: Effect of taxes and subsidies on price Ta(es and su sidies chan$e the price of $oods and services% + mar$inal ta( on the sellers of a $ood "ill shift the supply curve to the left until the vertical distance et"een the t"o supply curves is e)ual to the per unit ta(= other thin$s remainin$ e)ual, this "ill increase the price paid y the consumers &"hich is e)ual to the ne" mar#et price' and decrease the price received y the sellers% 0ar$inal su sidies on production "ill shift the supply curve to the ri$ht until the vertical distance et"een the t"o supply curves is e)ual to the per unit su sidy= other thin$s remainin$ e)ual, this "ill decrease price paid y the consumers &"hich is e)ual to the ne" mar#et price' and increase the price received y the producers%

+ cost incurred y a usiness "hen manufacturin$ a $ood or producin$ a service% Production costs com ine ra" material and la or% To fi$ure out the cost of production per unit, the cost of production is divided y the num er of units produced% + company that #no"s ho" much it "ill cost to produce an item, or produce a service, "ill have a clearer picture of ho" to etter price the item or service and "hat "ill e the total cost to the company%

2usinesses that #no" their production costs #no" the total e(pense to the production line, or ho" much the entire process "ill cost to produce the item% If costs are too hi$h, these can e decreased or possi ly eliminated% Production costs can e used to compare the e(penses of different activities "ithin the company% In production, there are direct costs and indirect costs% >or e(ample, direct costs for manufacturin$ an automo ile are materials such as the plastic, metal or la or incurred to produce such an item% Indirect costs include overhead such as rent, salaries or utility e(pense%

The costs related to ma#in$ or ac)uirin$ $oods and services that directly $enerates revenue for a firm% It comprises of direct costs and indirect costs% Direct costs are those that are tracea le to the creation of a product and include costs for materials and la or "hereas indirect costs refer to those costs that cannot e traced to the product such as overhead% Cost of production refers to the total sum of money needed for the production of a particular )uantity of output% +s defined y ?ulhrie and -allace, @In 1conomics, cost of production features a special meanin$% It is all a out the payments or e(penditures essential to $et the factors of production of land, la or, capital and mana$ement needed to produce a commodity% It si$nifies the money costs "hich are to e incurred for ac)uisition of the factors of production%A In the "ords of Camp ell, @Production Costs are the costs "hich should e essentially received y resource o"ners so as to presume that they "ill continue to supply them in a specific period of time%A Elements of Production Cost The #ey elements included in the production costs are as follo"s;
• • • • • •

Purchase of ra" machinery Installation of plant and machinery -a$es of la or 2uildin$ rent Interest on capital -ear and tear of uildin$ and machinery

• • • •

+dvertisement e(penses Payment of ta(es Insurance char$es The imputed value of factor of production o"ned y the firm itself is also added in the production cost% The production cost also includes the normal profit of the entrepreneur%



Formula for computing Production Costs The $eneral formula used for computin$ production cost is; Production cost per item = Fixed Cost (FC ! "ariable cost ("C # $o% of units produced Calculating production cost The #ey steps involved in computation of production cost are;


Determine the fi(ed cost% These are the costs "hich do not alter on the asis of the num er of products produced% This includes the rent paid for uildin$, salaries of the employees, and utility costs%



1stimate the varia le costs% These are the costs that chan$e "ith a chan$e in the )uantity of production% >or e(ample, if you are ma#in$ a ca#e, some of the varia le costs "ould e flour, e$$s, and su$ar%



+dd the fi(ed costs to the varia le costs and divide this num er y the num er of items produced thus reachin$ the production cost for one item%

S1BBIN? COST

“Cost of sales” if said in a phrase then it basically is, manufacturing cost of units sold in a particular period or simply cost. On the other hand “selling costs” include such costs that are incurred to make things available for sale. Important thing to understand here is that even after incurring cost of sales, you cannot sell the goods unless business incurs selling costs. Here it will be good we define finished goods also. here are many ways to define finished goods according the production process and business practices in a particular situation. !ut going specific and ignoring e"ceptions then finished goods are such goods that are completely manufactured.

!ut being completely manufactured does not mean that goods are also in salable condition. #et $eali%able &alue '#$&( means what business has realized on selling an inventory. It is calculated by deducting selling costs from sales value. he reason why only selling costs are deducted out of the sales revenue is that users of financial information might be interested in knowing that how much additional cost was incurred before the revenue 'that business has generated( was actually made possible to be generated. )s without selling costs, business might have not generated any revenue at all. *or e"ample, to drive a car, you have to give ignition. +ithout ignition, you cannot drive a car. ,ame way, to generate revenue and to earn profits ultimately, you have to incur selling costs. Otherwise, you will not be able to get any profits out of the value you have added into the manufactured goods by incurring manufacturing costs. +hile valuing the closing inventory for financial reporting purposes, we compare the cost 'manufacturing cost( and #$& of the inventory and as per I), -, inventory is to be valued at “lower of cost and #$&”.

Cost of goods sold
Cost of goods sold or COGS refer to the carrying value of goods sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out (FIFO , or average cost. Costs include all costs of purchase, costs of conversion and other costs incurred in !ringing the inventories to their present location and condition. Costs of goods made !y the !usiness include material, la!or, and allocated overhead. "he costs of those goods not yet sold are deferred as costs of inventory until the inventory is sold or written down in value.
#any !usinesses sell goods that they have !ought or produced. $hen the goods are !ought or produced, the costs associated with such goods are capitali%ed as part of inventory (or stoc& of goods. '() "hese costs are treated as an e*pense in the period the !usiness recogni%es income from sale of the goods. '+) ,etermining costs re-uires &eeping records of goods or materials purchased and any discounts on such purchase. In addition, if the goods are modified,'.) the !usiness must determine the costs incurred in modifying the goods. Such modification costs include la!or, supplies or additional material, supervision, -uality control and use of e-uipment. /rinciples for determining costs may !e easily stated, !ut application in practice is often difficult due to a variety of considerations in the allocation of costs. '0) Cost of goods sold may also reflect ad1ustments. 2mong the potential ad1ustments are decline in value of the goods (i.e., lower mar&et value than cost , o!solescence, damage, etc. $hen multiple goods are !ought or made, it may !e necessary to identify which costs relate to which particular goods sold. "his may !e done using an identification convention, such as specific identification of the goods,first-in-first-out (FIFO , or average cost. 2lternative systems may !e used in some countries, such as last-in-first-out (3IFO , gross profit method, retail method, or com!inations of these. Cost of goods sold may !e the same or different for accounting and ta* purposes, depending on the rules of the particular 1urisdiction. Certain e*penses are included in COGS. 4*penses that are included in COGS cannot !e deducted again as a !usiness e*pense. COGS e*penses include5

• • • •

"he cost of products or raw materials, including freight or shipping charges6 "he cost of storing products the !usiness sells6 ,irect la!or costs for wor&ers who produce the products6 and Factory overhead e*penses.

Importance of inventories[edit]
Inventories have a significant effect on profits. 2 !usiness that ma&es or !uys goods to sell must &eep trac& of inventories of goods under all accounting and income ta* rules. 2n e*ample illustrates why. Fred !uys auto parts and resells them. In +778, Fred !uys 9(77 worth of parts. :e sells parts for 987 that he !ought for 9.7, and has 9;7 worth of parts left. In +77<, he sells the

remainder of the parts for 9(87. If he &eeps trac& of inventory, his profit in +778 is 9=7, and his profit in +77< is 9((7, or 9(>7 in total. If he deducted all the costs in +778, he would have a loss of 9+7 in +778 and a profit of 9(87 in +77<. "he total is the same, !ut the timing is much different. #ost countries? accounting and income ta* rules (if the country has an income ta* re-uire the use of inventories for all !usinesses that regularly sell goods they have made or !ought.

Cost of goods for resale[edit]
Cost of goods purchased for resale includes purchase price as well as all other costs of ac-uisitions, '=) e*cluding any discounts. 2dditional costs may include freight paid to ac-uire the goods, customs duties, sales or use ta*es not recovera!le paid on materials used, and fees paid for ac-uisition. For financial reporting purposes such period costs as purchasing department, warehouse, and other operating e*penses are usually not treated as part of inventory or cost of goods sold. For @.S. income ta* purposes, some of these period costs must !e capitali%ed as part of inventory. '>) Costs of selling, pac&ing, and shipping goods to customers are treated as operating e*penses related to the sale. Aoth International and @.S. accounting standards re-uire that certain a!normal costs, such as those associated with idle capacity, must !e treated as e*penses rather than part of inventory. ,iscounts that must !e deducted from the costs of purchased inventory are the following5



"rade discounts (reduction in the price of goods that a manufacturer or wholesaler provides to a retailer - includes a discount that is always allowed, regardless of the time of payment.

• •

#anufacturerBs re!atesCis !ased on the dealerBs purchases during the year. Cash discounts (a reduction in the invoice price that the seller provides if the dealer pays immediately or within a specified time Cit may reduce COGS, or it may !e treated separately as gross income. ';)

Dalue added ta* is generally not treated as part of cost of goods sold if it may !e used as an input credit or otherwise recovera!le from the ta*ing authority.'8)

Cost of goods made by the business[edit]
"he cost of goods produced in the !usiness should include all costs of production. '<) "he &ey components of cost generally include5

• • •

/arts, raw materials and supplies used, 3a!or, including associated costs such as payroll ta*es and !enefits, and Overhead of the !usiness alloca!le to production.

#ost !usinesses ma&e more than one of a particular item. "hus, costs are incurred for multiple items rather than a particular item sold. ,etermining how much of each of these components to allocate to particular goods re-uires either trac&ing the particular costs or ma&ing some allocations of costs. /arts and raw materials are often trac&ed to particular sets ( e.g., !atches or production runs of goods, then allocated to each item. 3a!or costs include direct la!or and indirect la!or. ,irect la!or costs are the wages paid to those employees who spend all their time wor&ing directly on the product !eing manufactured. Indirect la!or costs are the wages paid to other factory employees involved in production. Costs of payroll ta*es and fringe !enefits are generally included in la!or costs, !ut may !e treated as overhead costs. 3a!or costs may !e allocated to an item or set of items !ased on time&eeping records. Costs of materials include direct raw materials, as well as supplies and indirect materials. $here non-incidental amounts of supplies are maintained, the ta*payer must &eep inventories of the supplies for income ta* purposes, charging them to e*pense or cost of goods sold as used rather than as purchased. #aterials and la!or may !e allocated !ased on past e*perience, or standard costs. $here materials or la!or costs for a period e*ceed the e*pected amount of standard costs, a variance. Such variances are then allocated among cost of goods sold and remaining inventory at the end of the period. ,etermining overhead costs often involves ma&ing assumptions a!out what costs should !e associated with production activities and what costs should !e associated with other activities. "raditional cost accountingmethods attempt to ma&e these assumptions

!ased on past e*perience and management 1udgment as to factual relationships. 2ctivity !ased costing attempts to allocate costs !ased on those factors that drive the !usiness to incur the costs. Overhead costs are often allocated to sets of produced goods !ased on the ratio of la!or hours or costs or the ratio of materials used for producing the set of goods. Overhead costs may !e referred to as factory overhead or factory !urden for those costs incurred at the plant level or overall burden for those costs incurred at the organi%ation level. $here la!or hours are used, a burden rate or overhead cost per hour of la!or may !e added along with la!or costs. Other methods may !e used to associate overhead costs with particular goods produced. Overhead rates may !e standard rates, in which case there may !e variances, or may !e ad1usted for each set of goods produced. Daria!le production overheads are allocated to units produced !ased on actual use of production facilities. Fi*ed production overheads are often allocated !ased on normal capacities or e*pected production. '(7) #ore or fewer goods may !e produced than e*pected when developing cost assumptions (li&e !urden rates . "hese differences in production levels often result in too much or too little cost !eing assigned to the goods produced. "his also gives rise to variances.

Identification conventions[edit]
In some cases, the cost of goods sold may !e identified with the item sold. Ordinarily, however, the identity of goods is lost !etween the time of purchase or manufacture and the time of sale. '(() ,etermining which goods have !een sold, and the cost of those goods, re-uires either identifying the goods or using a convention to assume which goods were sold. "his may !e referred to as a cost flow assumption or inventory identification assumption or convention. '(+) "he following methods are availa!le in many 1urisdictions for associating costs with goods sold and goods still on hand5

• • • •

Specific identification. @nder this method, particular items are identified, and costs are trac&ed with respect to each item.'(.) "his may re-uire considera!le record&eeping. "his method cannot !e used where the goods or items are indistinguisha!le or fungi!le. 2verage cost. "he average cost method relies on average unit cost to calculate cost of units sold and ending inventory. Several variations on the calculation may !e used, including weighted average and moving average. First-In First-Out (FIFO assumes that the items purchased or produced first are sold first. Costs of inventory per unit or item are determined at the time made or ac-uired. "he oldest cost ( i.e., the first in is then matched against revenue and assigned to cost of goods sold. 3ast-In First-Out (3IFO is the reverse of FIFO. Some systems permit determining the costs of goods at the time ac-uired or made, !ut assigning costs to goods sold under the assumption that the goods made or ac-uired last are sold first. Costs of specific goods ac-uired or made are added to a pool of costs for the type of goods. @nder this system, the !usiness may maintain costs under FIFO !ut trac& an offset in the form of a 3IFO reserve. Such reserve (an asset or contraasset represents the difference in cost of inventory under the FIFO and 3IFO assumptions. Such amount may !e different for financial reporting and ta* purposes in the @nited States.

• •

,ollar Dalue 3IFO. @nder this variation of 3IFO, increases or decreases in the 3IFO reserve are determined !ased on dollar values rather than -uantities. Eetail inventory method. Eesellers of goods may use this method to simplify record&eeping. "he calculated cost of goods on hand at the end of a period is the ratio of cost of goods ac-uired to the retail value of the goods times the retail value of goods on hand. Cost of goods ac-uired includes !eginning inventory as previously valued plus purchases. Cost of goods sold is then !eginning inventory plus purchases less the calculated cost of goods on hand at the end of the period.

Example[edit]
Fane owns a !usiness that resells machines. 2t the start of +77<, she has no machines or parts on hand. She !uys machines 2 and A for (7 each, and later !uys machines C and , for (+ each. 2ll the machines are the same, !ut they have serial num!ers. Fane sells machines 2 and C for +7 each. :er cost of goods sold depends on her inventory method. @nder specific identification, the cost of goods sold is (7 G (+, the particular costs of machines 2 and C. If she uses FIFO, her costs are +7 ((7G(7 . If she uses average cost, her costs are ++ ( ((7G(7G(+G(+ H0 * + . If she uses 3IFO, her costs are +0 ((+G(+ . "hus, her profit for accounting and ta* purposes may !e +7, (8, or (>, depending on her inventory method. 2fter the sales, her inventory values are either +7, ++ or +0. 2fter year end, Fane decides she can ma&e more money !y improving machines A and ,. She !uys and uses (7 of parts and supplies, and it ta&es > hours at + per hour to ma&e the improvements to each machine. Fane has overhead, including rent and electricity. She calculates that the overhead adds 7.= per hour to her costs. "hus, Fane has spent +7 to improve each machine ((7H+ G (+ G (> * 7.= . She sells machine , for 0=. :er cost for that machine depends on her inventory method. If she used

FIFO, the cost of machine , is (+ plus +7 she spent improving it, for a profit of (.. Eemem!er, she used up the two (7 cost items already under FIFO. If she uses average cost, it is (( plus +7, for a profit of (0. If she used 3IFO, the cost would !e (7 plus +7 for a profit of (=.

In year :, Cane sells the last machine for :D and )uits the usiness% She recovers the last of her costs% *er total profits for the three years are the same under all inventory methods% Only the timin$ of income and the alance of inventory differ% *ere is a comparison under >I>O, +vera$e Cost, and BI>O;
Cost of Goods Sold ------ Profit ------

Year Sales

FIFO

Avg.

LIFO

FIFO Avg. LIFO

(

07

+7

++

+0

+7

(8

(>

+

0=

.+

.(

.7

(.

(0

(=

.

.8

.+

.(

.7

>

;

8

"otal (+.

80

80

80

.<

.<

.<

Write-downs and allowances[edit]
"he value of goods held for sale !y a !usiness may decline due to a num!er of factors. "he goods may prove to !e defective or !elow normal -uality standards (su!normal . "he goods may !ecome o!solete. "he mar&et value of the goods may simply decline due to economic factors. $here the mar&et value of goods has declined for whatever reasons, the !usiness may choose to value its inventory at the lower of cost or mar&et value, also &nown as net realizable value.'(0) "his may !e recorded !y accruing an e*pense (i.e., creating an inventory reserve for declines due to o!solescence, etc. Current period net income as well as net inventory value at the end of the period is reduced for the decline in value. 2ny property held !y a !usiness may decline in value or !e damaged !y unusual events, such as a fire. "he loss of value where the goods are destroyed is accounted for as a loss, and the inventory is fully written off. Generally, such loss is recogni%ed for !oth financial reporting and ta* purposes. :owever, !oo& and ta* amounts may differ under some systems.

Alternative views[edit]
2lternatives to traditional cost accounting have !een proposed !y various management theorists. "hese include5

• • •

"hroughput 2ccounting, under the "heory of Constraints, under which only "otaly varia!le costs are included in cost of goods sold and inventory is treated as investment. 3ean accounting, in which most traditional costing methods are ignored in favor of measuring wee&ly Ivalue streamsI. Eesource consumption accounting, which discards most current accounting concepts in favor of proportional costing !ased on simulations.

Jone of these views conform to @.S. Generally 2ccepted 2ccounting /rinciples or International 2ccounting Standards, nor are any accepted for most income or other ta* reporting purposes.

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