COSTING OF PRODUCTION SYSTEMS – ELEMENTS OF COSTING

PRODUCTION CONCEPT

To a layman, production simply means the making of something, such as, bread from flour,
tables from planks, books from paper and so on. To the economist, each of these activities
represents only a stage in the production process. Production in economics refers to the creation
of utilities or wealth that yields some positive value to society’s welfare. In this sense, the
activities of a musician or garbage collector, a university don, a trader and a farmer, are all
economically productive because these activities are valued by society and people are willing to
pay for them.

Basically, production is classified into three: primary production, secondary production and
tertiary production.

Primary Production: It involves extraction of basic materials from the land or sea. Primary
production ativities are mostly found in agriculture, mining, quarrying, fishig and oil drilling.

Secondary Production: This is concerned with the rocessing of basic extractive materials into
consumer and producer goods. Consumer goods are goods which directly satisfy our wants, such
as food, shoes, clothes and so on. On the other hand, producer goods are those goods which do
not yield satisfaction in the current period because they are needed to produce other goods.
Examples of producer goods include industrial machines and equipment. Producer goods are
sometimes called capital goods or investment goods. Therefore, the processing of flour into
bread, hides and skin into shoes, rubber into tyre, iron ore into iron and steel, limestone into
cement, are some of the exmples of secondary production activities.

Tertiary Production: It refers to provision of services such as banking, insurance, transport,

consulting, health, legal, distributive trades- wholesaling and retailing and so on. For instance, an
accused may regain his freedom through the services of a solicitor and a sick person may become
healthy if attended to by a physician. In other words, people derive some sort of satisfaction or
experience improvement in their living conditions through services by the professionals.
Furthermore, production of good is not complete until the good reaches the final consumer. The
wholesales and retailers serve as a link between the producers and the consumers. More
specifically, the wholesalers purchase the goods in large quantities from the producer and sell to
a number of retailers. The retailers then sell in units directly to consumers. This explains why
both the wholesailers and retailers are called the middlemen. Their activities which constitute the
final stage in the production process are also grouped under tertiary production.

BASIC PRODUCTION TERMS

1. Inputs: These are resources which are used to produce good or service. For example, a
furniture maker will require inputs such as raw planks, nails, tools, workers and land on
which to erect the factory buildings and so on. Economists typically classify inputs under
four headings: land, labour, capital and entrepreneurship. Alternatively, inputs are called
factors of production.

2. Firm: A firm is a decision making unit which hires and transforms resources (or inputs)
into goods and services. Some firms produce tangible goods such as Nigerian Bottling
Company whose products include cocacola, Fanta, Sprite and Evans Medical Plc- the
producer of Glucose D. Other firms perform or produce services such as the accounting
and legal firm.

3. Industry: An industry is a collection of firms producing the same or similar goods or

service. For example, the Nigerian cement industries is comprised of the cement
companies located in Ewekoro, Nkalagu, Sokoto, Gboko and in other places.

4. Scale of Production: A firm’s scale of production is the total amount of various inputs
combined in a particular process. A firm is said to increase its scale of production, if it
uses greater amount of resources. The firm is said to increase its productive capacity.

5. Output: The term output refers to the total amount of commodity produced or services
rendered by a firm over a time period by using some quantity of inputs. To achieve a
greaer output, a firm may need to increase its scale of production.
 6. Fixed and Variable Factors: In the analysis of production process, we assume that all
factors of production can be grouped into two: fixed factors and variable factors. A fixed
factor is an input whose quantity cannot be changed during the period of time under
consideration. In other words, the quantity of it that is used will remain the same at
different output levels. The firm’s buildings, equipment and machinery are examples of
inputs that are often classified as fixed factors. Most often, they are called capital. On the
other hand, a variable factor is an output whose quantity varies directly with the output
level. For example, the quantity of limestone and the number of workers employed in
West African Portland Cement Plc, can often be adjusted according to the rate of output
desired. Labour and raw materials are therefore examples of variable factors.

THE FACTORS OF PRODUCTION

The number of goods and services being produced in today’s world is quite large that it would be
very difficult, if not impossible to produce a complete list of full inputs used in their production.
But for the purpose of analysis, economists grouped these inputs into three: land, labour and
capital. Sometimes, entrepreneurship is added to the list making it the fourth factor of
production. We consider these factors in turn.

1. Land: The term land as a factor of production refers not only to agricultural land but to
all other resources provided freely by nature. It includes minerals, fishing ground,
waterways and forests.

Land is often said to have some distinct features of its own:

 It is a provision of nature since nobody has done anything to bring it to existence.

This explains why land is said to have no cost of production.

 It is limited in supply, unlike other factors of production.

 Production activities which depend greatly on land are subject to diminishing

returns to scale at a certain level of the scale of production.
 However, another school of thought is of the view that land is not strictly different from
other factors of production. This view is baed on the following arguments:

 Most natural resources are of no economic importance if they are not discovered
and exploited by man and the process of discovery and exploitation entails
incurring substantial costs. Hence, it is not appropriate to claim that land has no
cost of production.

 Land is not limited to supply:. For example, natural disasters such as earthquake,
flooding or soil erosion have led to the reduction of agricultural land, while
technological progress culminating in the introduction of fertilizer and irrigation
have led to a greater supply of cultivable land. There are also instances where
land had been reclaimed from sea for other purposes. A typical example in
Nigeria is some portion of the land on which University of Lagos is situated
which was reclaimed from the Lagos Lagoon.

 Empirical evidence has also revealed that production that is capital-intensive can
also be subject to the law of diminishing returns, especially if inceasing units of
labour are supplied to a fixed quantity of physical capital like machines and
equipment.

The argumens that land differ from other factors of production were put forward by
the classical economists. This view was influenced by their experience and
observations in Europe before the industrial revolution.

2. Labour: The term labour is used to describe all human efforts utilized in the production
process. These can be manual or mental. The manual type is classified as unskilled labour
because it requires very little or no education or training. This is found in the services
rendered by office messangers, cleaners. ice-cream salesmen, etc. the mental type on the
other hand, is classified as skilled labour because it involves a considerable period of
formal schooling or training. This is found, for example, in the labour services of drug
analysts, medical doctors, engineers, accountnts, etc.
 The ease with which labour can be transferred from one form of employment to another,
or from one place to another is called mobility of labour. Thus, there are two types of
mobility of labour: occupational mobility of labour and geographical mobility of labour.
Occupational mobility of labour refers to the ease with which labour can change
employment from one industry to another- e.g from farming to tailoring. Occupational
mobility of labour is specifically constrained by the extent to which labour is specialized.
Geographical mobility of labour referes to physical movement from one place to another-
e.g from rural to urban areas, or vice versa. Generally, factors affecting mobiltiy of labour
include family consideration such as schooling of children, economic considerations such
as opportunities for better remuneration and political or religious persecution.

3. Capital: Capital can be defined as a stock of wealth created by man to be usd mainly in
the production of final goods and services. Therefore, capital includes plant, machines,
industrial buildings which are called physical capital. It also includes intermediate or
semi-finished goods such as raw cotton used for textiles, crude oil for petrol, motor spare
parts, etc. the term financial or liquid capital is used specifically to refer to money which
is either contributed by the business owners obtained as loan from the banks or from
other sources. The financial capital earmarked for the purpose of paying wages and
buying other inputs as well as the semi-finished goods are sometimes referred to as the
circulating capital. The social capital are the infrastructures like the roads, hospitals,
schools and railways, that are indirectly connected with production.

4. Entreprenureship: The entrepreneur hires and organizes the other factors of productin.
He decides what goods to produce, how to produce and in what quantity. The
entrepreneur bears the risk of production. He earns profit for effective management of
resources or suffers a loss for laxity and inefficiency.

On the basis of the aforementioned functions of an entrepreneur, there is a controversy as

to its inclusion in the list of the factors of production. There are to lines of argument
against considering entrepreneurship as a factor of production. One, that its function fits
into that of a sole trader. Two, that in large organization, those functions are performed
 by the management team, headed by a managing director. Hence, it is argued that
entrepreneurship should be considered as a specialized type of labour.

COST CONCEPT

Production of any goods or services requires the use of scarce resources and least cost
combination is a prerequisite for profit maximization. There is an inverse relationship between
production cost and profit. The lower the cost, the higher the profit. Profits are defined as the
amount by which the revenues received by the firm on the sale of its output exceeds the
production costs. It is desirable to consider the varios cost concepts, so as to be able to establish
the profit maximizing rule.

THEORY OF COST

When economists talk about cost, they often have something other than money at the back of
their mind. To them, the cost of producing any good or services is its opportunity cost or
sacrifice. That is, the value of the other goods and services forgone by not employing the
resources in their best or most profitable alternative uses. such sacrifice may or may not be
quantified in monetary terms. The cost of watching a football match between Nigeria and Ghana
on a Saturday afternoon, for instance, can be expressed in terms of the loss of the siesta you
might have had, or a lost opportunity to earn #200 if you had used the time to coach a child for
the national common entrance examination. Cost essentially entails looking at the alternative
sacrifice or loss incurred in doing anything.

More explicitly, costs attached to resources that a firm uses to produce its products are divided
into two groups: explicit costs and implicit costs. Explicit costs as earler defined, are payments
that must be made for those resources purchased or hired from outside. These include payments
for outside labour services, fuel and electricity, maerial inputs, transportation and
communication. On the other hand, implicit costs represent payments which the reurces supplied
by the owners could have attracted if they were employed in their next best alternatives. Such
resources inclue the owners’ managerial skill, financial resources and owner-occupier buildings.
It is apparent therefore, that the addition of explicit costs and implit costs gives the opportunity
cost or economic cost for the firm. It follows that the term opportunity cost, production cost and
economic cost can be used interchangeably.

Revenue, on the other hand, are the incomes a firm receives from the sale of its goods and
services. The firm is concerned with both the costs it incurs in producing any given output level
as well as the revenues it will receive on the output so as to be able to project its gain or profit.

COSTING OF PRODUCTION SYSTEMS

Costing is recently used in every sphere of modern day business. Of course it has its origin
from the ancient time. The farmers and the craftsmen were using the technique to ascertain
the cost of their product. But its real development has begun during the eighteenth and
ninetieth century.

COST CONCEPTS
Cost form the subject matter of cost accounting. Cost are the resources sacrificed to achieve a
specific objective. It is defined as the benefit sacrificed to serve some benefit.

COST CLASSIFICATION
Proper classification of cost is necessary for the clear understanding of the cost. The cost
can be classified according to their common characteristics. The classification may be:
1. Behavioural classification

2. Direct and indirect cost

3. Product cost and period cost

4. Relevant and irrelevant cost

5. Real cost

6. Opportunity cost

BEHAVIOURAL CLASSIFICATION
The behavioural classification shows how the cost behaves when production change. According to
behavioral classification, there are three types of cost, fixed cost, variable and semi-variable cost.

FIXED COSTS
Fixed cost is independent of output. Whatever may be the output, they remain constant. They are
generally time-based. Some typical examples are rent, insurance, taxes, salaries etc. The shape of
fixed cost curve is presented below:

COST

TFC

0 q q1

OUTPUT

Fixed costs are those costs which are independent of output may be more or less or even zero, fixed
costs are incurred. Costs of machineries, buildings, salaries of staff, maintenance of machine, costs
of telephone, wages of watch man. Insurance fee or administrative expenses are the example of fixed
cost. These costs are incurred whatever may be the size of output. These costs are incurred before the
factory starts production and after the factory closes down its production for some times. These fixed
costs are payment for the fixed factors of production. Fixed costs are supplementary costs because
these costs constitute a small portion of the total costs of production. These costs are also called as
the overhead costs of production.

VARIABLE COSTS
It may be defined as a cost which in the aggregate, tends to vary in direct proportion to
changes in the volume-of output or turn-over within relevant range for a given budget
period. Examples of variable costs are material costs, direct labour costs, sales commission,
power, royalty, carriage, packing cost etc. As output increases variable costs increases in the
same proportion. Thus, we can say that there exist a linear relationship between output
volume and variable costs. Consequently, variable costs are constant per unit of output.
Hence, total variable costs curve is a straight line passing through the origin and average
variable costs curve is a horizontal line.

Very often variable costs are called engineered costs because these have an explicit, specified,
physical relationship with a selected measure of activity. Direct material and “direct labour are a
prime example of engineered cost.

Marshall has made broad division of cost as fixed cost and variable cost. Variable costs are known as
the prime costs. Marshall said variable costs include the costs of raw materials, wages of the
labourers and wear and tear charge of machineries used for the purpose. Prime cost is called Variable
cost because it directly varies with the rate of production. Higher is the level of production, more is
the level of output, greater will be the amount or variable cost, Lower is the level of production,
lower is the volume of output lower will be the variable cost. It is called prime cost because this is
the main cost of production. In any factory or film if we analyse the cost of production, the amount of
variable cost constitutes the three-fourth of the costs of production. Therefore, it is primary or main
cost of production.
SEMI VARIABLE COSTS
The behavior of cost can't be expected to remain as fixed or variable under all circumstances and for
all the time spans. Thus, the concept of semi-variable cost may arise. Semi-variable costs stand mid-
way between fixed and variable costs. Semi-variable cost is defined as a cost containing both fixed
and variable elements, and which is thus, partly affected by fluctuations in the level of activity. The
fixed part of a semi-variable cost usually represents a minimum fee for making a particular
item/service available. The variable portion is the cost charges for actually using the service. For
example, most telephone service charges are made up of two elements:

i. a fixed charge for allowing to make a call,

ii. plus an additional variable charge for each call actually made.
Semi-variable costs are also known as mixed costs as they consists both of fixed costs and
variable costs. The first part is not affected by the changes in volume of production, while
the later part is sensitive to changes in the volume of production. Thus, semi-variables costs
change in the same directions as volume but not in direct proportion thereto. Hence, the
shape of semi-variable cost curve is as shown below :

The difference or distinction between the variable and fixed costs is not rigid. To take an example the
wage paid to a typist is called fixed costs. If the service of the typist is permanent it becomes a fixed
cost. If the services of the typist can be terminated when production stops, this will be variable cost.
Therefore, distinction is only found in the short-run. In the long run, every cost is variable cost.
AVERAGE COST AND MARGINAL COST :
total cost
Average cost per unit of output is
number of commodities produced

Mathematically speaking. (Average cost)= TC

¿
For example, if the total cost of producing 100 units of output, is #1000,
1000
then average cost = =¿#10
100
Total cost consists of two types of costs such as fixed cost and variable cost. Corresponding
to that we can have average fired cost and average variable cost.

Average fixed cost AFC = TFC

¿
AVC (Average variable cost)= TVC
¿
Therefore average cost is equal to average fixed cost and average variable cost.

Marginal Cost:
Marginal cost is the cost of producing an additional unit of output. That is a net addition to
the total cost. Marginal cost is the difference between the total cost of producing any
number of commodity minus the total cost of producing one units less than the number. If
the number is N the marginal cost or (MC) = The total cost of producing N units of
commodity TCn minus the total cost of production one units less i.e. TCn-1. So marginal
cost (MC) = TCn- TCn-1.
This can be illustrated with the help of an arithmetic example. Suppose, the total cost of
producing 100 units of commodity is 1000 naira and the total cost of producing 101 units of
commodity is 1020 naira. Here the marginal cost MC = 1020 -1000 = #20.
Marginal cost is associated with variable cost. It is in no way connected with fixed cost Because
there is no addition to the fixed cost when the additional unit of commodity is produced. Marginal
cost is independent of fixed cost. Producing one more units causes nothing to be added to the fixed
cost.

COST OF PRODUCTION OF A FIRM

Units of Total Total Total Average Average Average Marginal

out put fixed variable cost fixed cost variable cost (5+6) cost
costs cost (2+3) (2÷1) cost
(3÷1)
1 2 3 4 5 6 7 8
1. 100 100 200 100 100 200 200
2. 100 150 250 50 75 125 50
3. 100 200 300 33.3 66.7 100 50
4. 100 260 360 25 65 90 60
5. 100 320 420 20 64 84 60
6. 100 410 510 16.6 86.4 85 90
7. 100 503 603 14.3 71.7 86 93
8. 100 652 752 12.5 81.5 94 149
9. 100 827 927 11.1 91.9 103 175
10. 100 1035 1135 10 103.5 113.5 208

DIRECT COST AND INDIRECT COST

Direct costs are directly identified with a product, process or department. Raw materials
used and labour employed in manufacturing an article are common example of direct costs.
Indirect costs- These costs are not applicable to any particular product process or department but are
common to different products. Factory manager’s salary, factory rent, depreciation of machinery are
typical example of indirect cost.
Direct cost

Direct Material (Ex. Primary packing materials)

Direct Labour (Ex. Wages paid to workers)

Direct Expenses (Ex. Cost of special tools, patterns etc.) cost of excise duty,

hire charges of a special equipment royalties, insurance etc

Indirect Cost

Indirect Material (Ex. Fuel, Lubricating oil, Maintenance work, Small tools)

Indirect Labour (Ex. Wages of general supervisors, inspectors, workshop

cleaners, store keeper, time-keeper etc.)
Indirect Expenses (Ex. Rent, lighting insurance, canteen, hospital welfare
expenses, it is otherwise known as overhead expenses)
Factory/work overhead (Work manager’s salary, factory rent, factory
insurance, salaries of clerical & executive staff etc.)
Office & Administrative overhead (Office rent, office lighting, insurance
etc.)
Selling & Distributive overhead (advertising expenses, salaries of
salesman, indirect packing material etc.)

RELEVANT COST AND IRRELEVANT COST

Relevant cost are the cost which are relevant for decision making such as differential or incremental
cost, opportunity costs etc.

IRRELEVANT COST
Irrelevant costs are those which are not pertinent to a decision. These are the costs that will not be
changed by a decision because irrelevant cost will not be affected; they may be ignored in decision
making process.

PRODUCT COST AND PERIOD COST

Product costs are the cost directly identified with the product. These are the cost of goods
produced and kept ready for sale. They are direct materials, direct labour. Periods costs are
those cost which are not directly related with production of the commodity. It is otherwise
known as fixed cost.

REAL COST OF PRODUCTION.

Though in our analysis producer is interested in money cost of producing commodity, another view
of cost of production is known as real costs of production. Those who talk about the real cost of
production they talk about the sacrifices borne by the society to produce a particular commodity,
They hold the view that money costs to production is much less in comparison to the sacrifices made
by the society to produce a particular commodity. To illustrate, we can consider the wage of a factory
worker is not equal to the sacrifice he makes in terms of his mental and physical labour. He works
under great risks. Nobody pays for it. Similarly in factory area, the air and water get polluted. Slums
are created. It spreads diseases. Nobody pays for it. Growth of a factory brings indiscipline and
conflict. Society sacrifices much. Nobody pays for this sacrifice. So from social stand Point cost of a
commodity should be calculated in terms of sacrifices. Money cost does not give true picture of cost
Marshall defines real costs as “The exertions of all the different kinds of labourers that are directly or
indirectly involved in making it, together with the abstinence or rather the waiting’s required for
raising the capital used in making it, all these efforts and sacrifices together will be called the costs of
production of the commodity”.

Marshall conceived the cost of production in terms of pains and sacrifices. The sacrifices made by
labour to produce commodity, the sacrifices undertaken by-the savers to provide capital by reducing
their consumption and all other social sacrifices required to produce a commodity constitute the cost
of production of a commodity. These real costs give the true picture of cost of production which
cannot be measured scientifically, because it involves sacrifices. Sacrifice is a subjective feeling. Its
objective measurement is impossible. So people today are trying to make it objective by social cost
benefit analysis.

OPPORTUNITY COST:
Modern writers view another concept to measure the money cost. This is known as
opportunity or alternative cost. Opportunity cost is the cost of the alternative foregone. It is
known that every factor of production has several uses, and as we employ the factor for one
use, we forego the opportunity of employing it in another use. Resources or factors are
limited in supply. If we produce one commodity we do not produce another. Therefore, the
opportunity cost of producing a commodity is equal to the cost of not producing another
commodity. To take an example, if we have an acre that can produce potato on it and get
1000 Naira. Had we not produced potatoes and have produced rice on it, we would have
gotten 700 Naira. Therefore, the cost of producing potato would be equal to the alternative
foregone that 700 Naira would have been incurred from rice productions. The second point
to be noted about this it is not only the cost of the alternative foregone but also the cost of
the best alternative foregone Therefore, Benham defines opportunity costs thus. “The
opportunity cost of anything is the best alternative that could be produced by the same
factor by an equivalent group of factors costing the same amount of money''.

ELEMENT OF COSTS
The total cost is analysed by elements of cost.

Materials: Material indicates principal substances used in production. Examples

are: cotton, jute, iron-ore, and silicon. The cost of material is further divided in to
direct and indirect materials.
Direct Material: Direct materials refer to the cost of materials which become a
major part of the finished product. They are raw materials that become an integral
part of the finished product and are conveniently and economically traceable to
specific units of output. Some examples of direct materials are: raw cotton in
textiles, crude oil to make diesel, steel to make automobile bodies.
Indirect material: These are materials which are used ancillary to manufacture
and cannot be traced in to the finished product. These form a part of manufacturing
overhead. Examples are glue, thread, nails, consumable stores, printing and
stationary material
LABOUR: Labor is the physical or mental effort expended on the production of an
item. It is the active factor of production as against material which is a passive
factor. The cost of labor further divided into direct and indirect labor.
Direct Labour: Direct labour is defined as the labour associated with workers who
are engaged in the production process. It is the labour costs for specific work
performed on a product that is conveniently and economically traceable to end
products. Direct labour is expended directly upon the materials comprising the
finished product. Examples are the labour of machine operators and assemblers
Indirect labor: This includes wages paid for all labour which is not directly
engaged in changing the shape or composition of raw materials. It cannot be traced
directly to the product. Like indirect materials, indirect labour forms part of the
manufacturing overheads. Examples of indirect labor cost are wages paid to
foremen, supervisors, store-keepers, time-keepers, salaries of office executives and
the commission payable to sales representatives.
Direct Expenses: Direct expenses include any expenditure other than direct
material and direct labor directly incurred on a specific cost unit (product or job).
Such special necessary expenses can be identified with cost units and are charged
directly to the product as part of the prime cost. Some examples of direct expenses
are: (a) Cost of special layout, designing or drawings; (b) Hire of tools or
equipment for a particular production or product; (c) Maintenance costs of such
equipment.
Indirect expenses: Indirect expenses are those incurred for the business as a whole
rather than for a particular order, job or product. Examples of such expenses are
rent, lighting, insurance charges.
Overheads: Overheads may be defined as the aggregate of indirect material,
indirect labor and indirect expenses. Thus, all indirect costs are overheads. These
cannot be associated directly with specific products. Hence, the amount of
overhead has to be allocated and apportioned to products and services on some
reasonable basis. The synonymous term is “burden”. Overheads may be subdivided
in to following groups: a)Factory overheads. b) Administrative overheads. c)
Selling and distribution overheads.
Factory Overhead: Factory overhead also called manufacturing expenses or
factory burden may be defined as the cost of indirect materials, indirect labor and
indirect expenses. Examples of such items are lubricants, cotton waste, hand tools,
works stationery.
Selling and Distribution and Administrative Overhead: Selling and distribution
overhead is also known as marketing or selling overhead. Distribution expenses
usually begin when the factory costs end. Such expenses are generally incurred
when the product is in saleable condition. It covers the cost of making sales and
delivering/dispatching products. These costs include advertising, salesmen salaries
and commissions, packing, storage, transportation, and sales administrative costs.
Administrative overhead includes costs of planning and controlling the general
policies and operations of business enterprises.
 ELEMENT OF COST

Material Labor Other Expenses

Direct Indirect Direct Indirect Indirect

Overheads

Production or Administrative Selling Distribution

Works overhead overheads overheads overheads

By grouping the above elements of cost the following given costs are obtained.
a) Prime cost- Direct material + Direct Labor

b) Works or factory cost- Prime cost + works overhead

c) Cost of production- Works cost + administrative overhead.

d) Total cost of sales- Cost of production + selling and Distribution overheads.

e) Profit or loss- Sales - Total cost.

Example

Ascertain the prime cost, works cost, cost of production total cost and profit from the
following information.

Direct material = #7000

Direct Labor = #2,800
Factory expenses = #2,600
Administrative expenses = #1000
Selling expenses = #900
Sales = #20,000

Solution
Prime cost = Direct materials + Direct Labour
= # 7,000 + # 2,800
= # 9,800

Work cost = Prime cost + Factory expenses

= # 9,000 + # 2,600
= # 12,400

Cost of Production = Works cost + Administrative expenses

= # 12,400 + # 1000
= # 13, 400

Total cost = cost of production + selling expenses

= # 13,400 + # 900
= # 14,300

Profit = Sales – Total cost

= # 20,000 – # 14,300
= # 5,700