How to Calculate Product Costs (+4 Examples)
For every product in the market, there were some costs incurred to produce it. And for the continued availability of that product, the manufacturer must be realizing a profit.
Realizing profits is not simply determined by high prices or the sale of many units. The cost of the goods sold plays a big role.
You can sell all of your inventory but if your sales are not more than your production costs, you’ll make a loss.
Product costs are the sum of all your direct material costs, direct labor costs and manufacturing overhead costs.
Leaving out any of these, especially the manufacturing overhead, will not give you the true picture of your costs.
Of the three costs to be summed up, manufacturing overhead costs are the easiest to ignore.
This is because they don’t seem to directly impact the products being manufactured.
However, their place in the costing equation is guaranteed by the very role they play.
Let’s take a closer look at these three types of costs as pertains to manufacturing.
Direct Material Costs
Direct material costs are those you can trace directly into the finished goods.
If for example you manufacture soft drinks, direct material costs may include the plastic bottles you pack the drinks in.
These costs are easy to account for as they are visible.
They can be tracked with relative ease all the way from their arrival at the factory to the very last stage of transporting to your customers.
A simple inventory tracking exercise like counting the number of drinks leaving your warehouse can confirm the number of bottles used.
When you know that you used a certain number of bottles, then the cost of one multiplied by the number of bottles gives you the total material costs for the bottles.
Another characteristic of direct material costs is that they are almost always tangible.
This means that you can physically interact with them.
For example, with soft drink manufacturing, you may have a number of direct materials used.
They may include water, sugar, flavorings, color etc.
All these are ingredients you physically interact with to make up the final product.
Direct Labor Costs
Direct labor costs are those which are not tangible but are nevertheless required for production.
As the name suggests, these revolve around the work done to complete the manufacturing process.
With regards to the workers, you will first of all be looking at costs such as wages or salaries for the hours they put in. Every hour worked determines the level of production.
And that hour costs you. If your workers work in eight-hour shifts, then this is what you will be paying them for.
If you have an arrangement of two shifts in a day, maybe a day and night shift, then your production is high.
But this does not reduce your labor costs because both shifts will be a cost of production.
Where you have only one shift with provisions for overtime, this will also have to be taken into account.
Apart from the wages and salaries, you will also be incurring costs such as benefits and insurance.
These will be calculated per employee depending on their individual contract agreement.
Direct labor costs are not difficult to trace because the people working in the production line are the ones counting as cost.
These are the staff doing the packaging, mixing, labeling, tasting etc.
Manufacturing Overhead Costs
Manufacturing overhead costs are those which are not directly attributable to the production of your products.
When working out your manufacturing overhead costs, you will need to pay close attention to everything that happens in your factory.
Basically, your manufacturing overhead costs are the expenses incurred while facilitating the manufacturing process.
Manufacturing is your business.
But for it to happen, you need additional resources in order to achieve your goals.
These costs are divided into three:
1. Indirect material costs – in the course of your manufacturing, there are costs which you will incur yet they don’t go directly into the finished products. These are the materials you buy to facilitate the main work being done.
An example of this may be the cleaning products used to ensure the premises are clean.
2. Indirect labor costs – as far as your manufacturing labor costs are concerned, there are some indirect ones which you must include in your costing. These are the employees not directly involved in manufacturing but play a role in the overall smooth running of the factory.
Examples of these are security guards and machine maintenance staff. Whereas the security guard does not do any manufacturing, securing the area of production is part of the cost you should consider for your end products.
3. Other costs – there are other costs involved in your production which are not directly related to your products. These are those which affect your ability to manufacture. For example, you cannot run your manufacturing business in the open field. You will need a factory.
As such, the factory lease is one of the costs which contributes to your end product’s cost. Another cost is the taxes you pay on the property. These are costs associated with your business.
Were you not running the business, you wouldn’t be incurring these costs.
Your utilities will also count as other costs affecting your production.
PRODUCT COST VS PRODUCT COST PER UNIT
While working on product costs, there is a related cost which is equally important for you to calculate.
This is the product cost per unit.
Whereas product cost is the sum of all the expenses surrounding the production of your goods, product cost per unit is the cost of producing a single product.
For example, in producing 10 crates of soft drinks, your production costs could be $500. To find out the production cost per unit, you will divide this total cost by the number of individual drinks manufactured.
If one crate has 24 bottles and you have 10 crates, then the total is 240 bottles. You will then arrive at the product cost per unit by dividing 500 by 240 to get 2.08.
Therefore, every bottle produced cost $2.08.
IMPORTANCE OF CALCULATING PRODUCT COSTS
Calculating your product costs is a necessity if you are a manufacturer.
You have to be aware of how much it cost you to get your products available for sale.
This helps in many ways and some are discussed below.
Accuracy of Expenses Incurred
Any time you have a process running at the factory, there is a cost attached to it.
You cannot get your raw materials to the end of the production line without incurring costs.
Some costs are obvious and very direct while others are almost negligible.
Despite this, when you take note of all of them separately, you are able to discern where you are spending most of your money.
This will make it easier for you to know what area of production needs improvement so as to achieve maximum efficiency or lower costs.
Since you are producing goods for sale, you have to assign them a selling price.
And because you are in business, you must make profit otherwise you will shut down operations.
How do you know the best price to sell your products at?
There are several things to be done.
You must research the market, determine your target customers, consider the payment terms etc.
But all these things, as necessary as they are, cannot come close in importance to the need to know the actual cost of producing your product.
Market research may tell you that your soft drink needs to cost $3 because that’s the average price in the market. But what if your cost of production per unit is $2?
At this point, you have not yet calculated the cost of transporting the finished product to the market.
Moreover, what if your product is a better alternative to whatever is in the market?
Ideally, your market research should have come before setting up business. And you should have kept updating yourself on the trends in pricing.
But as a business, you have a unique selling point. This is what you have most likely built your product around.
This can often lead to a higher cost of production per unit. If producing one unit is higher compared to your competitors, then you cannot sell at the same price.
Knowing how much it cost to produce your goods will enable you determine your profit margin.
And with a specific profit margin, you can come up with a selling price.
If your prices are significantly higher than the competition, you may need to work on some form of promotion.
Or maybe do extra work on marketing.
All in all, pricing needs a lot of work and constant monitoring of the market as well as your operations.
Knowing the cost of production will also help you decide whether to sell a product after one stage of processing or after two other stages.
Some industries are able to produce different products from the same raw material at different levels of processing.
An example is the dairy industry.
From the raw material of milk, a creamery can produce pasteurized milk, skimmed milk, non-fat milk, cheese, butter and even a protein supplement like casein.
This wide array of options can be narrowed down to the most profitable by determining the production cost of each of these items.
Apart from finding out what the market needs are, you can also perform a test production of each of these.
With that production, you can determine which is the cheapest to produce and which is the most expensive.
After this determination, you can then compare this report with your market research findings on what the market needs.
The selling price of the products already in the market will also help you decide what to produce.
You may also find out the cost the manufacturers of the other options incur. With that, you can supply them in case you produce it cheaper.
For example, you may decide to produce skimmed milk and yogurt.
As part of your business, you can decide to supply other manufacturers with cream for butter.
Or even diversify by making cheese as your primary product and whey and casein as your secondary products.
Whey and casein are by-products of the cheese-making process thus may not be a big burden if already dealing with milk.
Either way, the production costs of each will determine your decision.
Every manufactured product can be viewed as a project. If you produce skimmed milk, cheese and whey protein, you can say that you have three projects running in your factory.
The success of every project depends on a number of factors. Key among them are the running costs and profitability.
For you to determine or guarantee the profitability of a project, you will have to keep a keen eye on the expenses involved in the project.
For example, three of your employees involved in ingredients mixing may fall sick.
Having no-one to cover for them, you may either shut down or hire a temporary staff. The temporary staff will have to undergo urgent training.
This is an unexpected expense.
If you do not know how much your direct labor costs are in regards to these two sick employees, then you may not make the best decision in your hiring process.
You may hire someone quickly and overlook the full cost of the hire.
This can result in a batch of drinks whose production cost is too high to realize a profit.
Being aware of the costs involved and the budget allocated for the active projects helps you make adjustments accordingly.
It also helps you stay in control and quickly notice when things are not going according to plan.
Project development is the process of developing new products which you intend to add to your portfolio.
Similar to the research done before setting up a business or opening a new outlet, there will be some work to be done.
Since you are a manufacturer, it is essential that you know the costs involved in manufacturing the new product.
If you decide to make a new flavor of the soft drink you have been producing, then you will have to factor in the relevant costs.
With knowledge of what it costs to produce the current flavor, determining the cost of a new flavor won’t be difficult.
You may still need to run a test to find out whether there are changes to be made in the production process for the sake of the new flavor.
If you have not been working out your production costs, you can easily miscalculate the costs involved.
This can happen when you make seemingly-small assumptions which only add up to a bigger cost later.
EXAMPLES OF HOW TO CALCULATE PRODUCT COSTS
Calculating product costs is key for every manufacturing business.
Without it, not only will you miss out the benefits, but could also suffer loss from making poor decisions.
To help you see how this can be implemented in an everyday manufacturing environment, consider the below examples.
Example 1: Truck manufacturing
Kanta Trucks is a company which manufactures trucks called Kanta.
In the course of their production, they have been able to keep their expenses to a minimum so as to maximize on profitability.
To achieve this, they keep track of their production cost.
Here is a breakdown of how they do it for their most profitable model, KT-AWD. This is an all-wheel-drive model of which 12 units are produced every month.
Direct Material Costs – $200,000
Direct labor costs – $125,000
Manufacturing overhead costs – $35,000
Total cost of production – 200,000 + 125,000 + 35,000 = $360,000
Total cost of production per unit – 360,000 / 12 = $30,000
Example 2: Beer manufacturing
Bamboo Distillers manufacture a spirit called Cane Spirit. It’s packed in a 450ml glass bottle and in a carton of 24 pcs. Bamboo Distillers operate a factory and run a separate office. They enjoy lower power bills since they recycle some waste material from the cane to generate electricity.
At the same time, they built their factory on a piece of land they bought thus they have no rent payments to make. This gives them an edge over the competition as their product is cheaper.
Here is a breakdown of their production costs. A single production contains a batch of 50 cartons.
Direct Material Costs – $2,750
Direct labor costs – $500
Manufacturing overhead costs – $350
Total cost of production – 2,750 + 500 + 350 = $3,600
Total cost of production per unit – 3,600 / (24 x 50) = $3
Example 3: Toy manufacturing
Rego Toys manufactures toys for children aged 3–6. Their main raw material is plastic though they also have some metal use for screws.
Some of their toys include cars, planes, tanks and motorcycles. They have grown to operate in different countries and serve customers around the globe.
The manufacturing costs differ per factory due to the different business environments in different countries.
The production costs of 1,000 remote-controlled plastic army tanks manufactured at the main factory in China are shown here. Final packaging is done in boxes of 3.
Direct Material Costs – $17,000
Direct labor costs – $5,000
Manufacturing overhead costs – $3,000
Total cost of production – 17,000 + 5,000 + 3,000 = $25,000
Total cost of production per unit – 25,000 / 1,000 = $25
Example 4: Clothes manufacturing
Harem manufactures ladies’ clothes using fine cotton imported from India. Dresses are their highest-selling products followed by nightgowns.
Every year, they manufacture 10,000 dresses which they sell across the country. Below are their production costs.
Direct Material Costs – $7,000
Direct labor costs – $3,000
Manufacturing overhead costs – $2,000
Total cost of production – 7,000 + 3,000 + 2,000 = $12,000
Total cost of production per unit – 12,000 / 1,000 = $12
It is important that you calculate your product cost so as to know how to price it.
This will also help you know what to adjust for maximum profitability.
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