Product Costs
It refers to the expenses incurred during the production of a good that is designed for customer sales
What Are Product Costs?
Do you ever find yourself curious about how your favorite products are priced? From the latest smartphones to your morning coffee, behind every product’s tag lies a complex process that involves multiple factors and costs.
In management accounting, there exists a classification of costs based on their capitalization as a part of finished goods inventory or expense as incurred. The classification segregates the costs as product costs and period costs.
Product Costs are the expenses incurred during a product's creation. Materials, labor, production supplies, and factory overhead are all included in these expenditures. A product cost includes the price of the labor needed to provide a service to a consumer.
The Product Costs are capitalized as a part of the finished goods inventory. These costs are eventually included in calculating the cost of goods sold to determine the gross profit. The costs include direct costs and direct labor.
The distinction is essential because of the required treatment of the manufacturing costs for external reporting purposes, also known as Absorption Costing.
Production cost is a market price used in internal accounting by various entrepreneurs and businesses, such as manufacturers and merchants. As part of the supply chain planning process, manufacturers frequently calculate the initial value for retailers.
Almost every physical product involves direct materials, direct labor, and overhead costs, which might include indirect labor and additional expenses like utilities and equipment depreciation.
The expenses are monitored in a cost accounting system to account for them and educate managers to make choices.
While all costing systems have a similar cost flow, there are some differences in the details: Material, labor, and overhead costs are all included in product costs, and each might be valued differently.
Raw materials are shifted from the raw materials inventory to the work-in-progress inventory in most manufacturing plants. One or more production departments are involved in the work process, where labor and overhead turn raw materials into completed commodities.
Understanding these costs is crucial for businesses as it affects pricing, profit margins, and overall competitiveness in the market. Companies can make informed decisions regarding pricing, production, and resource allocation by accurately calculating and managing the costs.
It also enables companies to evaluate their performance and make necessary adjustments to improve profitability.
Understanding Product Costs
Production costs are a vital concept for businesses, and it is composed of various essential elements that make up the final cost of a product.
In this breakdown of the critical components of the product cost (PC), we see that direct materials, direct labor, manufacturing overhead, and other miscellaneous costs are critical to understanding and monitoring costs.
Additionally, external factors like Product design, complexity, and supply chain disruption impact the pricing/ cost structure of the product.
Cost Components | Definition & Example | Example Of Costs | Importance Of Monitoring Cost |
---|---|---|---|
Direct Materials (DM) | The cost of raw materials used to make the product | Wood, plastic, steel. | Helps to ensure that the company is paying a fair price for materials and identifies areas for cost savings. |
Direct Labor (DL) | The cost of labor required to produce a product | Wages for assembly line workers and production supervisors. | Helps in the identification of inefficiencies in the production process and opportunities for labor cost savings. |
Manufacturing Overhead (MOH) | The indirect costs associated with producing a product such as rent, utilities, and maintenance expenses. | Rent, utilities, depreciation, maintenance fees. | Helps to determine the true cost of production and identify opportunities to reduce overhead costs. |
Other Costs (OC) | Miscellaneous costs associated with producing a product, such as shipping, packaging costs, taxes, and duties. | Shipping and handling fees, customs duties, taxes, packaging. | Helps to identify and control non-core expenses related to production that can impact the overall cost of the product. |
Product Design and Complexity. | The impact of design and complexity of a product on production costs | Use of expensive materials, intricate design elements, research, and development costs. | Helps to evaluate the cost-effectiveness of the design and identify areas for simplification and optimization. |
Supply-Chain Disruption. | Disruptions in the supply chain impact raw material availability and pricing. | Increased transportation costs, higher prices for raw materials, and delayed or canceled deliveries. | Helps to identify risks and mitigate potential disruptions to maintain stable production costs. |
Tax levied by the government, depreciation, and royalty expenses incurred by natural resource extraction are also considered a part of PCs. These are considered variable costs, as they tend to vary depending on changes in production.
Understanding the key components of PCs and monitoring them is crucial for businesses to make informed decisions regarding pricing, cost management, and profitability analysis.
By accurately calculating and analyzing these costs, companies can identify opportunities for cost savings and optimize their manufacturing processes.
Note
Companies like Ford and General Electric began using cost management techniques to improve their operations and increase profitability.
Production cost Management Challenges
Production cost management can be a challenging and nuanced process.
Some of the key considerations and strategies involved are:
1. Understanding The Distinction between Product Costs and Period Costs
Product cost and period cost are both important concepts in cost accounting, but they represent different expenses.
Product costs are the expenses that are associated with producing and manufacturing overhead costs, and they are capitalized as a part of the finished goods inventory. They are only expensed when the product is sold and are included in the cost of goods sold (COGS) calculation.
Period costs, in contrast, are not directly related to the manufacturing of a particular product. These are the operating expenses of a business that are not associated with the production process. They are expenses in the period in which they are incurred and are not included in the cost of goods sold calculation.
Examples of period costs include selling and marketing expenses, administrative expenses (SG&A), and research and development expenses (R&D).
To summarize:
Product Costs = Direct Materials (Dm) + Direct Labor (Dl) + Manufacturing Overhead (Moh)
Period Costs = Operating Expenses Not Directly Related To Production.
2. Understanding What are COGM and COGS
COGM & COGS are two important metrics used in cost accounting to track the cost of producing and selling a product.
COGM, or Cost Of Goods Manufactured, represents the total cost of producing a product during a given period. This includes all direct materials + labor and manufacturing overhead costs incurred during the production process.
COGM is used to determine the value of the finished goods inventory and is calculated as follows:
COGM = (Beginning WIP Inventory + Total Manufacturing Costs) - Ending WIP Inventory.
Work-in-progress (WIP) is a term used in manufacturing to describe products that are partially complete and still undergoing production. It includes raw materials, partially finished goods, and labor costs incurred during the production process.
COGS, or Cost Of Goods Sold, represents the costs of the products sold during a given period. This includes all the production costs associated with the goods sold, including the direct material, direct labor, and manufacturing overhead costs. COGS is calculated as follows:
COGS = Beginning Finished Goods Inventory + COGM - Ending Finished Goods Inventory.
Note
Manufacturing companies use a formula to calculate COGS which is different from the commonly known COGS formula. Their formula, COGS = Beginning Finished Goods Inventory + COGM - Ending Finished Goods Inventory, considers multiple stages of production. This is important to understand when analyzing manufacturing financial statements.
COGS refers to the expenses related to producing and selling a product, while COGM pertains to manufacturing the same product. COGS is computed throughout the production process.
To summarize:
- COGM: Total cost of producing a product during a period.
- COGS: The cost of the products sold during a period.
Not all manufacturing costs are product costs - some manufacturing costs, such as those associated with idle time or faulty production, may be considered period costs instead.
By understanding these differentiations, businesses can better analyze and manage their costs, leading to improved financial performance and competitiveness in the market.
Absorption Vs. Variable Costing
Are you confused about the differences between absorption costing and variable costing? Do you want to know how they impact the calculation of product costs? Look no further because we’ve got you covered.
Absorption costing is a method of accounting that assigns all manufacturing costs to the cost of the product, including direct materials, direct labor, and both variable and fixed costs. This means that fixed overhead costs are absorbed by the product and included in the cost of goods sold (COGS).
On the other hand, variable costing only includes direct materials, direct labor, and variable overhead costs in the PC, treating fixed overhead costs as period costs. So, what factors affect production costs under these two methods? Let’s take a look:
Product Cost Factors | Absorption Costing | Variable Costing |
---|---|---|
Direct Materials | Included. | Included. |
Direct Labor | Included. | Included. |
Manufacturing Overhead | Included but allocated based on a predetermined overhead rate. | Excluded. |
Fixed Manufacturing Overhead | Included but allocated based on a predetermined overhead rate. | Excluded. |
Variable Manufacturing Overhead | Included, but allocated based on actual usage. | Excluded. |
Product Costs | Excluded from PC, expensed in the period incurred. | Included in PC, expensed when sold |
Cost of Goods Sold (COGS) | Includes all PCs, including Fixed, Manufacturing, and Overhead. | Includes only variable PC. |
Profitability | Can be impacted by changes in inventory levels and production volume. | Generally less impacted by changes in inventory levels and production volume. |
Decision-Making | Can lead to incorrect product pricing decisions. | Provides a clearer picture of product profitability and can lead to more informed pricing decisions. |
In the vivid realm of accounting, absorption and variable costing are two different hues of the same color.
While absorption costing includes fixed overhead costs and can provide a comprehensive reflection of the actual cost of production, variable costing produces lower PC by excluding fixed overhead costs.
This can lead to differences in the cost of goods sold and overall profitability, depending on changes in inventory levels and production volume.
It is important to note that the choice between absorption costing and variable costing can significantly impact a company’s financial statements and decision-making processes. Companies should consider the nature of their business and the impact of each costing method before making a decision.
Calculating Product Costs
Let’s put our financial detective hats on and dive into the exciting world of calculations! In this adventure, we’ll be joining a small scented candle business as they determine the true cost of producing their beloved products.
Get ready to unravel the mystery of production cost calculations and discover the price they need to sell each candle to make a 20% profit margin. So, grab your magnifying glass, and let’s start investigating.
1. Calculate Direct Material Costs
We’ll assume that the business uses
- 1,000 pounds of wax per month, which costs $2 per pound.
- 500 pounds of fragrance oil per month, which costs $5 per pound.
At the start of the month, it had 200 pounds of wax and 100 pounds of fragrance oil in its inventory. By the end of the month, it had 300 pounds of wax and 50 pounds of fragrance oil remaining.
Direct Materials Cost (DMC) = Beginning Raw Materials Inventory + Raw Materials Purchased - Ending Raw Materials Inventory.
For wax:
Beginning Raw Materials Inventory = 200 pounds
Raw Materials Purchased = 1,000 pounds
Ending Raw Materials Inventory = 300 pounds
DMC for Wax = $2 × (200 + 1,000 - 300) = $1,800.
For fragrance oil:
Beginning Raw Materials Inventory = 100 pounds
Raw Materials Purchased = 500 pounds
Ending Raw Materials Inventory = 50 pounds
DMC for Fragrance Oil = $5 × (100 + 500 - 50) = $2,750.
Total Direct Materials Cost = Direct Material Cost for Wax + Direct Material Cost for Fragrance Oil
Total Direct Materials Cost = $1,800 + $2,750 = $4,550.
2. Calculate Direct Labor Costs
Let's imagine two hardworking employees who put in a total of 400 hours of labor each month and earn a just wage of $12 per hour.
Direct Labor Cost (DLC) = Total Hours Worked × Hourly Wage
DLC = 400 × $12 = $4,800.
3. Calculate Manufacturing Overhead Costs
Imagine that the business has monthly expenses to keep the operation running smoothly. They pay $1,000 for rent, $500 for utilities, and $250 for instrument maintenance.
Fixed Manufacturing Overhead Cost (FMOHC) = Rent + Utilities + Instrument Maintenance.
FMOHC = $1000 + $500 + $250 = $1,750
To calculate variable manufacturing overhead costs, we need to know the total direct labor hours worked. In this case, we assume it was 400 hours.
Variable Manufacturing Overhead Cost (VMOC) = Variable Overhead Rate×Total Direct Labor Hour
Let’s assume the variable overhead rate is $2 per hour.
VMOHC = $2 × 400 = $800.
Total Manufacturing Overhead Cost (TMOHC)= Fixed Manufacturing Overhead Cost + Variable Manufacturing Overhead Cost
TMOHC = $1,750 + $800 =$2,550.
4. Calculate Total Product Costs
Finally, we’ll add the above costs to determine the total product cost.
Total Product Cost (TPC) = Direct Material Cost + Direct Labor Cost + Manufacturing Overhead Cost
TPC = $4,550 + $4,800 + $2,550 = $11,900
Note
The weight of wax and oil used in each candle can vary depending on the candle's size. The calculation provided only considers the cost of wax and fragrance oil used in a production month but does not provide information on the number of candles produced.
With TPC in hand, it’s time for the small scented candle business to embark on its next mission: determining the optimal selling price for each candle that ensures a 20% profit margin while keeping their valued customers' content.
5. Calculate the Selling Price
To make a 20% profit margin, the selling price must be calculated as follows
Selling Price (SP) = (Total Product Cost / (1 - Desired Profit Margin))
Desired profit margin is 20% or 0.2, so:
SP = ( $11,900 / (1-0.2))
SP = ( $11,900 / 0.8)
SP = $14,875
Therefore, if 1,000 candles are produced, the selling price per candle to ensure a 20% profit margin should be $14.875 ($14,875 / 1000).
6. Calculate Gross Profit
Gross profit is the difference between the selling price and the TPC. In this case, the gross profit is
Gross Profit (GP) = Selling Price - Total Product Cost
GP = $14,875 - $11,900
GP = $2,975.
This means the business will earn a gross profit of $2,975 if they sell their candles at $14.875 each ( $11.90 + $2.975).
7. Calculate Net Profit
Net profit is what remains after all costs and expenses, including direct materials and labor expenses, manufacturing overhead, and other miscellaneous costs. Assuming there are no other expenses and tax @ 30%, the net profit is
Net Profit (NP) = Gross Profit - Operating Expenses - Other Business Expenses - Taxes - Interest on debt + Other income
*Tax = 30% of Gross profit = 0.3 ✕ $2,975 = $892.5
NP = $2,975 - $0 - (0.3 ✕ $2,975) - $0 - $0
NP = $2,975 - $892.5
NP = $2,080.5
Looks like the small scented candle business is currently generating profits, which is a positive sign. The business can now focus on expanding its sales to increase its profitability further. However, they need to be cautious about their expenses and explore ways to reduce costs to ensure sustained profitability in the long run.
Product Costs FAQs
Some challenges include accurately tracking and allocating costs, utilizing technology and software for cost management, and ensuring ongoing analysis and adjustments to cost calculations.
Collaboration between departments, such as finance and production, is also important for precise expense control.
Technology and software can automate the tracking and allocation of costs, provide real-time cost data, and allow for more accurate forecasting and analysis of costs.
It can also enable collaboration between different departments and facilitate communication and decision-making.
Ongoing analysis and adjustment of cost calculations help ensure that the costs are accurately reflected in product pricing and that the business is operating efficiently.
This can help identify areas of cost reduction or optimization and make informed decisions about product development and production process.
Collaboration between departments, such as finance and production, can help ensure that the costs are accurately tracked and allocated. It can also facilitate communication and decision-making and help identify areas for cost reduction or optimization.
Learn how the recent demise of silicon valley bank affects venture lending and how this could impact innovative startups' funding and production costs in this Forbes article.
or Want to Sign up with your social account?