Product costs are the total costs of producing a product. The expenses associated with making products like raw materials, labor and overhead are included in product costs.
A good example is shoes. Once you have decided to produce a pair of shoes, it doesn’t just include the price you charged for them but also the material prices in creating that pair of shoes.
And since every business has different requirements to keep track of their expenses in production, some companies decide not to fix an itemized list when recording their purposes.
As long as records or receipts show what was bought or used in the course of production, then this is considered sufficient.
The cost of commodities will vary with the market price. Some products are also subject to government fees or tariffs, which can further increase their costs.
However, in most cases, the costs of a commodity are made up of several components. Raw materials represent the most significant part of product costs.
An example is farming: inputs like seeds and fertilizer are needed to grow crops that can then be harvested, processed into foodstuffs, and packaged for sale.
Other raw materials used in manufacturing include minerals mined from Earth or asteroids, animal skins, furs, wood taken from forests – even recycled metals collected from scrap heaps require some amount of cultivation or work before they are ready for use in goods for sale to consumers or businesses.
Manufacturing is also a factor in product costs. This includes refining raw materials, assembling components into finished goods, and packaging the final products for sale.
The amount of labor required to manufacture a product will vary depending on how intricate it is. A factory that makes smartphones needs hundreds of employees working around the clock to meet their production quotas.
On the other hand, an artisanal glassblower might only need his own two hands and some ovens or furnaces to get his glassware made.
There are also distribution costs involved in moving commodities from where they are made to sell – whether transitioning from the manufacturer’s warehouse into a consumer’s shopping cart or from a miner’s holding facility to the dealer who will resell it.
Distribution costs are usually calculated based on the size of the package but can also vary with distance.
While these are the most common factors in product costs, other relevant issues may arise depending on how a commodity is produced and sold – whether its production significantly damages the environment.
Consumers rarely account for such externalities when deciding which goods to purchase – companies that have an incentive to sell their products cheaply often ignore them.
If you want to be sure your money is being spent responsibly, look for well-documented evidence of ethical practices when making purchases.
Product cost is all expenses incurred in bringing a product to its present state, including direct and indirect costs.
Product Costs can be broken down into two categories; “fixed” and “variable.” Fixed the costs that do not change with business operations (overhead), while variable costs will increase or decrease based on production volume (materials).
The fixed cost per unit is obtained by dividing fixed expenses by the number of units produced during the relevant time.
The following formula for this calculation is known as the high-low method:
Unit Level Expenses = Total Fixed Expenses / [(Number of Units Produced – Number of Lowest Units Produced) + Number of Highest Units Produced]
How to Calculate Product Cost
If you’re selling products, you need to understand what you need to calculate profit. Profit is the margin between revenue and cost; generally, profit is how much money is left over after all expenses are subtracted from sales.
Your costs may include the following:
- The direct materials (the items that go into your product)
- Indirect manufacturing costs (the labor and overhead not associated with a specific product but necessary for making or growing one)
- Packaging supplies (boxes, bottles, labels, etc.)
- Shipping and delivery costs (including warehousing and distribution)
- Administrative expenses (financial and legal fees, public relations staff salaries and benefits, etc.)
- Sales commissions (if your company uses commission-based pay)
- Product liability insurance
- The rent and utilities for the product’s building or warehouse (if your company is located in a facility that is not home-based)
Because there are so many different types of costs associated with running your business, it can be challenging to add them all up and make sure you’ve included everything.
Product cost is the sum of all the direct materials, direct labor costs, and overhead expenses (including production facilities and equipment, shipping and delivery services, etc.) needed to create a good or service.
To calculate the total product costs: multiply the number of units you plan on making by each cost factor, then add together each line item to get your final product cost.
Product Costs = (Number of Units to be Produced) x (Cost per Unit for Direct Materials + First Indirect Manufacturing Expenses) + (Additional Indirect Manufacturing Expenses Associated with Each Additional Unit Produced).
Example
Let’s say you run a gift basket company and want to produce 200 baskets in the next month. You’ll need ribbon, boxes, tissue paper, and other supplies, as well as flowers and grocery items for your gift baskets.
The direct material costs associated with producing one gift basket are $8 worth of ribbon at $0.20/yard, $10 worth of tissue paper at $0.13/sheet, $25 worth of boxes, $0.30/unit, and $5 worth of flowers at $0.50/stem for a total direct material cost per unit of $43.
The indirect manufacturing costs are estimated to be 40% of the first direct manufacturing expense (in this case, ribbon) plus 10% of the next two expenses (tissue paper and boxes); you’ll use these numbers to calculate your indirect product costs well. These figures would be:
You will also need to add $0.80 worth of materials for every additional gift basket you produce because each one will require another sheet of tissue paper and more ribbon, ribbon, boxes, etc.
Your final product costs = ($8 x 200) + ($10 x 200) + ($25 x 200) + ($5 x 200) + ($43 x 200) + ($72 x 200) = $5,400
The final product cost calculation would be: $5,400.00 = (200 gift baskets at $0.20/yard ribbon + $0.60 for each additional yard of ribbon used) + (200 gift baskets x $0.13/sheet of tissue paper used + $1.20 per extra sheet of tissue paper used )+ (200 gift baskets at $0.30/box unit + $0.40 for every additional box unit needed) + ($0.80 per additional gift basket needed for extra ribbon and tissue paper)+ the indirect manufacturing costs associated with producing 200 gift baskets(the first direct manufacturing expense of $8 x .40 + the next two expenses of $10 x .10 and $25 x .10)
Product cost is a key factor in business planning because it helps you determine your product’s profitability.
You may have to charge more for your goods or services so that you can cover all of your costs and make a profit. The final product cost must be less than or equal to the selling price if you want to profit.
In this example, if you plan to charge customers $100 per basket, your product will need to sell for at least that amount for you to break even.
Once you have determined your product cost, you can set a sales price to sell at least that number. If you wish to charge more than the product costs, you can factor in additional profit into your pricing or use that money to help cover the cost of offering the discount.
What Factors Affect Product Costs?
Generally, there’s no fixed ‘product cost.’ This varies across industries and from company to company. However, in a typical manufacturing environment, there is a direct relationship between the number of units produced per period and the total costs incurred over that same period.
For example, assume that Company X incurs $120 in production costs when producing two units in one week. In this case, each unit’s product cost would be equal to 60 dollars ($120/2).
The Most Important Factors Which Affect Product Costs Are:
1) Direct Material Costs: These are costs incurred for all raw materials and components required to produce a product. Any increase or decrease in the price of material has a direct effect on production costs.
2) Direct Labor Costs: This includes all wages paid to employees involved in producing a product. For example, let’s assume that an organization pays $50 for 3 hours of labor required to assemble 1 unit of product, so its direct labor cost will be $50 / 3 = $16.67 per unit.
3) Overhead Costs: Overhead costs are indirect production expenses that cannot be directly attributed to the production of one unit or batch of products (e.g., electricity bills, rent for factory space).
The most common overhead items include salary expenses of staff members who are not directly involved in production work (e.g., sales, administration staff), depreciation expenses on machinery used for production purposes, insurance costs related to the factory building, etc.
4) Product Mix: The mix of products produced also has a significant impact on product costs. This is because different processes and equipment in the production process, combined with different amounts of direct labor time required per unit, result in significant variances in product costs.
For example, if an organization uses highly automated equipment, per unit product cost will be relatively low compared to organizations that use manual, labor-intensive methods to produce their products.
Furthermore, manufacturing organizations that produce complex products tend to have higher production costs when compared to similar firms that produce simple products.
5) Volume of Production: The volume of production has a direct effect on production costs. In the context of manufacturing organizations, higher levels of capacity utilization enable businesses to utilize their fixed assets more effectively and achieve significant cost savings (e.g., large machinery is utilized more efficiently than similar machines used for short intervals).
For example, assume that an organization produces two units per week when its equipment is used at 50 percent capacity levels.
In this case, it would produce four units per week if its equipment was running at 80 percent capacity levels. As a result, any increase or decrease in production volume will directly impact product costs.
6) Location of Facility: Wage rates, local market conditions, and available labor pool, the proximity of factors to the production site would also play a significant part in determining the cost incurred in the production process.
7) Technology Used in Production Process: Technological Change – a new technology that may be more productive or less productive than the old one. It affects product costs by changing labor requirements per output unit and, therefore, overall labor costs.
Consequently, production technologies can create economies of scale (increasing per unit output with fixed inputs).
8) Condition During Transportation: The condition during the transportation is usually considered when delivering goods to customers over long distances using complex supply chains, which are usually more expensive.
Economics of Scales
The more units produced, the lower the cost per unit. This is known as economies of scale; economies of scale help benefit magnanimously from increased productivity.
The more efficiently a business can produce its goods or services, the less it will have to spend on average to produce that good or service over time.
Other factors affect product costs, such as materials used and labor required, but these do not change from one production cycle.
For example, suppose a company’s workers make a chair by hand, and they use wood from a local shop for this process.
In that case, once the price of the same amount of timber has been established in advance because it is always needed at every stage in the making of each chair, there is no further impact on total costs as the number of chairs increases.
There is no significant difference in the amount of wood needed for making ten chairs or hundred chairs. In short, economies of scale comes from a company’s ability to reduce its average total costs as it produces more output over time.
It can do this by producing with more extensive and more efficient plants or factories, getting better at managing its inventory levels so that it doesn’t have large amounts of unsold goods sitting around losing value, and negotiating lower prices with suppliers because it gets a good quantity discount.
So eventually, the benefits lead to more significant revenue due to lower product prices than competitors who don’t have economies of scale yet. They end up selling fewer products at higher prices per unit, which makes less money.
However, this doesn’t always happen because a company may lose early production runs to get its plants or factories producing at total capacity.
So it’s not always good news for companies who have economies of scale compared with their competitors because they could be losing money by selling their goods more cheaply until they can recoup their losses from the reduced costs that come from making more significant volumes of product over time.
Overall, economies of scale are one of the most important factors affecting product costs and business profitability.
Any business should aim to achieve them if possible, but there are many downsides too, which means it isn’t always possible or sensible to all companies.
What Are the Disadvantages of Using Product Costs?
When using product cost as a tool for decision-making, one should note that since these numbers do not take into consideration such things as sales price or sales volume, management may end up making some very wrong decisions because they’ve assumed that they will be able to sell all items at their target selling prices without considering any discounts.
Similarly, if the company produces only those goods that give them maximum profits (highest margins per unit), its business would become too risky because it would rely entirely on only a few products.
If one of these were to fail in the market, it could lead to significant losses. This is why business decisions should never be based solely on product costs.
Hence, they should always be analyzed in conjunction with other factors such as target selling prices, expected future demand for goods or services, alternative uses for resources, etc.
Product cost information is also complicated to accumulate when the production process requires large numbers of different materials at various stages of manufacture, which makes management difficult because it becomes next-to-impossible without having any form of commonality between all produced items.
In such cases, product costs can never accurately reflect manufacturing expenses per unit since some items require more expensive raw materials or labor.
In contrast, others require less expensive resources due to their nature. This is why it is very challenging for management to make decisions about production, pricing, and future income projections.
What Are the Advantages of Using Product Costs?
Product costs are essential because the information derived from them helps management decide how many units should be produced, which goods will give higher returns per unit, etc.
These numbers can also aid in decision-making regarding prices, sales, production levels, and inventory levels of products. Suppose they know that the per-unit manufacturing cost of one item is lower than its selling price.
In that case, reducing the number of items manufactured makes sense, thereby retaining their existing customers by not sacrificing quality or service levels while increasing the per-unit margin.
Suppose a company knows that for every $100 spent in manufacturing, each unit sold results in 20 dollars after all is said and done (net income).
In that case, it is a great idea to manufacture and sell more units than the customer base is willing to purchase. This will eventually lead to lower units sold, deteriorating market share, negative cash flows, and ultimately bankruptcy.
While there are disadvantages that accompany product costs, they remain important because they help make informed decisions regarding production levels, prices, and inventory levels.
First off, these numbers help companies to determine which products give higher returns per unit while also identifying items whose unit cost exceeds its selling price; by removing such items from the production process, management will reduce expenses on producing something which only results in losses and instead focus on manufacturing/selling more profitable goods.
It is especially critical for management to understand segmental margin analysis, which gives information regarding each product’s contribution margin per unit.
This allows management to know exactly how much money each unit produced/sold contributes towards bringing in after-all-expenses revenues.
If they find that certain products are not profitable, then it would be better to either reduce production or stop manufacturing them altogether because these items only increase total cost without adding anything positive to the company’s financial situation.
Product costs also help managers avoid making any decisions based on erroneous assumptions.
For example, suppose a manager assumes that the company will sell all units at its target selling price without any discounts but doesn’t realize that given market conditions, he may have no choice but to offer discounts.
In that case, this decision may lead to many problems later on, which could have been avoided if there had been historical information available to management regarding product costs. In such a case, the manager would have realized that certain items may not be as profitable as they thought.
This knowledge would allow them to make better decisions about how to market these products (i.e., by offering them at discounted prices or higher levels to marginal cost). Product costs are also helpful for projecting future cash flows.
This is especially important when companies borrow money from banks because lenders usually consider the value of current assets like inventories and receivables before deciding on the riskiness of lending out money; for this reason, companies with large amounts of existing inventories or long-term purchase contracts should disclose product costs as part of their cash flow projections to reassure bank managers that those items can be easily converted into cash if necessary.
For example, a company that has sold all its products and has substantial product costs still on its books should produce a spreadsheet showing how much money each unit is worth based on current market prices for similar items – this will show lenders the true value of the assets and help them make decisions about lending out money more efficiently.
Inventory management is another area where product costs play an important role because they allow companies to keep track of their inventory levels effectively instead of simply guessing numbers after looking at physical inventories; knowing exactly how much each unit in inventory costs means that there’s no longer any guesswork when it comes to determining whether or not the company should reduce ties with certain suppliers or keep their product storage areas full to prevent losing out on potential sales.
The bottom line is that product costs can be used in multiple ways, and ignoring them would be a big mistake because they help companies make more informed decisions; instead of using estimates, managers are now able to base their decisions on the correct calculation of real numbers which clearly show how much each unit is worth.
Product costs, therefore, take out all uncertainty surrounding financial figures by converting future expectations into today’s reality.
This means that no matter how well-crafted financial models might seem, they always rely on assumptions made by individuals; since predicting market conditions several years down the line is impossible (and especially considering how quickly economic situations change), reliance on these models alone could lead to very adverse outcomes if correct data do not support them.
Product costs can be used for non-financial purposes as well because they help managers increase the quality of work-life by allowing them to find better ways of doing things; this may seem trivial at first glance, but it’s pretty useful considering how much time management spends thinking about how to deal with specific issues or trying to come up with new concepts which would solve existing problems.
For example, many companies now realize that high production costs are linked with substandard products, leading some firms to reengineer their value chain before production begins.
This means that instead of using old processes, managers are looking for better ways of doing things that will allow them to produce high-quality goods at lower costs.
Product costs are therefore not just essential for making financial projections or keeping track of inventory levels; they also play a role in helping firms to become more efficient and effective because it’s no longer about whether or not products can be sold but also about how fast the company will recover initial investments through sales revenue while still producing cost-efficient, high-quality products.
The bottom line is that production costs are being used for so many different purposes today that ignoring them would be equivalent to tossing away one’s best chance of business success simply because someone thinks they don’t have to rely on numbers when making decisions.
Do this enough times, and eventually, losses will accumulate until the company closes its doors permanently; to prevent this from happening, managers must never stop thinking about ways these costs can help them achieve business objectives despite the current economic situation.
Discount pricing is particularly effective for attracting customers during economically challenging times. Companies are willing to offer lower rates as long as they see signs of potential growth due to high customer turnout.
In other words, instead of trying to maximize profits through product costs, intelligent managers have come up with a better way of doing things by simply using those numbers as stepping stones towards achieving bigger goals such as increasing brand awareness and sales volume among consumers.
The bottom line then is that organizations should not underestimate the role product costs play because they are linked with so many different parts of the business; ignoring them could easily lead to business failure due to poor decision-making, which is why it’s so crucial for managers to consider these numbers carefully when doing anything from projecting future revenues and expenditures to simply increasing the quality of work-life by streamlining all operations.
Conclusion
Product Cost is an essential aspect of any business’s success because it helps determine whether or not a company will turn a profit—and how much.
To determine this for yourself:
- Determine each direct material and indirect manufacturing expense needed for production by estimating the cost of materials, labor, and other direct resources used in production.
- Multiply those together by the number of units that must be produced to equal your desired final product cost.
- Add all these items (indirect manufacturing expense and direct material + additional material needed) together to determine your final product cost.
Once you know the final product cost, it is relatively simple to determine a sales price and any discounts or markdowns to profit; therefore, product cost assist you in determining the best price that should be attributed to production on which you can then seek to measure your expected profitability; hence the understanding of product cost is essential for strategic and operational decisions.
