Product cost is a monetary value used in internal accounting by various entrepreneurs and businesses such as manufacturers and retailers. Product costs are the costs incurred in the production of a product. Materials, labor, production supplies, and factory overhead are all included in these costs. A product cost also includes the cost of labor required to provide a service to a customer. Compensation, payroll taxes, and employee benefits should be included in service product costs. In this article, we will define product cost, what is included in that cost, how to calculate product cost with formula, and how it should appear in financial statements.
What is Product Cost?
Product costs refer to all costs incurred by the company in order to create the company’s product or deliver services to customers, and they are shown in the company’s financial statement for the period in which they become a part of the cost of goods sold by the company.
Financial statements must include production costs. Because these costs include overhead, both GAAP and IFRS require companies and individuals to disclose them in their financial statements. In some cases, however, managers may disregard overhead costs when making short-term production and sale-price decisions. In other cases, managers may only consider a product’s direct material cost and the time it spends in a bottleneck operation.
What Is Included in the Product Cost?
In general, the cost of products includes three types of expenses: direct material costs, direct labor costs, and manufacturing overhead costs.
#1. Direct Material
Direct material costs are the costs of raw materials or parts used directly in the manufacture of products. For example, if Company A is a toy manufacturer, the plastic used to make the toys is an example of a direct material cost.
#2. Direct Labour
Wages, benefits, and insurance are paid to employees who are directly involved in manufacturing and producing the goods, such as assembly line workers or those who use machinery to make the products.
#3. Manufacturing Overhead
Manufacturing overhead costs include direct factory-related costs incurred during the production of a product, such as the cost of machinery and the cost of operating the machinery. They include some indirect costs as well, such as:
- Indirect materials are those that are used in the manufacturing process but are not directly traceable to the product. They include glue, oil, tape, cleaning supplies, and so on.
- Indirect labor is the labor of those who are not directly involved in the product’s production. Security guards, supervisors, and quality assurance workers in a factory are examples. Wages and benefits would be considered indirect labor costs.
What To Exclude From Product Cost
While manufacturing costs may include non-manufacturing expenses, product costs may exclude marketing, sales, rent, auditing fees, and utilities. As product cost factors in manufacturing and retail, these are more difficult to quantify.
How to Determine Product Cost
Manufacturers and retailers calculate product costs in different ways.
Product Cost Calculation for Manufacturers
Businesses frequently produce multiple products of the same type, so in order to determine a product cost, you should:
- Sort manufacturing costs according to the product. Companies should track all expenses incurred while conducting business as part of their bookkeeping. Only costs directly related to the manufacturing process will be included in the product cost.
- Add up the costs of all direct materials used to create the product. This only applies to the parts or materials used in a single product during a single month.
- Add up all of the direct labor costs. Keep track of a month’s pay for employees who work directly with the manufacturing process.
- Calculate the total manufacturing overhead costs. Add the indirect material and labor costs each month.
- Total the number of new units. Count how many new units of a product are produced each month.
Total all costs and divide the total by the number of units produced. To calculate the per-unit cost (product unit cost), a company must add all of the costs associated with producing a batch of the product—direct materials (DM), direct labor (DL), and manufacturing overhead (MOH)—and divide the total number of units (TU) in the batch.
Here’s a product cost formula for businesses to use:
(DM + DL + MOH) / TU = Manufacturer Product Unit Cost
Product Cost Formula
Product Cost Calculation for Retailers
You can calculate your product cost in retail by following these steps:
Purchase a product from a manufacturer at a fixed price. The simplest way to calculate a product cost for a retailer is to double the manufacturer’s product unit costs:
Retailer Product Unit Cost = Manufacturer Product Unit Cost * 2
Product Cost Formula
This is also known as the manufacturer’s suggested retail price (MSRP). Certain products may be available to retailers for less than twice their production value in some cases.
- Add together all direct labor costs. Everyone responsible for stocking and selling the product during a specific time period should have their salaries and bonuses counted. This is done on a monthly basis.
- Add all overhead costs together. Overhead costs may include any expenses incurred by the company to obtain the product and display it to customers. This is also done on a monthly basis.
- Calculate the product cost using the dollar amounts listed above. Add together the supply, direct labor, and overhead costs, then divide by the number of products purchased that month.
How to Account for Costs in Financial Statements
When businesses record product costs, they typically follow these steps:
- Count each individual product manufactured or purchased during specific time periods. While most major accounting is done on a monthly and annual basis, manufacturers must count the number of products they produce on a daily basis. Retailers should keep track of how many products they buy each month.
- Product cost factors should be itemized. Businesses must keep detailed records of all salaries paid, direct material prices paid, and all relevant overhead costs for each month. During this step, businesses can also calculate product costs.
- Add the number of new products to the total number of unsold items. All unsold products are considered inventory.
- On a balance sheet, including all unsold products as assets. Because the production cost equals the value of the goods themselves, if a product has not yet been sold, the product cost will appear on a balance sheet as an inventory asset. The inventory would be listed as an asset on the balance sheet.
- Count the number of items sold during a specific time period. To ensure accurate recording, this is a daily process.
- Determine the total costs for each product sold. This is accomplished by multiplying the product cost per unit by the number of units sold.
- Transfer the product cost data for sold products to an income statement. The product costs for all items sold are converted to the cost of goods sold once the product is sold. They will then appear on a monthly or annual income statement.
- Changes to the balance sheet should be reflected. Subtract the number of sold items from the total number of items in inventory. Subtract the total costs of the sold products from the monetary total in the inventory account.
Product Cost Examples
Example 1: Budget for Direct Material Purchases
A budget for direct material purchases is required to create a product. The budget is required to calculate the amount of raw material that must be purchased for the manufacturing process, as well as the estimated costs.
Assume Roy’s Pvt. Ltd, a small shirt manufacturing firm, needs fabric, thread, and buttons. Consider fabric to be the direct raw material, while the requirements for the other two materials cannot be tracked directly and are thus considered indirect.
So, the company intends to produce the number of shirts listed below in each quarter of the year. Information gathered from the production budget:
Data collected from the production budget:-
Raymond management gathers the following information to develop its direct raw material budget:
- The cost of fabric per kilo is $80. The production department requires 500 grams (or 0.5 kg) of fabric to make a single shirt.
- Management decides to save at least 10% of the fabric for the following quarter’s production needs.
- The opening value of the fabric stock was 210 kilos at the start of the year (January 1).
- Assume the desired ending inventory value is 250 kilos at the end of the year (quarter 4).
Using the two accounting equations listed below will contribute to the budget’s creation:
Total Raw Material = Production Raw Material + Ending Raw Material Inventory
Total Raw Material Required – Beginning Raw Material Inventory = Raw Material to be Purchased
Product cost formula
Finally, the product cost associated with direct materials can be calculated using a budget that estimates the desired quantity of direct material required for a period and its associated costs.
Example #2 – Direct Labor Budget
The direct labor budget is required to estimate the labor force requirements to produce the required units of goods in accordance with the production budget.
It computes the cost based on the number of labor hours and the number of units produced per labor.
Assume the following in Roy’s Pvt. Ltd:
- A sewing machine operator needs 0.5 hours to stitch a single piece of a shirt; other laborers need 0.2 hours per shirt for buttoning and finishing work.
- The company costs $50 per hour for a machine operator and $15 per hour for other labor.
Finally, the Direct labor budget calculates the cost of the labor force involved in the manufacturing process and estimates the required labor force in numbers. As a result, management can anticipate hiring needs and budget for them.
Example #3 – Budget for Factory Overhead
The budget includes all costs associated with the production process other than direct material costs as well as direct labor. The balance sheet does not capitalize on the final costs determined by the overhead budget ut are expensed as the cost of goods sold on the income statement.
Furthermore, the overall cost is determined by the overhead budget. The cost of ending inventory is calculated in per-unit terms. The ending inventory is added to the balance sheet.
The following table shows the factory overhead budget cost of “Roy’s Pvt Ltd”:
Ending Note: The factory overhead budget not only assists the company’s management in estimating the variable and fixed factory overheads separately, but it also assists in determining the required amount of cash to be disbursed to meet overhead expenses.
Example #4 Budget
Roy’s management has estimated its costs to include direct material, direct labor, and factory overhead costs.
The most important step in the budgeting process is determining the overall and expected product cost per unit (shirt).
The company’s management adds all cost components together to arrive at the total product cost, which is shown below:
Ending Note: The Product cost budget determines the total expenses incurred by an entity on a regular basis to create a product. The cost per unit can then be calculated by dividing the estimated units to be produced by the production budget.
By estimating the per-unit cost, the entity can set an appropriate sales price and avoid situations where its products are under-priced or over-priced. Product underpricing and overpricing both results in losses for the entity.
- Under-pricing occurs when an entity charges less than the product’s cost -> Losses.
- Overpricing causes customers to seek substitutes, resulting in lower demand and losses.
In our example, Roy’s management determines all product cost components, such as direct material costs, direct labor costs, and factory overhead costs, on a quarterly basis. This data is used to calculate the total cost on a quarterly and annual basis.
Divide the total annual product cost of $2.23 million by the annual production of 21720 shirts to get an average product cost per shirt of $103. The company should charge more than $103 per piece of clothing.
Product Cost FAQs
What is a product cost in marketing?
Product costs are the costs incurred to create a product for sale to customers. Direct material (DM), direct labor (DL), and manufacturing overhead are all part of the product costs (MOH).
What are product costs examples?
Direct materials, direct labor, and allocated factory overhead are examples of product costs. General and administrative expenses, such as rent, office depreciation, office supplies, and utilities, are examples of period costs.
What is the unit product cost?
The total cost of a production run divided by the number of units produced is known as unit product cost. It is beneficial to delve deeper into the concept to understand how costs accumulate. A company typically produces similar products in batches of hundreds or thousands of units per batch.
