Product Costs

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.

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.

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.

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:

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 

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. 

Researched and Authored by Hajira Khan | LinkedIn

Reviewed and edited by Mohammad Sharjeel Khan | Linkedin

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Activity-Based Costing (ABC)
• Cost of Goods Sold (COGS)
• Gross Profit
• Inventory
• Marginal Cost