Manufacturing cost is the total expense incurred by the company during the production of any product. If you run a manufacturing unit, understanding the parameters that can impact the cost of manufacturing becomes significant. It is very important to understand manufacturing costs thoroughly to determine the correct pricing and become competitive as well as profitable in your industrial specialization. In this article, we have explained manufacturing cost, the total manufacturing cost formula, ways to reduce total manufacturing cost, the role of material requirements planning (MRP) in managing costs, and more.
What Are Manufacturing Costs?
Manufacturing costs are the total expenses incurred by a company during the manufacturing of a particular product or service. It mainly consists of direct and indirect costs. While the direct cost is the cost involved in raw materials and labor, the indirect cost includes administrative expenses, shipping, and rent.
Direct costs vary depending on the level of production, volume, demand in the market, and other factors. Indirect costs are also called overhead expenses, and it is the cost associated passively with the production of a particular product. However, this cost is necessary to ensure that production runs smoothly. This includes the rent of the property where the manufacturing unit has been set up, packaging costs, and others.
Manufacturing costs become significant for any organization as it eventually defines its profitability and pricing strategy. Both aspects help in the placement of the brand in the market.
Understanding the different types of manufacturing costs and the factors that impact the same, can also help in formulating a strategy that can help in managing costs without compromising on the quality and quantity of production. Thus, it helps them in the right allocation of resources.
Difference Between Direct and Indirect Manufacturing Costs
We have already discussed above that there are two types of manufacturing costs that eventually impact the pricing strategy of any manufacturing company. The following table further highlights the difference between the two:
| Direct Cost | Indirect Cost |
|---|---|
| This cost is directly associated with the production of a particular product or service | These are indirect costs that impact the manufacturing process. The company needs to incur this cost to ensure that the production process runs smoothly. |
| Examples: Cost of raw material, electricity cost, cost of labor. | Examples: Rent, insurance, maintenance costs, packaging costs, and shipping costs. |
| This cost is directly associated with the production of a specific product. | Indirect cost is indirectly associated with the production of a product or service. |
| The direct cost may vary because of internal and external factors. For example, if there is a demand for higher production, the cost may go high. Similarly, if the cost of raw materials in the market increases, then direct cost also increases. | The indirect cost is generally fixed and will not change as abruptly as the direct cost. |
Difference Between Manufacturing Cost and Production Cost
Often when we discuss the different costs involved in the manufacturing process, the thin line of difference between manufacturing cost and production cost gets blurred. These are two different costs.
Manufacturing cost is divided into three broad categories i.e. materials, labor, and overhead. All these are direct costs that are associated with production. Production costs include manufacturing costs as well as the cost of shipping the finished product to customers. So, production cost includes the cost of transportation, storage, packaging, and marketing.
In simple words, the manufacturing cost is part of the production cost. It includes the direct expenses incurred in the manufacturing process, whereas the production cost includes all the costs involved in bringing the finished product to the market.
Manufacturing cost tends to change as the production volume changes. The manufacturing expense increases as production increases.
Difference Between Total Cost of Manufacturing and Total Cost of Goods Sold
The Total Cost of Manufacturing (TCM) and Total Cost of Goods Sold (COGS) both are important for businesses to calculate profitability. The total manufacturing cost is defined as the cost associated with the production process, whereas the total cost of goods sold includes only the cost of goods that are sold.
The total cost of goods sold helps the manufacturers calculate the gross profit margin. On the other hand, the total manufacturing cost helps to focus on areas where production costs can be cut.
To elaborate further, the total manufacturing cost includes direct and indirect costs that are associated with the manufacturing of goods regardless of the fact that they are sold or not. This includes the cost of raw materials, utilities, energy costs, rent, and other expenses associated with the manufacturing of goods.
The total cost of goods sold is the cost associated with the production of those finished goods which have been finally sold in the market within a specific period. By deducting the cost of goods in the inventory from the cost of total goods produced, you can calculate the Total Cost of Goods Sold (COGS).
Benefits of Using Total Manufacturing Cost Formula
Manufacturing cost directly impacts the overall profitability of an organization. A manufacturing company must take into account different parameters to ensure that it maintains profitability without compromising on the quality of products.
With the help of the manufacturing cost formula, companies can assess the different factors that impact the cost of production, and how they can lower this cost. It also helps to understand the right strategy in formulating the pricing of a particular product.
The total manufacturing cost incorporates all the manufacturing expenses necessary for making a specific product during a set period. This method involves each department and the cost of operation. This is usually computed annually or quarterly. Some examples of manufacturing costs include:
Direct Materials and Labor Cost
Direct materials and direct labor costs are two important components of the cost of goods sold by a manufacturing company. Direct materials are the materials that go directly into the manufacturing of a product. For example, steel is the raw material for manufacturing guard rails; similarly, the fabric is the raw material or direct material involved in the production of clothing. Again, keeping a tab on the direct material cost becomes important. Since this cost is impacted by external factors, it directly impacts the final pricing of the product.
On the other hand, labor cost is directly involved in the production of a particular product or service. For example, it includes the wages or salaries of employees or workers who work on the assembly line, as well as any fringe benefits such as health insurance or retirement plans.
Manufacturing Overhead
Sometimes, a company needs to spend some extra amount besides a predefined cost involved in production. This falls in the category of manufacturing overhead. It includes water and electricity, repair of the machines, maintenance of equipment, quality inspection, insurance, and rent.
Here is the Total Manufacturing Cost Formula:
Total Manufacturing Cost = Direct Materials Cost + Direct Labor Cost + Manufacturing Overhead Cost
Total manufacturing cost is a valuable tool for manufacturing businesses as it helps them in projecting the exact cost of producing a particular product.
There are several other benefits of using the manufacturing cost formula. These are enlisted below:
Accurate Cost Calculation
The primary benefit of using this formula is that it gives you an exact estimation of the total cost involved in the production of a particular product. Since it takes into account all the aspects that directly or indirectly influence the product, it becomes easier for the manufacturing company to get an estimate of the total cost of production. This eventually helps in the budgeting and allocation of funds.
Cost Reduction
Once the manufacturing company is aware of the different costs involved in the manufacturing of a product, it can prioritize the costs and identify the area where it can save money. By analyzing each of these components, the manufacturers can highlight the inefficiencies and adopt the right measure to overcome the same.
Profitability Analysis
Every company aims at higher profits. With the help of the total cost manufacturing formula, the company can determine the profitability of a particular product. They can also make a comparison with others in the market and determine their pricing accordingly.
Decision Making
Another significant benefit of the total manufacturing cost formula is that it helps manufacturers to make the right decision. As a manufacturing company, every organization aims to gain a competitive edge in the market. Hence, defining the right pricing strategy and placement of products becomes significant here. With the help of manufacturing costs, the company can assess the factors which are affecting the cost of the product and the areas where it can reduce the cost. Overall, it helps in optimizing the utilization of resources.
Competitive Edge
A company that has a competitive edge above the others is able to sustain itself in the market for the long run and also maintain its profitability. With the help of manufacturing costs, companies can have an understanding of the pricing strategy. Many manufacturing companies also assess the pricing strategy of their competitors. All this eventually helps them in defining its strategy for success.
What Do You Need to Calculate Total Manufacturing Cost as Per the Formula?
The total manufacturing cost takes into account all the key factors that directly or indirectly impact the overall pricing of the product. These are categorized into the following:
- Direct Materials Cost: It involves all the raw material costs that are used during the manufacturing process.
- Direct Labor Cost: The pay of the workers involved in the manufacturing process falls under the direct labor cost. It includes parameters like salaries, wages, benefits, and taxes.
- Manufacturing Overhead Cost: The manufacturing company also needs to manage overhead expenses in the form of rent, utilities, administrative costs, and maintenance costs.
How to Find Total Manufacturing Cost?
Here is how you can calculate the total manufacturing cost:
Direct Materials + Direct Labor + Manufacturing Overhead = Total Manufacturing Cost
Example illustrating how to use total manufacturing cost formula
Let's understand how the manufacturing cost formula works. For example, your company manufactures steel chairs, and you need to calculate the total cost of producing one unit of the chair.
Step 1: Begin with determining the direct material cost
As we have discussed above, the direct material cost is the cost that the manufacturer bears on purchasing the raw materials that will be used in making the final product. In this case, steel, screws, and varnish are directly involved in the manufacturing of chairs. Let's assume that the cost of these materials comes up to Rs. 500.
Step 2: Calculate the labor cost
The next factor that you need to take into account is the labor cost. For example, if you pay the labor hourly, then the cost comes up to Rs. 200. And if you need 2 laborers for this task, the cost comes to Rs. 400 (2 x Rs. 200).
Step 3: Calculation of the overhead cost
The manufacturing company has to pay for rent, utilities, and depreciation of machinery. In this case, let's assume that the overhead cost comes up to Rs. 300.
Step 4: Now let's calculate the manufacturing cost
Direct Materials + Direct Labor + Manufacturing Overhead = Total Manufacturing Cost
Rs. 500 (direct materials cost) + Rs. 400 (direct labor cost) + Rs. 300 (manufacturing overhead cost) = Rs. 1200
So, the total manufacturing cost of producing one steel chair is Rs. 1200.
Above mentioned steps clearly highlight how a company uses the total manufacturing cost formula to determine the pricing of the product. Eventually, it helps a business make more informed decisions and define competitive pricing strategies, which give it an edge over the others.
How to Reduce Total Manufacturing Cost?
To get a competitive edge and ensure profitability, a company needs to reduce the total manufacturing cost. Here are some of the ways that can help a company keep control of its manufacturing cost without compromising on quality:
Streamline the Supply Chain
Streamlining the supply chain is of prime importance to achieve a lower manufacturing cost. The supply chain system is an integral pillar in the overall productivity of the organization. Optimizing the supply chain routes, minimizing the lead times, and improving inventory management can eventually help the company lower its manufacturing cost.
Improve Efficiency
By reducing labor costs, minimizing waste, and increasing output, a company can enhance its efficiency. To achieve this, it is important to streamline the production process and invest in business automation as and where possible.
Reduce Overhead Costs
Overhead costs can instantly escalate the overall cost of production. Hence, the company needs to keep a tab on these expenses. Strategies like reducing energy consumption and improving maintenance practices can help in cutting down the overhead cost.
Implement Lean Manufacturing Practices
Implementing lean manufacturing practices is yet another way to reduce manufacturing costs by optimizing the production process and minimizing waste. Moreover, implementing lean manufacturing practices like Kaizen value stream mapping can help in reducing the cost by enhancing the production process continuously.
Focus on Quality
Implementing quality control processes are very essential as it helps to reduce rework and returns. Manufacturing companies must therefore focus on training their employees on quality control measures and best practices to ensure a reduction in waste.
By following the above tips and strategies, cost reduction can be largely achieved without compromising on the quality of the product.
How Can MRP System Help You Manage Your Manufacturing Cost?
As the owner of a manufacturing unit, you need to focus on adopting the right measures that can help in managing the manufacturing cost well. A material requirement planning system is one such way that provides accurate and timely information on the inventory level, production schedule, and material requirements. Overall, it helps the manufacturing company to manage its material planning, thereby helping it in optimizing its manufacturing cost.
Inventory Management
An MRP system helps to make accurate forecasts based on historical data, current inventory levels, and production schedules. This helps to maintain optimal inventory levels that further help to reduce carrying costs, minimize stockouts, and avoid overstocking.
Production Planning and Scheduling
An MRP software can help you plan and schedule production based on demand, capacity, and material availability. This can help you minimize lead times, optimize production runs, and reduce changeover times, leading to lower production costs.
Material Requirements
A company can use the MRP system to assess its material requirement. Generating an accurate bill of material and tracking the material usage in the production process can eventually help in assessing whether there is a shortfall of material or there is any wastage. Eventually, it helps in optimizing material usage.
Cost Analysis
An MRP system can provide manufacturing cost analysis tools to help you monitor manufacturing costs in real-time. In addition, it also helps in identifying the areas where the company can lower the cost. This tool can help in real-time production cost assessment, identifying the areas of inefficiencies, reducing wastage, and optimizing production runs.
Integration with Accounting Systems
MRP systems have evolved with the times, and they are easy to integrate with the current accounting system. This helps to give accurate accounting and financial information about the company. It can also help in tracking manufacturing costs and analyzing profitability. Thus, it helps in making an informed decision about costs.
To sum it up, the MRP system can help you in managing the manufacturing cost significantly. It automates the process that helps manufacturing companies focus on their core solutions while optimizing the supply chain processes, managing inventory, and also succeeding beyond their competitors.
How Can TranZact Help You Manage Your Manufacturing Cost?
As an SME manufacturing business owner, managing different tasks simultaneously can impact the overall productivity of your organization. However, how well you manage your manufacturing processes can have both positive and negative impacts.
Ensuring optimal productivity is crucial to managing manufacturing costs efficiently. Manufacturing costs impact pricing strategy, cost control, innovation, quality of materials, and ultimately, profitability. Therefore, it is essential not to ignore this metric.
To ensure smooth management of manufacturing costs, switching to software offering cloud-based ERP solutions like TranZact is the need of the hour. TranZact is trusted by thousands of Indian SMEs for its easy-to-use manufacturing automation solutions. It provides a centralized platform to manage sales, purchases, production, inventory, logistics, reports, and more.
The platform offers a comprehensive business intelligence dashboard, making it easier for businesses to keep a tab on inventory and accounting trends. In this way, TranZact enables businesses to monitor costs associated with the manufacturing of products with smart graphs and charts, along with timely follow-up for payments.
It offers a complete insight into end-to-end operations enabling you to make smarter pricing strategies and reduce production costs. It also provides accurate inventory costing methods to help your business gain a competitive edge!
FAQs on Manufacturing Cost
1. What are the 3 elements of manufacturing cost?
The three key contributing elements of manufacturing cost are direct materials, direct labor costs, and manufacturing overhead expenses. When the cost of all these parameters is combined together, a company is able to assess the manufacturing cost.
2. Can a company control its manufacturing costs?
Controlling the manufacturing cost of the company can increase its profitability. However, this has to be done without compromising on quality. A company can achieve control of manufacturing costs by ensuring factors such as optimization of the supply chain, automating and streamlining processes, and implementing lean manufacturing practices.
