Understanding the concept of product cost is Important. Understanding this concept can help you to make informed decisions, set the product price accurately, and improve profitability. In this article, we have explored the fundamentals of the cost of a product and their significance in accounting.
What Is Product Cost?
If you want to understand it simply, then product cost is nothing but the amount of money a business needs to produce a single product. While calculating the cost of the finished goods, consider all the direct and indirect expenses used to manufacture the product. The direct cost may include raw material and labour expenses. The indirect cost can be your overhead, such as suppliers and expenses used in stocking the product.
There are three types of expenses involved in manufacturing the product
- Manufacturing Overhead Costs,
- Direct Materials, And
- Direct Labour Costs.
When it comes to calculating the total product cost, it is important to mention them in the financial statement.
It is important to disclose these statements in both Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRAS) due to their overhead costs. But in some cases, managers can ignore the overhead costs in the short-term production and sales pricing decision. In such cases, they only need to focus on direct material cost and time spent in manufacturing the product.
This is how manufacturers and retailers cost factors, and they use different methods mentioned below to determine the cost of a product.
Types of Product Costs
Though there are mainly three product unit costs, they can be categorized into several different types. These are some of the primary types of product costs that can help you make informed pricing decisions.
1. Direct Material Cost
As we have mentioned above, direct material is the cost of raw material or the components used to manufacture the product. These are the physical components that are used to make a finished product and can be directly traced to determine the product unit cost.
2. Direct Labor Cost
Labour cost is the wages and benefits that are paid to the employees who are directly involved in the manufacturing process. Here, each individual is responsible for manufacturing each product with their assembling and crafting skills. This labour can be directly added to manufacturing specific products.
3. Manufacturing Overhead Cost
Now, this can be a little complicated to understand, but we can try. Manufacturing overhead cost refers to product-related expenses that can't be traced to a single product. This category may include the expenses on maintaining the machines, indirect labour costs, utilities, and other expenses that are not directly involved in production.
4. Other Costs
One other type of expense that is involved in product unit cost is the variable cost that changes with changes in production level. Here, the fixed product unit cost remains constant, and period costs are defined over a defined time.
Product Cost Example
To understand the concept of product unit cost, you need to consider various factors while calculating the final cost. Let's take an example of an electric bulb manufacturing company.
- Direct Material Costs: The expenses used in aluminium, indium, gallium, and phosphorus as the main raw material to produce one bulb.
- Labour Costs: The company will also need skilled labour to craft these bulbs, which include their wages and benefits paid to them.
- Manufacturing Overhead Cost: To manufacture an electric bulb, some machinery will also be needed, and the expenses of electric power are also included.
- Other Costs: It is the cost that is used to purchase the materials that are used while manufacturing the product.
How to Calculate Product Cost?
For the accurate product cost analysis, you need to determine the following factors and add them together.
- Implement Direct Material Costs: Let's assume that raw materials in manufacturing a bulb cost Rs- 20.
- Determine Labor Costs: To make it simple for product cost calculation, let's assume that the direct labour cost per bulb is Rs-10.
- Calculate Manufacturing Overhead cost: Now, the company will need machinery to produce the electric bulb, the electricity power, and other expenses, which is, let's say, Rs-5 per ball.
- Estimate Other Supplies: While manufacturing the product, the company's other expenses are Rs-5 for each ball.
Now, using the below formula, let's calculate the product cost of each ball:
Total product cost = (Direct Material + labor cost + manufacturing overhead cost + Other supplies)
Now, on calculating: (20 + 10 + 5 + 5) = Rs-40
So, the total product cost of each bulb is Rs 40.
How to Record Product Costs on Financial Statements?
Once you have calculated your product cost and period cost, it's time to record this in your financial statements. You can do this by following the below-mentioned steps.
1. Create A Chart Of Accounts
The first step is to create an accounting chart for your business's financial record. This chart may include various sections such as calculation of raw material, director labour, manufacturing overhead cost, and work in progress.
2. Track Direct Material Costs
The second step is to track the direct material cost for purchasing the raw material. You can record this expense in the raw material section and be sure to include other expenses like suppliers and shipping charges.
3. Record Direct Labor Costs
The next move is to record the direct labour cost for each labour in the labour cost section. Make sure to estimate the appropriate production period for accurate product cost.
4. Allocating Manufacturing Overhead Costs
Now, allocate the manufacturing overhead cost for the expenses related to utilities, rent, depreciation, and others in the overhead cost section.
5. Calculate Total Product Costs
Now take the next step and calculate the total product cost for each unit mentioned in the finished goods.
6. Record Sales And Cost Of Goods Sold
Once you have sold the goods, calculate the sales revenue in the sales account by estimating the cost of goods sold per unit.
7. Prepare Financial Statements
Now, it is time to record all the figures in your financial statement in your balanced sheet and consult periodic reconciliation to ensure accurate product cost analysis.
Understanding product cost is important for businesses, especially SMEs. But, calculating product cost can sometimes be a difficult process. You can get help from SaaS companies like TranZact to automate your accounting process for product unit cost. TranZact provides cloud-based accounting software that helps to make your accounting process easy and fast.
FAQs
1. What's the difference between Product Cost and Period Cost?
Product costs are direct expenses related to producing the goods. However, period costs are all indirect expenses that are spent during the production or the expenditure to store the goods.
2. How do I determine the cost of a product?
You can add the cost of a product by adding:
- direct material cost,
- labour cost,
- material overhead cost, and
- other expenses.
3. How can I reduce the production costs of my product?
There are several ways through which you can reduce your product unit cost, some of which we have mentioned below.
- Work on the production process
- Negotiate with the supplier
- Improve your labour efficiency
- Find less expensive material
- Use energy-efficient equipment
- Improve the quality control process
- Invest in research and development
- Reduce shipping costs
4. Why is it important to factor in overhead costs when pricing a product?
The overhead cost helps to ensure the profitability of the company. It helps to maintain financial stability and enables business owners to make informed decisions. Therefore, including overhead costs when pricing a product is crucial.
