As a business that thrives on product sales, you know that keeping track of the cost of production is essential. Even the smallest reduction in cost can amount to millions of dollars when the scale is large enough. You can then use this profit to scale the business, pursue more profitable causes, or just to keep the business running.
But before we even start talking about profit and loss, do you really know what production cost is? Do you know how we can calculate the production cost? This article is the answer to your question.
What is Production Cost?
We can define production cost as the amount incurred by a business in order to manufacture a particular product. In recent times, we have seen this term extend to businesses that provide services too. Before we can classify an expenditure as a production cost, this expense must directly translate to revenue for the company.
This condition means that production cost for manufacturing companies relates to both the supplies and the labor required. In addition to this, companies providing service to clients will classify the cost of managing labor, as well as other expenses associated with materials, as production cost.
What Does Production Cost Include?
Usually, production cost has to do with several expenses and these are listed below;
- The cost of labor
- The cost of raw materials
- Manufacturing supplies
- Overhead cost
- Royalties owed, etc.
Direct Production Cost and Indirect Production Cost
When it comes to production, there are two broad categories of production cost. The first is direct production cost and this entails the costs that directly influence the production of that particular good. For instance, an automobile manufacturing company like Mercedes would include the cost of raw materials like metals, welding costs, plastic, etc. under this category.
The next classification we have is indirect production cost. This factors in expenditure that doesn’t directly influence the cost of production. Factors like the rent, administrative salaries, utility expenses, etc. often fall in this category.
How Do You Calculate Unit Production Cost?
In essence, the simple way by which you can calculate production cost is by summing all your expenses, both direct and indirect, and then dividing it by the number of units produced.
For a domestic enterprise, it is not unusual to have a formula such as the one provided below.
Total production cost = cost of raw materials + cost of operating equipment to produce the goods + basic salary of employees + additional payment is given to hired experts + overhead cost + commercial expenses + cost of fuel and energy + miscellaneous.
The total production cost is then divided by the total number of units produced (according to the materials provided).
How Often Production Cost is Computed
Even though the product cost per unit for a company is calculated for the whole year, companies usually estimate their manufacturing cost quarterly. For larger companies, the calculation is done monthly. The computation of this value is essentially the same and it’s the frequency at which it is carried out that varies.
For companies producing a wide range of products, the cost will vary for individual products and the production cost of one product might even vary with seasons. For instance, a restaurant might realize that certain supplies are more available in certain seasons, hence resulting in a cheaper delivery.
Calculating Production Cost when You Sell Different Products
In a case where a company only sells a particular product for a particular price, the production cost is really easy to compute. However, we all know that the probability of this happening is quite low; most companies produce more than one product at any given time.
So even if it’s a production store that sells toys, we have different products that have unique features and unique production costs. This product is taken individually, and the production cost of each product is calculated. With time, the cost of each product is recorded and used as a threshold for future products.
We have established that the different products in a company will have different costs and the production cost can be computed via the method outlined in this article. Based on your overhead cost and other variables that go into the production process, you can add or do without certain factors mentioned.