Total manufacturing cost is the amount of money a company spends on its manufacturing operations or how much it generally costs to produce goods that customers will buy.
There are three different cost categories to calculate total manufacturing costs:
- direct material;
- direct labor;
- and manufacturing overheads.
These are expressed as a formula:
Total Manufacturing Costs (TMC) = Direct Materials + Direct Labor + Manufacturing Overheads.
It takes much more than knowing the formula to calculate total manufacturing costs correctly. This article will look at total manufacturing costs, calculate their parts, and reduce some charges in a business.
What are the total production costs?
Total manufacturing costs are associated with all the resources used to create the finished product. Calculating the total cost of production requires an accurate analysis of the various departments in your company to determine how much they contribute to the production process and the associated costs. This includes a detailed accounting of all materials, overheads, and labor to determine the cost of producing the finished product.
The three main components of total manufacturing costs are direct materials, direct labor, and manufacturing overheads.
Direct materials consist of raw materials that go into the finished product, while direct labor is all the workers involved in the preparation, assembly, and production of goods. Manufacturing overheads are costs associated with processing, maintenance, and indirect materials or labor used for ancillary purposes.
Here’s how you calculate each of these various costs.
- Direct Materials: Calculate the cost of materials purchased in a given period, add this amount to the cost of opening the Inventory, and subtract the cost of the ending list, which provides you with direct material costs incurred during the period.
- Direct Labor: Calculate all direct labor costs used in the manufacturing process for the period, including any related payroll taxes.
- Manufacturing overheads: Combine the cost of all factory and manufacturing overheads incurred during the period, including expenses such as rent or mortgage fees, repair and maintenance costs, wages, and depreciation of machinery and equipment.
What are direct materials?
Direct materials are materials that were bought and used to create the final product, including:
- raw materials;
That are directly used in production. When calculating the total cost of direct materials, you must determine how many direct materials you have, sum the total cost of new direct materials, and then subtract the ending Inventory at the financial period end.
These are direct materials. Not all materials are included in products. Some go to scrap metal or other areas. We focus on direct materials such as the rubber used to make tires or the fabrics for clothing.
Opening Inventory + Added Purchases – Closing Inventory = Total Direct Cost of Materials
This formula is used to calculate total direct material costs.
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What is direct labor?
There is no formula needed to calculate direct labor. Direct labor is the cost correlated with paying people to create a product. We focus on those involved in the production of products, such as employees working on the assembly line. We are not talking about HR.
To calculate direct labor costs for your fixed and variable employees, you must include wages, benefits, pension funds, vacation pay, payroll taxes, workers’ compensation insurance, etc.
What is manufacturing overhead?
You need to calculate the total manufacturing overhead. That’s all you need to get your production running, which is a little more indirect. Overhead costs can impact your balance sheet and income statement, so you need to keep track of these costs. Knowing your firm’s overhead costs means you can allocate the money needed to cover those costs.
Fixed overhead examples:
- keeping equipment running (maintenance, water, electricity, etc.) costs;
- equipment depreciation;
- product quality checks;
- taxes and amortization of the objects.
We’re not talking about the costs of keeping your company running, such as marketing or accounting. To get the total production overhead, add up the costs associated with actual production.
Difference between Direct and Indirect Manufacturing Costs
It is essential to distinguish direct and indirect production costs. When business expenses are associated with manufacturing activities, they are classified as “direct” or “indirect.” They include charges for raw materials, finished goods, manufacturing movements, and customer service (but do not include rent, insurance, utilities, office supplies, and office depreciation).
The crucial difference between direct and indirect costs is that direct costs can be traced to a specific item and are usually variable. Direct costs include direct labor, materials, wages, commissions, and production materials.
Total Manufacturing Cost Advantages
The calculation of the total manufacturing cost has many advantages. First, a complete understanding of these costs makes it easier to compare them and determine which ones can be reduced. It is an ongoing cost reduction process that can result in significant cost savings over time.
Manufacturing Costs Planning
A better understanding of total manufacturing costs allows a business to plan those costs in the future, what provides transparency in making money, and what can be done to improve the situation. The knowledge can lead management to new, less costly distribution channels, such as an online store. This analysis may even lead management to scrap some products and develop new ones with higher gross margins. Management may try to increase prices in cases where the product cost is high to see if profits can be increased without reducing production.
Financial Health Clarity
Manufacturers who do not have an accurate picture of their spending often have a distorted view of their financial health, leading to poor budgeting. Total production costs compared to revenue and earnings provide clarity on the profitability and overall performance of the business.
If your findings in this area are not favorable, you can at least use the data as fuel to make things right. This information will drive critical decisions about your company’s direction, such as being cautious or bold (and therefore downsizing or investing in core features).
The profitability picture derived from total operating costs will also guide other strategies, such as your sales and pricing policy approach. If your profits are low, you may decide that the current sales model is not working and that you may need new methods or the opening of new sales streams (for example, e-commerce).
If you have concluded that the costs are minimal and the income is still small, the next step may be to change the price. If your fees are too high, customers may go to competitors where they can find a better deal. Likewise, if prices are too low, you won’t be generating the income you need to make your business profitable.
There must be a balance in setting a price within the market norm while still providing an acceptable return (based on the investment spent on the production of each good).
Looking at the total cost of production, you can find out that the materials purchased are too expensive and that too many materials are purchased in the first place. By analyzing the surplus that typically occurs during production, you can take a more economical approach to buy what brings financial benefits and improves your environmental standing. By having fewer products in stock at any time, you will incur lower storage costs, and your business will be much more organized.
Cost-cutting actions can often also optimize your processes. Removing steps from the manufacturing process to save money also increases efficiency by ensuring that products are created faster (resulting in greater customer satisfaction).
Purchasing materials from local suppliers can reduce costs through cheaper shipping and allows your supply chain to turn around faster and meet expectations when orders are placed at the last minute.
When looking for more cost-effective equipment/technology, you may stumble upon more complex mechanisms that provide a much greater ROI (return on investment).
Why is it important to calculate total production costs?
In manufacturing, the profit is directly related to efficiency. Once you’ve calculated your total production costs, you can subtract this figure from your total income to see the relationship between production, profits, and sales to understand how your costs affect your earnings. With such an accurate, real-time view of your production costs, you can improve efficiency.
You may find that you can reduce direct material costs by replacing an expensive material or supplier with a more affordable one that does the job just as well. Perhaps you could cut down on shipping costs by buying more in bulk or locally. You may see your direct material costs increase because you are pre-producing too much Inventory or more than you can sell in a given period. Better forecasting can significantly reduce costs.
Once you know your total production costs, you can ask yourself some essential questions:
- Are there any costs that are much higher than I expected? Are there much lower? What contributed to this?
- Does my selling price meet my profit target?
- What Inventory do I have at the end of the financial period?
- Where can I improve processes or procurement to reduce costs or time wisely?
Total manufacturing costs and productivity relationship
Productivity, expressed as a percentage between inputs and outputs, measures how efficiently inputs such as labor and capital are used to produce a given output level.
Calculating total manufacturing costs allows for establishing the amount spent on producing goods. Businesses use this figure to track income that goes towards manufacturing costs. By reducing overall production costs, companies become productive.
Author: Charles Lutwidge