June 26, 2021

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Product Cost Meaning and Calculation

Product Cost Meaning and Calculation

Overview

Any business activity involves costs. The company’s finances are spent on diverse processes and purchases necessary for the making of products, maintenance of equipment, the purchase of raw materials, packaging, transportation, as well as on management processes, not to mention wages. Such diverse nature of costs indicates the need for their classification and separate accounting.

Product cost as the name implies represents the costs a company incurs in the course of product manufacturing. This can be the cost of raw materials, wages of the main production personnel, and manufacturing overhead. In the case of the provision of services, an example of such costs might be the salary of a specialist who “produces services”, for example, a consultant in a consulting firm, a lawyer in a law firm, and so on.

Product Cost Meaning and Calculation

When managing a large manufacturing enterprise, tracking production costs is important. Moreover, product costs are one of the focus areas of management accounting, since they directly affect the cost of manufactured goods, and, consequently, their market price and profit that the company can receive.

It is important that the cost accountant provides management with accurate cost calculations in order for management to determine a competitive selling price. Luckily, the modern accounting software makes it easy to track, calculate, and keep a record of the product cost. In addition, most software allow the preparation of various reports, which makes analysis of costs simpler and less time-consuming.

These costs are the main costs of any manufacturing business, therefore, management always keeps the task of reducing them as a priority. The cost accountant will work closely together with the purchasing and production departments to try to reduce costs as much as possible.

Components

During the production process, companies accumulate costs as they have to pay the wages and rents, purchase capital to make production possible, and so on. Note that in accounting, you do not look at the implicit production costs, such as the opportunity costs. Let’s look at the actual components of the product cost that a bookkeeper has to keep track of to be able to compute the final product cost.

Direct materials

Direct materials are materials that form an integral part of a finished product and that have a physical presence that is readily traced to that finished product. In other words, you can physically see and touch that particular material component in the final finished product. Some costs that might be physically present in the finished product, but are not material are considered to be indirect material costs. Some minor material costs are simply not practical to trace or account for on a product-by-product basis, so they are included in the overhead costs.

Product Cost Meaning and Calculation

Direct labor

This category includes all costs of paying workers who actually physically work in the production facility or provide the service. These include the wages of machine operators and other line workers. The amount of direct labor costs changes in direct proportion to the volume of production. The wages of factory guards, janitorial support, and other similar personnel are not included in the direct labor cost.

Overheads

Not all expenses a company incurs can be directly planned and accounted for in the product cost. Nevertheless, some of these funds turn out to be clearly an important cost that must be incurred to produce the final product. The concept of overhead costs accepted in business implies expenses or costs that relate to all manufacturing activities that occur during the course of production other than the two abovementioned categories. For example, there are rent and taxes, the salary of supervisors, insurance, depreciation of machinery, and similar expenses.

Sometimes, you will see these costs combined together under one term. For example, the term prime costs is meant to refer to direct material and direct labor. Another term that is often used is conversion cost, which is how much a company spends to change raw materials into finished goods. That would consist of direct labor and manufacturing overhead. Accordingly, your product cost can also be considered as a prime cost plus overhead or conversion costs and the cost of the actual materials.

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Author: Charles Lutwidge

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