Product Costing

What is Product Costing?

Product Costing is the process of determining the cost of a product to be sold in the market, which encompasses materials, labor, and overheads associated with manufacturing. It is a part of the controlling module and can be applied to for-profit or not-for-profit organizations. Product costing includes costs associated with production, marketing, and distribution, and will vary depending on the purpose. It can be used for pricing open market products, making product mix decisions, and rating customers as well as financial statements and market penetration pricing. The product costing formula takes into account costs relating to materials used in production, labor used in production as well as the total cost of the product itself to determine profit or loss.

Product costing has undergone a dramatic metamorphosis in America over the past 50 years, as Textile World's Frank Wilson noted: "In the 1940s, cost estimates normally included nothing more than total manufacturing costs. In the late '50s direct costing was implemented to separate variable (cost of materials, cost of transportation) and fixed (interest payments on equipment and facilities, rent, property taxes, executive salaries) costs." Indeed, Lessner remarked that "fifty years ago, when manufacturing was far less automated than it is today, the costs of materials, labor, and overhead were just about evenly divided. Now, the production of a product's various components is often so synchronized on highly automated production lines that there is little or no need to maintain component inventories; thus, the old costing formulas, still used by many industries, are no longer applicable…. Further complicating the costing equation is the trend in manufacturing to focus more attention on quality, flexibility, and responsiveness, to meet customer needs. This makes production-line cost analysis more difficult because each line requires small, but significant, changes in production techniques." As a result, today's managers and business owners have found that the limited information available through older job costing methods is inadequate for making informed decisions in the contemporary business environment.

With this in mind, companies have increasingly turned to detailed, long-range examinations that provide a more accurate representation of a product's true costs and benefits. "Companies are discovering that their competitiveness is enhanced when purchasing, manufacturing, logistics, and product design groups begin using total life cycle costing," wrote Joseph Cavinato in Chilton's Distribution. "Total life cycle cost recognizes that the purchase price of an item is only part of its total cost, just the beginning of a series of costs to be accumulated by the firm, its downstream customers, and users until the end of the product's life." This analysis is further enhanced when companies include suppliers/vendors in the process because the costing process can help create a partnership relationship that enables both parties to move away from competitive stances on pricing, delivery dates, etc., toward cooperative initiatives that optimize the expense of creating and maintaining new products.

Some manufacturers distort true product costing results by evenly distributing costs for a certain aspect of production across all product lines, even though costs might vary with each specific product. In some instances, this practice might have little or no impact on a business's well-being; a company that is enjoying record growth and profits on all three of its product lines, for instance, is unlikely to be seriously harmed by accounting practices that evenly divide transportation costs three ways, even though one of the product lines may account for, say, half of the firm's transportation expenses. Huge profits mask such inequities fairly well. But relatively few companies are in such a luxurious position. Most companies—and especially most small businesses, which typically have less margin for error than their larger cousins—need to work hard to arrive at true product costing figures. "As national and global competition increase," wrote Lessner, "even tiny costing disparities can have an overwhelming impact on whether a product—or an entire company, for that matter—survives…. Over the long term, product profitability analyses that use these distorted costs cause management to erroneously assume custom products generate better margins than they actually do," and top-performing goods end up subsidizing other, less profitable, product lines.

Although product costing is primarily associated with manufacturing businesses, it also has applications in non-manufacturing industries. "Merchandising companies include the costs of buying and transporting merchandise in their product costs," observed Ronald W. Hilton in Managerial Accounting. "Producers of inventoriable goods, such as mining products, petroleum, and agricultural products, also record the costs of producing their goods. The role of product costs in these companies is identical to that in manufacturing firms." Business experts also note that while service-oriented companies (both service businesses and non-profit organizations) do not offer products that can be stored and sold in the manner of manufactured items, they nonetheless need to track the varied costs that they accrue in offering their services. After all, the services that they offer are in essence, their "product" line. "Banks, insurance companies, restaurants, airlines, law firms, hospitals, and city governments all record the costs of producing various services for the purposes of planning, cost control, and decision making," wrote Hilton.[1]

Product Costing Categories

  • Direct Labor: Direct labor is a key component for successful product costing because the wages and benefits paid to employees who work on the production line, as well as other indirect expenses such as overhead, are included within direct labor costs. Allocating these direct labor costs to product costs helps to account for these indirect costs. This includes security guards and other staff not directly involved in creating the product but whose cost is allocated to the product's cost. Ultimately, this allows businesses to better track and assign accurate prices for their products.
  • Direct Material: Direct material is an essential component of successful product costing, as it encompasses the costs of the raw materials used in a product's production. This incorporates wages, payroll taxes, benefits, and insurance paid to employees directly involved in the manufacturing process. Indirect material costs encompass transportation, storage, and insurance related to components sourced from other businesses. These direct and indirect materials can significantly contribute to high manufacturing overhead costs.
  • Manufacturing Overhead: Manufacturing overhead is an important key component for successful product costing because it incorporates both direct and indirect costs into the cost of a product. The three components that comprise this cost include direct material, direct labor, and manufacturing overhead costs. Manufacturers and retailers are able to accurately assess the total cost of a product by taking these factors into account. Manufacturing overhead costs also include some indirect costs, such as the following:
    • Indirect materials: Indirect materials are materials that are used in the production process but that are not directly traceable to the product. For example, glue, oil, tape, cleaning supplies, etc. are classified as indirect materials.
    • Indirect labor: Indirect labor is the labor of those who are not directly involved in the production of the products. An example would be security guards, supervisors, and quality assurance workers in the factory. Their wages and benefits would be classified as indirect labor costs.

Product Costing Formula[2]

The total product costing formula is:

Total Product Cost = Cost of Raw Materials + Cost of Direct Labor + Cost of Overhead

Cost of Raw Materials = expense paid to purchase the materials needed to create or manufacture the product

Cost of Direct Labor = payment made as salary or wages to workers who are directly associated with the production process, such as factory workers

Cost of Overhead = other expenses that are paid for rental space and equipment, repairs, insurance, taxes, utility bills, and salary of office workers and management

Costs are sometimes represented in terms of fixed costs and variable costs. Overhead expenses are mostly fixed, while raw materials and labor costs are variable. Fixed costs are constant during each payment period, while variable costs depend on work hours or the number of units produced. The total cost of the product may also be determined by adding these costs together.

After knowing the total cost of the product, this value may be divided by the number of units to get the production cost per unit. This measure is very helpful in determining the break-even sales price or the minimum price that the company should be willing to sell its product.

Production Cost per Unit Formula The production cost per unit formula is:

Production Cost per Unit = Total Production Cost/Total Number of Units Produced

Production cost per unit is the value on which the item's price setting should be based. If the product's sales price is set higher than this price value, the company will generate profits. The company will have losses if the sales price is set below this price value.

Methods of Product Costing

  • Job Order Costing: Job order costing is an important method for businesses to determine the cost of individual units. It allows companies to track the material and labor costs associated with specific units, helping them make decisions related to pricing and profitability. Hybrid costing combines process and job order costing, providing businesses with additional flexibility when managing their cost structure. Job order costing is a method of cost estimation that can be used in various industries. It involves breaking down the costs associated with producing one unit of a product into various components, such as labor and materials. The process assigns an individual cost to each component and then combines these costs to calculate the total cost of producing one unit of the product. Hybrid costing combines job order costing with process costing in order to get benefits from both methods. This approach allows for more accurate product cost estimations by taking into account all inputs in production, including both direct and indirect activities or processes associated with creating a product.
  • Process Costing: Process costing is an accounting technique used to accurately track the costs of production over a given period of time. It helps businesses determine their profits, budget for new projects, and develop strategies for controlling costs. Process costing is important in successful product costing because it allows businesses to keep track of each individual cost associated with making a product. By having an up-to-date understanding of the total cost associated with producing a particular item, companies are able to create accurate pricing models and anticipate potential issues before they arise. Additionally, process costing can help identify areas that need improvement and provide data that can be used in future decision-making processes related to production costs. Process costing is a type of cost accounting used to estimate product costs. It takes into account direct labor as well as manufacturing overhead fees associated with the production process. This method of calculation helps businesses better understand product costs and can help them adjust their long-term projections in response to modernization, such as the elimination of certain components from the production process.
  • Standard Costing: Standard costing is a method of accounting that determines the cost of producing a product or providing a service. It involves estimating projected costs and then comparing these to the actual cost that was incurred. This allows businesses to identify and track production costs through the use of six process costing methods: direct, indirect, variable, fixed, incremental, and total cost. Standard costing can be used in tandem with alternative costing methods in order to get an accurate portrayal of actual costs.
  • Activity-Based Costing: Activity-Based Costing is a method of accounting for inventory that considers the various activities used in producing a product. This method can use different cost drivers, depending on the situation, to calculate the total cost of a product. Activity-Based Costing can help managers better understand their company's expenditures and make informed decisions on how to allocate resources.
  • Backflush Costing: Backflush costing is a method of product costing used in just-in-time inventory systems that do not require the incorporation of inventory maintenance costs. It is one of six different product costing systems which include job order costing, process costing, hybrid costing, standard costing, backflush costing, and activity-based costing. Backflush costings impact the way businesses price and manage their products by streamlining the system to better track production costs.
  • Hybrid Costing: Hybrid costing is a combination of process and job order costing methods that allow businesses to utilize the benefits of both systems. This method takes into account both direct and indirect costs, making it an effective way for organizations to accurately price their products and services. Hybrid costing is important for product costing as it provides businesses with a comprehensive understanding of all the different costs associated with production, allowing them to make better decisions about pricing. By becoming familiar with six different hybrid costing methods, businesses can ensure that their products are properly priced in relation to available resources and market conditions.

Product Costing vs. Cost Accounting[3]

product costing and Cost accounting are two accounting methods for determining the cash needed to create goods and services. A company's decision to use either accounting technique can have lasting implications on how the business interprets financial data and makes business decisions. Product costing may work better for a business lacking modern manufacturing facilities, while cost accounting better suits a company using large-scale production methods.

Product costing is the accounting process of determining all business expenses pertaining to the creation of company products. These costs can include raw material purchases, worker wages, production transportation costs, and retail stocking fees. A company uses these overall costs to plan a variety of business strategies, including setting product prices and developing promotional campaigns. A company also uses product costing systems to find ways to streamline production costs to maximize profits. For example, choosing raw materials that are more cost-effective can allow a company to increase profit from retail sales by lowering its product creation costs.

Cost accounting is the process of collecting, classifying, and recording all the costs associated with accomplishing a business objective or particular company project. A business uses management accounting costing methods to analyze data collected from completing a business task to determine the fair value or selling price of the product created from that task. For example, a company creating a line of snow skis performs cost accounting to determine a selling price for the skis that both cover the company's costs and allows the business to return a profit on each sale. Cost accounting can also help a company streamline its production process to reduce costs and return a greater profit on individual product sales.

The modernization of manufacturing techniques and improvements in product shipping have greatly changed the ways businesses calculate product costs. Manufacturing facilities in the 21st century can assemble products so quickly that there's little need for component inventories. This renders many old methods of calculating product cost irrelevant. Additionally, shifts in manufacturing focus to meet customer needs through production have led to manufacturing lines with small variances in production techniques. These seemingly small differences in production techniques create complicated accounting situations where companies have difficulty determining actual production costs in the short term. Compensating for this lack of clarity requires companies to make long-term projections regarding costs over the life of product lines instead of costs leading up to the sale of products.

Unlike product costing, cost accounting doesn't have the problems associated with adjusting projections to suit modern manufacturing techniques or counting individual inventory components. This allows cost accounting to deliver detailed reports regarding the cost of each phase of production. A business can use these reports to specifically target areas of the company for cost reduction or efficiency improvement. Additionally, cost accounting focuses solely on the cash spent to create goods as an economic factor of production. This means a business using cost accounting views money as the single factor affecting the company's ability to produce goods and services.

Improving Business Operations with Product Costing

  • Identify the type of product costing system: The first step in using product costing to improve business operations is to understand the six different methods for product costing. Businesses must become familiar with the benefits and drawbacks of each system, and identify which one best meets their needs. Once a system has been chosen, businesses can use it to estimate the total costs of products or services, helping them better determine their financial requirements and production processes in order to maximize profitability.
  • Count the number of products produced: Product costing is an important factor in business operations as it allows businesses to track the costs of individual products and calculate the total cost of all products produced during a given period. This helps businesses list any unsold products as assets on their balance sheet and accurately reflect the cost of what was purchased in inventory. Additionally, product costing enables businesses to calculate profit or loss from a sale by subtracting the cost of goods sold from the monetary value of what was sold. By keeping track of inventory, costs, and profits through product costing, managers responsible for business operations can make informed decisions about future investments.
  • Itemize the cost factors of each product: It is important to itemize the cost factors of each product in order for businesses to accurately track their costs and ensure that all costs related to the product are accounted for. By doing so, businesses can better understand their financial standing by having a clear picture of what it costs them to produce and sell products, as well as any profits or losses incurred from sales. This knowledge allows companies to make informed decisions about future investments, pricing strategies, and more. With accurate cost information available, businesses can also forecast more accurately and prepare for unexpected expenses.
  • Calculate the cost of each product: To calculate the cost of each product, one should begin by purchasing a product from a manufacturer at a set price. Next, they should calculate the product unit costs for the manufacturer and double them. Direct labor costs should then be added in, followed by combining related overhead costs (such as procurement and employee salaries) to get the total cost of the product. Additionally, indirect expenses such as marketing and distribution expenses should be accounted for when calculating the cost of each product. Variable costs (time and materials) need to be added together to get an item's "ideal" revenue before taking advantage of income. Finally, fixed costs (such as rent, salaries, and advertising) must also be taken into account when calculating the cost of each product in order to ensure that these are fully covered by any deals made on them.
  • Use the product costing formula: Businesses can use the product costing formula to improve their operations. By calculating costs based on the number of products sold, businesses can more accurately price their products and set a rate for their labor. Additionally, businesses must take into account both fixed and variable costs when determining an item's value. Finally, retailers use MSRP to determine the cost of a product which includes all direct labor costs. With this information, companies can better determine how much to sell during a specific time period and ensure accurate salary and bonus calculations are made.
  • Find the total costs of products sold: Businesses can use product costing to improve their operations by tracking the cost of specific products and services. By understanding the product cost, businesses can make decisions on how to optimize their supply chains and adjust prices or quantities accordingly. Product costing also helps businesses understand the financial implications of changes to product prices or quantities, enabling them to make more informed decisions.
  • Move the information to an income statement: Product costing is related to the income statement in that it is used to calculate a company's revenue and expenses. By listing all the cost factors associated with each product, such as materials, labor, and shipping, companies can accurately reflect changes in their income statement due to changes in product pricing. Product costing also helps companies keep track of unsold products on their balance sheet. Through the careful calculation of total costs for goods sold, companies can effectively use product costing to inform their overall financial decisions.
  • Reflect the changes on the balance sheet: Product costing affects the balance sheet by recording the number of products produced and purchased, itemizing cost factors, and adding unsold products to inventory. Unsold products are added to the balance sheet as an asset. The process of recording product cost and selling products is done daily or monthly, which allows companies to subtract the number of sold products from the total number of products in inventory and calculate their monetary value on the balance sheet. This calculation is also used in determining changes to an income statement as a result of selling a product.
  • List all unsold products on the balance sheet: It is important to list unsold products on the balance sheet in order to provide a more accurate view of the company's financial health. By doing so, businesses can track their product costs and inventory, as well as calculate how much money was spent on each product and how much profit was made from each sale. Additionally, moving this information to an income statement allows companies to see how their overall financial situation has changed due to selling products.
  • Add new products to inventory: Adding new products to inventory can improve business operations by reducing the per-unit cost and finding the manufacturing cost. Additionally, businesses will record their product costs by counting the number of products produced daily, itemizing product costs, and adding the number of new products to all other unsold products in inventory. This ensures that all unsold items are counted as inventory without impacting total profits. By subtracting total costs from sold products from the monetary total in the inventory account, businesses can more accurately track their profits while ensuring they remain competitive with lower prices.

See Also

Product Life Cycle