How to calculate the cost of a manufactured product: methods and a worked example

What is product cost and what is it made of?

Product cost is the sum of all costs incurred to make one unit of product ready for sale. In cost accounting these costs fall into three main groups:

• Direct materials: materials that go straight into the product and can be measured per unit, such as steel sheet, paper pulp or coating powder.
• Direct labour: wages of people who work directly on making the product, such as line operators or welders.
• Manufacturing overhead: every other production cost that cannot be traced directly to one unit, such as depreciation, energy, maintenance, indirect materials, supervisors' salaries and quality control.

Selling, distribution and administrative expenses are not part of manufacturing cost and appear separately in the income statement. For product or customer profitability analysis, however, we sometimes allocate them on a sensible basis too, to reach a "fully loaded" cost.

Costing methods: which one fits your plant?

The costing method has to match how you produce. The four main methods and where each fits:

In practice most plants combine methods, for example process costing for actual cost and standard costing for monthly control.

Overhead allocation: where most errors happen

Direct materials and direct labour are usually recorded reasonably well. Overhead is the real problem. The most common error I see is allocating all overhead with a single rate, such as "overhead equals 150 per cent of direct labour". It is simple, but when products use machines and services very differently, it paints the wrong picture.

A better way is to define cost centres first: production centres (such as the casting line or the paper machine) and service centres (such as maintenance, utilities and stores). Service centre costs move to production centres on a sensible basis (maintenance by repair hours, utilities by electricity use), and then each production centre's overhead reaches the products on its own driver.

• Machine-paced lines: machine hours
• Labour-intensive lines: direct labour hours
• Energy-heavy processes (furnaces, dryers): energy use or output weight
• Setup and changeover costs: number of setups

Worked example: product cost in a hypothetical plant

Take a hypothetical cookware plant with two products: a simple frying pan and a granite-coated pot. In one month it made 10,000 pans and 4,000 pots. All figures are in thousands of a currency unit and chosen only to show the method.

Step one, direct materials: each pan uses 1.2 and each pot 2.5 of materials (from the bill of materials and recorded actual use). Pans: 12,000; pots: 10,000.

Step two, direct labour: a pan takes 0.5 hours and a pot 1.5 hours, at a rate of 0.4 per hour. Pans: 10,000 × 0.5 × 0.4 = 2,000; pots: 4,000 × 1.5 × 0.4 = 2,400.

Step three, overhead: total monthly overhead is 9,000. Allocated on direct labour with a single rate (total labour 4,400), pans get 4,091 and pots 4,909. A closer look shows that 6,000 of the overhead belongs to the granite coating line, which only pots pass through, and the remaining 3,000 to pressing and forming, which both products use in proportion to machine hours (pans 60 per cent, pots 40 per cent).

With cost centres, pan overhead is 3,000 × 60% = 1,800 (0.18 per unit) and pot overhead is 6,000 + 3,000 × 40% = 7,200 (1.80 per unit). Now suppose a pan sells for 2.0 and a pot for 5.0. With the single rate, the pot seemed to earn about a 13 per cent margin; with the closer method, only 2 per cent. The pan, which looked like the weaker product, actually earns about 21 per cent. That difference can completely change decisions on discounts, promotion or adding capacity.

Standard cost and variance analysis

Actual cost tells you what a product cost; comparing it with standard cost tells you why. Standard cost is what should be spent under normal conditions: standard material quantity from the bill of materials with allowed scrap, standard time per operation and a standard overhead rate. Each month the gap between actual and standard is split into its parts:

• Material price variance: materials were bought above plan.
• Material usage variance: scrap or use above the bill of materials.
• Labour efficiency variance: work took longer than standard, for example because of downtime.
• Overhead volume variance: output below planned capacity spreads fixed cost over fewer units.

Efficiency and volume variances usually trace straight back to production line downtime. To measure downtime precisely, see MTTR, MTBF and OEE.

Common mistakes in product costing

• Calculating only at year end: by the time the figure is ready, the chance to correct prices has passed.
• Ignoring scrap and rework: the cost of defective units belongs in the cost of good units.
• Allocating overhead with one blanket rate for every product.
• Using old purchase prices in inflationary periods; look at replacement cost next to historical cost.
• Not separating idle capacity cost: when the plant runs half empty, all fixed cost should not land on the units produced.

Costing software or an analytical model?

Many companies look for "product costing software". The costing modules of ERPs such as SAP Business One are useful for official recording and calculation, but often lack flexibility for management analysis: changing allocation drivers, comparing scenarios or seeing profit by customer is hard in them. What has worked in my projects is an analytical model in Power BI or Excel that reads materials, production and cost data straight from the ERP, calculates with documented logic and refreshes automatically every month.

On that model you can build a product profitability dashboard and connect it to the financial and profit and loss dashboard, so every product's and customer's margin rests on actual cost. The service, deliverables and common questions are on the product costing page.

Frequently asked questions