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Product Costing in 7 Simple Steps


    There are two ways in which inaccurate product costing can affect a business. 

    If you set your prices too low, you might lose potential profit. Yes, sales may increase, but it won’t be sustainable in the long run.

    If you set your prices too high, you might chase your customers away. By “away,” we mean they will quickly opt for the next best option. 

    And if you have managed or overseen the sales department in your manufacturing firm you already know that options are plenty. 

    That is the importance of effective product costing. It should not hinder sales. In fact, it should give you a competitive edge and keep people coming back. 

    The goal is to satisfy your customer and allow overall growth.

    What is Product Costing?

    You are done manufacturing a product. Now you have to get it out to the market. How much will you sell it for? Product costing is how you determine the answer to that question.

    Calculating product cost focuses on determining the actual cost to manufacture one unit of the product. This then allows us to define the profit margin. Managers potentially use this to decide which products the company can move forward with.

    Different Types of Manufacturing Costs

    In this scenario, accountants have to calculate various costs to determine the final cost. 

    Direct Labor Costs

    What are manufacturing companies without their employees! 

    Employee wages have to be constantly monitored to ensure production mirrors the investment. Direct labor costs occupy a major part of your manufacturing cost as they will be overseeing the complete process from raw materials to a full-fledged product.

    Material cost

    Without raw materials, you won’t be able to make any products. The cost of raw materials is a tricky expense. You have to get a “good deal” without compromising on quality. To avoid wasting raw material, you have to have quality control methods. 

    Other factors that contribute to material cost are inventory and warehousing capacity.

    Indirect Overheads

    As a manufacturing company, your facility will incur some expenses whether you manufacture or not. Some of the indirect overheads you might have to deal with are:

    • Utilities (water, electricity, etc.) 
    • Rent or Mortgage
    • Equipment depreciation
    • Security 

    Incidental Expenses

    These are additional expenses, but you probably cannot afford to say no to them. Tools, tapes, lubricants, and other important safety gear supplies are one such set of extra expenses. Defective products can cost you too, as they tend to add up quickly.

    They may not always be needed, but these incidental expenses penetrate your pricing nonetheless. 

    Top 7 Product Product Costing Steps

    1. Identify the Cost Object

    Manufacturers usually have to deal with standard products. In that case, one unit of the said product is taken as the cost object.

    In cases where custom products are sold, you have to use the cost it takes to do the job.

    2. Identify Direct Costs of Individual Items

    Simply add the expenses of direct materials and direct labor taken to produce a certain product.

    3. Pool Together the Overhead Costs

    These are the indirect material costs:

    • Lubricants
    • Fasteners
    • Other untracked goods

    Add those costs with indirect labor:

    • Planning
    • Maintenance
    • Quality Assurance & Control
    • Warehouse Supervisors
    • Janitors

    It is also advisable to include rent and utility costs in this calculation.

    4. Apply Overheads Accurately

    Now, overhead affects different products differently. Some products may take less time to finish. Some may consume more material. Therefore, it is not advisable to apply indirect costs evenly to all products.

    Therefore, be accurate when allocating your overheads. These overheads are usually machine hours or labor hours, or they can change according to measurement factors.

    5. Calculate the Overhead Allocation Rate

    This applies to customized products, or where the same amount of overhead is not applied to each product. The equation goes like this:

    OH allocation rate = Total OH / Total hours.

    If your total overhead per month is estimated at $10,000 and it took your production workers a total of 100 hours, the overhead allocation rate would be $100 per hour.

    6. Allocate the Overhead Costs

    This concerns the case where the same amount of overhead is allocated for each product. For the previous example, let’s assume that you successfully produced 200 products.

    OH per product = Total overhead / Total no. of products.

    Therefore the overhead cost per product would be $50.

    In case you use the overhead allocation rate, you must calculate the time spent on making different products.

    Let’s assume you make two different products: a dining table takes 3 hours, and a chair took you 0.5 hours to finish.

    Overhead per table: 3 x 100 = $300

    Overhead per chair: 0.5 x 100 = $50

    7. Calculate the Total Cost

    This is the final touch before you decide on the selling price. The cost per unit is calculated as follows:

    Cost per unit = Direct labor cost per unit + Direct material cost per unit + Overhead per unit

    Identifying your ideal customer persona is going to be crucial. If your selling price is out of their budget, there is going to be a problem.

    So, make sure your market research is thorough. No amount of accurate costing will help you if your customers do not look past your price tag.

    At MMI, we have helped leading brands leverage our extensive network and sub-brands to overcome manufacturing and supply chain challenges. Our decades of experience will help you bring products to market on time both domestically and abroad.