Every business needs to have a good understanding of its product costing. If it doesn’t it could end up quoting or pricing incorrectly. You could have a situation where losses on one product are wiping out profits on another product.
So how do you improve your understanding of product costing?
Components of Product Costing
There are two components to product costing.
The first component is the direct costs. These are costs where it’s easy to see a direct link between the elements making up the product and the product itself.
The second element is the indirect costs. These usually relate to the general costs of running the business but it’s hard to quantify the link between the cost and the finished product.
How to understand this
Let’s take a simple example. Sean has a sandwich-making business supplying local retailers with sandwiches. Sean’s direct costs include bread, butter, fillings, packaging, and the labour of the staff who make the sandwiches. Sean’s indirect costs include marketing costs, premises costs, rent of this production unit, labour cost of staff who do provide admin support, office costs, delivery costs, accounting, and legal costs, financing costs, etc. While it’s easy to see how many slices of bread go into a sandwich. It’s harder to quantify how much of the marketing costs should be charged to a single sandwich.
So the first thing Sean has to do is to put together a recipe for each product. This is sometimes called a bill of materials. It will set out how much of each raw material is used to make one unit of a product.
When doing this, remember that you may well have to buy more raw material than will end in the product. We are likely to have some waste in the process – we may have raw materials getting damaged or going out of date. We may have to take product samples for testing or possibly to be given as samples.
When we are looking to develop a unit cost, we are better to think in terms of a batch. Let’s say that we want to make 100 sandwiches. How much bread, spread, fillings, and packaging will we use to make those 100 sandwiches? Then we cost those materials and divide by 100 to get the costs of a single finished sandwich. This has the benefit of averaging out any overs or under on an individual sandwich.
What to Include When Calculating Product Costing
There are a few things to remember when doing product costing calculations. While we should standardise as much as possible, not every employee will use the exact amount of raw materials. We need to allow for this variation mostly when working with batches.
Additionally, we may not sell every item that we make. Therefore, we need accept the fact that we will have some overproduction. We have to identify all the costs of making our batch and then allocate them as best we can to the sold units.
Next, we need to think about indirect costs or overhead.
The first step is to estimate your indirect costs for a specific period – could be done annually or quarterly.
We need to make the best estimate of each of the marketing costs, premises costs, and rent of this production unit. Additionally, we should estimate labour cost of staff, office, delivery, accounting, legal and financial processes. This is an effective exercise when preparing a budget for the period under review.
That will give us our total overhead costs.
Linking Overhead Costs to Costs of Each Individual Item
We need to link the overhead costs to the costs of each individual item.
One way is to express our total overhead costs as a percentage of our direct costs. Then add that percentage to the direct cost of each product. So in Sean’s example, let’s say the direct costs for the year are 50K and the indirect costs are also 50K. Then Sean will determine his direct costs for each product and double that to get a total product cost. He will do that for each product.
There are a few things to watch out for when doing this.
The initial estimate of how many products are to be made and sold in a year. Direct costs vary with production quantities but indirect costs tend to be flat or else not vary to the same extent.
Let’s say you planned on having production quantities that used 100K of direct costs. You also had 80K of indirect costs. Therefore, you would be expecting to have total costs of 180K in the year. If you are making 100K units then each unit would cost 1.8K.
However, if you only did 80K units, your direct costs would be 80K. Your indirect costs would still be 80K as they don’t vary in line with production quantities. So your total costs to produce 80K units would be 160K giving you a unit cost of 2 each.
So the initial assumption on production volumes is quite important.
When pricing there are three broad approaches. One is to use a cost-plus approach. A second is to match the current market rates. The final approach is to price the product based on the value of the product to the customer.
For any of these approaches, you need a good understanding of what is happening in the market place and you need a good understanding of your own product costing.
If you have any questions about this article, feel free to contact me on 086 2323525 or by email at jim@accountsplus.ie.