Production Costs – A Simple Guide

There are many metrics available for measuring the financial side of the manufacturing process. Whereas production managers mostly make do with the total manufacturing cost KPI, management and accounting often need a wider perspective.

What are Production Costs?

Production costs are expenses that companies incur when manufacturing their products. There are several types of production costs, useful in different use cases. For example, in manufacturing cost accounting, production costs are divided into direct and indirect costs. In inventory valuation and management, the total, average, and marginal costs are useful metrics. Further still, fixed and variable costs can be used for calculating production volume-specific expenses.

Perhaps the most relevant distinction that informs production costing is between direct and indirect costs. Direct costs are all expenses directly related to a physical product as it is being manufactured, such as the cost of raw materials and labor. Indirect costs, also called overhead costs, are other expenses related to the overall manufacturing process.

There are a number of financial metrics that companies use to measure production costs and financial health. The most important ones include Total Manufacturing Cost, Cost of Goods Sold, and Cost of Goods Manufactured. Let’s take a closer look.

Total Manufacturing Cost

The total manufacturing cost represents the total sum that has been spent solely on production activities. It consists of three key costs:

1. Direct material costs. This shows the value of the raw materials and components you have used to produce goods in this period. Direct materials only include goods that are part of a product’s bill of materials, as opposed to indirect materials which are used in insignificant quantities per product (e.g. adhesives, screws, nails) or as auxiliary goods that do not end up in the finished product (sandpaper, disposable protective equipment, factory floor cleaning supplies, etc.)
2. Direct labor costs. These include only this part of your staff that is directly involved in the manufacturing of products, i.e. line workers, craftspeople, machine operators, etc. Other production department staff such as supervisors, quality assurance, cleaning staff, maintenance, etc. are considered indirect labor.
3. Manufacturing overhead costs. Manufacturing overhead includes indirect costs related to the production of goods such as facility rent, utilities, indirect materials, indirect labor costs (production supervisors, quality assurance, shop floor cleaning staff, etc.), maintenance, depreciation, and so forth.

The total manufacturing cost is an important metric for measuring the productivity and profitability of the company. Likewise, it can be used to identify and eliminate inefficiencies and overspending.

Read more about Total Manufacturing Cost.

Cost of Goods Manufactured and Cost of Goods Sold

The total manufacturing cost is also used to calculate the cost of goods manufactured (COGM) as well as the cost of goods sold (COGS). If the total manufacturing cost indicates the spend on all production activities, the COGM accounts for only the production of those goods that were finished during the period, and the COGS for those goods that were sold.

The formula for the cost of goods manufactured is, therefore:

COGM = Beginning WIP Inventory + Total Manufacturing Cost – Ending WIP Inventory

The cost of goods sold formula, on the other hand, is:

COGS = Beginning Finished Goods Inventory + COGM – Ending Finished Goods Inventory

Fixed vs. variable production costs

The main difference between fixed costs and variable costs is that fixed production costs are incurred even if no production occurs while variable production costs can be adjusted quickly according to the volume of production.

Fixed production costs (also referred to as sunk costs) include facility rent or mortgage, monthly payments on machinery, facility and equipment depreciation, but also some labor costs when there are long-term service contracts with set fees in place.

Variable production costs, however, include expenses that can quickly be adjusted if the volume of production changes, e.g. expenses for inputs such as raw materials and fuel, utilities like electricity, heating, and water, as well as labor and shipping costs.

Analyzing your fixed and variable costs is important to understand what role they play in the total costs of your operation and in your bottom line. Differentiating between the two costs also allows you to predict how your business could react in the case of market changes.

Total cost, average cost, and marginal cost

Adding the fixed and variable production costs together gives you the total cost, which you can then use to calculate the average cost.

Average cost (also called unit cost) refers to the costs accrued with manufacturing one unit of a product. This is calculated by taking the total cost (fixed costs + variable costs) and dividing it by the total number of units produced. Companies can use the unit cost to price their products.

Marginal cost, however, refers to the incremental cost of manufacturing extra units at any given time. As fixed costs stay the same most of the time, marginal cost is mostly influenced by changes in variable costs. It is calculated by dividing the total change in costs by the change in quantity. The marginal cost can then be used to decide whether increasing production capacity would be profitable or not.

Marginal Cost = Change in Costs / Change in Quantity

Example

Let’s say a bicycle manufacturer produced 400 bicycles which incurred $65,000 in variable costs, along with the fixed costs of $15,000 per month. That means the total cost of production is $80,000. The average production cost per unit would then be $80,000 / 400 = $200.

As a production capacity increase would only affect variable costs, the average variable cost per unit in this scenario would be $65,000/400 = $162.50. That means producing one more bicycle would cost an extra $162.50, which is noticeably lower than the average cost.

Let’s say the manufacturer is thinking about producing 500 units next month. Thanks to ordering more materials, the supplier offers the company a discount. This leaves the company with a projected total cost of $95,000. The marginal cost in that case would be:

Change in Costs = $95,000 – $80,000 = $15,000

Change in Quantity = 500 – 400 = 100

Marginal Cost = $15,000 / 100 = $150

This means that it would be economically viable to produce more bicycles, as long as the demand is there. At some point, however, the marginal cost curve will turn upward and each additional unit becomes more expensive to produce than the previous one. This means you can either raise your selling price or reduce the volume of production in order to control costs.

Accounting costs vs. economic costs

Accounting costs are what end up on the balance sheet of the company – they comprise all of the aforementioned costs, fixed or variable. There is a broader cost category, however, called economic costs.

Economic costs include accounting costs (also called explicit costs), but also take opportunity costs (implicit costs) into account. That means business decisions that have been taken are weighed against their alternatives and the cost of what has been given up is compared to the benefits gained from the decision.

For example, your company might have extra resources for either opening a new production line or investing in a recreation area for your shop floor employees. The major benefit of a new production line would be a production output increase of 10%, which would ideally mean a 10% increase in revenue, but also an increase in labor, material, and overhead costs. Investing in employee recreation, however, would reduce staff turnover and increase worker motivation so that less money would be spent on hiring and the throughput of the existing production lines would increase. This means that even though opening a new production line could seem like a more logical step, the better option could be to invest in an employee recreation area.

Key takeaways

• When a manufacturer thinks about production costs, they most often mean the total manufacturing cost that includes direct material costs, direct labor costs, and manufacturing overhead.
• The total manufacturing cost can also be used to calculate the cost of goods manufactured and the cost of goods sold.
• There are also other types of production costs that can be very useful in a growing manufacturing business.
• Fixed costs are costs that do not change according to production volume, these include rent, mortgage, monthly machinery payments, etc.
• Variable costs, however, change depending on how much you produce. These include material costs, utilities, labor costs, etc.
• Differentiating between fixed and variable costs can help companies predict how a change in the market could affect their costs.
• Fixed and variable costs make up the total cost, which can then be used to calculate the average unit cost. The unit cost is key to determining the selling price of your products.
• Marginal cost is used to determine what it would cost to produce extra units. This can be helpful when trying to find an optimal volume of production.
• While accounting costs are the costs that end up on the balance sheet of a company, economic costs also include implicit costs such as the cost of opportunity. Economic costs are used to create what-if scenarios to weigh the pros and cons of several different courses of action.

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