Product Cost Definition
Product cost refers to all those costs which are incurred by the company in order to create the product of the company or deliver the services to the customers and the same is shown in the financial statement of the company for the period in which they become the part of the cost of the goods that are sold by the company.
Examples of Product cost mainly includes the following expenses:-
- Direct material (DM)
- Direct labor (DL)
- Factory overheads (FOH)
The cost to material and labor are the direct costs while the factory overheads are the indirect costs, all of which are required to create a finished good (or service) ready to sell from raw material.
As per GAAP and IFRS, the product costs are required to get capitalized as inventory in the balance sheet and should not be expensed in the statements of profit and loss because the expenditures to such costs generate benefits and value for future periods also.
Types of Product Costs
#1 – Direct Material
The raw materials that get transformed into a finished good by applying direct labor and factory overheads are referred to as direct material in cost accounting. Direct materials are those raw materials that can be easily identified and measured.
For example, an automobile manufacturing company typically requires plastic and metal to create a car. The amount of these resources can be easily counted or kept a record of. However, manufacturing a car also requires lubricants like oils and grease. Still, it is very difficult or insignificant to trace the low value of grease used in a particular vehicle hence referred to as indirect costs.
#2 – Direct Labor
Direct labors are the employees or the labor force that gets directly involved in producing or manufacturing finished goods from raw material. The direct labor costs are the salaries, wages, and benefits (like insurance) that are being paid to these labor forces against their services.
For example, the workers in an assembly line of an automobile factory that weld the metal, fix the screw apply oil and grease, and assembles pieces of metals and plastic into a car are direct labors. A particular employee to be classified as direct labor, it must be directly associated with a specific job. E.g., a secretary at a large automobile manufacturing company has to perform a variety of roles as and when required. Thus it gets difficult to quantify the amount of benefits created to assemble a car. Hence it is not direct labor.
#3 – Factory Overheads
The indirect expense related to manufacturing a finished product that cannot be directly traced is referred to as the factory or manufacturing overheads. In other words, overheads are that cost that is neither direct material nor direct labor. That is why overheads are referred to as an indirect cost that includes indirect labor and material costs.
- Indirect Material – The materials that get used in the manufacturing process but cannot be traced directly as a raw material are the indirect material. E.g., grease, oil, welding rods, glue, tape, cleaning supplies, etc. are all indirect materials. It is difficult as well as not cost-effective to determine the exact expense of indirect materials applied upon a single unit of a product.
- Indirect Labor – The workers or employees that are required for the smooth functioning of the production process but do not get directly involved in creating a finished product are referred to as indirect materials. E.g., quality assurance teams, security guards, supervisors, etc. in the manufacturing premise are classified as the indirect labor force, and the associated costs in the form of their salaries, wages, and other benefits are considered to be the indirect labor cost.
- Other Overheads – The factory overheads that falls under neither of the above two categories of factory overheads can be classified as other factory overheads. E.g., electricity expenses cannot be classified as material or labor. Similarly, costs like factory and equipment depreciation, insurance costs, property taxes on factory premises, factory rent or lease, the cost to utilities, etc.;
However, it is always better to calculate this cost per unit as it can help decide the appropriate sales price of the finished product. To determine this cost on a per unit basis, just divide this cost as calculated above by the number of units produced.
The sales price must be equal to or greater than the product cost per unit to avoid losses. If the sale price is equal, then it is a break-even situation, i.e., no profit, no loss, and the sales price are just covering the cost per unit. Sales price higher than the cost per unit results in gains.
Examples of Product Cost
Example #1 – Direct Material Purchase Budget
Direct Material Purchase Budget is required to create a product. The budget is required to calculate the amount of raw material that needs to be purchased for the production process and the estimation of the related costs.
Let’s say Raymond’s Pvt. Ltd, a small shirt manufacturing company, requires fabric, thread, and buttons. Consider the direct raw material to be just fabric while the requirements of the other two materials cannot be directly tracked and hence considered as indirect.
The company targets to produce the following number of shirts in each quarter of the year. Data collected from the production budget:-
Raymond management collects the following details to create its direct raw material budget:
- The cost of fabric is $80 per kilo. To manufacture a single shirt, the production department requires 500 grams (or 0.5 kg) of fabric.
- Management decides to store at least 10% of fabric for the following-quarter requirements of production.
- At the beginning of the year (January-1), the opening value of the stock of fabric was 210 kilos.
- Assume the desired value of ending inventory is 250 kilos at the end of the year (quarter 4)
Use the following two accounting equations will help to create the budget:-
Ending Note: The product cost related to direct materials can be determined through a budget that estimates the desired quantity of direct material required for a period and its related costs.
Example #2 – Direct Labor Budget
Direct Labor Budget is required to estimate the labor force requirements to produce the required units of goods as per the production budget. It calculates the cost based on labor hours and units produced per labor.
Assume that in Raymond’s Pvt. Ltd:
- The time required by a sewing machine operator to stitch a single piece of shirt is 0.5 hours—also, other laborers need 0.2 hrs per shirt for buttoning and finishing work.
- The company costs $50 per hour for a machine operator and a $15 per hour for other labors.
Ending Note: The Direct labor budget calculates the cost related to the labor force engaged in the production process and estimates the required labor force in numbers. Thus management can anticipate hiring needs and budget its costs.
Example #3 – Factory Overhead Budget
The budget that includes every cost related to the production process other than costs relates to direct material and direct labor. The final costs determined as per the overhead budget are not capitalized under the balance sheet but get expensed in the income statement as cost of goods sold.
Also, the overall cost determined under the overhead budget is converted into per unit terms to determine the cost of ending inventory. The ending inventory becomes a part of the balance sheet.
The budget to factory overhead cost of “Raymond’s Pvt Ltd” is presented in the following table:-
Ending Note: The factory overhead budget not only helped the management of the company to estimate the variable and fixed factory overheads separately but also helps in the determination of the required amount of cash to be disbursed to meet overhead expenses.
Example #4 – Budget
The management of Raymond’s has estimated its costs to direct material, direct labor, and factory overhead costs.
Now the most crucial step of the whole budgeting process is the determination of the overall and expected product cost per unit (shirt).
The management of the company adds all the components of cost together to reach the total product cost as presented below:-
Ending Note: The Product cost budget determines the overall expenses incurred by an entity to create a product on a periodical basis. The management can further calculate the cost per unit by dividing the estimated units to be produced as per the production budget.
By estimating the per unit cost, the entity can set an appropriate sales price and avoid the situations of under-pricing or over-pricing its products. Both product under-pricing and overpricing bring losses to the entity.
- Under-pricing means the entity is charging less than the product cost -> Losses.
- Overpricing leads customers to look for substitutes -> less demand -> Losses.
In our example, Raymond’s management determines all the components of product cost viz. direct material costs, direct labor costs, and factory overhead costs quarterly. With the help of this data, an overall cost is determined on both quarterly as well as annual basis.
An average product cost per shirt of $103 is then determined by dividing the total annual product cost of $2.23 million by annual production of 21720 shirts. The company should charge an amount higher than $103 per piece of its shirts.
This article has been a guide to what is Product Cost and its definition. Here we discuss how to calculate product costs using its formula along with practical examples. You can learn more about accounting from following articles –