Product Cost Definition
Product cost is defined as those costs that are incurred by a business entity in order to manufacture products and create services. Product cost examples mainly include 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 sale 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 product costs generate benefits and value for future periods also.
#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, but it is very difficult or insignificant to trace the low value of grease used in a particular car hence referred to as indirect costs.
#2 – Direct Labor
Direct labors are the employees or the labor force that gets directly involved to produce or manufacture finished goods from raw material. The direct labor costs are the salaries, wages and benefits (like insurance) that are being paid to these labor force against their services.
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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. In order to classify a particular employee as direct labor, it must be directly associated with a particular job. E.g. a secretary at large automobile manufacturing company has to perform a variety of jobs as and when required, thus it gets difficult to quantify the amount benefits created to assemble a car, hence is not direct labor.
#3 – Factory Overheads
The indirect costs related to manufacturing a finished product that cannot be directly traced are 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 cost 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.
How to Calculate Product Cost?
As we have discussed product cost includes direct material, direct labor, and factory overheads, therefore the calculation is:
However, it is always better to calculate product cost per unit as it can be helpful in deciding the appropriate sales price of the finished product. In order to determine product cost per unit, just divide the product 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 in order 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 is just covering the product cost per unit. Sales price greater than cost per unit results in profits.
Example of Product Cost
Assume Ford motors an automobile manufacturing company, manufactures 1200 cars on an annual basis. The actual production is 80% of the total production capacity of the manufacturing unit. The company was able to sell 1100 cars during the year and 100 cars remained unsold.
Ford requires 100 tons of metal @ $80 per kg and 20 tons of plastic @ $15 per kg. It also requires oil and grease with an overall cost of $25000. The company employs 10 workers at the assembly line at $35000 per month.
The following is the calculation of Product Cost formula –
The unsold 100 cars will increase the value of inventory in the balance sheet by $1.13 million. And for the cars that got sold; an amount of 12.48 million gets charged in the income statement as cost of goods sold.
This has been a guide to what is Product Cost and its definition. Here we discuss how to calculate product cost using its formula along with practical examples. You can learn more about accounting from following articles –