Production Cost Formula

What is Production Cost Formula?

The production cost formula is composed of costs that the business or a company incurs in making finished goods or delivering specific services and includes typically direct labor, general overhead expenses, direct material expenses, or expenses on raw materials and supplies expenses.

The production costs should be directly aligned with the revenue generation of the business. The manufacturing business typically has raw materials costs and labor costs. In contrast, typical service industry is composed of technical labor developing a specific service and material costs incurred in delivering such services to the clients. Production cost formula is generally used in managerial accounting to segregate costs to direct and indirect costs.

The production cost formula can be expressed as follows: –

Production Cost Formula = Direct Labor + Direct Material + Overhead Costs on Manufacturing
Production-Cost-Formula

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For eg:
Source: Production Cost Formula (wallstreetmojo.com)

Here,

Overhead costs on manufacturing= Indirect labor cost + Indirect Material cost + Other variable overhead costs.

Explanation of the Total Production Cost Formula

The calculation of Production Cost Equation can be done by using the following steps:

  1. Firstly, Determine the costs of direct material. Direct materials usually are composed of costs that are related to the procurement of raw materials and utilizing them to produce finished goods.

  2. Next, determine the costs of direct labor. The cost of direct labor is usually composed of costs on labor costs and costs on manpower that are in line with the process of production. Such costs generally consist of wages, salaries, and the benefits the business compensates to the labor for delivering finished goods or services.

  3. Next, Determine the costs of manufacturing. Such costs typically comprise of costs that can’t be attributed to the production process but indirectly impacts the production. Such costs can be bifurcated into indirect labor costs, indirect material costs, and variable costs on overhead.

  4. Next, add the resulting value in step 1, step 2, and step 3 to arrive at the cost of production.

Examples of Total Production Cost Formula (with Excel Template)

Let’s see some simple to advanced examples of Production Cost Equation to understand it better.

You can download this Production Cost Formula Excel Template here – Production Cost Formula Excel Template

Production Cost Formula – Example #1

Let us take the example of a manufacturing business that incurs $25,000 indirect labor. It incurs $30,000 in manufacturing overheads and $50,000 in the direct material costs. Help the business to determine the overall cost of production.

Use the given data for the calculation of production cost.

Production Cost Formula Example 1

Calculation of Production Cost can be done as follows:

Production Cost Formula Example 1.1
  • = $25,000 + $50,000 + $30,000

Production Cost will be  –

Example 1.2
  • Production Cost = $105,000

Therefore, the manufacturing business incurs a production cost of $105,000 when manufacturing finished goods.

Production Cost Formula – Example #2

Let us take the example of a business that specializes in the production of chairs. The raw material cost accounts for $75,000. The wages and salaries for the labor and workers account for $40,000. The company compensates benefits worth $3,000 to the labor for delivering exceptional service. The company additionally bears once in a while polishing costs on chairs of $30,000.

The business stores the finished chairs in a rented warehouse. They pay a rental amount of $20,000. They additionally pay $15,000 as the wage for security guards. Help the business of finished chairs to determine the cost of production.

Use the given data for the calculation of production cost.

Production Cost Formula Example 2

Calculation of Direct Labor using below formula can be done as follows,

Production Cost Formula Example 2.1

Direct labor = Wages of Production Workers + Benefits of the Production Workers

  • = $40,000 + $3,000
  • Direct Labor = $43,000

The direct material costsDirect Material CostsDirect Material Cost is the total cost incurred by the company in purchasing the raw material along with the cost of other components including packaging, freight and storage costs, taxes, etc. that are related directly to the manufacturing and production of various products of the company.read more correspond to the cost of raw material procured by the business, and it would be regarded as $75,000. The costs of manufacturing would account for the sum of polishing, rental expense, and wages for the security guards.

Calculation of Manufacturing Cost using below formula can be done as follows,

Example 2.2

Manufacturing Cost = Polishing Cost + Rental Expense+ Wage for Security Personnel

  • = $30,000 + $20,000 + $15,000
  • Manufacturing Cost = $65,000

Calculation of Production Cost can be done as follows:

Production Cost Formula Example 2.3
  • = $43,000 + $75,000 + $65,000
Example 2.4
  • Production Cost = $183,000

Therefore, the manufacturing business incurs a production cost of $183,000 when manufacturing chairs.

Relevance and Uses

The determination of production costs formula is necessary as well as critical for the business to ensure the profitability of the businessProfitability Of The BusinessProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more and sustainability. It also helps in the comparative analysis of the costs. Once the manufactured items reach the completion stage, the business records the value of the item as an asset in the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more until the time the product is sold to the customers.

It means that the production cost has to be initially capitalized and not expensed. Additionally, reporting the value of the end products could be termed as a sophisticated way to inform all the necessary stakeholders on the level of productivity that is being delivered.

Production cost formula usually is composed of direct materials, direct labor costsLabor CostsCost of labor is the remuneration paid in the form of wages and salaries to the employees. The allowances are sub-divided broadly into two categories- direct labor involved in the manufacturing process and indirect labor pertaining to all other processes.read more, and variable manufacturing overheads. The management accountants often transform these costs per unit basis. By doing so, they easily compare the per unit with the selling price the management is considering for the business and thereby determine the sustainability of the business.

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