This is one of the most important questions a company needs to understand. It is not the only question, but is certainly one of the most important. Understanding the cost helps identify what products are making or losing money and what can be done to improve margins. Let us take a look at how to determine product cost.
In my first job, a senior manager explained product cost in a simple way. He held a pencil in his hand and said there are three things needed to make this pencil. The first is materials; the wood, lead, eraser and metal to hold the eraser. The second is labor; the workers to run the machines that assemble the pencil. And the third is Overhead; the building, the machines and everything else needed to produce the pencil.
This is still the example I use today to explain product cost to people. The concept is so easy. Execution is so complex.
Let's look at each of these items and how they make up the product cost.
Items normally NOT INCLUDED in Overhead:
Once the overhead costs that are included are established, how is the overhead allocated (charged) to each product? It is a simple math equation. The cost of all the expenses is divided by the total amount of labor time.
· Total Overhead expense / Total Direct Labor hours = Overhead per hour
· Production Time x Overhead per hour = Product Overhead costs
Below is an example to illustrate.
The total overhead expenses for the month at the Widget Plant were $1 million and the total number of direct labor hours for the month were 10,000. It takes two and a half hours to produce the product.
· $1,000,000 / 10,000 = $100 per hour
· 2.5 hours x $100 per hour = $250
· Each part will be allocated $250 for overhead
To carry the example to completion, let’s include the material and overhead.
Material Cost
· The widget material purchased for this product cost $1,750,000
· The plant produced 17,500 widgets
· Cost of material used / units produced = material cost
· $175,000,000 / 17,500 units = $100 per unit
Labor Cost
· Each widget required 2.5 hours of labor
· The average worker is paid $55 per hour (including wages and benefits)
· Direct labor hours x labor rate = labor cost
· 2.5 hours x $55 = $137.50 per unit
Total Widget Product Cost
· $100.00 Material Cost
· $137.50 Labor Costs
· $250.00 Overhead
· $487.50 Widget unit cost
Hopefully, this provides a basic understanding of how to understand the cost of the product you are selling. In a future blog we will cover how to understand the costs of a service organization. (Hint: it is not too different).
In my first job, a senior manager explained product cost in a simple way. He held a pencil in his hand and said there are three things needed to make this pencil. The first is materials; the wood, lead, eraser and metal to hold the eraser. The second is labor; the workers to run the machines that assemble the pencil. And the third is Overhead; the building, the machines and everything else needed to produce the pencil.
This is still the example I use today to explain product cost to people. The concept is so easy. Execution is so complex.
Let's look at each of these items and how they make up the product cost.
- Material is the easiest cost to calculate. The Bill Of Materials (BOM) lists every part in the product. The amount and cost of the wood, lead, eraser and metal are known. Add up the costs of all the materials and you know the material cost.
- Labor is the next easiest cost to calculate. The procedure to make the product is studied to determine how much time is required to make one unit. Then multiply the time to make the part by the labor cost of the people making it. Sounds straight forward, and sometimes it is, but usually not.
- Does each worker perform the process in exactly the same amount of time? Of course not.
- How is the cost of the person setting up the machine before any parts are produced charged to the part cost? It takes the same amount of time to set the machine to run one part as it does to set up for 5000 parts. To make it more complex, customer demand requires different amounts to be run each time.
- The most difficult cost to allocate is Overhead. What costs are included? Which are excluded and why? How are the costs charged to the product? To be honest, there is some science and some art to answering these questions. The answer is based on the individual situation and makes it imperative to understand the methodology at your company. But there are some basics that will assist you.
Items normally NOT INCLUDED in Overhead:
- Marketing and Advertising
- Research and Development
- General and Administrative costs (e.g. Finance, HR, General Management)
- Inventory carrying costs
- Shipping costs
- Building costs (e.g. rent or depreciation)
- Machine rent or depreciation
- Consumables (oils, cutting tools, papers, etc.…) used in production
- Machine maintenance
Once the overhead costs that are included are established, how is the overhead allocated (charged) to each product? It is a simple math equation. The cost of all the expenses is divided by the total amount of labor time.
· Total Overhead expense / Total Direct Labor hours = Overhead per hour
· Production Time x Overhead per hour = Product Overhead costs
Below is an example to illustrate.
The total overhead expenses for the month at the Widget Plant were $1 million and the total number of direct labor hours for the month were 10,000. It takes two and a half hours to produce the product.
· $1,000,000 / 10,000 = $100 per hour
· 2.5 hours x $100 per hour = $250
· Each part will be allocated $250 for overhead
To carry the example to completion, let’s include the material and overhead.
Material Cost
· The widget material purchased for this product cost $1,750,000
· The plant produced 17,500 widgets
· Cost of material used / units produced = material cost
· $175,000,000 / 17,500 units = $100 per unit
Labor Cost
· Each widget required 2.5 hours of labor
· The average worker is paid $55 per hour (including wages and benefits)
· Direct labor hours x labor rate = labor cost
· 2.5 hours x $55 = $137.50 per unit
Total Widget Product Cost
· $100.00 Material Cost
· $137.50 Labor Costs
· $250.00 Overhead
· $487.50 Widget unit cost
Hopefully, this provides a basic understanding of how to understand the cost of the product you are selling. In a future blog we will cover how to understand the costs of a service organization. (Hint: it is not too different).
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