Product costs are called the costs involved in creating a product. This covers materials, labor, supplies for manufacture, and factory overhead. The labor cost required to supply a customer with a service is also taken into account as product cost. Service-related product costs should include compensation, payroll taxes, and benefits for employees.
As the overheads required by both the GAAP and the IFRS include the production costs, the cost of the product should be reported in financial statements. In order for overhead costs to be eliminated, a manager may alter the cost of the products when deciding short-term product prices. Otherwise, managers could decide to focus on the effect a product will have on a bottleneck operation, with the focus on the direct cost of materials and the time spent in the bottleneck operations.
The cost of the product is shown in the financial statements as it includes the overhead production, which both GAAP and IFRS require. However, when making short-term production and sales price decisions, management can change product costs so as to eliminate the overall component. Managers may also prefer focusing on the impact of a product on a bottleneck operation, which means that they focus mainly on the direct costs of a product’s materials and the time spent on bottlenecks.
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Categories of Product costs:
Product costs are the costs directly incurred from the manufacturing process. The three basic categories of product costs are detailed below:
Direct material costs are the costs of raw materials or parts that go directly into producing products. For example, if Company A is a toy manufacturer, an example of a direct material cost would be the plastic used to make the toys.
Direct labor costs are the wages, benefits, and insurance that are paid to employees who are directly involved in manufacturing and producing the goods – for example, workers on the assembly line or those who use the machinery to make the products.
Manufacturing overhead costs include direct factory-related costs that are incurred when producing a product, such as the cost of machinery and the cost to operate the machinery. Manufacturing overhead costs also include some indirect costs, such as the following:
- Indirect materials: Indirect materials are materials that are used in the production process but that are not directly traceable to the product. For example, glue, foil, tape, cleaning supplies, etc. are classified as indirect materials.
- Indirect labor: Indirect labor is the labor of those who are not directly involved in the production of the products. An example would be security guards, supervisors, and quality assurance workers in the factory. Their wages and benefits would be classified as indirect labor costs.
What is the Product Cost Formula?
The cost of a product on a unit basis is typically derived by compiling the costs associated with a batch of units that were produced as a group and dividing by the number of units manufactured. The calculation is:
Product unit cost = (Total direct labor + Total direct materials + Consumable supplies + Total allocated overhead) ÷ Total number of units
Product cost can be recorded as an inventory asset if the product has not yet been sold. It is charged to the cost of goods sold as soon as the product is sold, and appears as an expense on the income statement.
Example of Product Costs
Company A is a manufacturer of tables. Its product costs may include:
- Direct material: The cost of wood used to create the tables.
- Direct labor: The cost of wages and benefits for the carpenters to create the tables.
- Manufacturing overhead (indirect material): The cost of nails used to hold the tables together.
- Manufacturing overhead (indirect labor): The cost of wages and benefits for the security guards to overlook the manufacturing facility
- Manufacturing overhead (other): The cost of factory utilities.
Company A produced 1,000 tables. To produce 1,000 tables, the company incurred costs of:
- $12,000 on wood
- $2,000 on wages for carpenters and $500 on wages for security guards to overlook the manufacturing facility
- $100 for a bag of nails to hold the tables together
- $500 for factory rent and utilities
Total product costs: $12,000 (direct material) + $2,000 (direct labor) + $100 (indirect material) + $500 (indirect labor) + $500 (other costs) = $15,100. As this is the cost to produce 1,000 tables, the company has a per unit cost of $15.10 ($15,100 / 1,000 = $15.10).