Production Costs: Paramount to Business Success

Production costs, manufacturing costs, break even, full absorption, etc. These terms can stress a small business owner. Some of these terms are interchangeable. Some have only slight difference. These terms ultimately get the owner to the same place—knowing the true costs associated with production of your product. This knowledge can mean the difference between a profitable or a distressed business.

In this post, we will examine what production costs are, the importance of understanding these costs, and simple examples of the calculation.

What are production costs?

Production costs are incurred by a business and are directly linked to revenue production. These costs include direct material, direct labor, and overhead.

Why are they important?

Understanding the concept of production costs is paramount for any business owner to succeed. These costs are more than just direct materials and direct labor to make a product. These costs include indirect costs associated with production.

When making a product or even providing a service, the company will incur expenses outside of the direct costs. These costs range from rent on the building to the accountant’s salary who tracks the costs. Anything necessary to track, store, secure, insure inventory are generally considered part of costs.

These costs give owners and management the ability to calculate an accurate breakeven point. The breakeven point is critical for cash flow purposes. Accurately calculated costs allow management to analyze operations on a more granular level. From this analysis management can determine:

- - What is the effect to the breakeven when production increases?
  - What is the effect on operations with a decrease in production?
  - Where are the bottlenecks?
  - What is the cash efficiency by product?

Without an understanding of costs, a company will be blind as to the proper sale price of their product. The calculation gives management a powerful tool to be able to succeed.

How to Calculate Production Costs

Production costs are made up of three primary areas. They are:

- - Direct material
  - Direct labor
  - Overhead or indirect costs

The first two items—direct material and direct labor—are fairly straight forward. These represent the actual cost of raw material and the cost of labor associated with assembly. The third primary area is the more complicated to calculate, and that is overhead allocation.

Overhead, or indirect cost, adds a level of complexity. The company needs to determine what indirect costs are necessary to produce inventory. Typical costs to consider are:

- - Factory utilities
  - Depreciation on factory assets
  - Rent on the factory
  - Salaries for factory management, equipment maintenance, materials handling, etc.

Once these costs are determined, the company then needs to implement a method for allocating costs to the products. The two most common allocation methods are:

Standard Costing – Standard costing allows management to set an overhead rate to be used to allocate costs throughout the year. The rate is usually determined by taking all indirect costs and dividing by an allocation base, such as direct labor hours. This rate is then used for all production throughout the year. This is the simplest form of allocating overhead.

The draw back to this type of costing is there can be over applied or under applied overhead at the end of the year. If the over/under applied overhead is material, than the breakeven calculation will not be correct. This type of costing assumes all products will incur overhead uniformly. Sometimes referred to as ‘peanut-butter’ costing as it spreads the cost regardless of actual indirect costs needed for each product.

Activity Based Costing (ABC)- ABC attaches costs to activities rather than physical goods. A cost pool is set up for each major activity. The costs in each pool are assigned based on a cost driver specific to that activity. This causes the indirect costs to be allocated to activities, which reduces any spreading affect.

For example, assume a printing press sells 1 ton of paper to two different customers. One receives a 4 rolls of 500lb paper and one receives 100 boxes of 20lb of copy paper. The time for handling the 4 rolls would be less than the time for handling 100 boxes. Under ABC, the major activity of handling would have its own cost pool. Using ABC, the overhead allocated to the handling activity would be less for the 4 rolls than it would be for the 100 boxes. Each product would receive a portion of overhead. However, the allocation would be based on the activity necessary for the product.

This method of allocation gives management an accurate picture of the drivers of the overhead, based on product.

There are other methods used in allocating overhead, such as life-cycle costing, operating costing, backflush costing, etc. Regardless of the method used, the overall premise is to make sure all costs are properly assigned to the product or service being delivered.

Example of Production Costs – Standard

Widget, LLC produced 1,000 trinkets in their lasts production run. The raw material used per trinket is $3. The assemblers can assemble 25 trinkets in an hour at $20/per hour.

The direct costs for this production run would be:

Now assume Widget had the following overhead costs in the prior year and they have decided that direct labor hours are the proper allocation base. The total overhead rate to be used in the current year is as follows

The total costs for this product run is as follows:

As you can see from the example above, had Widget, LLC not allocated overhead costs to each of their trinkets, then they could be in danger of selling their inventory at a price that does not cover all costs.

Tips and Recommendations

- - Understand the actual costs necessary for production. Overhead allocation can mean the difference between covering production costs or going out of business.
  - Continuously analyze and refine allocations. The more refined and accurate the allocation, the more flexibility management and ownership can be with the sales price.
  - Utilize the costs to identify backlogs and enhance cash conversion efficiency.