Volatile and unstable global markets have widespread implications for manufacturing organizations. From rising energy costs to unexpected fluctuations in raw material costs, unforeseen obstacles are destabilizing supply chains and making it difficult for manufacturers to remain in the black.
Setting the right price for a product is the vital first step for any manufacturer. By applying the appropriate costing method for your business, you have the insight you need to determine whether to either absorb additional costs, find new ways to mitigate the expenses or pass price increases along to customers who are already reluctant to spend.
As a refresher, let's do a quick overview of manufacturing costs and the different costing methods.
Manufacturing Costs vs Production Costs: What’s the Difference?
Production costs are more comprehensive. They include the cost of manufacturing, plus the administrative and overhead costs that are necessary for having a viable business. These costs include insurance, record keeping, rent, marketing, and the salaries of employees involved with indirect or non-value-added labor.
Different Types of Costs:
Fixed: These are costs that do not change based on the number of items produced. For example, the depreciating value of a building or the price of a piece of equipment.
Variable: These costs are tied to a company’s level of production.
Operating costs: These are expenses incurred by an organization to maintain the product on a day to day basis.
Direct
In-direct
What’s The Difference Between Direct And Indirect Manufacturing Costs?
Many tasks are performed on the factory floor. Some tasks directly affect the fabrication of raw material into a finished or semi-finished product. Depending on the nature of the work being done, these tasks might involve cutting, stamping, gluing, sewing, welding, painting, drilling, molding, assembly, etc.
The list is long, but in every case, there is a specific action being performed by an operator on the workpiece, which adds value to that workpiece on its production journey.
There are other important, but indirect, manufacturing costs as well. This group includes material testing and measurement, storage, moving, cleaning, etc.
What are the factors affecting manufacturing costs?
Labor
Raw materials and components
Part complexity
Tooling
Volume
Precision & Quality Standards
Components & Elements of Total Cost
Prime Cost
This comprises direct material, direct wages, and direct expenses. It is also called basic cost, first cost, or flat cost. It can be defined as an aggregate of the price of the material consumed, the wages involved in production, and the direct expenses.
Prime cost = Direct material + Direct wages + Direct expenses
Direct Material Cost
The cost of raw materials used or consumed during a given period. To calculate the amount of raw material actually consumed during a given period, you add the opening stock and the amount of material purchased, and deduct the closing stock.
Material consumed = Material purchased + Opening stock of material – Closing stock of material
Factory Cost
This is made up of prime cost plus factory overhead, which includes indirect wages, indirect material and indirect expenses. Factory cost is also known as works cost, production cost, or manufacturing cost.
Factory cost = Prime cost + Factory overhead
Total Costs / Cost of Sales
This is the sum of the total cost of production and the total of selling and distribution overhead.
Total cost = Cost of goods sold + Selling and distribution overhead
Common Costing Methods
Standard Costing
Standard costing uses predetermined costs for materials and labor.
The advantage of this approach is that it is relatively easy to compute, making it the least time-consuming. It also provides a consistent basis that determines the cost of the product.
The disadvantages of standard costing are that it can be inaccurate if circumstances change significantly from the time the business established the standards. It can also be challenging to update the standards on a timely basis.
In addition, this method does not provide information about where cost variances occur.
ABC Method or Activity-Based Costing
Activity-based costing looks into the cost of each unit from mass production runs depending on the activities involved in making it.
In activity-based costing, overhead costs are assigned to activities rather than products.
Since ABC considers all manufacturing activities, it provides a very accurate picture of the unit cost.
The disadvantage of ABC is that it can be expensive to implement. With ABC, you need to identify all the activities involved in the production process. Once that’s done, you need to allocate a portion of these costs to every activity.
Process Costing
Process costing, a process referring to a particular stage in manufacturing, helps mass production manufacturers who only have slight variations in products track costs.
To calculate the cost of a process, you add up all the direct expenses incurred in that specific production stage — including the materials used and wages of your operators. You then allocate a portion of the indirect costs based on how much the process uses the resources.
Job Costing
Job costing tracks the direct and indirect costs for each project separately.
Job costing records all the direct costs. Then, allocates a portion of the indirect costs based on how much resources are consumed for the particular project.
Target Costing
Target costing is a method used to ensure that products are designed and priced to meet customer needs. You know what the sale price needs to be, and you work backward to calculate the cost of manufacturing it.
The obvious disadvantage of this method is controlling costs. Production can ultimately be more expensive than expected, and to preserve margins there could be a decrease in product quality and customer satisfaction, or a renegotiation of the contract.
Costing methods not covered here but worth a mention:
Mass production processes might use batch costing.
Large-scale construction projects may want to use contract costing or terminal costing.
Manufacturers producing similar products through a single process may opt for output costing.
Manufacturers producing products with several different parts may use multiple or composite costing.
Direct or Variable costing, only includes the variable production costs.
It’s important to choose the correct costing method for your industry and the products you manufacture. And once you’ve decided on the costing method to use, you will need to start gathering, recording, and analyzing cost data. That’s where an outsourced CFO with extensive experience in your industry can help. The CAS Group works with only a few industries, so their experience, network and resources help you gain data-driven financial insights and help you make more informed decisions as you grow.
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