Manufacturing cost terms to understand
You need to think beyond profit and loss to manufacturing costs such as the costs of materials, plus the cost to convert these materials into products.
This is necessary, for example, to understand how you should be pricing your product and how to achieve or exceed your set profit margins.
In a manufacturing business, there are some important terms you need to understand when it comes to calculating the costs of manufacturing your product, as well as the amount of inventory you hold.
Direct materials
Direct material (or raw material) inventory is a calculation of all the materials your manufacturing business is using to make your product – all the materials consumed or identified with your product.
Very often, this is listed in a bill of materials, which itemizes quantities and costs the materials used in your product.
In process manufacturing, such as food and beverage or chemicals, the bill of materials is known as a production recipe.
Direct labor costs
Direct labor is the value given to the labor that produces your goods, such as machine or assembly line operators.
Generally, this includes the cost of the regular hours, overtime, and relevant payroll taxes.
Manufacturing overheads
Along with direct materials and direct labor, you must include the cost of manufacturing overhead to ensure you get the right valuation when it comes to inventory and selling price.
Manufacturing overheads might include the costs for powering a factory’s equipment and personnel not directly involved in producing the product.
Work-in-process goods
As part of the manufacturing process, your business is likely to have items in production that have not yet been completed.
This will be an accumulation of the money you have spent on direct materials, direct labor costs, and manufacturing overheads on each work-in-process item in your inventory.
Finished goods
This is the cost associated with the goods you have completely ready to sell to your customers.
You would also add the cost of storing these finished goods and other associated expenses.
On your typical manufacturing balance sheet, you should have raw materials, work in process, and finished goods as part of your inventory calculation.
You will also want a periodic or perpetual inventory system to track how many products you have in your production line at any one time.
Production costing methods
When it comes to accounting, you need the right costing method to help you achieve higher profitability. Accounting software for manufacturers may offer different costing methods. Here are the ones that you should be aware of:
Standard costing
Standard costing is an accounting system where you establish standard rates for materials or labor used in production or inventory costing. By doing this, you can work out the labor and material costs to produce a single unit of your product.
Having these standards allows you to detect variances that can be analyzed, allowing trends to be spotted, and enabling you to make the right adjustments to pricing. If you are spending more on manufacturing the product than necessary, you will not meet your income targets.
Look at where the inefficiencies are in the production process and where the waste is coming from, adjusting the pricing if required. Standard costing is useful if you are making similar products or large quantities of a specific product.
Job costing
Job costing, also known as variable costing, is better if you manufacture to order or focus on a small amount of units. For example, this could include a custom-built machine or a small batch of products.
This accounting system allows you to work out the individual cost of manufacturing for a product and apply the right mark-up to get the project margin you desire.
You might look at each project in detail – down to costs, materials, and overhead. It is particularly popular in construction.
Activity-based costing
This is a costing method that differs from job costing in that it incorporates more indirect costs, such as resource consumption.
It can help you hone which products are profitable and spot opportunities to drive better results for your existing products.
This might be good if you have a complex product mix.
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