Production costs, also known as costs of goods manufactured, refer to the costs incurred by a company to manufacture a product. These costs include both direct and indirect expenses that are necessary to convert raw materials into finished goods.
Here are the primary components of production costs:
- Direct Materials: These are the raw materials that are directly involved in the manufacturing process and can be easily traced back to the final product. For instance, in the case of a furniture manufacturer, the wood used to make a table is a direct material.
- Direct Labor: This includes the wages paid to workers who are directly involved in the manufacturing process. For example, the wages paid to a carpenter who is making a table would be considered direct labor.
- Manufacturing Overhead: These are indirect costs that are associated with the manufacturing process but cannot be directly tied to a specific unit of output. They include costs such as factory rent, utilities, equipment depreciation, indirect labor (like maintenance staff or supervisors), and production supplies.
For a cost to be classified as a production cost, it must be necessary for the production of goods and used in the manufacturing process. Costs that are not involved in the manufacturing process, such as selling, general, and administrative expenses, are considered period costs and are not included in production costs.
Understanding the production costs is vital for a company as it helps in pricing the products, budgeting, financial analysis, and decision-making related to production activities. It also assists in determining the cost of goods sold on the income statement and the inventory valuation on the balance sheet.
Example of Production Costs
Let’s consider a hypothetical example of a company called “WoodCrafters” that produces wooden chairs.
- Direct Materials: The wood, screws, and paint used to produce the chairs are considered direct materials. Suppose the direct materials cost $50 per chair.
- Direct Labor: The wages paid to the craftsmen who are directly involved in the process of making the chairs are considered direct labor costs. Suppose this cost comes to $30 per chair.
- Manufacturing Overhead: The cost of utilities (like electricity for running the woodworking machines), depreciation on the machinery, the salary of the factory supervisor, and the rent for the factory are all examples of manufacturing overhead costs. These costs can’t be directly linked to a specific chair but are necessary for the production process. Let’s assume these overhead costs amount to $20 per chair when averaged out over all the chairs produced.
The total production cost per chair would therefore be the sum of these costs:
Production cost per chair = Direct materials + Direct labor + Manufacturing overhead
= $50 + $30 + $20
So, in this example, it costs WoodCrafters $100 to produce one chair. They would use this cost as the basis for setting the selling price of the chair, aiming to cover not only the production costs but also the selling and administrative expenses and to make a reasonable profit.
This is a simplified example. In real-life scenarios, calculating these costs might be more complex, especially the overhead costs, which often need to be allocated based on cost drivers using cost accounting techniques.