Product Cost
Product cost refers to the total costs associated with creating a product. These costs are recorded as an asset (inventory) until the goods are sold, at which point it becomes cost of goods sold (COGS) on the income statement.
There are three main types of costs that typically make up product cost:
- Direct Materials: These are the raw materials used in the creation of a product. For instance, in the manufacturing of a car, this could include steel, rubber, glass, etc.
- Direct Labor: These are the wages paid to the employees who are directly involved in the manufacturing process. For example, the wages of the assembly line workers in a car factory would be considered direct labor costs.
- Manufacturing Overhead: These are the indirect costs associated with producing a product. They include things like factory utilities, depreciation on factory equipment, factory supervisor salaries, etc. Basically, they include any factory costs that are not direct materials or direct labor.
It’s important for businesses to accurately calculate product cost as it affects the pricing of products, profitability, and inventory valuation. Misestimating product cost can lead to setting the wrong selling price, which can either lead to losses if the price is set too low, or loss of competitiveness if the price is set too high.
Example of Product Cost
Let’s take the example of a company that manufactures wooden tables:
- Direct Materials: The company uses $50 worth of lumber and $10 worth of screws, brackets, and other hardware to manufacture each table. So, the direct material cost per table is $60.
- Direct Labor: Each table requires 2 hours to manufacture, and the company pays its factory workers $15 per hour. So, the direct labor cost per table is $30 (2 hours x $15 per hour).
- Manufacturing Overhead: The company’s factory costs $10,000 per month to operate (including utilities, depreciation on factory equipment, and factory supervisor salaries), and they produce 1,000 tables per month. So, the manufacturing overhead allocated to each table is $10 ($10,000 per month ÷ 1,000 tables per month).
Adding all these costs together, the total product cost per table is $100 ($60 for direct materials + $30 for direct labor + $10 for manufacturing overhead).
Knowing this product cost, the company can then determine how to price its tables to cover these costs and achieve a desired profit margin. For example, if they want a profit margin of $20 per table, they might price their tables at $120 each.
