Definition of Product Cost
Product cost is the cost incurred in creating a product or delivering a service for the customer. This cost can include direct labor costs, material costs, overheads, etc. The cost of goods sold in the income statement can be one of the components of the product costs.
It costs to create a product or deliver a service to the customers. Below can be included in the product cost:
- Direct Labor: Direct labor is the effort of employees to create the product or deliver the service. The direct labor cost can include the employees’ salaries or other benefits such as medical or meal allowance. For example, a carpenter’s salary for creating a table from wood can come under the cost of direct labor.
- Direct Material: Raw material or inventory used to create the final product can come under this category. For example, the cost of wood and nails needed to create the table will come under Direct material cost.
- Factory Overhead: Company will need the space/ facilities or other support staff to create the product. The cost of these will come under overhead. This kind of cost is an indirect cost. For example, overhead costs can include electricity costs or the salary of guard/security staff.
Out of the above-given costs, Direct labor and direct material come under direct costs, while factory overload comes under indirect costs in a company’s income statement. Since this cost is incurred upfront, the revenue for the same comes over the period; hence as per GAAP and IFRS, this cost is capitalized over the period.
Example of Product Cost
Suppose a carpenter has received a firm’s orders to prepare 1000 tables. To manufacture the tables, he needs to have raw materials and man-hours, and some other equipment. These costs will be considered the cost incurred to create the tables, hence coming under product costs.
He will need wood and nails in raw material and some other small items. In addition, he will need man-hours to create the table. Also, he will need electricity for his space and other overhead items.
Product Unit Cost = (Direct Materials + Labor+ Overhead+ Other Costs)/Number of Units
Below is the table for the costs, product, and unit costs.
|Total Product Costs||$13,000|
|Number of Units||1,000|
|Product Unit Cost||$13.00|
Hence total Product cost for creating 1,000 tables is $13,000, and the unit product cost is $13.
Types of Product Cost
Different types are mentioned below:
- Direct Material/Inventory: The raw material used by direct labor with the help of overheads in creating the product will come under this category. For example, the raw material for making a shirt can be fabric, thread, etc.
- Direct Labor: Employees who create or produce the final products can come under this category. The direct labor cost can include their salary and other benefits such as medical or food expenses.
- Overheads: These are indirect expenses that are incurred in creating the product or delivering the services. It is hard to trace the overhead cost for a specific product, and it can be allocated between different products based on some methodologies. Overheads can include indirect material or indirect labor. For example, a security guard is not directly involved in creating the product, but his cost is allocated to the product costs.
Some of the advantages are mentioned below:
- Analysis of production costs can offer a great deal of accuracy in estimating project expenses and variable costing.
- Tracking helps in analyzing the project and product-based profit and loss tracking.
- Senior management can make the appropriate decision by analyzing the product costs. This helps in deciding on pricing and margin.
- When a company is planning to allocate some budget for a new project, then analysis of product costs helps design the business case for the project.
Some of the disadvantages are mentioned below:
- First, there are chances of errors in calculating product costs.
- Tracking indirect costs such as factory overhead can be difficult and provide wrong analysis, which may lead to wrong pricing decisions.
It helps analyze and get the product and project costs that the company has incurred. Unit product costs can be found based on the number of units produced. With this, management can decide on the margin and then make appropriate pricing decisions for the same product.
This is a guide to Product Cost. Here we also discuss the definition, types of product costs, and advantages and disadvantages. You may also have a look at the following articles to learn more –