Product Costing in 7 Easy Steps

Product costing is a necessity not only for accountants but also for managers. Understanding the costs related to manufacturing your products gives you the chance to determine optimal selling prices and take steps toward cost reduction. Here is a simple guide to performing product costing.

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What is Product Costing?

Product costing is the process of calculating the costs incurred with manufacturing a single product. This total cost includes the consumption of raw materials and components, labor, and overhead allocated to a sole unit.

For accountants, product costing is essential for inventory valuation and for calculating the cost of goods sold. Managers, however, use product costing as a jumping-off point for deciding which products to manufacture as well as for pricing the manufactured products. After calculating the cost per unit, you can use various pricing methods to determine an optimal selling price for the product. The cost per unit also serves as a manufacturing performance metric to help keep tabs on production costs.

Types of manufacturing costs

Every business operation incurs both direct and indirect production costs. Direct costs are expenses directly related to manufacturing the product (raw materials, shop floor employees) while indirect costs are incurred with auxiliary activities, materials, and services, i.e. overhead.

In a manufacturing company, direct costs are made up of raw material costs, packaging costs, and factory floor employee salaries, i.e. of people and items that are directly involved in the manufacture of goods. Indirect or overhead costs, however, include indirect materials such as fastenings, glue, lubricants, etc.; indirect labor costs for supervisors, production planning, QA, and maintenance workers, and other manufacturing overhead expenses (rent, utilities, insurance, etc.).

Although there are several different ways to approach product costing, you can follow these seven basic steps in any situation.

Identify the cost object. If your company manufactures standard products, you can take a single product as the cost object. If you build custom products, then you can also use job costing to determine the costs related to a full order.
Track the direct costs of individual items. Simply add together all direct material and direct labor costs that go into making a particular product.
Pool together the overhead costs. These include indirect materials (lubricants, fasteners, and other goods used for manufacturing that are not tracked), indirect labor (production planning, maintenance, quality assurance and control, supervisors, shop floor janitors, etc.), and manufacturing overhead (rent, utilities, insurance, depreciation, etc.).
Pick the overhead cost allocation base. You may just pool together the indirect costs and apply it evenly over all your products. But for better accuracy and decision-making, you should allocate the overhead according to how resource-heavy a product is. In this case, more overhead is allocated to those items that take more time or materials to make, and less overhead is allocated to those products that consume less. Generally, either m