Manufacturing and Inventory Management Software
Is knowing the total cost manufacturing cost important to you?
As a manufacturer, this is a cost you must know. By taking the time to calculate it and understanding it will pay long term dividends.
You do not want to have gaps in your financial statements. Accurately calculate all your costs so that you can make informed decisions.
By knowing the manufacturing costs, you can get visibility into your production processes. Maybe there is an opportunity to lean-up your production by cutting down on some costs or even trying other things such as subcontracting certain operations to reduce the overall cost.
So, how do you get started with this calculation? What are your additional costs besides the cost of your raw materials? Why do you need to know these costs? How can you reduce the extra costs as much as possible?
We have answers to all these questions below, so keep reading!
Total manufacturing cost is the sum of the raw materials and the resources (Labor and Overhead) spent in creating your finished product.
It is essential to know what each part of your production process costs you. It would be best if you also split your costs into the appropriate areas to get an overview of your costs.
Here are the three key areas:
Each added together will create a total manufacturing cost.
Understanding total manufacturing costs is an important step for businesses that want to improve manufacturing productivity.
Every business cost related to production activities is classified as ‘direct’ or ‘indirect’.
Direct costs are anything you spend on the manufacturing process. This is the raw materials and labor costs (staff wages) involved.
Typically with direct costs, they have to play a physical role in the production to be considered a direct cost.
Some materials and labor are indirect costs and you must distinguish between the two types so that you are not counting these costs twice.
Further Reading: The ultimate guide to raw material inventory management
These are costs in your manufacturing that don't come from the raw materials and labor used directly in your manufacturing process. This includes everything from utility bills to equipment maintenance and depreciation of equipment.
Here is a small list of indirect manufacturing costs to consider:
Direct materials are items used to create a finished product. This includes raw materials, components, parts and packaging used in the production or manufacturing process of finished goods.
If you are a juice manufacturer, for example, the cost of the fruits and vegetables is a direct cost. And for a furniture manufacturer, their direct material costs would include the lumber, paint and nuts / bolts used.
Also very important to consider is the costs incurred in purchasing these materials such as packaging, freight and storage costs, taxes, etc.
To calculate direct material costs, add the materials value at the beginning of the time period to the materials purchased during your time period and subtract the ending materials value for the period.
Total Direct Material Costs = Beginning Direct Materials Value + Direct Material Purchase Costs - Ending Materials Value
For Example, Scott is a protein manufacturer who produces 5lb protein bags in 3 flavors and he has $10,000 worth of raw ingredients at the beginning of the period, purchased an additional $5,000 worth of raw ingredients and at the end of the period has $3,000 worth of raw ingredients.
Total Direct Materials Costs = $10,000 + $5,000 - $3,000 = $12,000
Materials costs are not fixed costs, they vary depending on your production activity, inflation and other factors. It will rise as you increase production activity and decrease when activity decreases.
Since these costs vary, calculating these costs is the first step in reducing your cost.
Typically material costs account for the majority of a company's manufacturing expenses so how can you as a business reduce these expenses without affecting the quality of your final product? Here are some common ways manufacturers do this.
Products can be manufactured using a variety of different materials, depending on your market requirements and manufacturing practices. Technology is constantly improving older materials and creating new ones, prices move up and down due to political agendas as much as supply and demand and processing methods changing.
When considering a change in your materials, make sure to consider all these factors. For example, alternative raw materials which produce the same or similar end product, but which are more economically sustainable. Consider, for instance, ways you may be able to recycle materials into new products or use substitute materials which are less expensive. These small changes can drastically help you reduce manufacturing costs.
Custom products cost more than mass produced products because a custom product typically requires an additional step in the production process, increasing the expense.
Examine your market and why your customers buy your products. Do they buy it for low cost, high quality, branding or another reason? For Example, customers buy your product because of its high quality then focus on improving quality over the idea of adding more product features. By determining what is important to your customers and market, you can selectively choose what is not important and reduce that cost.
If your cost of raw ingredients is low, you may not worry about the excess material that is being wasted compared to the cost of labor. Overtime, prices of materials and labor may shift and now your excessive waste is more costlier than before. It’s important to modify your production process to utilize raw ingredients efficiently while reducing excessive waste and its associated costs.
Overproduction is another primary cause of waste. Producing too much stock in advance means you are spending a lot on direct materials costs and you will also incur the cost of holding this excess inventory. If you are a business that deals with perishable goods then overproducing and not being able to sell off your inventory can lead to waste.
Look for alternative suppliers that can provide similar products. Figure out how different these products are and if these features will benefit you or your customers. Is it worth it, for example, to have JIT (Just In Time) delivery vs buying in bulk ahead of time and incurring costs to hold it in your warehouse.
Build better supplier relationships by implementing service level agreements which aid transparency, support product delivery schedules and help to maintain consistent materials quality.
Direct labor cost is wages that are incurred in order to produce goods or provide service to your customers. This can include workers on the assembly lines or employees that use machinery and equipment to produce the final product - processing team, quality assurance team, delivery team and any member that is responsible for the production and delivery of the product.
The total amount of direct labor cost is more than wages paid. It also includes payroll taxes, insurance, workers compensation, holiday pay, and other company benefits.
Clearly, understanding how to calculate direct labor cost is a must for any production business. But what does it look like?
The direct hourly rate is the sum of all wages, plus payroll taxes and benefits for the period. Divide this by the number of working hours in the pay period.
Direct Average Labor Hourly Rate = [Wages + Payroll Taxes + Fringe Benefit + Taxes] / [Total number of hours worked in the pay period by the employees]
This measures the number of direct labor hours it takes to produce one unit. To calculate this, divide the number of working hours during the time period by the number of units produced.
Direct Labor Hours Per Unit = [Labor Hours in the pay period ] / [Units Produced]
Now we know how to calculate the average hourly labor rate per employee and the direct labor hours to make one unit, we can calculate the direct labor cost per unit.
Direct Labor Cost Per Unit = [Direct Average Labor Hourly Rate] x [Direct Average Labor Hours]
Scott runs a food production company where his company produces bulk 5lb protein bags in 3 flavors Chocolate, Vanilla and Cookies & Cream. He wants to see if he is making enough profit for the business with raw materials costs going up due to inflation and supply chain issues and increased labor costs due to the pandemic. He wants to know the direct labor cost of each 5lb bag to see whether he needs to adjust his prices.
Scott has 5 employees, 2 shop floor workers and 1 production specialist.
The shop floor employees who earn $20 per hour, their payroll taxes are $4 per hour and their benefits (Insurance + Company Benefits) cost $3 per hour.
The production specialist earns $30 per hour, their payroll taxes are $5 per hour and their benefits (Insurance + Company Benefits) cost $5 per hour.
All the employees work 40 hours per week.
Total labor costs for the two shop floor employees are ($20 + $4 + $3) x 40 Hours X 2 Employees = $2,160 / Week
Total labor costs for the specialist is ($30 + $5 + $5) x 40 Hours X 1 Employee = $1,600 / Week
Total cost of the employees per week = $2,160 + $1,600 = $3,760
Total hours worked weekly by all employees = 40 Hours x 3 Employees = 120 Hours
Therefore Scott's Direct Average Labor Hourly Rate = $3,760 / 120 Hours = $31.33
Scott's team makes 900 5lb protein bags per week. The team works 120 hours per week.
Direct Labor Hours Per Unit = 120 Hours / 900 Units = 0.13 Hours Per Unit
Scott knows that his direct hourly rate is $31.33 and his direct labor hour per unit is 0.1333 Hour / Unit
Direct Labor Cost Per Unit = $31.33 x 0.1333 Hour / Unit = $4.18
Now Scott knows it costs him $4.18 in Labor per 5lb Protein bag. In the previous section we learned the weekly raw ingredient cost of $12,000 per week and we know that Scott’s team makes 900 units per week.
Materials Cost Per Unit = $12,000 / 900 Unit = $13.33
So to sum it up Total cost of production without knowing the manufacturing indirect overhead costs are: $13.33 Materials Cost + $4.18 Labor Cost to get, $17.51 per unit. This is also known as the average cost of making the product.
Now let's look at overhead costs to get the accurate product costs.
Manufacturing overhead costs is an indirect cost and typically includes:
As an indirect cost, manufacturing overhead is challenging to assign overhead costs to each of the units produced. For example, rent and insurance on the manufacturing facility is based on the assets, not on the number of units produced. These indirect costs need to be divided and allocated to the units manufactured.
To get the monthly manufacturing overhead, identify the overhead costs at a monthly rate and sum them up. Then also find the units sold per month.
Manufacturing Overhead Per Unit = $30,000 / 1000 Units Sold = $30.00 Cost / Unit
Average Production Cost Per Unit = $30 Overhead Cost / Unit + 13.33 Material Cost / Unit + $4.18 Labor Cost / Unit = $47.51
If you sell each unit for $79.99
Total Sales = $79.99 * 1000 Units Sold = $79,990 Sales Per Month
Manufacturing Overhead Rate = [Overhead Costs / Sales] x 100
Manufacturing Overhead Rate = [$30,000 / $79,990] x 100 = 37.50%
A low manufacturing overhead rate indicates that your manufacturing operations are utilizing resources efficiently and effectively. The Harvard Business Review studied the challenge of reducing factory costs and concluded that “across the spectrum of U.S. industry, manufacturing overhead averages 35% of production costs.”
Overhead manufacturing costs directly impact a business’s balance sheet and income statement so it’s important to track and allocate these expenses. Allocating overhead helps you to identify areas to improve efficiency and reduce costs. It is important for pricing decisions because by incorporating indirect costs into pricing, you can cover costs by effectively pricing products to improve profitability.
For Example, if Scott wanted to keep lower his Overhead rate to the nation average of 35% he can increase his sale prices by $5-6 or reduce his overhead monthly costs by $2,000 per month.
Total manufacturing cost differs from the cost of goods sold, where the total manufacturing cost is the total expenses related to creating a finished product, COGS is the cost of finished inventory sold within the reporting period.
Calculating total manufacturing cost allows manufacturers to establish the amount they are spending to make goods. Businesses can use this metric to monitor the percentage of revenue that goes into manufacturing costs. By reducing total manufacturing costs, businesses become more productive and profitable.
Keep track of everything and run the actual total costs against the estimated total costs. See if they align at the end of a set period. This will help you see if you are underestimating or overestimating your production costs.
One thing to keep in mind: if you want to scale your production, you need to consider that not every production costs scale at the same rate.
Knowing and anticipating these changes will help you stay on top of your production costs and keep your business profitable.