Calculating the Final Cost of Your Products or Services
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Production Costs
Production costs are costs that can be directly or indirectly associated with the production or delivery of products or services. They include the material you purchase to make your products, the wages, taxes, and fringe benefits for the employees involved in producing the goods you sell, the shipping costs to get the product to your customer, and any other expenses directly related to the manufacture of your products.
Example 1
You are in the shipping business. Your production costs would include the rent and utility expenses for warehouse space, the wages paid to the supervisor overseeing packing and shipping, packing material, trucking, and air freight expenses related to getting the product to its destination.
Example 2
You run a pest control business. You must purchase chemicals, sprayers, and other tools, use gas on a truck to get to your customers, and wear protective clothing—all these are production costs.
Example 3
You run a hair salon. Your costs include the rent and utilities (water, electricity) for the salon, wages paid to staff directly working with customers, and the cost of shampoos, conditioners, and other hair products.
Direct production costs
Production costs that can be directly allocated to each unit are known as direct production costs. Examples of direct production costs include the wood used to produce a chair and the hourly salary of your pest control professional.
Indirect production costs
Production costs that cannot be directly allocated to individual units are called indirect production costs. Examples include the salary of a warehouse supervisor and the rent of the building where your factory is located.
To calculate the final individual cost of each unit of product or service your company produces, you need to consider direct and indirect production costs.
Direct production costs are easy to assign to individual units. If, hypothetically, producing a chair takes 3 pounds of wood ($15), 20 nails ($1), and half an hour of factory worker time ($8), the direct production cost for this chair is 15+1+8 = $24.
Indirect production costs must be prorated and assigned to individual units to calculate the final cost per unit. For example, if the salary of the factory supervisor was $5000 during a given month in which 10,000 chairs were produced, $0.5 of the supervisor’s cost should be assigned to the cost of each chair.