What Are Production Costs?
Production or product costs refer to the costs incurred by a business from manufacturing a product or providing a service. Production costs can include a variety of expenses, such as labor, raw materials, consumable manufacturing supplies, and general overhead. Product costs may also include those incurred as part of the delivery of a service to a customer. Taxes levied by the government or royalties owed by natural resource-extraction companies also are treated as production costs.
Understanding Production Costs
For an expense to qualify as a production cost it must be directly connected to generating revenue for the company. Manufacturers carry production costs related to the raw materials and labor needed to create the product. Service industries carry production costs related to the labor required to implement the service and any materials costs involved in delivering the service.
Production incurs both direct costs and indirect costs. Direct costs for manufacturing an automobile, for example, would be materials like plastic and metal, as well as workers’ salaries. Indirect costs would include overhead such as rent, administrative salaries, and utility expenses.
Total product costs can be determined by adding together the total direct materials and labor costs as well as the total manufacturing overhead costs. To determine the product cost per unit of product, divide this sum by the number of units manufactured in the period covered by those costs.
Deriving Unit Costs for Product Pricing
Data like the “cost of production per unit” can help you set an appropriate sales price for the finished item. To arrive at the cost of production per unit, divide the production costs by the number of units produced. To break even, the sales price must cover the cost per unit. Prices that are greater than the cost per unit result in profits, whereas prices that are less than the cost per unit result in losses.
If the cost of producing a product exceeds the sale price, producers might first try to lower their production costs. If they could not, then producers might shut down operations, temporarily or permanently. For example, in December 2018, the selling price of a barrel of oil fell to $45 per barrel. If production costs of oil varied between $20 and $50 per barrel, then a cash negative situation would occur for producers with steep production costs. Those producers could choose to stop production until sale prices return to profitable levels.
Production Costs and Asset Recording
Once a product is finished, the company records the product’s value as an asset in its financial statements until the product is sold. Recording a finished product as an asset serves to fulfill the company’s reporting requirements, as well as inform shareholders.