Product Costs

Accountants prepare product costs to serve two purposes: Decision making by managers, and external reporting. Decision making product costs approximate the marginal costs economists discuss, i.e., the unit costs includes the amount that total company costs increase when an additional unit is produced.

Product costs for external reporting in contrast include a portion of company costs that do not vary with units produced. These product costs include material costs, labor costs, and overhead costs.

Product Costs for Decision Making

In many manufacturing companies labor costs remain constant over wide ranges of output, so managers can consider labor a fixed cost for many short-term output decisions. In addition, most overhead costs change only when managers decide to restructure the company, so these costs do not change as output fluctuates from day to day. The only costs that definitely does go up and down with production is the material cost.

Estimating Material Cost for Products

If a company has a reliable bill of materials , the accountant can simply take the total material cost from it as an estimate of product cost. The following example illustrates a bill of materials for a paint sprayer. As this example shows, the bill of materials lists all the materials and purchased components that make up the product, their quantities, and the unit cost for each one. The summation of the material cost for each piece gives the total material cost for the finished product. Accountants usually refer to this cost as the unit variable cost.

The accountant will estimate the unit production cost for the paint sprayer at $310 because this equals the materials cost for the product.

Bill of Materials for a Paint Sprayer
Description Quantity Unit Cost Extended
Cost
Head casting
Block casting
Head bolts
Head gasket
Bushings
Piston casting
Piston connection assy.
Crankshaft
Base casting
Gaskets
Check valve assembly
Intake valve assembly
Output valve assembly
Hose--18 inches
Hose--five feet
Metal frame
Wheels
Mounting platform
Label set
Packing materials
Packing box
1
1
6
1
4
1
1
1
1
5
1
1
1
1
1
1
2
1
1
1
1
$54.23
81.25
0.12
0.15
0.85
35.00
5.14
45.32
24.13
0.08
5.64
12.45
15.14
1.25
3.24
1.13
1.85
3.25
12.45
0.75
1.26
$54.23
81.25
0.72
0.15
3.40
35.00
5.14
45.32
24.13
0.40
5.64
12.45
15.14
1.25
3.24
1.13
3.70
3.25
12.45
0.75
1.26
Total material cost                     $310.00

To estimate the increase in company cost from producing another 100 paint sprayers, the accountant merely multiplies the unit cost of $310 by the 100 units to arrive at a total cost increase of $31,000. If the accountant or manager expects any of the materials costs to change because of this order, he or she can just incorporate the new materials cost into the bill of materials to compute a new unit cost.

Product Costs for External Reporting

Many cases you will study in your MBA program will present you with product costs that have been developed for external reporting. These costs do not approximate marginal costs, so you have to modify the product costs to arrive at the values you need. First, consider how an accountant develops the unit cost used for external reporting.

Developing a Unit Cost for External Reporting
Labor Cost

Assume an accountant wants to develop a unit cost for external reporting for the paint sprayer illustrated above. First, the accountant must estimate the amount of labor cost for the product. A product routing shows every step a product goes through in the manufacturing process, and these routings usually include labor times for each step. So the accountant can use these labor times from the routing to estimate the labor time required to make the product.

Assume in this case the total labor time equals 10 hours to make the paint sprayer. Next the accountant reviews payroll records to estimate the labor cost per hour and finds workers usually make $12 per hour; in addition, the company pays a variety of fringe benefits that amount to 30% of the hourly wage. Total company cost for an hour of labor, then, equals $15.60 ($12 + (30% x $12). The total labor cost for a paint sprayer for external reporting then equals $156 (10 hours x $15.60).

Overhead Cost

Overhead cost consists of numerous types of expenses ranging from depreciation and taxes to various kinds of supplies. Because it is such a miscellaneous collection of costs, accountants spread this total lump of costs across products made to assign a portion of overhead costs to each unit produced.

In companies that run their cost systems primarily to generate unit costs for external reporting, accountants must estimate the total annual overhead at the start of the year. Usually they divide this total estimated overhead by the estimated number of labor hours the company will use during the year. The resulting value is called an overhead rate per labor hour, and accountants multiply this rate by the number of labor hours in a product to assign overhead cost to the product. Remember, accountants perform this calculation only because financial reporting rules require them to do so. This has no relevance for decision making.

Assume in the paint spraying example that accountants estimated at the start of the year that total overhead would equal $820,000 and that the company would use 100,000 labor hours. This provides an overhead rate of $8.20 per labor hour. Putting the material, labor and overhead costs together provides a unit cost for external reporting of $548. This $548 value appears in the balance sheet and income statement issued to creditors, investors and taxing authorities.

Materials (from bill of materials) $310
Labor cost (10 hours @ $15.60) 156
Overhead cost ($8.20 per labor hour) 82
Total unit cost for external reporting $548

However, this product cost has no relevance for management decision making.

Peeling Back Costs to Develop Decision Making Product Costs

Since the product cost developed for external reporting is not suitable for decision making, you must peel off some of the costs to create a product cost you can use for decision making. Most of the cases you will encounter in your MBA studies will include product cost designed for external reporting instead of for decision making. Consequently you must peel off the irrelevant costs to get at a number you can use.

To do this, just reverse the process used above to generate a unit cost for external reporting. Follow these steps:

  1. Discard the overhead cost per unit
  2. Carefully examine the information to see if labor is really variable. Remove it if it appears it really is a fixed cost.

Consider the following example. This product cost is typical of those found in many cases used in MBA programs.

Cost Component Steel Bushing Plastic Bushing
Material
Direct Labor
Overhead*
Departmental
Administrative
$ 6.50
21.40

42.80
32.10

$ 1.25
12.60

25.20
18.90

Total costs $102.80 $57.95

*Overhead is allocated to products on the basis of direct labor dollars.

In this case the information indicates that the company multiplied the direct labor costs by some factor to arrive at the overhead cost allocated to each product. A review of the data indicates that Departmental overhead is applied at 200% of direct labor cost and that Administrative overhead is applied at 150% of direct labor cost.

For decision analysis you should ignore the overhead costs. It is clear that managers have given no thought to how overhead behaves relative to product output because they just apply a factor to labor cost. Consequently, you should use only the material and labor cost for decision analysis. This means you should use a unit cost of $27.90 for the steel bushing instead of the $102.40 and that you should use a unit cost of $13.85 instead of $57.95 for the plastic bushing.

Generally speaking, the smaller the proportion of the product cost devoted to labor, the more likely the labor cost is fixed and should be eliminated from the unit cost.

Evaluating Product Profitability

Product profitability consists of two things:

  1. The difference between unit variable cost and the selling price, and
  2. Product velocity

Revenue minus variable costs equals contribution margin, or some accountants just call it margin. Product velocity refers to how many units per time period a company can sell. Multiplying velocity by unit margin gives the total margin a product can generate in a given time period.

Given a choice, managers will usually choose the product that can generate the most margin per time period. So when choosing which product to push, managers always look at product velocity as well as unit margin. Consider the following example.

Account Product A Product B Product C
Revenue
Variable costs
Margin
Margin percentage

Velocity
Units per week

Total margin

125
75
50
40%


500

25,000

350
200
150
43%


100

15,000

420
220
200
48%


50

10,000

Although Product C has the highest margin percentage, it generates the lowest total margin per week of the three products. However, Product A with the lowest margin percentage generates the highest weekly margin.

Always remember to consider product velocity when looking at product profitability so you do not overlook the real profit potential for a product.