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Product cost is the process of tracking and studying all the various expenses that are accrued in the production and sale of a product, from raw material purchases to expenses associated with transporting the final product to retail establishments. It is widely regarded as an extremely important component in evaluating and planning overall business strategies. In today’s hotly competitive business environment, accurate product costing has become critically important to a business’s survival.

Many years ago when manufacturing was far less automated than it is today, the costs of materials, labor and overhead were just about evenly divided. Now, production of a product’s various components is often so synchronized on highly automated production lines that there is little or no need to maintain component inventories; thus the old costing formulas, still used by many industries, are no longer applicable.  Further complicating the costing equation is the trend in manufacturing to focus more attention on quality, flexibility and responsiveness, to meet customer needs. 

This makes production line cost analysis more difficult because each line requires small, but significant, changes in production techniques. As a result, today’s managers and business owners have found that the limited information available  through older job costing methods is inadequate for making informed decisions in the contemporary business environment.

Costs associated with manufacturing products 

There are potential costs associated with selling a product which may be directly or indirectly linked to the actual production process. Possible costs include:

  • Developing and maintaining supplier relationships.
  • Transportation costs, including carrier payment terms: special payments in the realm of packaging, handling, and loading and unloading; and loss and damage expenses.
  • Sales and freight terms that define payment terms, sales, and title transfer.
  • Payment terms: Options here range from 15 days to as many as 90 days in some industries and letter of credit terms provide additional options. These options, often are not considered by managers in purchasing, traffic, and sales. Instead, most firms mandate these terms and they become ‘boiler plate’ in purchase order, carrier contracts, and invoices. It can be mutually beneficial to negotiate these terms with suppliers and carriers.
  • Costs to receive, process, or make ready, including unloading, counting, inspection, and inventory costs, as well as expenses associated with disposal of packaging and other product protection/transportation materials.
  • Logistics expenses (warehousing, loading, unloading, inventory control), which are typically lumped together under catch all title “Overload,” despite the fact that costs for each of these can vary significantly depending on the arrangement.
  • Production costs accrued in actual manufacturing of goods.
  • Warranty costs.
  • Quality costs, including costs associated with defective products (what percentage and how far down the production line), inspections, product returns, chargeback, cooperage, and storage.
  • Lot size costs, including inventory and cash flow costs associated with lots of varying size.
  • Supplier inventory.
  • Overhead costs of supplier and customer transactions, including billing, collection, payment, and receiving processes.
  • Product improvement and modification, including costs of correcting defects and standardization of materials and packaging.
  • Regulatory/environmental costs associated with meeting federal or state laws and community expectations on environmentally friendly production and packaging processes.

Product costing in multiproduct environments

Some manufacturers distort true product costing results by evenly distributing costs for a certain aspect of production across all product lines, even though costs might vary with each specific product. In some instances, this practice might have little or no impact on a business’s well being: a company that is enjoying record growth and profits on all three of its product lines, for instance, is unlikely to be seriously harmed by accounting practices that evenly divide transportation costs three ways, even though one of the product lines may account for, say, half of the firm’s transportation expenses.

Huge profits mask such inequities fairly well. But relatively few companies are in such a luxurious position. Most companies, and especially most small businesses, which typically have fewer margins for error than their bigger cousins, need to work hard to arrive at true product costing figures. As national and global competition increase, even tiny costing disparities can have an overwhelming impact on whether a product, or an entire company, for that matter, survives.

Over the long term, product profitability analyses that use these distorted costs cause management to erroneously assume custom products generate better margins than they actually do, and top performing goods end up subsidizing other, less profitable, product lines.

Product costing in non-manufacturing firms

Although product costing is primarily associated with manufacturing businesses, it also has applications in non-manufacturing industries. Merchandising companies include the costs of buying and transporting merchandise in their product costs. Producers of goods such as mining products, petroleum, and agricultural products, also record the costs of producing their goods.

The role of product costs in these companies is identical to that of manufacturing firms. While service oriented companies (both service businesses and non-profit organizations) do not offer products that can be stored and sold in the manner of manufactured items, they nonetheless need to track the varied costs that they accrue in offering their services. After all, the services that they offer are in essence their ‘product’ line.

Banks, insurance companies, restaurants, airlines, law firms, hospitals, and city governments all record the costs of producing various services for the purpose of planning, cost control, and decision making.

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Bernard Taiwo

I am Management strategist, Editor and Publisher.

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