How to Derive a Product Cost (#256)
/In this episode, we discuss how to derive a product cost. Key points made are noted below.
Problems with Developing Product Costs
Coming up with a product cost doesn’t sound all that hard – or is it? There are a bunch of issues to consider. First, a cost accountant can’t begin to do this alone. You have to talk to the engineering department about the components that supposedly went into the product. They should have a bill of materials that goes along with the design drawings, but that list may not be entirely correct. Still, it’s a good starting point. Then, take that bill of materials over to the materials management staff and have them verify it. They have to order the parts or have them made in-house, so they should have a pretty good idea of what goes into the product.
Bill of Materials Verification
Or, do they? In some companies, fittings and fasteners aren’t included in the bill of materials. Instead, these items are bought in bulk and are available in bins on the shop floor for anyone to use, so no one thinks there’s any need to record them in the bill of materials. So, you have to look into that. If you miss it, your product cost will be too low. If you have to adjust the bill of materials for these missing items, take it back to the engineering department and have them verify it. There’s a fair chance that there’s still something wrong, so the extra meeting is worth your time.
Cost Identification by Volume
So far, you’ve only identified the components – there’s no costing associated with them. Now for the fun part. Unit costs vary by volume, so you need to identify at what point the unit cost goes up or down, depending on how many units are purchased. For example, a widget that goes into a product might cost a dollar if you buy it in quantities of at least a thousand, but it costs three dollars if you buy it in smaller quantities. So, your next trip is to the production scheduler, to talk about production volumes.
Volume Purchasing Considerations
So, let’s say that the production scheduler thinks that 2,000 of those widgets will be needed in the next year. Does that mean you can automatically assume that the product cost will include one dollar’s worth of a widget? Not necessarily. It’s possible that the purchasing department plans to buy in smaller quantities in order to reduce the inventory investment. Or, maybe they want to buy in really large quantities, because that widget can be used in multiple products. If so, they could be able to buy the widget for a lot less than a dollar per unit.
If this sounds like a lot of interviewing to do, you can cut through everything and just look up the supplier invoice to see what unit price is being charged to the company.
Impact of Future Decisions
Another point to consider is that the unit price might change depending on future decisions. For example, if management intends to push this product really hard in the marketplace with a big ad campaign, it might be useful for them to know that the product cost will decline if unit sales increase past a certain point.
The Need for Multiple Versions of Product Costs
So, what all of this means is that you really need to come up with a couple of variations on the product cost. The main one is for the production volume that everyone expects, and you might want to consider deriving a cost that applies to a low level of production, as well as to a high level of production. As the production volume declines, the unit cost will increase, and as the production volume goes up, the unit cost will drop.
Consideration of the Scrap Rate
Of course, we’re not done yet. There’s also a scrap rate to build into the product cost. This can be difficult when you’re using components that have never been used before, since there’s no history for them. That means you may have to make an educated guess at the amount of scrap, and then come back after one or two production runs to see if the estimated scrap rate turned out to be correct, or if you need to adjust it. In general, you probably ought to issue a preliminary product cost, and then discuss it with the production manager after there’s some experience with actually manufacturing the product, and decide whether another version of the costing should be issued.
Fixed Nature of Labor Costs
And then we have labor. It can be considered a fixed cost, rather than a variable cost, like materials, because there usually has to be a minimum crew size to man a production line, no matter how much volume runs through the production line. That being said, I’ll assume that you’re adding the cost of labor to the product cost.
There are a couple of problems with deriving a labor cost. The first issue is that the cost of the labor itself keeps changing. The people working on a product may be getting paid at different hourly rates, based on their seniority or skill level, and the people assigned to producing the product may change, even within a single day. The usual solution is to use the average hourly rate for everyone in the production area. The next issue is that labor rates tend to increase over time, as people gradually get bumps in pay, so you have to go back from time to time and see if your average labor rates built into the product cost are still correct.
And a third issue is that the industrial engineering staff is always looking for ways to automate parts of the production process, so it’s entirely possible that the total amount of labor hours assigned to a product will gradually go down.
My main points in regard to labor cost are that you need to use an average labor rate, you need to update the calculation of that rate on a regular basis, and you need to update your assumptions regarding how many hours it still takes to make the product.
Overhead Costs
And finally, we have the cost of overhead. No matter how well you try to refine the allocation of overhead to a product, keep in mind that it’s still an estimate. And on top of that, the overhead may still be there even if the product is never manufactured, so there’s a pretty reasonable argument that you shouldn’t even include it in the product cost.
But let’s say that you do. If so, break it out from the rest of the cost. For example, put the materials cost in a subtotal that’s in bold and maybe in a bright color, so that management knows that this is the real variable cost of the product. Then layer on a line item for labor, which is a reasonably valid inclusion. And then insert a couple of blank rows to really give it some separation, and then state the assigned overhead cost. Just trying to put the costing emphasis where it belongs.
Summary
In summary, product costing is more complex than you might initially think. It can vary by production volumes, it needs to be adjusted over time to account for estimates and cost changes, and some of the elements in the report maybe shouldn’t even be there, depending on how you intend to use the information.