How to Calculate the Unit Cost of a Product.
The easiest way to calculate the unit cost of a product is through the Direct Costing technique.
This means that we will assign to the product the cost of the materials acquired or the raw materials transformed in production processes.
When assigning the cost of the product, we can use a valuation of standard cost or fixed cost, average cost, FIFO, LIFO or, for example, the last purchase cost.
The simplest of all the methods is the standard cost or fixed cost, it is a cost of materials or raw materials that we estimate will have and we will review it in a period of time, every quarter, every six months or once a year…
But first we must consider the purpose of the calculation that we are going to develop.
We can develop a budgeted or forecast cost method or an actual cost method.
The purpose of each method is different.
In the method of calculating budgeted or forecast costs, the purpose is planning, simulation, scenario development, strategy establishment, budgeting and decision making.
While the actual costing method is for the purpose of inventory valuation and margin control and analysis.
If we develop a system for calculating budgeted or forecast costs, we cannot use real cost valuation methods such as the average cost, the fifo or the lifo, we will necessarily have to use the standard cost, which is a forecast cost.
But if our objective is to develop a cost calculation system to valuate stocks and analyze and control the margins and historical profitability of sales, to perform reports like the analysis by products, customers, commercials, sales channels, geographical areas… then yes, we can use any valuation method that the management program or ERP allows.
For this method of calculating costs, we need to rely on a management program or ERP, since the calculation of costs will necessarily be related to purchases, inputs and outputs of products from the warehouse, and sales. All this information is in the management program or ERP, however the analysis can be done in the management program itself or export the information to Excel spreadsheets or some business intelligence application to process the information and display the results to analyze.
If our objective is to analyze margins and value inventories, it is normal to use a valuation method such as average cost or fifo. It must be considered that when a product or several products are purchased, in addition to the cost of acquisition, the order or purchase invoice may include other costs not included directly in the purchase price. These costs can be transport, fees, insurance… If we buy a single product, we just add these costs to the total and divide it by the units purchased to obtain the unit cost that will enter the management system. If we buy several products, we will have to distribute these costs with a defined criteria and calculate the unit cost of each product.
Until now we have only focused on the direct cost and specifically on the materials or raw materials.
But depending on the activity of the company, you may need to include other direct costs to the product, the usual one is direct labor or indirect costs with great importance for the unit cost of the product.
If the company is dedicated solely to the storage and distribution of products, such as a wholesaler, a retailer, a supermarket, or an online store. The direct cost of the material will be sufficient to calculate the cost of the product. In this type of company, cost calculation does not represent major problems.
This does not happen in manufacturing companies.
Depending on the type of manufacturing and the needs of each company, one type of calculation or another will be chosen.
There are companies that only include the direct cost of raw materials in their products. The indirect ones go against the total margin.
In this case, it is used by companies with such complex manufacturing processes that the cost of the calculation when incorporating direct labor costs and indirect manufacturing costs exceeds the benefit obtained.
In addition, the cost of raw materials is usually the most relevant cost, so it is the one that must be controlled the most when calculating margins. The rest of the costs are managed through budget control systems such as the example you can see here.
There are companies that are very intensive in direct labor, although this is becoming less common. It is true that service companies or those that work for projects, direct labor have a lot of relevance. But in this case what we are seeing is the calculation of the unit cost of a product and not of a service.
In this type of company, if we can easily calculate the time that direct labor allocates to the transformation of the product through manufacturing processes directly, then it can be included. If its calculation is not easy, that means we cannot associate what an employee has worked or is going to work directly on the transformation of the product, in this case it would be considered an indirect manufacturing cost, which would have to be considered whether to include it in the calculation of the unit cost of the product.
If the company is more intensive in the use of machinery in the manufacturing processes, then it would be necessary to consider whether it is worth calculating indirect costs solely for manufacturing. We are not yet considering the distribution of all the costs of the company; this would be to use the full costing methodology.
The indirect manufacturing costs can be workers that we cannot directly associate with the handling or transformation of a product, all the costs associated with the machines (depreciation, energy consumption, maintenance, repairs…) all the costs derived from the manufacturing activity, such as internal logistics, maintenance of the manufacturing plant, quality control, process engineering, supervisory personnel…
As you can see, there is not a single method for calculating the unit costs of products, the calculation formula depends on many factors, so it must be adapted according to the needs of each company.
Each company is different not only in activity, but also in processes and resource consumption, so the calculation of the unit cost of the product will have to reflect these factors. In these cases, the direct allocation of costs is made through cost centers instead of products.
The cost centers can be classified into main and auxiliar, it is usual to consider as main centers the machines that participate directly in the transformation of semi-finished and finished products and as auxiliar centers those that do not have a direct relationship with semi-finished or finished products. .
Therefore we would have to make 2 distributions, the first distribution would be made from the auxiliar centers to the main ones. The distribution criteria may be different for each center. And a second distribution from the main centers to the product, as the main centers are machines, the distribution criterion that is usually used is machine-hours.
Finally, there are companies that perform a complete cost calculation or full costing, that is, they accumulate all the indirect costs, like manufacturing, commercial, administrative, financial… and with a distribution criteria according to the company’s activity, they assign it to the unit total cost of the product.
Other companies do not even distinguish between direct or indirect costs, they add up all the expenses from the previous year and divide it by the quantity of units sold or manufactured, regardless of the unit of measurement of the products sold or manufactured. The simplest method of all, but the one that least reflects the reality of the company and therefore the greatest risk of control, analysis and decision-making.
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Industrial company financial manager
Dani is helping us to use ODOO more efficiently, we are rapidly leveling up with the ERP. It is also preparing us very useful analysis and control reports and outstanding management tools. Always available by phone or email, willing to help and collaborate in everything that is proposed. Very professional and fast work. A key service for our company.
Controller ODOO ERP