What is the cost of the products and services that you sell?
Now, that may sound like an odd question. After all, you generate and review your income statement each month, which reports the total costs incurred on the items you’ve sold.
That review, however, doesn’t address an issue that may have a huge impact on your profitability: the price of your product must allow you to recover every cost you incur in your business. Said another way, the only way you can cover all of your costs is to generate sales.
If you understand your actual product cost, you can more accurately quote customers for services ahead of time, and make sure your products are priced accurately. Basically, knowing your product cost keeps you from selling yourself short.
With pricing issues being a leading cause of business failure, you can only afford to sell yourself for all your worth. (And you’re priceless!)
To better understand product cost, let’s take a look at the bare-bones formula used to calculate cost, then let’s consider some common issues that arise when calculating product cost. Finally, we’ll walk you through a scenario in which one business owner figures out their product and overhead costs to make sure they’re billing customers the right amount.
How to calculate product cost
Determining total product cost can be straightforward for some businesses. It all depends on the manufacturing process and how involved it is. If you’re using numerous raw materials and have a wide number of specialists involved in the making of finished goods, your product cost formula could entail tracking the cost of numerous materials and workers. The formula used for determining product cost is:
Product cost = direct labor + direct material + supplies consumed + total overhead
For direct labor, that’s the labor involved in making the product. This doesn’t include indirect labor costs, which are additional employees not involved in the creation of the product. These can be people like accountants or security guards. These also aren’t a part of the total overhead, which includes the price of utilities, the space itself, and the other elements that make production possible.
The direct material is the same, as this is any material used in the actual manufacturing. This doesn’t include indirect material, which is any kind of material used within your manufacturing location. Indirect materials can include items like cleaning supplies, various nuts and bolts for maintenance, and so on.
Supplies consumed are any kinds of consumables used during the manufacturing process, like disposable gloves used with each product made. Lastly, total overhead is your factory overhead, meaning the cost to run machines, etc.
It’s easy to see how the manufacturing costs can be easy for businesses with straightforward production processes and few employees. The moment you have multiple employees of varying pay grades, the equation gets more complicated.
If you want to determine the cost of a product ahead of time to give a customer a quote and you manufacture a physical product, simply use the above formula and multiply it by the number of units you’re planning on selling.
If you’re going to have to ship the products or get them to a storefront, remember to factor in the inventoriable costs when giving an estimate. This is the cost of getting the product ready for the customer, which can entail getting it to a storefront or storing it in a warehouse until the customer is ready.
This isn’t a part of the product cost formula, typically. But, if it’s a regular occurence, in that it happens 100% of the time, you should include it in the formula as part of the total overhead.
If you don’t sell products but you sell services, you’re going to have a process that’s even more involved. To better-understand how to calculate product cost for service businesses, let’s take a look at common issues with product cost calculations, and then join Julie and her landscaping company as she determines her service costs.
Trouble with calculating product cost
Some costs are easier to assign to a product or service, while other expenses are more difficult to pin down.
Overhead costs are the most difficult costs to assign to a product, and business owners frequently have difficulty analyzing these costs. This is because overhead or indirect costs cannot be directly traced to a product or service.
Insurance premiums and utility costs are two good examples of the difficulty that comes with analyzing overhead costs.
When looking at manufacturing overhead costs, you can easily look at the price of raw materials used early in the process, the price of direct materials involved in the production process, the cost of labor used, and the cost of goods sold.
With a service, like an online marketing service or tax assistance company, it’s harder to pin down the cost of the energy being used, the services being rendered, and so on, as they’re not tangible goods.
On the other hand, direct costs can be easily traced to a product or service. If you manufacture baseball gloves, you can compute the amount of leather material you use in each glove, and the amount of labor cost it takes to run machines. As a result, material and labor costs are frequently classified as direct costs.
To determine the true cost of your product or service, you need a method to allocate overhead costs. To illustrate this, let’s take a look at how one business owner estimates their product cost.
Illustrating the importance of product cost with a business
Julie owns and operates Hillside Landscaping, a business that provides lawn care, landscaping and tree removal services. Here is Hillside’s income statement for 2018:
|Income Statement for the period ending December 31, 2018|
|Cost of Sales|
|Materials(sod, mulch, flowers)||150,000|
|Labor (work crews)||230,000|
|Total Cost of Sales||380,000|
|Home office costs||7,000|
|Repair and maintenance||4,000|
|Total Operating Expenses||70,000|
As you scan the income statement, note the following:
- Direct costs: You’ll notice that the income statement lists gross profit as sales less cost of sales. Cost of sales, in this case, includes material (sod, mulch, flowers) and labor costs. These are direct costs because they can be directly traced to a particular client.
- Operating expenses: Gross profit, less operating expenses, equals net income for the year. Operating expenses, such as depreciation on assets and insurance costs, cannot be directly traced to a particular job. These costs are indirect costs or overhead.
- Each customer job: To calculate the profit earned on each job, Julie must subtract both direct costs and some amount of overhead costs from each sale.
Julie’s first step is to decide on a method to allocate overhead costs to each customer job. For this, she will need to understand her business’s activity level.
Why activity level is important
Overhead costs can be allocated based on a level of activity.
The logic here is that a business incurs costs based on activities, such as the number of labor hours worked, total miles driven, or total units produced. If your company didn’t produce or sell anything during a particular month, many costs would not be incurred.
Your next step is to decide on an activity level that causes you to incur each overhead costs. In some cases, the connection is obvious. You can allocate mileage costs based on the number of miles driven to and from a particular customer’s location.
Other connections between costs and activity level are harder to determine.
Julie’s allocation process
Here are three overhead costs, and the activity level used to allocate the costs:
|Type of overhead cost||Activity level||Amount to allocate|
|Mileage costs||Miles driven||$1,500|
|Office salaries||Direct labor hours worked||$30,000|
|Home office costs||Direct labor hours worked||$7,000|
Mileage costs have an obvious connection to miles driven, but the other two costs are harder to allocate. When there is no obvious connection to an activity level, companies most often use direct labor hours worked.
If “Job A” required more labor hours than “Job B,” it makes sense to assign more overhead costs to “Job A”. It simply takes more effort and should be assigned more costs. It’s not a perfect allocation, but it’s an accepted approach that many companies use.
If Hillside Landscaping’s total direct labor hours worked is 6,000 hours, Julie will assign office salary costs at a rate of ($30,000 ÷ 6,000 hours), or $5 per labor hour.
If the Johnson landscaping job requires 5 labor hours, the customer would be allocated $25 in office salary costs.
Every expense in the operating expenses category will be allocated, based on this same process.
Creating a job estimate for Hillside
In the landscaping business, Julie must provide a bid price to each customer, and the price is based on a specific job estimate. Assume that the Johnson family needs a 30-foot tree cut down and removed. Hillside’s job estimate may look like this:
|Job Description:||30-foot tree removal|
The customer is quoted a price of $300, and that price includes a $45 profit. Note also that the $50 overhead cost includes a dollar amount for each type of operating expense.
The bottom line?
Every cost required to complete the job is included in the job estimate, and Julie is able to quote a sales price that includes all costs, plus a profit amount.
Why product cost estimates are worth the effort
Allocating all of your costs to each sale requires a great deal of effort, so why bother?
Cost allocation helps you identify individual sales that are not profitable.
In 2018, Hillside generated a total net income of $52,100, but that total does not reveal the profitability of each sale. That’s important information, because you may need to increase the price of some jobs, or not pursue that work at all.
Julie notices that she earns far less money on jobs that are more than 10 miles from her office. Those jobs require more mileage, and she must pay workers who are on the clock during longer trips to the work site. Based on her cost allocation work, Julie doesn’t pursue jobs that are more than 10 miles away.
Julie’s business serves as a great example of the aforementioned difficulty that can come with trying to estimate product cost when you’re not selling a manufactured good. There aren’t a bunch of raw materials to base cost off of. Instead, you have services being rendered, cars being used, hours being spent, and so on.
Determining product cost in this case isn’t something that happens overnight, it takes time. But it’s time well-spent.
Increase profits and work smarter
All businesses, even those that are profitable, can benefit from cost allocation and a better understanding of product costs. Sure, it can be a lot of work to determine your product cost and overhead costs, and to understand how to set the best prices. But, with enough time and practice, you’ll eventually strike the perfect balance where you’re making more money without doing additional work.
Now that is worth the homework.