In this post, we’ll be sharing useful information on how to calculate the total manufacturing costs for a new product. Making early estimates of a product’s total manufacturing cost helps determine whether your new product design will be profitable. Although “early” estimates are not always accurate – since the production process has not started and unexpected costs will arise – they can give insight into the product’s long-term viability. Manufacturing services costs are the expenditure to purchase the resources required to make a product. To turn raw materials into a finished ready-to-sell product, a company has to spend money on at least three things:
- The materials needed to make the product itself
- Labor to handle the manual work
- Overhead to keep the business and manufacturing facility operational
The total manufacturing cost (per unit produced) is an important metric for evaluating a company’s expenses. In addition to ensuring a proper bookkeeping routine, identifying the cost also helps determine appropriate pricing. If direct manufacturing cost is high, product pricing changes become crucial to maintaining or increasing profitability.
Table of Contents
Production cost
The total amount of money spent to conduct its entire business is known as production cost. It’s the budget to fund every single business operation the company does. In comparison, manufacturing cost includes only the expenses, including overhead, that go into making products. Not every overhead cost contributes to total manufacturing cost, however. As an example, the maintenance cost of company cars is an overhead, but the company must exclude this expense from the calculation because it’s not directly related to the product manufacturing process.
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Manufacturing cost
The basic formula to determine a company’s total manufacturing cost is to add up the expenses for direct materials, labor, and overhead incurred during a given production run.
Direct Materials
The volume of raw materials required to manufacture the desired products is known as direct material. For a company that makes wooden furniture pieces, the typical raw materials include timber, padding, fabric covers, paint, lacquers, and fasteners. Direct material cost is the price you pay to acquire all the raw materials used.
The formula is as follows:
| Direct material cost = existing direct materials + purchased direct materials – remaining direct materials |
Let’s say the custom furniture design company has $10,000 worth of raw materials, but it needs to purchase $5,000 more for the next month’s production run. If at the end of the period the company still has $1,000 worth of raw materials, then the total direct material cost is $10,000 + $5,000 – $1,000 = $14,000.
Direct material cost fluctuates not only with the volume of production, but also the volume of purchases. Buying raw materials in bulk often means lower prices overall. All things equal, higher manufacturing output increases direct material cost, and lower output decreases it.
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Direct labor
Depending on company size, there can be a lot of other employees hired in positions not directly related to the manufacturing services, such as those in legal and marketing departments. They must be excluded in the direct labor cost calculations. The only company expenditure that contributes to direct labor cost is the salary and wage along with incentives as well as benefits for employees who work in the manufacturing department.
Ideally, they are everybody working in the production line, including team managers, machine operators, quality assurance inspectors, and so on. Direct labor cost is typically calculated by the unit of product. But first, you need to know how much the company pays for the direct labor hourly rate and direct labor hours.
| Direct labor hourly rate = (hourly pay rate + payroll taxes + fringe benefit costs) ÷ number of hours worked in the pay period |
| Direct labor hours = units produced ÷ labor hours |
Now that you have the results for direct labor hourly rate and direct labor hours, determine the overall direct labor cost using the following formula:
| Direct labor cost per unit = direct labor hourly rate x direct labor hours |
Using the aforementioned results, you get 0.75 x 2 = $1.5 direct labor cost per unit. Similar to raw materials, direct labor cost per unit can also change depending on the number of workers and production volume.
Overhead cost
The most time-consuming step in calculating total manufacturing cost is, by far, determining the overhead cost. Various expenses count as overheads, but as mentioned earlier, not every single one of them is relevant to the subject and must be excluded from the formula. What you should include is:
- Indirect labor: If direct labor cost includes wages, salaries, benefits, and incentives for workers directly involved in the production line, indirect labor is all of that but for other employees. Although they are not involved in manufacturing, their roles contribute to the company’s operation. For example, legal and human resources department employees perform administrative roles that have nothing to do with how the company makes its product. But for every hour they spend working, the company keeps a log of how much they earn. The total cost is assigned to each product manufactured.
- Indirect materials: With the exception of raw materials and components that go into the finished products, many items used in the manufacturing process are categorized as indirect materials. In a broad sense, indirect materials can be defined as finished product components that cannot be conveniently allocated or identified on a per-unit basis. Some prominent examples are fuel and lubricants for manufacturing equipment. Like cleaning chemicals and disposable protective devices, they are consumed but do not form the final product. In furniture production, one may argue that small components like adhesive, nails, and masking tape should be regarded as direct materials. Those are, however, used in insignificant quantities compared to upholstery and wood, so they are considered indirect materials.
- Utilities: Almost all utilities that keep the manufacturing facility functional and operational will incur overhead costs. They typically include electricity, water, plumbing, telephone, and internet services. Their cost can change depending on the service provider and how much they are consumed. The cost is calculated for the entire manufacturing facility and allocated over production output.
- Repair and maintenance: The amount of money spent on the repair and maintenance of not only the manufacturing equipment and machinery but also the facility itself.
- Insurance and tax: The financial cost that cannot be avoided. Any of the insurance and tax on the machinery and property is part of the overhead cost. It may include property taxes on the manufacturing facility, insurance policies on the building and assets, and legal fees. Overheads incurred from tax and insurance do not change that often, and they are allocated over product inventory.
- Depreciation: Assets may depreciate over time because of usage or obsolescence. It is considered a financial loss as a consequence of the manufacturing process, hence an overhead cost. If an asset has no particular depreciation pattern, the loss of value is distributed across its entire useful life – a calculation process known as the straight-line method. On the other hand, a constant depreciation rate allows for a declining balance method in which the loss of value is applied to the company’s assets book every year.
Total manufacturing overhead cost is every expense incurred by all the overheads added up. In case you want to know the amount of overhead per unit, use the following formula:
| Manufacturing overhead per unit = total overhead ÷ total units produced in a given period |
If the total overhead cost per month is $1,200 and the company can produce 200 furniture units over that period of time, it means the company has to pay 1,200 ÷ 200 = $6 manufacturing overhead per unit throughout the entire month.
To calculate the overhead rate, identify the overhead cost per month then divide it by the value of monthly sales before multiplying it by 100. Here is the formula:
| Monthly manufacturing overhead rate = monthly overhead costs ÷ monthly sales x 100 |
Assuming the company has an overhead of $1,200 per month and makes $24,000 in monthly sales, the monthly overhead rate is calculated by $1,200 ÷ $24,000 x 100 = 5%. In other words, 5% of the revenue that month will cover the overhead cost. A lower overhead rate means the company uses its resources more efficiently.
Total manufacturing cost
The sum of every expense directly related to making finished products is the company’s total manufacturing cost. To calculate the amount:
| Total manufacturing cost = direct materials + direct labor cost + overhead cost |
Remember that all variables used in the formula must represent the same period of production either daily, weekly, monthly, or annually. Say you want to determine the total manufacturing cost per month, using the same set of variables previously used:
| Direct materials per month: $14,000 Direct labor cost per month = direct labor cost per unit x monthly product output $1.5 x 200 furniture: $300 Overhead cost per month: $1,200 Total manufacturing cost per month : $15,500 |
It is also possible to calculate the total manufacturing cost per unit, with the following method:
| Direct materials per unit = direct materials per month ÷ monthly product output $14,000 ÷ 200: $70 Direct labor cost per unit: $1.5 Overhead per unit: $6 Total manufacturing cost per unit: $77.5 |
Or you can simply divide the total manufacturing cost per month by the number of units produced per month, so $15,500 ÷ 200 = $77.50
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Why it’s important
Unless you keep track of manufacturing costs, there’s no way to know if you hit the revenue targets or suffer a loss following a production period.
For a company to make a well-informed business decision, there needs to be a clear insight into the current profit margin. The calculation for total manufacturing costs may reveal otherwise hidden inefficiencies, improper pricing strategies, and wasted resources. Data from your most recent calculation of total manufacturing cost can help steer the company’s direction in the near future, whether you want to scale up or down.
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