Product Costing and Pricing: Direct Production Costs
Product Costing and Pricing: Direct Production Costs
This chapter describes the essential elements of costing procedures. Because of the
importance of the competitive environment in both international trade fairs and global
trading, crafts enterprises have to be certain that their costing and pricing are correct. In
view of the complexity of the costing and pricing process, the reader is strongly advised
to look for specific in-depth guidance from specialist sources.
Note: Since this book is intended for use in many different countries, the term 'NU' has
been used in this chapter to represent an imaginary 'national unit of currency'.
Costing is the process of assembling all the financial ingredients that go into making a
product. It is vital that all the costs involved in the manufacture of a product be accounted
for. A price should never be set before the cost is calculated, or the product may be sold
at a loss. This final sum is the base price of a product upon completion in the workshop.
The final selling price is determined by the point at which the product is handed over to
the customer. The cost of producing any item includes two basic components: direct
production costs (materials, wastage and labour); and overheads (fixed and indirect
overheads).
Raw materia l costs . These should cover every item of material used in the manufacture
of the product. It is important to calculate the exact amount of raw material used, because
inaccurate assessments can mean the difference between profit and loss on a product.
Wastage costs . These cover any material discarded during the production process. Some
timber may be diseased and unusable. Off-cut pieces of fabric may be too small to be used.
These are known as 'scrap material'. They are a major challenge for manufacturers because
they are expensive. In some cases, smaller products can be manufactured from waste, thus
reducing the quantity being discarded. In certain cases scrap can be sold (e.g. waste paper).
It may also be recycled (e.g. clay). It should not be forgotten that all waste material has a
financial value which must be calculated as part of the raw material costs.
Labour costs . The time consumed in making any product is a cost in the form of
production labour. Many small enterprises calculate labour cost on the basis of quantity
of finished products per day In certain instances this method of calculation produces
inaccuracies, resulting in higher costs. It is advisable to calculate costs in terms of hours
and minutes per operation. Each product can be calculated according to the exact number
of labour operations required to obtain a finished item. Whether operations take days or
merely seconds, all costs should be taken into account.
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Box 5
Timber NU 3.75
Assembly 1.2
Finishing 0.9
Equals (= )
Equals (= )
This is the basic price of a product in the workshop. To this should be added
the overhead allocation (Boxes 6 and 7), packaging costs (Box 8), and
percentage profit markup (Box 8), to obtain the selling price (ex-works) (Box 8).
Overhead costs
The direct production cost does not include the other costs that a craft enterprise has to
pay in the course of daily operations. Some costs can be easily overlooked, whereas they
should be part of those built into the product price. For example, the wages paid to a
security guard who watches the company offices are also part of the costs of running the
enterprise. These additional costs are known as overheads. There are two types of
overheads: fixed and indirect.
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Fixed overheads
Fixed overheads are those costs which are incurred on a regular basis regardless of
production output activity. If there is a workshop building, for example, then this building
has to be paid for or rented, even when there is no production taking place. Full-time staff
involved in production have to be paid even if there are no orders being completed. Fixed
overheads include:
Rent/mortgage. As mentioned above, workshops have to be paid for, even when not in
production. In many smaller companies, the workshop is in a family home. In this case
only a portion of the total cost need be included as an overhead. With a separate building,
however, the whole rental or mortgage cost is an overhead.
Machine/tool depreciation . Machines and tools purchased for production purposes have
to be replaced in due course. In order to be able to purchase replacement equipment, the
cost of the machinery must be reclaimed by way of a percentage on the overhead account.
All machinery and equipment depreciate throughout their working life.
Taxes. Certain taxes in most countries are paid only by the manufacturing industries.
These include special business taxes and charges made by municipal offices, water supply,
province or state levies on trucks transporting goods between cities. All such taxes should
be included in overhead costs where they affect the product cost price.
Loan repayments . Loans and interest on loans, which are directly related to the
manufacturing business, should also be considered as part of the overhead costs of
production. Buildings, machines, vehicles and equipment are frequently purchased with
loans.
Insurance. Craft enterprises sometimes take out insurance cover to protect their
investment in a business against fire and theft. Others take out insurance to protect the
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Indirect overheads
Other costs involving staff, equipment and activities are not a direct part of the
production process. Such costs are indirect. Yet all or part of these should be included
in the production cost.
Wages (suppor t staff) . Most companies have personnel who are not directly involved in
production, for example, administrative and secretarial staff, drivers, mechanics and
security guards. Their wages have to be considered as an overhead. In some cases, for
example, a security guard may be watching over a workshop in a larger complex, yet only
a portion of his wages would be charged to the workshop overheads.
Equipment and vehicle operatin g costs. All equipment needs maintenance, cleaning and
general care. Small electrical power tools such as bench drills and paint-spray equipment
need labour to clean them and mechanics to service them. Handlooms need parts
replacement. Such costs have to be charged to the enterprise and repaid from the product
price.
Electricity, gas, wate r utilities . All power consumption related to office and production
units should be allocated to overheads. If workplace and residential accommodation are
combined, then a portion of the power bills has to be calculated and applied to costs.
Postage. Many artisan enterprises fail to account for postal charges incurred on business
accounts. Sample parcels, bills, accounts, catalogues and price-lists involve high costs for
postage, especially to foreign countries. Complete records should be kept to calculate
overheads.
Sample-making costs . Samples have to be made to send to customers. This takes time
and considerable effort, costing more than production items. The samples must be
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properly prepared, labelled, packaged and sent by surface or air mail. This is costly, all the
more so since customers are not prepared to pay for them. The cost must therefore be
borne by the artisan enterprise. As business develops, more and more samples have to be
sent to an ever larger range of customers. Sample costs have to be planned and a budget
prepared to meet these costs, which are also part of the overheads of a craft business.
Telephone/fax/telex/telegram charges . All businesses are now using more and more
technology to communicate. Orders, specifications, confirmations, modifications and
dispatch notes are being faxed daily round the world. E-mail is increasingly used to
communicate with customers, and is cheaper than fax or telephone. But all such systems
cost money and the charges have to be entered as overheads.
Business-related travel . Many crafts enterprises now send representatives abroad to their
target market to meet customers, attend fairs and make study tours. This is an essential
part of keeping in touch with trends in a market-place, and face-to-face contact with a
customer is far preferable to telephone conversations between different time zones. But
international travel is not cheap, and transport and hotel costs in developed countries are
high. Manufacturers have to find ways to generate the funds for these journeys, and a
planned budget figure can be costed into the overheads of a product.
Inflation. National inflation rates vary from country to country. These inflation costs hit
manufacturers with increased costs for utilities, transport and services, wages and materials.
The inclusion of national inflation percentages as a portion of overheads is very important.
Contingency allowances . No matter how well organized and managed a business may be,
there will always be the unexpected event that calls for money to repair or reorganize in
order to maintain the flow of business. Good business practice dictates that the overheads
include a small percentage to provide for such incidents.
Multiplying the actual hours it takes to make a product by the overhead rate gives a
proportional amount of overheads for that particular product. One product might take
longer to make than another, and so has a higher allocation of overheads.
For example, if an ABC Toy Company product takes five hours to make, then the overhead
cost allocated to it is NU 6.05 (5 hours x 1.21 overhead hourly rate). If the time taken in
making another item is twelve hours, then the overhead cost in that case is NU 14.52 (12
hours x 1.21 overhead hourly rate). In each product the proportion of overhead cost is
directly related to the number of hours spent making it.
Overhead calculations should be included in every product price if the overheads are to
be recovered during a business year.
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Box 6
Plus (+)
National inflation (at 6.5 per cent per annum) NU 1,676.68
Sub-total overhead+inflation NU 2 7 , 4 7 1 . 6 8
Plus (+)
Contingencies (at 10 per cent per annum) NU 2,747.17
Total estimated annual overheads NU 3 0 , 2 1 8 . 8 5
To calculate the weekly overhead rate
(From Box 5) total direct production cost (of wooden toy) NU 15.90
Plus (+)
Multiplied by (x)
(From Box 5) total labour time (to make wooden toy) 2.85 hours
Equals (=)
Equals (=)
Packaging costs
A product cannot be sold on a large scale without packaging. The cost of any individual
display or protective packaging for the product has to be added to the price of the product,
on a price per piece basis. Bulk transport packing for shipment has to be included, broken
down into an item cost per piece. This is then added to the finished product price.
The more products are manufactured and sold, the cheaper the selling price because of the
narrower profit margin and larger orders. Certain key products - particularly in luxury
items, for example, alpaca garments in the high fashion market - can charge prices far
higher (premium prices) than the real value of the merchandise. Many companies work
on the basis of the maximum profit margin that the market will be prepared to pay. The
resulting price is the ex-works price.
Selling price
Following the addition of packaging costs and the profit margin, the product has a price
at which it can be offered to the market. If the costing calculations have been carefully
worked out, and the profit margin added with consideration of the prevailing competing
prices in the target market, then the product has a chance of selling. As mentioned above,
this is the workshop price. It is the lowest price at which the product should be sold.
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For products sold locally, negotiations will take place with buyers to determine
responsibility for transport costs.
In the export market, prices are often more open to negotiation. This reflects the demand
for the product and the quantities to be ordered. Buyers from importing companies are
highly competent in obtaining the best price for the product. Finalizing export prices
requires detailed negotiation of export prices and contracts and is dealt with below.
Box 8
(From Box 7) take the finished product price (one wooden toy) NU 19.35
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Transport costs
If the product is being sold in the local market it will be necessary to calculate the
itemized cost of transporting the product to the market-place. This is in addition to the
ex-works price and covers the transport of the product from workplace to port or airport
and to another country It should be calculated on a per piece basis and added to the
product price.
For the export market there are common international pricing methods which incorporate
transport and other costs using standard terms and calculations. These are explained in
Chapter 11.
2. Overheads
• Fixed overheads (rent, construction, depreciation, taxes, wages, loan repayments,
insurance, pension schemes)
• Indirect overheads (wages for support staff, operating costs of equipment/vehicles,
utility charges, postage, stationery, sample-making, telephone, fax and telex
charges, business travel, inflation, contingencies)
5. Packaging costs