Product Cost

A product cost is any cost that is necessary to manufacture a product or to acquire goods for resale. For a manufacturer, product costs are direct materials, direct labor and manufacturing overhead. For a retailer or wholesaler, they are the purchase price of merchandise plus inbound freight and other costs of getting it ready for sale. Product costs are recorded as part of inventory on the balance sheet and become an expense, cost of goods sold, only when the goods are sold.

Product costs are also called inventoriable costs; that entry covers which costs can be capitalized into inventory. This entry focuses on how product costs behave and how they are used. The contrasting category is period costs, such as selling and administrative expenses, which are expensed as incurred.

• Direct materials: raw materials and components that become part of the product and can be traced to it.
• Direct labor: wages and related costs of employees who make the product.
• Manufacturing overhead: all other production costs, including indirect materials, indirect labor, factory utilities, rent, insurance and depreciation of production equipment. See the entry on factory overhead.

Direct materials plus direct labor are prime costs, and direct labor plus overhead are conversion costs.

A ceramics company makes 20,000 mugs in a year. Its product costs are clay and glaze of $40,000, direct labor of $60,000 and manufacturing overhead of $50,000, of which $30,000 is fixed. Under absorption costing, the product cost per unit is:

Here the numerator is the total product cost for the period and the denominator is the number of units made. The unit cost is $150,000 divided by 20,000, or $7.50 per mug. If the company sells 16,000 mugs, cost of goods sold is $120,000 and ending finished goods inventory is $30,000.

Under variable or direct costing, used for internal analysis, fixed overhead is treated as a period cost. The unit product cost is then ($40,000 plus $60,000 plus $20,000) divided by 20,000, or $6.00. Ending inventory is valued at $24,000, and the full $30,000 of fixed overhead is expensed this year. Profit under absorption costing is therefore $6,000 higher, because $6,000 of fixed overhead (4,000 unsold mugs times $1.50) is carried forward in inventory.

Under US GAAP and IFRS, inventory in external financial statements must include all product costs, including a share of fixed production overhead based on normal capacity. Abnormal costs, such as excess waste or idle capacity, are expensed rather than added to inventory. For US tax purposes, section 263A, the uniform capitalization rules enforced by the Internal Revenue Service, can require additional indirect costs, such as some purchasing, storage and administrative costs, to be included in inventory, though many small businesses are exempt.

Accurate product costs support pricing, product mix decisions and profitability analysis. If overhead is allocated using a single, poorly chosen base, some products will appear more profitable than they really are, which is one reason companies adopt activity-based costing. Managers should also remember that unit product costs that include fixed overhead are averages; they fall when volume rises and should not be treated as the extra cost of making one more unit. Costs move from work in process to finished goods inventory as production is completed, and the classification matters because misclassifying period costs as product costs inflates both inventory and current profit.