Cost of production: Complete guide to calculate it in your company

Every Small and Medium Enterprise (SME) needs to bring its products to market to earn revenue. But to achieve that, there is a cost of production that comes from all areas of the manufacturing process. This issue becomes relevant when you consider the fact that current inflationary pressures are driving up production costs for growing companies.

A survey by Kabbage, the small business financing arm of American Express, found that 37% of business owners believe that raising prices is the best option in the face of rising inflation. However, another 22% said they plan to negotiate better deals with their suppliers to reduce costs.

Without a doubt, it is crucial for growing companies to reduce manufacturing costs as much as possible to ensure efficient use of their resources. The key to achieving this is to be proactive and look for efficient methods to calculate production costs, evaluate current operations and find opportunities for greater profitability.

In this blog post, we are going to talk about the cost of production and its elements, the types of costs that exist, as well as how to calculate a company's production costs.

What is the cost of production?

The cost of production is the total cost incurred by a company to produce a product or offer its services, to sell those goods or services and to deliver them to its customers.

Production costs can include a variety of expenses, such as:

- Labor

- Raw materials

- Manufacturing supplies

- Consumables

- Overhead costs

In manufacturing accounting, a company's production costs are generally divided into direct costs, which are expenses related to production floor labor and raw material costs, and indirect costs, other expenses associated with the production of goods, also called manufacturing overhead.

The 3 elements of the cost of production

We can say that a company's production costs are basically made up of three key elements from which all production costs are derived.

Materials. This element refers to the cost of the material or raw material used by the company for its production purpose. The material is the substance from which a product is manufactured, therefore, it may be in a raw or manufactured state, and may be direct or indirect.

Labor. This is the cost incurred in the form of remuneration paid to the company's employees for their labor in converting materials into a finished product or service. These costs may be direct, when they refer to those employees who are directly involved in the manufacturing process; or indirect, when they involve those employees who are not directly involved in the manufacturing process.

Production overhead. This element of the cost of production is generally very high. It refers to manufacturing overhead or general production costs incurred by a company in the production area or within the factory facilities. Among these are costs for indirect materials, rent, factory fees and taxes, canteen expenses, etc.

Types of production costs within companies

In order to manufacture a product or offer a specific service, companies may incur multiple types of expenses. Derived from this, there are several types of production costs, among the most common we can mention:

- Fixed costs.

These are manufacturing costs that do not change when production changes. A company has to pay fixed costs, whether the level of production increases or decreases. Fixed costs are also costs that a company incurs when the production level is zero. The higher these costs are in a business, the higher production must be for the business to break even. Examples of fixed costs include: Costs of maintaining a factory or office building, rent, interest on loans, advertising, and business rates.

- Variable costs

Variable costs are costs that change when production volume is adjusted. These costs are directly related to the production or sale of a product. Examples of variable costs include: wages, basic raw materials, energy costs, fuel costs and packaging costs.

Total costs

These are the sum of fixed and variable costs incurred by a company to produce a given level of output. All costs incurred during the production of a product or the provision of services are included in this calculation.

- Average costs

This type of production costs essentially refers to the expenses that occur when producing a unit or offering a service. Average costs are crucial when it comes to making decisions on how to price a product or service. Ideally, average costs should be minimized to increase the profit margin without increasing expenses.

- Marginal costs

These costs determine how much it would take to produce an additional unit of product, showing the increase in the total cost of that additional product. Variable costs primarily affect marginal cost, since fixed costs do not change with the level of production. Marginal costs are generally used to decide where resources should be allocated to optimize production profits. These costs will vary with the volume of production and are affected by factors such as price discrimination, asymmetric information, transaction costs and externalities.

How to calculate the cost of production in your company?

To calculate the cost of production and achieve more efficient processes that lead to an optimization of business resources, it is necessary to identify and add up the costs of the three elements of the cost of production mentioned above, i.e. direct materials, direct labor and indirect manufacturing costs or overhead.

There are a number of financial metrics that companies can use to measure production costs. These KPIs include total manufacturing cost, cost of goods sold, cost of goods manufactured, average cost, etc.

To streamline and automate this process, you need to use an appropriate tool to easily manage your records and calculate costs simply.

An ERP system that adapts to your company's needs and improves overall business processes can directly contribute to cost management. These technology applications are ideal for establishing key metrics related to your own business and focused on your project objectives, helping to identify cost savings to determine what is working and what needs further improvement.

Let there be no doubt about it! It is essential that as a growing business owner, knowing your company's cost of production will help you build and manage a much more profitable business.