How to Calculate the Production Cost – Unit Cost Calculation?

How to Calculate the Production Cost – Unit Cost Calculation?

In manufacturing businesses, the issue of manufacturing cost calculation is quite important. In the simplest terms, a business should firstly know how much cost is needed for the production to make a profit from. Businesses that manufacture more than one product should also calculate the manufacturing cost for each product independently and demonstrate the actual contribution of each product to the business.

Manufacturing cost calculation methods which have different perspectives have been developed that the manufacturing businesses can determine their manufacturing costs. The most popular one of these methods is to determine the fixed and variable expenses (costs) of production and calculate the breakeven point of the business. Raw material cost, labor cost, workplace cost and all other similar costs are divided into two groups as variable or fixed fees and the manufacturing cost calculation proceeds in this way. Accordingly, some businesses also manage the unit cost calculation processes. For a better understanding, we need to discuss the fixed and variable costs in more detail.

Related Article: How to Reduce Production Costs?

What is Fixed Cost?

Fixed cost is the sum of the expenses which do not change regardless of the production amount and should be spent regularly to keep the business active. In other words, fixed costs are the expenses that a business should pay regularly on a monthly or yearly basis, regardless of the business’s commercial activities. Rental expense is the best example for fixed costs. A manufacturing business is obliged to pay its rent regularly every month independently from the production amount. Apart from that, taxes which are independent of sales such as insurance, fixed salary payments and real estate tax are other expenses included in a business’s fixed cost list.

What is and How is Calculated the Variable Cost?

Variable cost is the sum of the expenses that change depending on the business’s production volume. Variable costs of a business increase when it manufactures products more than normal and decrease when it goes downsizing. Raw material cost is the best example for variable costs. For instance, when a bakery produces more bread than normally does, it will spend more flour and for this reason its variable cost will increase. Another item included in variable costs is labor costs according to production amount. It can be said that in businesses which increase their production amounts periodically and employ temporary worker in these periods, labor costs show a change depending on production amount.

The last thing we need to say about variable costs is that it is wrong to claim that there is always a direct proportion between variable costs and production. Some variable costs may not show a linear increase with the increase of manufacturing costs in some cases. For instance, if a textile factory which buys both piece goods and fabric bolts reduces margin of error in case of purchasing fabric bolt, it will face a lower cost increase than the expected cost in the scenario of receiving the same amount of fabric. In summary, it is not right to say that there is always a direct connection between variable costs and production volume.

How to Calculate the Manufacturing Cost?

Although there are some theoretical formulas for calculating the manufacturing cost, which is the main subject of our article, it is not easy to process these formulas and audit the actual manufacturing cost through these complex formulas. Especially when you attempt to make this calculation with a paper and pencil, it will be almost impossible to make the calculation correctly. In this section, we will both explain the easy method and share our alternative proposal which is complicated but more objective. At first, we will explain the easy method.

Each manufacturing business continues its production to make profit. At this point, you should first calculate the manufacturing cost to find out how profitable the production is. The first thing you need to do as a manufacturer is to write down all the expense items that you can encounter in production process. You can start the manufacturing cost calculation by noting your rental expenses, labor costs, tax payments, invoices, loans and marketing expenses one by one. Then you need to determine your expense items are included in which of fixed or variable cost groups described above. It is obvious whether some expenses are fixed or variable. For instance, your monthly rental expense is a fixed cost of for business as it is a fee that you are obliged to pay regardless of your production.

On the other hand, in some cases it not an easy task to place some expense items in these two expense groups. For instance, let’s handle the electric bill. Most manufacturing businesses use one or more electronic device during manufacturing process and make electrical expenditure per production. These expenses generated when the machines are in operation, namely during the manufacturing process is a variable cost by its nature. However, it not easy to calculate the electric expenditure per product. The best method is to determine how much an electric devise spends electricity hourly, measure the amount of electricity needed for a unit production and multiply it by the cost of electricity per kilowatt. With such a calculation method, you can determine electric expenditure per unit and write it down to the variable costs list. However, there some points confusing this calculation. For instance, non-production (independently from machines) expenditure such as the electricity that you spent for dinner is not a variable cost of production. Under normal circumstances, you should consider this expenditure as a fixed cost and make your calculation in this respect. As this type of calculation details makes it difficult to calculate the overall sum, many businesses evaluate the monthly electricity bill as a fixed cost and make their calculation in this manner.

As you can see, at the point that we are trying to make the calculation more objective and decrease the margin of error, the calculation will become quite complicated and increase your chance of making mistakes. At this juncture, we can say that even if it increases the margin of error it is easier for you to evaluate your complex expense items as fixed cost with an average value.

If you want to make the calculation on a more accurate value, we recommend you to use pre-accountancy and income/expenditure account programs which have advanced infrastructures. Paraşüt, the pre-accountancy program integrated into the Fabrikatör which is a manufacturing management system, has features allow you to manage such complex processes through a simple interface.

What to Do After Calculating the Production Cost?

The process of manufacturing cost calculation gives us a general knowledge about the cost we will face with as a result of the production activity. However, our basic impulse in calculating the manufacturing cost is to learn which sales prices we will determine in accordance with the final cost and at which point we will make profit from our business. Breakeven analysis is the most popular method used to make this kind of evaluation.

What is and How to Calculate the Breakeven Point?

Breakeven point is a simple and functional calculation method used by manufacturers in accounting, economic calculation and financial management. In its simplest terms, the breakeven point is a point at which the manufacturing business meets all the fixed and variable cost associated with the production, in other words it is to be out of the woods. For a business reached to the breakeven point, it cannot be said that it has either made a loss or profit. In short, a business reached to the breakeven point has paid all the expenditures obliged to and reached the zero point.

The value of breakeven point differs in each business. While it is enough to make a small number of sales in order to reach the breakeven point for a business that manufactures high-cost products and sells them with a high sales price, it may be necessary to make a large number of sales for a business that manufactures low-cost products and gains from demand. On the other hand, independently from structure of the business, the breakeven point calculation is based on a similar formula.

What is the Formula of Breakeven Point Calculation?

The formula used in breakeven point calculation is to divide the total fixed costs into difference between sale price per unit and variable cost per unit. The most important thing to be considered here is that all the items included in the calculation should belong to the same accounting period and evaluated in the same currency. Our formula used in breakeven analysis is as follows.

Breakeven Point = Fixed Cost / (Unit Sale Price – Variable Cost Per Unit)

Let’s explain this calculation method, also known as breakeven analysis, with an example.

Suppose you are a carpenter. You manufacture tables and sell each table for 150₺. The raw materials of these tables are wood, lacquer and nails. All these raw materials are expenditures that will arise as you manufacture, that is your variable cost. The total cost of these raw materials needed for you to manufacture one table is 25₺. Now let’s look at your fixed costs. The total fixed cost including monthly rent of your workshop, monthly salary you pay to your employees and the taxes you are obliged to pay regardless of the income is 40.000₺. (At this point, if we have information about the average cost of electric, water and natural gas bills, we can take them as fixed costs.)

Considering all this information, recreate the formula.

Breakeven Point = Fixed Cost / (Unit Sale Price-Variable Cost Per Unit)

Breakeven Point = 40.000 / (150-25) = 40.000/125=320

As you can see, the breakeven point of your carpentry workshop is 320. In other words, the number of tables that your business should sell to meet the fixed and variable costs is 320. Another meaning of this is that your business will be profitable as from the sale of table 321.

What is the Benefit of Calculating the Breakeven Point?

The biggest benefit of calculating the breakeven point is to analyze income and expenditure of your business in general. In the first step of this calculation all costs are determined, and the overall expenditure of production is calculated. Then, the sales price of product and the amount of production deemed to be successful is determined.

Another benefit of calculating the breakeven point is to determine the sales price in scenarios where there is an uncertainty about selling price. Especially for a business that makes production for the first time can learn after how much cost and how many productions it will reach to the zero point, by adding the expected costs about sales price to the analysis. For instance, manufacturer in our carpenter example will reach breakeven point when selling 320 tables with sales price of 150₺, and s/he will make a profit when selling 200 tables with sales price of 225₺. Or if manufacturer determines a sales price of 30₺, s/he will know that s/he will make a profit after the sale of 8.000 tables. In this way, the first steps of measuring the overall sales performance can be taken by comparing the sales price with the information about the periodical sales forecast and the actual sales amount.

A manufacturer who calculates the breakeven point and knows the fixed cost, variable cost and sales price of the product can take healthier steps about increasing operational efficiency. A manufacturer analyzes the calculation of breakeven point can increase the productivity of the product by reducing fixed and/or variable costs or increasing the sales price. Different combinations of these actions can give different results in different businesses. Manufacturer may consider buying the same quality material from a supplier other than the current suppliers. However, it should be considered the change in the quality of the product. On the other hand, in case of raising the sales price, it should be considered the decrease in sales due to the supply and demand relation. Calculating the breakeven point will give the manufacturer an outline of the consequences of such actions.

Related Article: What Are the Methods of Production Cost Calculation?