What Are the Methods of Production Cost Calculation?
The goal of each business is to achieve profitability or to increase its current profit. Controlling and keeping under control the costs are the most important factors affecting profitability. Manufacturing businesses make various calculations in order to reduce costs. You can find the subjects of manufacturing cost types and breakeven calculation in our How to Calculate the Manufacturing Cost article. In this article, we will explain the specific methods used in calculation of manufacturing cost.
The first factor determining how the manufacturing cost to be calculated is how the “inventory management” is performed. There are two different inventory management systems used by manufacturing businesses. These are perpetual inventory and periodic inventory methods.
Perpetual Inventory Method
In perpetual inventory method, each movement of materials on the production process is controlled. All stock inputs and outputs of the materials are recorded. Thus, any information can be obtained at any time about current status of stocks.
Periodic Inventory Method
In periodic inventory method, not all movements of materials are controlled. The actual amount of stock and the consumption made in that period are determined by counting at certain periods. The amount of stock between two stocktakings is unknown.
Inventory Valuation Methods
Inventory valuation and/or calculation methods are value systems used in determining the manufacturing costs, in addition to inventory management solutions. These methods are vital instruments when it comes to the inventory management and product / company valuation.There are four different inventory valuation methods:
- Actual Cost
This is used in cases that material cost of each production unit is known. It is usually preferred by businesses which make production made to order.
- First in First out (FIFO)
The first purchased prices of the first material used in production are calculated over the price of the first entry of the relevant material in the inventory.
For instance, let’s consider that a business purchased cheese for three times at different periods.
First purchase = 20$
Second purchase = 25$
Third purchase = 2$
When the manufacturing cost is calculated, it is first calculated over the materials costing 20$. If the materials costing 20$ are not enough, then the calculation is made on the materials costing 25$.
If prices show an increasing trend, it will result in high inventory rate and low manufacturing cost.
- Last in First out (LIFO)
In LIFO method, the calculation is performed over the last price of material entered inventory.
For instance, let’s consider that a manufacturing business which has purchased timber twice in different periods.
First purchase =100$
Second purchase = 120$
When the cost of production is calculated, all purchases are calculated over 120$, price of the last inventory input.
If prices show an increasing trend, it will result in low inventory rate and high manufacturing cost.
- Weighted Average Cost
Weighted average cost method is performed by using the following two methods as weighted moving average cost and period-end weighted average cost.
- Weighted Moving Average Cost
In this method, average cost is calculated for each material purchase. In other words, the purchase cost of the new material and the inventory cost are summed, then divided by the amount of newly purchased material and the amount of material in inventory.
For instance, let’s consider that a business has 1200 liters of paint in stock with an average cost of 15$. This business is purchasing 300 liters of paint costing 18$ per kilogram as a new material. In order to calculate the current average cost:
((15 * 1200) + (18 * 300)) / (1200 + 300) = 15.6
In this case, average cost is 15.6$ per liter until new material is purchased.
- Period-End Weighted Average Cost
This method is used in periodic inventory management, and cost calculation is not performed after each purchase. Period-end inventory amount and the amount taken during the period are summed. Amount spent is found by subtracting the amount of inventory at the beginning of the period from this amount. Average cost of all purchases made in the same period is calculated and amount spent is multiplied by this cost.
For instance, let’s consider that a business which has 120 sacks of cement at the beginning of the period. This business is purchasing 40 sacks of cement 25$ for per sack and 50 sacks of cement 27$ for per sack. Let’s suppose that this business will has 130 sacks at the end of the period. In this case:
Amount spent is (120+40+50)-130=80sacks.
Average cost of a sack is (25+29)/2=27$.
Material cost of the relevant period is 80*27=2.160$.
Related Article: How to Reduce Production Costs?