To calculate total manufacturing cost you add together three different cost categories: the costs of direct materials, direct labour, and manufacturing overheads. Expressed as a formula, the total manufacturing cost calculation is: Total Manufacturing Cost = Direct Materials + Direct Labour + Manufacturing Overheads.
That’s the simple version. However, there’s a lot more to properly calculating total manufacturing costs than just knowing the formula. In this article we look at the details of what makes up total manufacturing costs, how to work out its component parts – and, importantly, how to reduce some of these costs in a manufacturing business.
First let’s look at total manufacturing costs in more detail.
What are total manufacturing costs?
Total manufacturing cost is the total expenses related to all resources used in the process of creating a finished product. Calculating total manufacturing cost requires an accurate analysis of your company’s different departments to identify how they contribute to the manufacturing process and the associated costs. This involves detailed accounting of the cost of all materials, overhead, and labour to identify the manufacturing costs of finished goods in their entirety.
The three primary components of total manufacturing cost are direct materials, direct labour, and manufacturing overheads.
Direct materials consist of the raw materials that go into the finished product. Direct labour is all employees involved in the preparation, assembly, and manufacture of these goods. Manufacturing overheads are all costs associated with your manufacturing process, maintenance, and any indirect materials or labour used in a supporting role.
Understanding total manufacturing costs is an important step for those who want to improve manufacturing productivity.
How to calculate total manufacturing cost
Here’s how you calculate each of the different costs that go into total manufacturing cost:
- Direct materials: Tally the cost of materials purchased for a given period, add this total to the cost of opening inventory, then subtract the cost of ending inventory. This will provide you with your direct material costs incurred during the period.
- Direct labour: Calculate all direct labour costs used in the manufacturing process for the period, including any related payroll taxes.
- Manufacturing overhead: Combine the cost of all plant and production overhead incurred for the period, including costs such as rent or mortgage fees, repair and maintenance expenses, production salaries, and depreciation of plant and equipment.
To calculate total manufacturing cost, add your direct material costs to the sum of your direct labour costs and manufacturing overhead.
Total manufacturing cost formula
Total manufacturing cost can be calculated using the total manufacturing cost formula:
Direct Materials + Direct Labour + Manufacturing Overheads = Total Manufacturing Cost
The total manufacturing cost formula can be used alongside your net revenue to work out how profitably your business is producing goods. The higher your production costs, the thinner your profit margins are likely to be.
After using the total manufacturing cost formula to work out your overhead expenses, direct, and indirect costs, you can start to break down where inefficiencies in your production process exist.
For example, if you notice that indirect materials costs are driving up the total manufacturing cost in your manufacturing business, it would be wise to investigate alternative suppliers or types of material.
What’s the difference between direct and indirect manufacturing costs?
It’s important to distinguish between direct and indirect manufacturing costs. When business costs relate to production activities they are generally classified as ‘direct’ or ‘indirect’. These can include the costs of raw materials, finished goods, production activities and customer service (but do not include administrative activities or period costs such as rental fees, utilities, office supplies, and office depreciation).
The key difference between direct costs and indirect costs is that direct costs can be tracked to specific item, and tend to be variable. Examples of direct costs include direct labour, materials, wages, commissions, and manufacturing supplies.
Indirect costs are likely to be fixed costs that include rent, insurance, quality control costs, depreciation, and the salaries of production supervisors and managers.
Direct materials costs
Direct materials are the inventory stock items used to create a finished product. Direct materials include raw materials, components and parts directly used in the production or manufacture of finished goods.
In coffee manufacturing, for example, the cost of coffee beans is a direct material cost. And for craft brewers, their direct material costs would include the yeast, hops and water used.
How to calculate direct material costs
To calculate direct material costs in a manufacturing business, add your beginning direct materials to your direct materials purchased and subtract the ending direct materials for the period.
The total direct material costs formula can be expressed as:
Beginning Direct Materials + Direct Materials Purchased – Ending Direct Materials = Total Direct Material Costs
For example, a coffee roaster has $2,500 worth of coffee beans at the beginning of the period, purchased an additional $4,000 worth of coffee beans and has $2,000 worth of beans left at the end of the period.
Total direct material costs = $2,500 + $4,000 – $2,000 = $4,500
Unlike fixed costs, which remain relatively constant, direct material costs are variable costs that fluctuate with varying levels of production activity, rising when output is increased and decreasing when production slows.
How to reduce direct material costs
Direct material costs can account for a significant portion of a company’s manufacturing expenses so how can you significantly reduce the material costs of inventory stock without affecting the quality of your final product? There are three common ways manufacturers do this.
1. Substituting lower cost materials
When looking to substitute materials for a lower-cost alternative, always ensure you are not compromising the quality of your product and potentially damaging your brand.
2. Manage your supply costs
Do some research – are there alternative suppliers available to you that can provide similar products at a cheaper price?
A couple of simple ways to substitute direct materials without compromising on the quality include sourcing from suppliers that can provide the same or similar item cheaper, or by reducing shipping costs through bulk purchases or buying local.
3. Reduce waste
A primary cause of waste in manufacturing is overproduction. Producing too much stock in advance means you are spending a lot more on direct material costs. Equally, you will also incur the costs of holding excess inventory stock or risk being left with stock you cannot sell.
Improved demand forecasting will minimise waste from overproduction. Implementing online inventory control software can help improve forecasting. Changing production methods to better utilise raw materials is another way manufacturer can reduce direct material waste.
Leveraging suppliers also helps. It is good practice to regularly evaluate your supply chain and to identify opportunities for improvement. Take advantage of any bulk-buy discounts or seasonal supply-side surplus to guard against off-season price increases.
Build effective supplier relationships to ensure that you get the direct materials you need when you need them. Good supply chain relationships mitigate the expense of material delays. Implementing service level agreements aid transparency, support product delivery schedules and help to maintain consistent materials quality.
Direct labour costs
Direct labour costs consist of more than just wages.
Costs include benefits for all staff who are directly involved in the manufacture and production of your product, such as:
- PAYE tax
- Superannuation contributions
- Holiday pay
- Sick leave entitlements
- Workers compensation insurance
This can include workers on the assembly line or employees that use machinery and equipment to manufacture the final product — the processing team, quality assurance inspectors, and warehouse staff responsible for delivering your finished goods.
How to calculate direct labour costs
Before calculating the direct labour costs per unit you need to know how to calculate the direct hourly labour rate and direct labour hours.
Step 1: Calculate direct hourly labour rate
The direct labour hourly rate is the sum of all wages, plus payroll taxes and fringe benefit costs for the period. Divide this amount by the number of hours worked in the pay period. The goal is to factor in variable costs – like staff with higher or lower pay rates – to gain a single value for the cost of an hour of work.
The formula to calculate direct hourly labour rate can be expressed as:
(Wages + Payroll Taxes + Fringe Benefit Costs) / Number of Labour Hours Worked = Direct Labour Hourly Rate
Step 2: Calculate direct labour hours
Next, calculate your direct labour hours.
This measures the number of working hours it takes to produce one unit. To calculate this, divide the number of units produced by the number of hours needed to produce them.
The formula to calculate direct labour hours can be expressed as:
Units Produced / Labour Hours = Direct Labour Hours
Step 3: Calculate direct labour cost per unit
Now that we know the direct hourly labour rate and the direct labour hours per unit, we can figure out the direct labour cost per unit by multiplying the direct hourly labour rate and the direct labour hours per unit.
The formula to calculate direct labour cost per unit can be expressed as:
Direct Labour Hourly Rate × Direct Labour Hours = Direct Labour Cost per Unit
Example: Calculating direct labour cost
Richard runs a coffee roasting facility where his team roasts and assembles 80kg bins of coffee.
He’s not making as much profit as he’d hope and he thinks it’s because his coffee isn’t priced correctly. He wants to know the direct labour cost of each bin of coffee to gauge whether he needs to change his prices.
Step 1: Calculate direct hourly labour rate
Richard has two staff members who earn $25 per hour, their payroll taxes costs $5 per hour and they have $3 worth of fringe benefit costs per hour. They each work 40 hours per week.
Total labour costs for these two employees are therefore: (25 + 5 + 3) × 40 =1320 × 2 staff members = $2640
One other staff member – a specialist coffee roaster – earns $35 per hour, with payroll taxes of $5 per hour and $3 fringe benefit costs per hour. They also work 40 hours per week.
The total labour cost in the period for this employee is therefore: (35 + 5 + 3) × 40 = $1720.
Richard’s total labour costs are therefore: $2640 + $1720 = $4360.
And the total hours worked by the three employees is: 40 × 3 = 120 hours.
Therefore Richard’s direct hourly labour rate is:
$4360 / 120 = $36.33
Step 2: Calculate direct labour hours per unit
Richard’s team can roast and assemble 150 bins of coffee in 40 hours.
Direct Labour Hours per Unit = 150 ÷ 40 = 3.75 hours
Step 3: Calculate direct labour cost per unit
Richard knows that his direct hourly labour rate is $36.33 and his direct labour hours is 3.75 hours.
Direct Labour Cost per Unit = 36.33 × 3.75 = $136.23
Now that Richard knows that it costs $136.23 to make each bin of coffee, he can decide to raise his prices to cover all his costs, or manage his labour costs, for instance by raising his productivity through more efficient manufacturing processes that reduce labour inputs per output.
Manufacturing overhead costs in detail
Manufacturing overhead is an indirect cost and includes:
- Taxes and depreciation on the manufacturing facilities
- Depreciation on manufacturing plant and equipment
- Salaries of employees such as managers, supervisors, quality control staff and maintenance teams
- The material cost of repairs and maintenance
- Utility costs such as electricity and gas used in the manufacturing facility
As an indirect cost, manufacturing overhead it is challenging to assign overhead costs to each of the units produced. For example, rent and insurance on the manufacturing plant are based on the assets’ value, not on the number of units produced. These indirect costs need to be apportioned to the units manufactured.
How to calculate manufacturing overhead
To find manufacturing overhead, identify the manufacturing overhead costs then add them up. Now you can determine the manufacturing overhead rate — this is the percentage of your monthly revenue that goes towards paying for overheads each month. To do this, divide the monthly manufacturing overhead by the value of your monthly sales, multiplying that by 100.
Overhead Costs / Sales × 100 = Manufacturing Overhead
For example, if your company has monthly manufacturing overheads of $60,000 and $490,000 in monthly sales, the overhead percentage is:
Manufacturing Overhead Rate = $60,000 / $490,000 x 100 = 12.24%
Therefore, 12.24% of monthly revenue will go toward the business’ overhead costs.
A low manufacturing overhead rate indicates that your manufacturing operations are utilising resources efficiently and effectively.
Why it’s important to allocate manufacturing overhead costs
Overheads directly impact a business’ balance sheet and income statement so it’s important to track and allocate these expenses. Allocating overhead helps you to identify areas to improve efficiency and reduce costs. It is important for pricing decisions because by incorporating indirect costs into pricing, you can cover costs by effectively pricing inventory stock to improve profitability.
Determining manufacturing overhead expenses also helps with budgets for manufacturing overhead. Knowing your manufacturing overhead costs means you can budget the money needed to cover these costs.
Total manufacturing cost versus COGS
Total manufacturing cost differs from the costs of goods (COGS). Where the total manufacturing cost is the total expense related to all labour and supplies used to create a finished product, COGS sold are simply the cost of finished inventory sold within the reporting period.
How COGS work in manufacturing
Here’s a short video explaining how the cost of goods sold formula works in manufacturing.
The relationship between total manufacturing cost and productivity
Expressed as a percentage between input and output volumes, manufacturing productivity measures how effectively production inputs, such as labour and capital, are being used to produce a certain level of output.
Calculating total manufacturing cost allows manufacturers establish the amount they’re spending to make goods. Businesses can use this figure to monitor the percentage of revenue that goes into manufacturing costs. By reducing total manufacturing costs, businesses become more productive.
In short, tracking total manufacturing cost can reveal how well a business is operating. A low figure indicates that resources are being used efficiently. If the figure increases between manufacturing accounting periods, it can indicate that resources are not being used efficiently.