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, that’s: 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 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.
As mentioned above, 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, while direct labour is all employees involved in the preparation, assembly, and manufacture of these goods. Manufacturing overheads are all costs associated with machining processes, maintenance and any indirect materials or labour used in a supporting role.
Here’s how you calculate each of these different costs.
- Direct materials: Tally the cost of materials purchased for a given period, add this total to the cost of beginning 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
Understanding total manufacturing costs is an important step for those who want to improve manufacturing productivity.
Manufacturers need to understand their total manufacturing costs if they want to lift productivity.
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 in detail
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.
Accurately calculating the cost of your direct materials is the first step in reducing these costs.
How to calculate direct material costs
To calculate direct material costs, add your beginning direct materials to your direct materials purchased and subtract the ending direct materials for the period.
Total Direct material costs = Beginning direct materials + Direct materials purchased – Ending direct materials
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.
Accurately calculating direct materials costs is the first step in reducing the cost of your material inputs.
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 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. 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 in detail
Direct labour costs consist of more than just wages. Costs include benefits such as PAYE tax, superannuation contributions, holiday pay, sick leave entitlements, and workers compensation insurance for all staff who are directly involved in the manufacture and production of your product. This can include workers on the assembly line or employees that use machinery and equipment to manufacture the final product — processing team, quality assurance inspectors, coffee roasters and brewing 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 hourly pay rate plus, payroll taxes and fringe benefit costs. Divide this amount by the number of hours worked in the pay period.
Direct labour hourly rate = (Hourly pay rate + Payroll taxes + Fringe benefit costs) / number of hours worked in the pay period
Step 2: Calculate direct labour hours
This measures the number of direct labour 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.
Direct labour hours = Units produced / Labour hours
Step 3: Calculate direct labour cost per unit
Now that we know the direct hourly labour rate and the direct labour hours, we can figure out the direct labour cost per unit by multiplying the direct hourly labour rate and the direct labour hours.
Direct labour cost per unit = Direct labour hourly rate x Direct labour hours
Richard’s coffee roasting facility benefits from transparency on direct labour costs.
Example: calculating direct labour cost
Richard runs a coffee roasting facility where his team roasts and assembles 1kg bags 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 bag of coffee to gauge whether he needs to change his prices.
Step 1: Calculate direct hourly labour rate
Each staff member works for 40 hours and gets paid $25 per hour, their payroll taxes costs $5 per hour and they have $3 worth of fringe benefit costs per hour.
Direct labour hourly rate = (25 + 5 + 3) / 40 = $0.83
Step 2: Calculate direct labour hours
His team can roast and assemble 150 bags of coffee in 40 hours.
Direct labour hours = 150 ÷ 40 = 3.75 hours
Step 3: Calculate direct labour cost per unit
He knows that his direct hourly labour rate is $0.83 and his direct labour hours is 3.75 hours.
Direct labour cost per unit = 0.83 x 3.75 = $3.11
Now that Richard knows that it costs $3.11 to make each bag 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 processes that reduce labour inputs per output.
Depreciation on your manufacturing plant and facilities count as overhead costs.
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 get the monthly 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.
Manufacturing overhead rate = Overhead costs / Sales x 100
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 is 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. Here’s a refresher on how to calculate COGS.
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 accounting periods, it can indicate that resources are not being used efficiently.
Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists. Melanie has been writing about inventory management for the past three years. When not writing about inventory management, you can find her eating her way through Auckland.