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The business circumstances will dictate how best to analyse and assess product cost.  Factors to consider are the manufacturing location, material and labor content, and product configurations. 

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Quick reference

Product Cost

Companies that manufacture products will have several different perspectives on the costs of the products.

When to Use Product Cost

The business circumstances will dictate how best to analyse and assess product cost.  Factors to consider are the manufacturing location, material and labor content, and product configurations. 

Instructions

  • The elements of product cost are direct material, direct labor, and the manufacturing overheads associated with the day-to-day operation of the manufacturing facility.  These are the same components of Cost Of Good Sold (COGS).  The product cost of all units that are sold during a specific time period are totalled to determine the COGS for that time period.
  • While the actual product cost occurs when the product is manufactured.  The components of product cost are determined during the design and development process.  Typically over 70% of product cost is inherent in the design decisions, not the manufacturing management.  Design constrains product cost.
  • Many companies will create a product cost value that is called standard cost, which is different from the variable cost or COGS for a product.
    • Standard cost includes the variable cost plus a component of fixed costs associated with the facility of production.  This component is to represent the cost of maintaining the facility.
    • The use of standard costs simplifies budgeting and forecasting by providing a common standard that can be used throughout the budgeting process.
    • The standard cost does require product standard  - at least at a product family level – that can be costed and used in the creation of the standard cost.
    • If components and subassemblies are shipped between operating locations, standard cost can simplify the calculation of profit and loss at each facility which may be required for tax purposes.
    • Normally at the end of the fiscal year, actual costs and standard costs are reconciled and the standard cost is adjusted for the next year.
  • The primary components of product cost are material and labor.  Through redesign and either outsourcing or insourcing, the split between material and labor can be changed.  Depending upon industry and business conditions, product cost can be reduced by making these changes.
    • Generally less labor will be lower cost.
    • Convert labor to material by using embedded software to control product functionality
    • Convert labor to material by purchasing or fabricating more complex parts or subassemblies and reducing the amount of assembly labor that must occur in-house.   This can increase tooling costs, but these can usually be amortized over the cost of the production parts.
  • Many companies use multiple manufacturing locations in multiple countries.  This may be required due to a country’s local content laws and regulations.  When this occurs the cost to the business changes.  If the production is in a low labor cost area, the cost of labor in the product cost can be reduced.  However, there are other costs that may increase.
  • When making business or budgeting decisions concerning manufacturing locations, ensure to include changes to these categories of cost:
    • Shipping
    • Insurance while shipping
    • Customs and duties
    • Increased need for inventory  (WIP or Finished Goods) to account for longer logistics and supply train
    • Increased cost of supervision – remote supervision requires the establishment of high cost communication technology or increased travel.
    • If any aspect of the product has shelf life concerns, there may be increased losses due to a shorter effective shelf life – since more of the shelf life time is consumed in logistics.

 

Hints and Tips

  • Beware of the use of standard cost when deciding in which factory to manufacture a new product.  A product being built in an underutilized factory will have a high standard cost since the facility costs are spread over just a few products.  Building the new product in that facility will lower the standard costs for all products in that facility.  If instead the product is placed in a facility that is at full capacity, and therefore has a low standard cost impact, the new product may overstress the capacity of that facility and lead to cost and quality problems for all the products manufactured there.
  • As supplier and labor costs vary from year to year, the decisions to shift the product cost to more labor or material may change.  Don’t try to chase small changes in material costs or labor rates by constant redesigns.  Design and manufacturing stability will do more to lower cost than chasing incremental changes.
  • The learning curve effect will often lead to lower labor costs over time.  However, beware of low cost labor countries; often they have high labor turnover and the benefits of learning curve are never realized.
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  • 00:03 Hi, I'm Ray Sheen.
  • 00:05 Let's talk about some of the ways that we track and manage product cost.
  • 00:10 First, just a quick review of what we mean by product cost.
  • 00:15 The elements of product costs, are the ones we talked about back when we were
  • 00:18 discussing the cost of goods sold, COGS, on the earning statement.
  • 00:21 The product cost, or cost of goods sold for a unit, is the material that is
  • 00:25 in the product, the label required to build the product, and a small allocation
  • 00:29 of the overhead cost that are directly related to the production process.
  • 00:32 Such as consumables, shop supplies, or transportation and supervision costs.
  • 00:38 The components of production cost, are determined by product design decisions.
  • 00:42 Now of course, the cost doesn't actually occur, until the product is produced, but
  • 00:46 the design decisions constrain the product cost.
  • 00:49 The product must use the materials specified, and
  • 00:51 the product must be assembled and tested certain ways.
  • 00:54 Studies have shown that over 70% of product cost is constrained by design
  • 00:58 decisions.
  • 00:59 And it doesn't matter what manufacturing or purchasing do, they can only reduce and
  • 01:04 manage a small amount of the product cost.
  • 01:06 With that said,
  • 01:07 it should be clear, that product cost management starts with design.
  • 01:11 Let's look at standard cost.
  • 01:13 This is the value often used in the financial system for the product cost.
  • 01:17 Now standard cost and COGS, are normally different.
  • 01:20 The definition for COGS is the variable cost that we just mentioned.
  • 01:24 Direct material, direct labor and
  • 01:25 manufacturing overhead, of the product that was sold.
  • 01:28 Standard cost is that same variable cost.
  • 01:30 And it usually includes a component of facility support costs.
  • 01:34 That is allocated to the product and
  • 01:36 represents the on going management of the product in the production facility.
  • 01:40 This is over and above the manufacturing overhead, that is in the variable costs.
  • 01:45 Setting standard costs require product standard configurations.
  • 01:48 For commodity products, that's easy to determine.
  • 01:51 For custom products, I usually create a cost for different models, or
  • 01:55 complexity levels within the product family.
  • 01:57 It is a judgement call on your part, as to how many to create.
  • 02:01 I would recommend that if the product cost difference between two models is less than
  • 02:04 about five percent, just combine them into one model.
  • 02:07 Standard costs will simplify budgeting and
  • 02:10 forecasting, because it creates a standard that can be used, with sales forecast and
  • 02:14 production forecast to estimate the impact of changing volumes.
  • 02:18 It can be used to size both the labor force and
  • 02:20 the quantity of materials negotiated with suppliers.
  • 02:23 This can also simplify the transaction cost between facilities,
  • 02:27 if different components are manufactured at different sites.
  • 02:30 Products and assemblies are shipped at the standard cost, and detailed cost reports
  • 02:33 showing actual costs for each unit do not need to be maintained.
  • 02:37 However, when using this approach, the standard costs will need to be reconciled
  • 02:41 with actual costs at least once a year.
  • 02:43 Normally at that time, the standard costs are updated to reflect what
  • 02:46 actually has been happening, and a new standard cost is set.
  • 02:49 A common concern of product costs, is the trade off between material and
  • 02:53 labor costs.
  • 02:54 Changing from material to labor, or labor to material may lower cost.
  • 02:58 This is usually done by outsourcing or insourcing some aspect of production.
  • 03:03 Generally less labor is better, even in low labor cost areas.
  • 03:06 Labor is more uncertain and often more susceptible to quality problems.
  • 03:11 One of the more common methods to reduce labor is to redesign the product, so that
  • 03:14 functionality is in embedded software, and not the product configuration.
  • 03:19 From a manufacturing standpoint software, once it is developed, is essentially free.
  • 03:24 You can also convert labor to material by designing more complex parts,
  • 03:28 that require less assembly.
  • 03:30 This will often increase the part cost but lower the labor cost.
  • 03:33 If the production volume is high, the new tooling equipment cost and non-recurring
  • 03:38 engineering costs, are quickly amortized over the production parts and
  • 03:41 the overall product cost is lower.
  • 03:44 Another common way to lower costs,
  • 03:45 is to move the manufacturing to a low cost manufacturing part of the world.
  • 03:49 This can be a great approach, and I've used it many times to lower costs.
  • 03:53 But when doing that, you need to recognize that some costs will increase, and
  • 03:56 those need to be included in the analysis also.
  • 03:59 An obvious one is the increase in shipping.
  • 04:01 Then there is also an increase in insurance costs,
  • 04:04 to cover the product while it is being shipped.
  • 04:06 I lost a whole shipment of parts one time when the boat sunk.
  • 04:08 There will be customs and duties, now there may also be lower customs and
  • 04:12 duties for some customer locations.
  • 04:14 So let finance work this one out.
  • 04:17 The longer inventory cycle time will mean that there is more finished goods and
  • 04:20 work in process inventory in the logistics pipeline, and this costs money.
  • 04:24 The one that surprised me was the magnitude of the increased cost of
  • 04:27 supervision.
  • 04:28 Suddenly, I had two or three people doing international business trips of a week or
  • 04:32 two duration.
  • 04:33 This was much more expensive, than when they could get in their car,
  • 04:36 drive 30 minutes, and be at the manufacturing facility.
  • 04:39 So we built expensive video conferencing facilities to try to lower cost.
  • 04:43 And we had to put in new ERP systems to consolidate the information across sites.
  • 04:47 None of these costs were considered, when we made some of our first
  • 04:50 decisions to move product to low manufacturing cost areas.
  • 04:53 They are considered now.
  • 04:55 The last one may or may not apply, that is if you have shelf life products.
  • 04:59 You can find a great deal of your shelf life consumed,
  • 05:02 while giving the product to the shelves.
  • 05:04 One of my clients, almost half the shelf life of a medical product was effectively
  • 05:08 lost, when they made this move.
  • 05:12 You can improve your ability to manage your operation, when you know and
  • 05:16 understand how to manage products costs.

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