Manufacturing Cost- How To Determine And Minimize

In any business, large or small, one of the most important goals is to keep costs down while maintaining high-quality standards. Knowing where to start when looking to minimize manufacturing costs can be challenging, but there are a few key steps that can make the process easier. 

This article will explain how to determine your company’s manufacturing costs and offer ways to reduce those costs.

Table of Contents

• An Overview of Manufacturing Cost

• How To Determine Manufacturing Cost

• Methods To Determine Manufacturing Cost

• Top 5 Ways On How To Minimize Manufacturing Cost

• Why Does Manufacturing Cost Matter?

• Manufacturing Cost- How To Determine And Minimize – A Conclusion

An Overview of Manufacturing Cost

Manufacturing cost is the total cost incurred by a company to produce finished products from raw materials. This includes the cost of direct labor, materials, and overhead expenses associated with production.

Manufacturing costs can be further divided into two categories: variable costs and fixed costs. Variable costs change concerning the number of units produced, such as the cost of labor or raw materials. Fixed costs remain constant regardless of production volumes, such as rent or insurance.

Knowing the total manufacturing cost is vital for businesses to determine their selling price and profitability. By understanding all the costs associated with production, companies can make informed decisions about pricing, operations, and expansion.

How To Determine Manufacturing Cost

To determine the manufacturing cost of a product, businesses must first consider the direct materials, direct labor, and overhead associated with production.

Three Categories of Production Costs

• Direct materials 

These are materials that are directly used to produce a good or service. This would include things like lumber for a furniture company or steel for a car company.

The cost of direct materials can be variable or fixed, depending on the type of business and the production process. The cost of direct materials can significantly impact the overall manufacturing cost. If the price of raw materials increases, the company will have to raise its prices or take a hit to its bottom line.

• Direct labor

Direct labor is the cost of labor directly associated with producing goods. This includes wages for workers involved in the production process, benefits, and other forms of compensation. The direct labor cost also includes any taxes associated with employee wages.

Direct labor is a crucial component of manufacturing cost, representing the most significant portion of the total cost. Companies must carefully manage their direct labor costs to remain competitive.

• Overhead

Overhead costs are not directly tied to producing a good or service but are necessary for the company to function. Examples of overhead costs include rent, utilities, insurance, and office supplies. 

While some overhead costs are fixed and do not change based on production volume, others are variable and will increase or decrease as production increases or decreases.

Companies need to understand both types of overhead to price their products and services accurately. If a company does not adequately account for its overhead costs, it may be in financial trouble.

Methods To Determine Manufacturing Cost

1. Absorption Costing

In business, many decisions must be made to ensure products are produced cost-effectively. One way to determine the manufacturing cost of a product is through absorption costing. 

Absorption costing is a method used to calculate the total cost of production by considering all direct and indirect costs associated with production. This includes raw materials, labor, overhead, and shipping costs.

By considering all these costs, businesses can get a better sense of the actual cost of production and make informed decisions about how to price their products. While absorption costing is not the only method available for determining manufacturing costs, it is a commonly used method that can provide valuable business insights.

There are benefits and drawbacks to using absorption costing. On the plus side, it provides managers with better information for decision-making. It can also help identify areas where cost savings can be made.

On the downside, it can be complex and time-consuming to calculate. By understanding how this method works, businesses can make more informed decisions about their production processes and pricing strategies.

Example- Absorption Costing

To calculate the absorption cost per unit, we first need to calculate the total manufacturing cost. This is done by adding all the direct and indirect costs incurred during production. Once we have the total manufacturing cost, we divide it by the units produced to arrive at the per-unit cost.

For example, let’s say that Company XYZ has total manufacturing costs of $100,000 for the year. They produce 10,000 units of their product during that same period. The absorption cost per unit would be $10 ($100,000 / 10,000).

2. Variable Costing

Variable costing is a managerial accounting technique that can be used to trace and allocate the variable costs of production, to understand better and manage a company’s financial performance. 

Unlike traditional absorption costing, which includes fixed and variable costs in calculating product cost, variable costing only includes direct materials, direct labor, and variable overhead costs. This makes it an important tool for management when identifying which production areas are incurring the most cost. 

Variable costing is particularly useful in manufacturing settings with high unit-level activity and significant fluctuations in raw material prices. In these cases, using variable costing can provide managers with timely information about changes in production costs to make necessary adjustments.

Moreover, this is beneficial because it provides managers with information about the most profitable products. In addition, it can help managers make decisions about pricing, production levels, and product mix. 

Despite these advantages, there are some drawbacks to using a variable costing system. For example, this system does not consider fixed costs when manufacturing per unit. As a result, it may underestimate the actual cost of production and lead to decision-making errors.

Example- Variable Costing

The goal of variable costing is to show the actual cost of each unit produced. Variable costing is often used in management decision-making because it provides a more accurate picture of the marginal cost of producing each additional unit. 

To calculate the marginal cost under variable costing, we need to add the variable costs for each unit produced. For example, if the company produces 100 widgets for $1,000, then the marginal cost of producing one additional widget is $10 (($1,000/100) + 10). If the company produces 200 widgets, then the marginal cost of each widget falls to $9.

3. Marginal Costing

In business, marginal costing is a way of allocating manufacturing costs to products. It involves adding direct materials, labor, and variable overhead costs to produce a product.

In contrast, fixed overhead costs are not included in the calculation. The goal of marginal costing is to determine the cost of each unit produced so businesses can price their products accordingly and make informed decisions about production levels. 

There are several benefits to using marginal costing. First, it provides accurate information about the actual cost of production. This is important for pricing products and making decisions about production levels. Second, it is a relatively simple method to calculate costs.

This makes it easy to use and understand for decision-makers. Finally, marginal costing can be used with other methods, such as activity-based costing, to provide a more comprehensive picture of manufacturing costs.

Example-Marginal Costing

In business, marginal costing is a technique used to calculate variable production costs. This information is then used to make decisions about pricing and output levels.

For example, let’s say a company produces widgets. The fixed costs of production are $10,000 per month. The variable costs of production are $0.50 per widget. The company sells the widgets for $1 each.

If the company produces 10,000 widgets, the total cost of production will be $15,000 (10,000 x $0.50 + $10,000). The total revenue will be $10,000 (10,000 x $1). 

The company’s profit will be $5,000 (total revenue – total cost of production).

4. Activity-based costing

Activity-based costing (ABC) is a way to determine the manufacturing cost of a product. It assigns manufacturing overhead to products based on their activities rather than using a single, plant-wide overhead rate. This makes it possible to assign costs to products more accurately and better understand the actual cost of manufacturing. 

ABC has become increasingly popular as manufacturers look for ways to improve their cost accounting. It can be used with other costing methods, such as process or job-order costing. ABC benefits organizations that produce various products or have complex production processes. 

While ABC can help understand the cost of manufacturing, it does have some drawbacks. One is that it can be costly and time-consuming to implement. Additionally, ABC relies on accurate information about the time spent on each activity and the resources used.

Example- Activity-based costing

In activity-based costing, overhead costs are assigned to products based on their use of resources. This provides a more accurate picture of the actual cost of each product.

For example, imagine a company that manufactures products: Product A and Product B. The company has two types of overhead costs: manufacturing overhead and marketing overhead. Under traditional costing methods, manufacturing overhead would be allocated to the products based on their direct labor hours. 

So if Product A required 10 hours of direct labor and Product B required 20 hours of direct labor, then Manufacturing Overhead would be allocated as follows: Product A – 50% x Manufacturing Overhead = $5; Product B – 100% x Manufacturing Overhead = $10.

However, this doesn’t consider that Product B may require more resources than Product A.

Top 5 Ways On How To Minimize Manufacturing Cost

To reduce or minimize manufacturing costs, it is vital to understand all associated costs with production. This includes both direct and indirect costs. There are several ways to reduce manufacturing costs. 

1. Review your process and identify areas to streamline or eliminate steps. 

As a manufacturer, it is essential to constantly review your process and identify areas where you can streamline or eliminate steps. This is one of the best ways to minimize manufacturing costs.

There are many factors to consider when streamlining your manufacturing process.

1. First, you must identify which steps are essential and which can be eliminated. Often, manufacturers add unnecessary steps that add no value to the final product.

2. Next, you need to look at ways to simplify each step in the process. This may involve automating specific tasks or redesigning the process flow.

By streamlining your manufacturing process, you can reduce costs without sacrificing quality.

2. Evaluate your suppliers and negotiate better terms or prices

The cost of goods sold (COGS) is one of the essential factors in determining a company’s profitability. To minimize COGS, evaluating your suppliers and negotiating better terms or prices is essential.

There are several ways to evaluate your suppliers. One way is to analyze their financial statements. This will give you an idea of their overall financial health and whether they are likely to be able to offer you better terms or prices.

Another way to evaluate your suppliers is to assess their customer service. Do they respond quickly to inquiries? Do they provide accurate and timely information? Are they easy to work with? Good customer service can save you time and money by preventing problems before they occur.

Lastly, you should consider the quality of your suppliers’ products or services.

3. Automate as much of the process as possible

As the world progresses, so does the technology available to manufacturers. To stay ahead of the competition and minimize cost, automating as much of the process as possible is crucial.

There are many benefits to automating the manufacturing process. Perhaps most importantly, it reduces the amount of labor that is required. This, in turn, reduces the overall cost of production. Additionally, automating as much of the process as possible helps speed up production time and improve accuracy.

While there are many advantages to automating the manufacturing process, some challenges must be considered. One such challenge is ensuring that all equipment is compatible with one another.

Additionally, it is vital to clearly understand the manufacturing process before attempting to automate it. Otherwise, there is a risk of errors and inefficiencies.

4. Review your overhead costs and see where to make cuts or reductions

As the cost of labor and raw materials continue to rise, manufacturers feel the squeeze in their bottom line. One way to combat these rising costs is to review your overhead costs and see where you can make cuts or reductions.

One area where you can reduce costs is your marketing budget. Look closely at your marketing campaigns and see if any can be scaled back or eliminated. You may also consider reallocating your marketing budgets to more cost-effective channels like online advertising.

Another area to take a closer look at is your production process. See if there are any areas where you can streamline or automate tasks to reduce labor costs. In addition, take a look at your suppliers and see if you can negotiate better terms or find cheaper alternatives.

5. Implement lean manufacturing principles throughout your operation 

Implementing lean manufacturing principles throughout your operation is an effective way to minimize manufacturing costs. Lean manufacturing is a systematic approach to identifying and eliminating waste in all production areas from the initial concept stage to final delivery.

You can improve overall efficiency and quality by eliminating waste and reducing costs. Many lean tools and techniques, such as value stream mapping, 5S, kanban, and poka-yoke, can achieve these objectives.

When implemented correctly, lean principles can significantly impact your bottom line. Many organizations have reported reduced lead times, inventory levels, and cycle times of 30% or more.

Why Does Manufacturing Cost Matter?

There are many reasons why manufacturing cost matters. Here are three critical reasons:

1. Manufacturing cost is a significant determinant of price

When a company plans to manufacture a product, it must consider how much it will cost to make each unit. The company must also consider how many units it can sell and at what price. The goal is to make enough money from sales to cover the costs of making and selling the product and still have some profit. 

The amount it costs to make each unit is called the manufacturing cost. The manufacturing cost includes materials, labor, and overhead (rent and utilities). The company will have to charge more for its product to profit if the manufacturing cost is high.

2. It is a significant driver of profitability

In business, profitability is king. Every company wants to be as profitable as possible, and there are several ways to achieve this. One primary driver of profitability is manufacturing cost.

Simply put, the lower your manufacturing costs, the higher your profits will be. This is because manufacturing costs are a significant expense for businesses. The lower these costs are, the more money the company will have left over to reinvest or distribute to shareholders.

There are some ways to reduce manufacturing costs, and companies should always be on the lookout for ways to do so. By keeping manufacturing costs low, businesses can increase their profits and become more successful overall.

3. Manufacturing cost is an essential factor in financial decision-making

In manufacturing, it is crucial to understand and control costs. This is because manufacturing costs are a significant factor in financial decision-making.

For example, if a company wants to increase its profit margin, it must sell more products or decrease its manufacturing costs. To decrease manufacturing costs, the company must find ways to make its production process more efficient. This could involve investing in new technology or changing how raw materials are sourced.

Therefore, understanding and controlling manufacturing costs is essential for any business that wants to stay competitive and profitable.

The Impact Of Manufacturing Costs On Businesses

The manufacturing industry’s ever-changing landscape directly impacts large and small businesses. With the volatile nature of raw materials, labor, and transportation costs, companies must be agile in managing these expenses.

The most successful businesses keenly understand their cost structure and can quickly adapt when market conditions dictate a change. Companies must clearly understand their manufacturing costs to stay ahead of the competition.

Several factors can impact the cost of manufacturing, including the price of raw materials, labor costs, and transportation expenses. By understanding how these factors affect their business, companies can make informed decisions that will help them control costs and remain profitable.

Manufacturing Cost- How To Determine And Minimize – A Conclusion

There are a few key things when determining your company’s manufacturing costs.

1. First, consider all direct and indirect costs associated with production.

2. Next, establish a baseline cost per unit and track any changes over time.

3. Finally, work to minimize these costs by streamlining your processes and eliminating unnecessary expenses.

By following these steps, you can ensure that your manufacturing costs are as low as possible, giving you a competitive edge in today’s marketplace.

Manufacturing Cost- Recommended Reading

1. Absorption Costing – What is it, Why it Matters (benjaminwann.com)

2. Manufacturing Profitability- Defined & Explained (benjaminwann.com)

3. What Is The Total Manufacturing Cost Variance? (benjaminwann.com)

4. The Complete Guide To Calculating Total Manufacturing Costs – Unleashed Software

5. 10 Ways To Reduce Manufacturing Costs – Industry Trends – Rowse

Updated: 5/21/2023