What are production costs? How to calculate and classify production costs

Production costs play an important role in determining product prices as well as business revenue. So what are production costs and what types of production costs are there? Please join 1C Vietnam in reading the article below for more detailed information.

1. What are production costs?

Production costs are all direct or indirect costs that businesses have to pay for resources such as labor, raw materials, production supplies,... to create products or services. This product/service will be sold to consumers to generate revenue for the business.

Production costs to create products will be recorded in the cost of goods sold of the enterprise in the business income statement. At the same time, this cost helps administrators provide reports to shareholders about the business's operations and production investment.

Businesses often calculate production costs based on the basic formula below:

Manufacturing costs = Direct material costs + Direct labor costs + Manufacturing overhead costs incurred from the beginning to the end of the production process

To calculate the production cost per unit, the administrator divides the total production cost by the number of finished products produced. To break even, the selling price must cover the cost of production per unit. If the selling price is higher, the business will earn a profit and vice versa, leading to losses in the business and investment process.

2. Types of production costs

Production costs are divided into different categories based on 3 specific criteria as follows:

2.1. Based on the purpose and use of the cost

Based on purpose and use, production costs are divided into the following categories:

• Direct labor costs: Are the costs businesses must pay to workers directly involved in creating products or services. This cost includes salary, allowances, deductions such as social insurance, health insurance and other taxes.
• Direct material costs: Is the cost of purchasing raw materials to create products and services, including the amount the business must pay to purchase raw materials used directly in the production process. Direct materials costs can be easily determined and calculated per unit of a specific product or service.
• Manufacturing overhead costs: This is the sum of the costs that occur during the production process, excluding direct labor costs and direct materials costs:

• Cost of auxiliary materials: Costs related to auxiliary materials combined with main materials to change the color, appearance of the product, etc. Costs of auxiliary materials not directly involved in production , but still needed for the product/service creation process.
• Fixed asset depreciation expense: Is a cost that helps evaluate and reallocate the value of fixed assets (machinery, equipment) during use due to wear and tear.
• Factory employee costs: Are the costs of employees working in the production workshop, excluding costs included in direct labor costs. These costs may include expenses for clothing, protective gear, and equipment needed for production staff.
• Outsourced service costs: These are costs paid for external services incurred by the business, such as consulting services, technical support services,...
• Other cash expenses: Are all other expenses not included in the above categories, calculated in cash. This cost may include special or irregular expenses that the business must pay. For example, incident or emergency handling costs, maintenance and repair costs for machinery and equipment for production are included in other monetary costs.

Classifying production and business costs according to purpose and use helps businesses better understand the cost structure. From there, the company can easily calculate total costs and product prices to make appropriate adjustments and plans.

2.2. Based on economic properties

Based on this criterion, production costs are divided into 5 main categories:

• Labor costs (Labor costs): Is the total amount of money businesses have to pay to workers. These costs are fixed costs including benefits, insurance, and taxes according to state regulations. As the rate of production increases, fixed costs remain unchanged.
• Raw material costs: Raw material costs account for a large proportion of production and business costs, including the cost of purchasing the raw materials that make up the product, the cost of purchasing and transporting from the place of purchase to the warehouse. The cost of purchasing raw materials is calculated according to the actual value when used.
• Fixed asset depreciation expense: A cost that helps evaluate and reallocate the value of a business's assets because assets wear out over time during use. Fixed assets include machinery, equipment, vehicles, factories, etc. Depreciation costs of fixed assets are allocated over periods of use to show the degree of decrease in value of the asset according to time.
• Outsourcing service costs: Are the costs businesses must pay to purchase external services such as consulting services, technical support services, advertising, transportation,...
• Other costs in money: Are costs incurred and not included in the list of depreciation costs or service costs purchased from outside, such as fines due to contract violations, remaining value of liquidated fixed assets, collapse,...

2.3. Based on the relationship with workload and products by period

Based on the relationship with the volume of work and products in the period, production costs are divided into 2 types:

• Fixed costs: These are costs that do not change according to the amount of work or products completed in a certain period of time. For example, factory rental costs or monthly worker salary costs are fixed costs.
• Variable costs: These are costs that increase or decrease according to the number of jobs or products completed. For example, direct materials costs and hourly wages are variable costs because they increase when production or work increases and decrease when production or work decreases.

Classifying fixed costs and variable costs helps businesses better understand the impact of costs on business operations. This helps administrators make decisions effectively.

2.4. Based on the production and manufacturing process

Based on the production and product manufacturing process, production costs are divided into basic costs and general costs:

• Basic costs: Are direct and fixed costs in each specific step of the production or manufacturing process. These costs are often closely related to a certain stage in the process and cannot be separated. For example, direct material costs and direct labor costs are basic costs.
• General costs: These are costs that cannot be specifically divided into each stage of the production process. Overhead costs are usually support costs, not directly dependent on the product or specific production step. For example, depreciation costs of fixed assets and general operating costs of factories are common costs.

Classifying production costs based on production and manufacturing processes helps businesses have an overview of the cost structure in production or manufacturing. From there, businesses can evaluate and come up with solutions to maximize profits for each stage.

2.5. Based on the method of gathering production costs into cost objects

With this method, production costs are divided into 2 categories:

• Indirect costs: Are costs that cannot be clearly identified with a specific object. At that time, companies often have to use allocation methods such as percentage, workload or similar indicators to divide indirect costs to each respective object.
• Direct costs: These are costs that can be clearly identified and divided to each specific object. Managing and allocating direct costs is often easier because there is a clear connection to specific factors within the business.

These ways of dividing production costs help businesses identify and use resources effectively. This ensures costs are properly allocated and meet the business goals of the business.

3. Meaning of production costs

Production costs play an important role in business operations:

• Determining effective product prices: Production costs help businesses determine the cost of a product or service, ensuring that the selling price includes all production costs and can make a profit.
• Effective cost management: To maintain profits and competitive advantage, businesses need to manage and control production costs effectively, find ways to save and optimize resources.
• Make quick business decisions: Information about production costs provides businesses with data to make important business decisions. Managers can determine which products should continue to be produced, which products should be discontinued, or improve product quality and performance.
• Performance Evaluation: Production costs are also used to evaluate the performance of a business. By comparing expected cost metrics and with competitors, businesses can evaluate actual performance levels.
• Financial planning: Information about production costs is an important part of supporting administrators in planning the business's finances, determining necessary financial sources, maintaining production and development activities. business.
• Optimize the production process: By understanding and analyzing production costs, businesses can find ways to optimize processes, reduce waste, increase efficiency and improve product or service quality.

Production costs are an important aspect of financial management and business operations of an enterprise. This cost greatly affects the ability of businesses to survive and develop in the market. Therefore, businesses must manage production costs in the most effective way.

4. Production costs and product prices

Many managers still confuse the two concepts of production costs and product costs. In fact, production costs and product prices have certain differences:

• Product costs are all costs related to the production or completion of a product, including labor costs, raw material costs, etc. However, these are directly related costs. to production.
• Production costs include direct costs of calculating product prices plus other costs such as purchasing service costs, depreciation costs,...

Production costs and product prices have similarities in that they both reflect the costs that businesses have to spend during the production process. However, production costs are the basis for creating the price of a product/service. Product cost is a measure to accurately calculate the cost of creating a perfect product.

Thus, production costs play an important role in contributing to the development of a business and can be divided into different categories, depending on specific business goals. To learn more useful content, don't forget to follow 1C Vietnam's website!