Total manufacturing cost definition
/What is Total Manufacturing Cost?
Total manufacturing cost is the aggregate amount of cost incurred by a business on its production operations within a reporting period. It includes all possible costs incurred by the production function, including direct materials, direct labor, and factory overhead. It does not include administrative costs, which are classified within the selling, general and administrative section of the income statement.
How to Calculate Total Manufacturing Cost
The more common usage of the term is that total manufacturing cost follows the first definition, and so is the amount charged to expense in the reporting period. For this situation, the calculation of total manufacturing cost is as follows:
Direct materials. Add the total cost of materials purchases in the period to the cost of beginning inventory, and subtract the cost of ending inventory. The result is the cost of direct materials incurred during the period.
Direct labor. Compile the cost of all direct manufacturing labor incurred during the period, including the cost of related payroll taxes and employee benefits. The result is the cost of direct labor.
Overhead. Aggregate the cost of all factory overhead incurred during the period. This includes such costs as production salaries, facility rent, repairs and maintenance, and equipment depreciation.
Add together the totals derived from the first three steps to arrive at total manufacturing cost.
The calculation of this cost is somewhat different if we use the second definition, where some of the cost may be assigned to goods that are produced, but not sold. In this case, use the following steps (assuming that standard costing is used):
Assign a standard materials cost to each unit produced.
Assign a standard direct labor cost to each unit produced.
Aggregate all factory overhead costs for the period into a cost pool, and allocate the contents of this cost pool to the number of units produced during the period.
When a unit is sold, charge to the cost of goods sold the associated standard materials cost, standard direct labor cost, and allocated factory overhead.
Note: If more units are sold than are produced in a period, then costs assigned to inventory from a previous period are being charged to expense, in which case the cost of goods sold will be higher than the total manufacturing cost incurred in the period.
In these calculations, the cost of direct materials includes those materials and supplies that are consumed during the manufacture of a product, and which are directly identified with that product. Items designated as direct materials are usually listed in the bill of materials file for a product. The cost of direct labor includes the labor, payroll taxes, and benefits of the production crew that produces goods, such as machine operators, assembly line operators, painters, and so forth. Factory overhead is the costs incurred during the manufacturing process, not including the costs of direct labor and direct materials. Overhead costs include rent, utilities, depreciation, supervisory salaries, equipment setup costs, and so forth.
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Accounting for Total Manufacturing Cost
There are two approaches to the accounting for total manufacturing cost. They are as follows:
Charge to expense. You can charge the entire amount of this cost to expense in the reporting period, which means that total manufacturing cost is the same as the cost of goods sold. This situation arises when a business is barely keeping up with customer demand, so there is no residual inventory on hand at the end of a reporting period.
Split between expense and inventory. You can charge a portion of this cost to expense in the period, where some of it is allocated to goods produced in the period, but not sold. Thus, a portion of total manufacturing cost may be assigned to the inventory asset, as stated in the balance sheet. In the latter case, a business is manufacturing more goods than is initially demanded by customers. This is a common situation in a seasonal business that needs to build up its stocks prior to the peak selling season.
Total Manufacturing Cost vs. Cost of Goods Sold
Total manufacturing cost includes all production costs incurred during a reporting period, while the cost of goods sold is the cost of any goods actually sold to customers during that period. The cost of goods sold can be higher or lower than the total manufacturing cost. It is higher when more goods are sold than were produced in a period, which means that some goods were sold from inventory. It is lower when fewer goods were sold than were produced, which means that some of the goods produced were still in inventory at the end of the period.
Advantages of Total Manufacturing Cost
There are multiple advantages to calculating total manufacturing cost. First, having a complete understanding of these costs makes it easier to benchmark them and determine which ones can be reduced. This is an ongoing process of paring back expenses that can result in significant cost reductions over time. It may also trigger an understanding of which suppliers are charging too much, which may lead to a realignment of the company’s mix of suppliers towards those more willing to work with the company on price.
Another advantage is that having a better understanding of total manufacturing cost allows a business to budget better for these costs in the future. Doing so allows for greater transparency concerning where the company makes money, and what can be done to improve the situation. In situations where costs are unusually high, this analysis might even lead management to terminate some products and develop new ones with larger gross margins. Alternatively, management might try to increase prices in cases where product costs are high, to see if margins can be improved without reducing unit volumes too much. The reverse approach might be attempted when unit costs are low, by setting prices lower in an attempt to attract business away from competitors. Or, this knowledge might lead management toward the use of new distribution channels that are less expensive to operate, such as an Internet store that cuts out wholesalers and retailers, thereby preserving margins.
Yet another advantage is that the cost analysis might uncover unusually large amounts of inventory obsolescence or scrap write-offs. If so, management might delve into the purchasing process, to see if inventory can be acquired and stored in smaller volumes. It might also push management in the direction of outsourcing some production activities that are generating excessively high scrap levels in-house. Either approach has the added benefit of reducing inventory storage costs, which reduces factory overhead charges.
Finally, a total manufacturing cost analysis might lead to a review of production processes, to see if they can be made more efficient. Doing so may reduce costs, increase product quality, and speed up the production process - which in turn may attract more customers due to the company’s reduced order turnaround times.
In short, having a detailed understanding of total manufacturing cost can lead to a variety of internal investigations that can fine-tune a business, so that it produces higher-quality products more quickly, reduces its costs, and attracts more customers.