How to Calculate Production Costs (with Pictures)

Table of contents:

How to Calculate Production Costs (with Pictures)
How to Calculate Production Costs (with Pictures)
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The cost of production (CoP) is the total cost of manufacturing a product or delivering a service. CoP varies between products and services, but usually includes labor costs, material costs and fixed costs. On your company's income statement, the CoP is subtracted from the total revenue to calculate the gross profit margin. In general terms, it is possible to calculate the CoP by determining the change in the value of the inventory over a given period. To do this, it is necessary to assume that this variation is due to the production of the units sold in the period considered.

Steps

Part 1 of 4: Calculate Initial Inventory, Costs and Purchases

Account for Cost of Goods Sold Step 1
Account for Cost of Goods Sold Step 1

Step 1. Calculate the starting inventory value

The value should always be equal to that of the closing inventory of the previous fiscal period. If you are a reseller, the value is the cost of all goods in stock available for sale. If you have a manufacturing activity, the value is made up of three items: raw materials (all materials used for production); semi-finished products (items that are in production but have not been completed); finished products (objects completed, ready for sale).

As an example scenario, let's assume that the closing inventory value of the previous fiscal period is € 17,800

Account for Cost of Goods Sold Step 2
Account for Cost of Goods Sold Step 2

Step 2. Add the value of all purchases to your inventory

You can calculate this figure by adding the balance of all purchase invoices you received during the period under review. You should also assign a value to products received, but not yet billed by the seller, according to the purchase order. If you have a manufacturing business, also consider the cost of all raw materials purchased during the period under review to obtain finished products.

Let's assume that the total purchases of raw materials amount to € 4,000 and that the purchases of finished products for that period amount to € 6,000

Account for Cost of Goods Sold Step 3
Account for Cost of Goods Sold Step 3

Step 3. Calculate the cost of labor required to produce the goods

When calculating the cost of products, you must include direct and indirect labor costs, only if you have a manufacturing or mining company. Calculate the salaries of all employees in the manufacturing department, plus the cost of their benefits. Usually, retailers do not include labor costs in this calculation, because it cannot be attributed to the cost of goods.

  • For manufacturing activities, it is necessary to include all direct work (employees directly responsible for the production of the goods from raw materials) and indirect (employees who perform a function necessary for the company, but not directly linked to the production of goods). Administrative expenses are not included.
  • In our example, the cost of labor in the period under review amounts to € 500 per person x 10 employees = € 5,000.
Account for Cost of Goods Sold Step 4
Account for Cost of Goods Sold Step 4

Step 4. Calculate the expenses for materials, supplies and other production costs

For manufacturing activities only, the cost of transport and containers, fixed costs such as rent, heating, light, electricity and other expenses related to the use of production facilities can be included in this calculation. Add these values together to calculate the cost of available goods (initial inventory, purchases and production costs).

  • Note that the fixed expenses for the use of the production plant can only be considered in this calculation. They include rents, utility bills and other expenses related to the manufacturing plant. Similar expenses for other areas of your business, such as the office building, are not directly related to the manufacturing of the products. For this reason, they should not be included.
  • In our example, we include € 1,000 for transport, € 500 for raw material containers, and € 700 for fixed costs attributable to production, such as heating and lighting. The total various costs therefore amount to € 2,200.
Account for Cost of Goods Sold Step 5
Account for Cost of Goods Sold Step 5

Step 5. Calculate the total cost of goods available in stock

This is the value from which we will subtract the final inventory to determine the cost of production. In our example, € 17,800 (initial inventory) + € 10,000 (purchases) + € 5,000 (labor costs) + € 2,200 (miscellaneous costs) = € 35,000 (cost of available goods).

Part 2 of 4: Calculate the Final Inventory

Account for Cost of Goods Sold Step 6
Account for Cost of Goods Sold Step 6

Step 1. Choose between two methods to estimate the final inventory

When it is not possible to calculate the exact value of the inventory, it is necessary to use an estimate. It can happen if your sales have increased at the end of the fiscal period, or if you don't have the staff on hand to do an exact count of all the goods in stock. The methods described below rely on statistical precedents and are therefore not 100% accurate. By adopting one, however, if your company has not recorded abnormal transactions during the period under review, you can achieve satisfactory results.

  • The first method uses the company's previous gross profit margins.
  • The second method, called the sales inventory, compares the price of the goods sold with the cost of production in the previous period.
Account for Cost of Goods Sold Step 7
Account for Cost of Goods Sold Step 7

Step 2. Use the gross profit method to estimate the final inventory

This result is driven by previous gross profit margins. As a result, it may not be entirely accurate, because the data you use may have different values in the current fiscal period. It can be used with a good approximation during the transition periods between one physical inventory and the next.

  • Adds the initial inventory value to the cost of purchases during the current fiscal period. This figure represents the value of the goods available during the period under review.
  • Let's assume that the initial inventory amounts to € 200,000 and the total purchases to € 250,000. The total goods available are worth € 200,000 + € 250,000 = € 450,000.
  • Multiply your sales by (1 - expected gross profit margin) to estimate the cost of production.
  • For example, let's say your gross profit margin over the past 12 months was 30%. In the present period, we can assume that it has remained the same. If the sales were € 800,000, you can estimate the cost of production with the equation (1-0.30) * € 800,000 = € 560,000.
  • Subtract the value of available goods from the newly calculated production cost to get an approximate final inventory value.
  • Using the example above, the estimated final inventory would be worth € 110,000. € 560,000 - € 450,000 = € 110,000.
Account for Cost of Goods Sold Step 8
Account for Cost of Goods Sold Step 8

Step 3. Use the sales inventory method to estimate the final inventory value

This method does not use the company's previous gross profit margins. Instead, compare the selling price with the cost of goods in previous periods. Note that this method is valid only if the same percentage mark-up is always applied to the products in question. If a different markup was used or discounts were offered during the period under review, the method will not provide accurate results.

  • Calculate the relationship between cost and sales using the formula (cost / sales price).
  • For example, let's say you sell vacuum cleaners for $ 250 each and their cost is $ 175. Calculate the cost / sale percentage with the equation € 175 / € 250 = 0.70. The percentage is 70%.
  • Calculate the cost of goods available for sale with the formula (cost of initial inventory + cost of purchases).
  • Let's assume that the initial inventory amounts to € 1,500,000 and the total purchases to € 2,300,000. The cost of available goods is € 1,500,000 + € 2,300,000 = € 3,800,000.
  • Calculate the cost of sales during the period under consideration with the formula (sales * cost / sales ratio).
  • If sales in the period were € 3,400,000, the cost of sales is € 3,400,000 * 0.70 = € 2,380,000.
  • Calculate the final inventory with the formula (cost of goods available for sale - cost of sales during the period).
  • Following the example above, the final inventory is worth € 3,800,000 - € 2,380,000 = € 1,420,000.
Account for Cost of Goods Sold Step 9
Account for Cost of Goods Sold Step 9

Step 4. Periodically obtain an accurate evaluation of the final inventory, thanks to a physical count of the goods in stock, periodic or cyclical

In some situations, it is necessary to invest time and resources to make an exact physical inventory. For example, when your company needs to prepare for a tax audit, or when it comes to corporate acquisitions or mergers. In these cases, you need an exact inventory calculation, because an estimate is not accurate enough.

  • Make a complete account of the company's inventories. This is known as physical inventory and must be done at the end of a month, quarter or year. It requires a lot of work, so typically, companies do physical counting only a few times a year.
  • Cyclical inventory is a perpetual calculation method. A small portion of the inventory value is calculated each day. In a defined period, inventories are fully controlled, because all items are counted in rotation. This method is very precise and allows you to calculate the inventory with excellent approximation.

Part 3 of 4: Calculate the Cost of Production

Account for Cost of Goods Sold Step 10
Account for Cost of Goods Sold Step 10

Step 1. Calculate the cost of production if you use a periodic physical inventory method

Use these steps if you do an exact inventory count at regular intervals, for example, every month, quarter, or year. The formula is very simple: (Initial Inventory + Purchases - Final Inventory = Production Cost).

  • Let's say your business sells toasters. At the beginning of October 2015, the inventory amounted to € 900. During October 2015, you purchased € 2,700 worth of goods. Physical inventory at the end of the month showed that the value of inventories had dropped to € 600.
  • Calculate the cost of production with the equation € 900 + € 2,700 - € 600 = € 3,000.
  • If you count inventory every month, you will always know the starting and ending inventory values for the accounting period.
  • If you do physical inventory less frequently, such as quarterly, during months when you don't have accurate data, you will need to estimate the final inventory value using the methods described above.
Account for Cost of Goods Sold Step 11
Account for Cost of Goods Sold Step 11

Step 2. Calculate the cost of production if you are using a cyclical physical inventory method

Adopt this formula if you keep the count of goods in stock by recording every single item. For example, if you are a reseller and you scan the barcodes of the items you sell, you will have control over the size of your inventory in real time.

  • If you record the inventory changes of each individual unit, to calculate the final inventory value, you need to approximate which units were used first during the accounting period.
  • This way you can take into account changes in the cost of items in your inventory.
  • These approximations are known as the first-in-first-out (FIFO), last-in-first-out (LIFO) method. out) and the average cost.
Account for Cost of Goods Sold Step 12
Account for Cost of Goods Sold Step 12

Step 3. Calculate the cost of production using the FIFO method

Imagine owning a company that sells dog collars over the internet. All collars are purchased from a single supplier. In mid-November 2015, the supplier raised the price of one of the products from € 1 to € 1.50. Using the FIFO method, assume that you have sold the $ 1 collars before the newer $ 1.50 collars.

  • Determine the starting inventory. At the beginning of November 2015, you had 50 collars in stock, which cost € 1 each. As a result, the initial inventory value was € 50 (€ 50 * 1 € = € 50).
  • Calculate your total purchases. During the month of November 2015, you purchased 100 dog collars: 60 to 1 € each and 40 to 1, 50 € each. Total purchases amount to (60 * 1 €) + (40 * 1, 50 €) = 120 €.
  • Calculate the total inventory available for sale. Add the initial inventory (€ 50) to purchases (€ 120), for a total of € 170. Since you have a cyclical inventory system, you know that of these 170 € of goods available for sale, 110 units were purchased for € 1 each (€ 110) and 40 were purchased for € 1.50 each (€ 60).
  • In November 2015, you sold 100 dog collars. Using the FIFO method, imagine that you have sold the oldest items in stock first. You had a stock of 110 units of collars purchased for € 1 each. Your hypothesis, therefore, is to have sold throughout the month of November only collars purchased for € 1. Your production cost for November 2015 is 100 * 1 € = 100 €.
  • There are still 10 collars left in stock, purchased for € 1. In the next accounting period, this information will be useful for you to calculate the cost of production with the FIFO method.
Account for Cost of Goods Sold Step 13
Account for Cost of Goods Sold Step 13

Step 4. Calculate the cost of production using the LIFO method

Using the same example, imagine selling the newest collars first. Collars bought in November 2015 are 100. According to the LIFO method, you sold 40 units which cost € 1.5 and 60 units which cost € 1.

The production cost is equal to (40 * 1, 50 €) + (60 * 1 €) = 120 €

Account for Cost of Goods Sold Step 14
Account for Cost of Goods Sold Step 14

Step 5. Calculate the cost of production using the average cost method

With this method, you will find the average of the initial inventory value and purchases made over the month. First, calculate the unit cost. Then, multiply that value by the number of units in inventory at the end of the accounting period. You will use this calculation to determine the cost of production and the final inventory balance.

  • Calculate the average unit cost with the formula (Initial inventory + purchases in euros) / (Initial inventory + purchases in units).
  • Using the above example, the unit cost is € 1.13: (€ 50 + € 120) / (50 + 100) = € 1.13.
  • In our case, at the beginning of November, there were 50 units in stock. During the period under review, 100 units were purchased for a total of 150 units available for sale. 100 units were sold, leaving 50 collars in stock at the end of the month.
  • Calculate the cost of production by multiplying the average unit cost by the total number of units sold.
  • 1, 13 € * 100 = 113 €.
  • Production cost = 113 €.
  • Calculate final inventory by multiplying the average unit cost by the number of units remaining in stock at the end of the month.
  • 1, 13 € * 50 = 56, 50 €.
  • Final inventory = 56.50 €.

Part 4 of 4: Writing the Balance Sheet Items

Account for Cost of Goods Sold Step 15
Account for Cost of Goods Sold Step 15

Step 1. Fill in the double entry if you are using a periodic inventory method

Using this system, the inventory value on the balance sheet remains the same until the next physical count. In each accounting period, when the value of inventories is not known, the "Purchases" item is used instead of the "Inventory" item. After completing the physical inventory, the value of the "Inventory" item will be changed.

  • Imagine that you own a business that sells T-shirts. You buy the t-shirts for € 6 and sell them for € 12.
  • At the start of the review period, you have 100 shirts in stock. The initial inventory value is € 600.
  • Buy 900 shirts for € 6 each, for a total of € 5,400. Credits € 5,400 to the Accounts payable account and debits € 5,400 to the Purchases account.
  • Sell 600 shirts for € 12 each, for a total of € 7,200. Debits € 7,200 to the Customer Loans account and credits € 7,200 to the Sales account.
  • The final inventory value is € 2,400 (400 shirts for € 6). Charges € 1,800 to Inventory and € 3,600 to Production Cost account. Credit € 5,400 to the Purchasing account.
Account for Cost of Goods Sold Step 16
Account for Cost of Goods Sold Step 16

Step 2. Fill in the double entry if you are using a cyclical inventory

If you use this system, you record the cost of production and change the inventory value for the whole year. In this case, no further changes need to be made at the end of the accounting period.

  • At the start of the review period, you have 100 shirts in stock. The initial inventory value is € 600.
  • Buy 900 shirts for € 6 each, for a total of € 5,400. Charge Inventory € 5,400. Credit to the account Payables to suppliers € 5,400.
  • Sell 600 shirts for € 12 each, for a total of € 7,200. Debits € 7,200 to the Customer Loans account and credits € 7,200 to the Sales account. He charges € 3,600 to Production Cost and credits € 3,600 to Inventory.
  • The final inventory value is € 2,400 (400 shirts for € 6). You don't have to enter any other entries. You have already registered an item in the Inventory account which has brought its value to € 2,400.

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