The cost of production (or cost of operation) is the expense necessary to manufacture a good or to generate a service.
In this way, the cost of production is related to those necessary expenses, leaving out others such as financial ones. It usually includes raw materials and supplies, direct and indirect labor, and other management costs such as depreciation, rent, or consulting expenses.
Production cost elements
As we have mentioned, there are three key elements in the cost of production. We explain each of them below:
- One is raw materials and supplies. The first are those materials that are transformed in the production process. An example would be flour and salt in bread. The second are those that are not transformed but are necessary, such as the bags in which some goods are sold.
- The second, as important as the first, is labor. In this case, only direct labor is included, that is, that involved in the production process, for example, employees who work in the manufacturing chain.
- The third is the other indirect costs of production. Here we include indirect labor, which is what, even if it is not involved in the process, is necessary. For example, the administration department staff. We must also add the rest of the necessary expenses such as amortizations, rentals or taxes.
How to calculate the cost of production
The form of calculation depends on which of the three cost aspects we are interested in. Let’s see each one of them:
- For raw materials and supplies, all necessary expenses must be included. These can be transportation, insurance, customs, non-deductible taxes, and the like. For the calculation it is convenient to know the cost per unit produced.
- For labor, the gross salary and other social costs must be included. For example, the contributions that the company pays to social security for unemployment, training or pensions. For the calculation it is convenient to know the cost per hour.
- Finally, in relation to indirect costs, which must include the rest of them. In this case, we must include everyone except the financial ones.
Production cost example
Let’s imagine a company that, for simplicity, manufactures a single product. The raw material required for each unit manufactured is also one unit. Procurement is calculated by its total amount. For direct labor, we consider a production of 5 units for each hour of work. The indirect one is the administration salaries. Finally, 1500 pcs are produced. to 30 monetary units (mu) each.
Unit costs are calculated by dividing the total by the units produced. Once we have them all, we add them up and calculate the total unit production cost. The difference between the selling price and this cost is the gross unit margin or profit. Multiplying by production gives the gross profit of the company. After calculating the financial result, we obtain the net profit, which we have not included in the example.