What Is Cost Production? (A Guide to Product Costing)

By Indeed Editorial Team

Published June 10, 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

In business accounting, there are many processes and methods for tracking and analyzing expenses and revenues. Cost production, or product costing, is an accounting method that assigns a value to inventory based on expenses associated with its production or procurement. If you're considering or just starting out with a career in business or accounting, answering, "What is cost production?" may help you prepare for it.

In this article, we define cost production, explain why companies use product costing, explore its advantages and disadvantages, outline the difference between product costing and cost accounting, and list some methods of product costing.

Related: How to Calculate the Cost of Goods Manufactured (COGM)

What is cost production?

If you are learning about accounting procedures for a business that handles inventory, you may wonder, "What is cost production?" Cost production is a term associated with the product costing accounting process. Product costing involves calculating the total cost of products in inventory by considering all the expenses involved in the production or purchasing process. These expenses can include the cost of materials, labour, transportation, overhead, and merchandising.

Service industry businesses may also use product costing to assign a monetary value to each of their services. For example, a beauty salon might base the value of its hair treatment on the expenses required to provide it, like the hairstylist's wages, supplies, and indirect labour expenses like a portion of a receptionist's wages.

Why do companies use cost production?

Product costing can be useful for determining the sale price of products and evaluating the feasibility of a product line. It can also be helpful when identifying opportunities to increase profits or improve efficiency. Product costing is a key component of the budgeting and forecasting process because it assigns a total cost to each unit of inventory. It's typically an important process for manufacturing companies, but can also be useful for other types of businesses, such as wholesalers, retailers, small-scale manufacturers, or artisans.

For example, a bicycle manufacturer might use the cost of raw materials, direct labour expenses, and factory overhead costs to assign a value to each bicycle produced. The manufacturer then determines an ideal sale price based on the assigned value and the desired profit amount. If the ideal sale price wasn't realistic due to market conditions, the company might streamline operations to create efficiencies or source cheaper materials to reduce production costs.

Advantages of product costing

Product costing can offer several advantages to different types of businesses. Below are some advantages of product costing:

Providing a realistic inventory value

Product costing can provide a company with a realistic representation of its inventory's actual value, calculated using all expenses associated with producing or buying each item. This value may differ from an estimated value, or a value assigned based on only the cost of materials or purchase price. Having an accurate and realistic understanding of inventory value can be helpful when developing profit projections and budgeting.

Project tracking

Project tracking involves monitoring product budgets to evaluate whether projected costs align with the actual costs. To do this, managers or financial officers assign costs to various stages of a project prior to beginning work on it. While the project is ongoing, they assess the actual costs continuously to determine whether the project isn't incurring additional expenses. Product costing is a key part of this process, as it provides a comprehensive analysis of the expense of products or inventory involved in a project.

Related: Understanding Project Management Methodology (With Examples)

Providing a basis for decision making

Product costing provides valuable information for making business decisions. When making decisions, business managers often focus on the comparative profits connected to each alternative. For example, product cost might be an important factor when deciding whether to continue producing a particular item or whether to add a retail outlet to an existing operation. The cost of inventory usually affects profits, so product costing can be important to the decision-making process.

Related: What Is the Rational Model of Decision-Making? (With Steps)

Disadvantages of product costing

While product costing has many benefits, there are also some drawbacks. A business manager might compare the impact of the benefits on their situation to the drawbacks when deciding whether to use a product costing method in their accounting process. Some of the main disadvantages of product costing include:

It doesn't account for variances in manufacturing processes

Variances in production techniques can negatively impact the accuracy of product costing. While variances are typically minor, over time, they can cause moderately significant discrepancies between calculated and actual costs of products or inventory. For example, labour expenses incurred to produce an item may vary due to transportation costs, which might vary due to variability in the cost of fuel or factors like weather.

Related: How to Calculate Variable Cost With Examples

It can be time-consuming and expensive

Product costing involves significant time and effort, meaning it can be expensive. For a company with different products, particularly if each product has a low value, it may not be feasible. Similarly, a business that has variability in its production or procurement process may also have difficulty using product costing. For example, a manufacturing business that works with multiple suppliers to source its raw materials might have too much range in material cost for the product costing method to be accurate.

The difference between product costing and cost accounting

Cost accounting is another accounting method used to analyze expenses of business activities and projects. While product costing focuses on the cost of individual inventory components, cost accounting focuses on the overall expenses involved in accomplishing a project or business objective. Sometimes, cost accounting can be a more effective accounting method, as it provides companies with a broader perspective compared to product costing.

Like product costing, cost accounting is useful for determining selling prices, identifying opportunities for streamlining operations, and evaluating the feasibility of product lines. Cost accounting can be a preferable method for large-scale manufacturing or manufacturers using modern or variable production techniques.

Methods of product costing

There are several methods of product costing that can be helpful in a certain type of business or sector. Here are some of the most common methods of product costing:

Job costing

Job costing involves assigning costs to each stage of the manufacturing process. This method requires monitoring employee time by job or projects. For instance, if a manufacturing employee worked on multiple different products throughout the day, the company might record the number of hours they spent on each task. Tracking the labour costs separately allows the company to assign a specific labour cost to each product.

The job costing method is typically the preferred method of product costing in situations involving unique, high-value items. This is because it's usually the best option when the company bills the production costs of an item directly to a customer. For example, a store can directly base the price of a custom vehicle or piece of furniture on production costs. Job costing can also be a good option when a customer audit is likely.

Process costing

The process costing method involves calculating the overall cost incurred by a department or across an entire company and then assigning a portion of the total to each product unit. Expenses considered in the calculation can include raw materials, labour, depreciation of equipment, and overhead costs like supplies and utilities.

Process costing is a useful method of product costing for manufacturing companies that produce large batches of the same product. It can also be a good option for manufacturers of items manufactured using a similar process. It isn't an ideal method for companies that use a variety of production methods to produce different products, because typically, different methods and products require different amounts of resources. This means that the process costing might not provide an accurate value for each item.

Incremental costing

Incremental costing focuses on the additional cost of producing each item, ignoring overhead costs. This method assigns a cost to each unit of product based on direct expenses like labour, transportation, and raw materials.

Management teams typically use this method when determining whether to add a particular product line to their manufacturing operation. It's also useful in situations with fixed overhead costs. When using this method, it's necessary to consider what additional production volume is possible without increasing overhead costs. For example, a manufacturing facility may be able to accommodate additional production until it reaches capacity.

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