What Is Production Cost & What Are It’s Various Components?

Production cost is the cost incurred to procure raw materials & convert those raw materials into finished products. In other words, all costs related to the factory are included in the production cost.

Production cost = Direct material cost + Direct labor cost + Factory/Manufacturing overheads

Direct Material Cost

Direct material cost is the cost incurred to procure raw materials. It includes material purchase cost & expenses incurred to bring the material from supplier location to your factory location. Tax paid on purchase, being a input tax credit element, is not included in direct material cost.

Direct labor cost

Direct labor cost is the labor cost incurred to convert raw material into finished product.

Manufacturing/Production Overheads

Manufacturing Overheads are the costs incurred in the factory excluding direct material cost & direct labor cost. Such overhead costs cannot be easily allocated directly to a product. That’s the reason they’re also known as Manufacturing indirect expenses.

Selling & administrative expenses (falling outside the purview of the factory) aren’t included in the production cost. They’re instead included in income statement as indirect expenses.


Track The Numbers

At the outset, you got to track your key expenses. If you aren’t doing it, then start doing it right now.

You can’t reduce something which haven’t yet recorded. Makes sense?

Get started by tracking at least the following key numbers:

  • Production capacity
  • Actual used capacity
  • Direct material cost
  • Direct labor cost
  • Manufacturing overhead
  • Labor efficiency
  • Carrying cost of inventory
  • Cost of goods sold
  • Overtime expenses
  • Stock in & out
  • Cash in & out

If you don’t want to use an accounting software, then try recording the numbers in a simple excel file. The point is: Do anything but please track your numbers.

If you’ve a big team then share the templates with them (or create users in the accounting software) & instruct them to start feeding the numbers. Do it now.

It’s hard to believe but the fact is– even a simple recording of numbers will give you a lot of idea about what’s wrong with your factory.

Reduce Direct Material Cost

Direct material cost constitutes a substantial portion of the total manufacturing costs.

There are a number of techniques to control the direct material cost. Let me share a few:

  • Invite quotations from as many suppliers as possible
  • Consider signing a long-term contract with the shortlisted supplier. That’ll give a quantity assurance to the supplier who in turn can reduce the price accordingly.
  • Offer cash payment in return of cash discount. Most suppliers will be willing to trade off discount in return of prompt payment.
  • Ask for turnover discount at the end of a financial year. Suppliers are willing to give discounts to customers who’ve contributed significantly to their turnover or revenue.
  • Consider re-structuring your product. Can a particular raw material be replaced with an alternative without compromising on quality?. Example: A furniture manufacturer can consider replacing cost raw wood with a cheaper alternatives like plywoods.
  • Prepare a database of suppliers with details like name, phone number, email, address. That’ll act like a backup in case you face an adverse market situation like price increase, lack of supply or economic depression.
  • Tie-up with a transport company that’ll help you bring stuff from the supplier location to your factory. Invite quotations & enter into a long-term contract with the shortlisted transport company. Even a verbal engagement may work.
  • Request the transport company to take care of unloading raw material into your factory. Mention the same in the contract. That’ll save you a lot of money. (Pro tip: Local un-branded transport companies offer cheap rates for transport. Avoid using DHL or FedEx kind of branded transport services)

Leverage Automation

The automation of processes makes them more efficient. It gives more opportunity to save in terms of cost.

Human beings are more prone to mistakes than machines. Hence, with the use of technology, it’s possible to bring down errors. Further, you won’t have the liability in terms of warranty or refunds to customers who’ve been served with defective products.

Thereby the customers will be satisfied and the reputation of the business will improve due to the low error rate.

You’ve to use sophisticated machineries which will process the products at a faster rate and minimize the firm’s manufacturing cost in the long run.

Here’re a few examples of processes that can be automated:

  • Picking
  • Sorting
  • Packing
  • Cleaning
  • Painting, etc.

Of course, automation comes a huge upfront cost. So, study the cost & benefits before taking a decision in this regard. Alternatively, you may also try leasing the automated machines if it makes sense.

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