Businesses that sell physical products must be able to determine which expenses are incurred to manufacture the product and which expenses are just a general cost of doing business. Costs that the company can directly link to creating the product are referred to as production or product costs. These costs are assigned to the inventory account and eventually become the cost of goods sold. Period costs, in contrast, are listed on the income statement as selling, general and administrative costs.
Production Costs Under Absorption Costing
If a company follows generally accepted accounting principles, it must use absorption costing for its external financial statements. Under absorption costing, production cost is direct materials, direct labor and manufacturing overhead. Direct materials are the raw materials used to manufacture the product. Direct labor is the cost of the workers who directly manufacture the product. Manufacturing overhead is all other factory costs that aren't encompassed in direct materials or direct labor. Factory rent, utilities, manager salaries, janitorial costs, packaging, shipping and equipment supplies can all be manufacturing overhead costs.
To calculate production costs under absorption costing, sum the total amount of direct materials, direct labor and manufacturing overhead incurred during the accounting period. For example, if direct materials is $100,000, direct labor is $200,000 and manufacturing overhead is $300,000, production cost is $600,000.
Production Costs Under Variable Costing
Although absorption costing is required by generally accepted accounting principles, some managers don't like to use it for analysis purposes. Companies that want to track and analyze costs for efficiency purposes prefer variable costing. Production costs under variable costing are the same except that fixed manufacturing overhead is excluded. A business may use only variable costing if it isn't required to follow generally accepted accounting principles, or it may calculate production costs using both methods.
Variable manufacturing overhead costs are the overhead costs that vary based on production levels. Equipment supplies, electricity, gas, water, shipping materials and production bonuses are variable overhead costs. The overhead costs that don't change with production -- like rent, property taxes and salaries -- are fixed costs.
To calculate production costs under variable costing, sum the total amount of direct materials, direct labor and variable manufacturing overhead incurred during the accounting period. For example, if direct materials is $100,000, direct labor is $200,000 and the variable portion of manufacturing overhead is $150,000, production cost is $450,000.