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Determining Product Costs Using Art and Science

By Colleen Hiscock


As a food scientist and a Red Seal certified chef, I value both science and art and use attributes of both disciplines for everything from cooking to running a business. Why? Hard numbers and observational evidence provide reliable metrics that every business person needs in order to know what’s happening with her organization.


While the product costing model is heavily numbers based, creating anything also means taking risks: coming up with bold new ideas and following your gut or your heart or your intuition—whatever you call it.


Some art to go with the science


My actual costing model is all about the math. But what numbers you put into the equation is entirely up to you. Just like with personal budgeting, you determine what you will splurge on and where you want to save.


The brand you develop and its brand standards will determine the quality of the product or service makeup and its packaging. You may need to pay extra to support some aspects of your brand if your focus is on luxury, quality, or ethical choices.


Your understanding of your value in the industry and of what your business means to you determines how you will price your time and how you will pay yourself.


An educated assessment of the market’s appetite for your goods and of trends in your industry will help you decide whether to proceed, and if so, what your profit margin should be.


External market forces will also affect your pricing—the prices of oil, shipping, and storage will all influence the choices you make and the product cost.


The science—gathering data and crunching numbers


The cornerstone of financial analysis for any manufacturer is calculating an accurate product cost. The product cost is the major factor in determining pricing and the company’s overall profitability.


Cost accounting is an accounting method that captures a company’s production costs by assessing the variable costs of each step of production and the fixed costs, such as depreciation of capital equipment and administrative expenses.


Cost accounting deals with direct costs and indirect costs, both of which can also be fixed or variable. It is important to understand all these factors to determine a product’s cost.

Fixed costs and variable costs


Fixed costs typically refer to overhead and administrative expenses. They are known, established costs. For example, a supervisor’s salary is a known cost, but production levels are variable and based upon sales.


Direct costs and indirect costs

A direct cost is a monetary value that can be completely attributed to the production or delivery of specific goods or services. Elements that go into direct cost include direct labour, direct materials, and direct manufacturing metrics, such as yields and wastage.


You’ll need the following information to calculate direct labour costs:


  • the number of workers required for the entire production process

  • the workers’ wages, including any additional company-paid costs such as group benefits and CPP and EI contributions

  • the specific amount of time it takes to complete each process step and the time required to complete the entire production process


You’ll need the following information to calculate direct material costs:


  • the exact materials needed to create the product

  • External influences can affect material costs. For example, could you get discounts for volume purchases? Do locally supplied goods cost more or less than items sourced from farther away?

  • the exact materials needed for product packaging and case packaging

  • the exact quantities needed to produce a specified amount of the product, including allowing for wastage

  • the per-unit cost measurements


Indirect costs are the activities that support the production process but that are not directly involved in the active conversion of materials into finished products. Indirect costs have to be paid whether any goods are services are produced or not.


Indirect costs are often referred to as overhead expenses (e.g., rent, taxes, and utility fees) and administrative expenses (e.g., salaries and office supplies).


Here’s a list of indirect costs that need to be accounted for when you determine the cost of a product or service:

  • employee compensation (salaries, bonuses, paid overtime, benefits, and discounts)

  • rent

  • water, heat, and electricity

  • internet services

  • insurance

  • cost of support staff and quality control expenses

  • depreciation of inventoried materials and equipment

  • maintenance and repairs of property and equipment


How to create the product cost


You’ll need answers to these questions in order to calculate the product cost.

1.          What are the steps required to make your product?

    

2.          What are the inputs (e.g., raw material, services, and packaging) and outputs from each process step?


  • What are the measurements and costs of each input?

  • What are the measurements and costs of each output?


3.           How much waste or loss is experienced in the manufacturing process? This figure is derived from the difference between your input costs and your output costs.

    

4.          How long does it take to complete each process step?

  • How many people are required to complete each step?

  • What is their wage per hour?


Now calculate the cost per unit sold.


Once you’ve determined the cost per unit, tally your indirect costs. Divide your indirect costs by the number of units sold. Add this figure to the per-unit cost to come up with the final, total cost of the product.


My costing model is thorough and effective. I’ve used it at some of Canada’s largest food manufacturers. While it may seem overwhelming at first, you can use this article as a launching point for your own costing process.


The most important point to remember is to consider both direct and indirect costs. When you take both types of expenses into consideration, you get an accurate per-unit product cost.



Bon Appetit Development Inc. (BADI) is a freelance food consulting company based in Eastern Canada. Our mission is to enable organizations to simply and easily stretch their budget to achieve more. We enhance the efficiency of each client’s costs using customized and comprehensive programs to eliminate waste and streamline processes. With Principal Colleen Hiscock’s three decades of experience of product development and food manufacturing from A to Z, she helps companies of all sizes. She has a proven track record of successful commercialization from concept to market and helps clients with project management needs, cost reduction, and processing efficiencies, as well as strategic planning to get to market faster with a higher rate of success. As well, BADI offers customized educational programming and staff coaching in food science, food safety, and lean manufacturing.


Contact: Colleen Hiscock, colleen.hiscock@gmail.com, 905-875-8590, www.chefcolleen.ca.



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