How to Calculate Product Cost: Formula + Example

In the equation companies use to balance their books every month, product costs are an essential variable. A product cost is an expense a company takes on that’s directly related to manufacturing or selling goods or providing a service.

Understanding what a product cost is and how to calculate total product cost can help you accurately conduct accounting and prepare financial statements. Learn more about the different types of product costs and how to calculate total and per-unit product costs, so you can streamline your supply chain and make sale-price decisions.

What are the different types of product costs?

Product costs can either be:

• Direct. Relating directly to the production of your products, like raw material costs and factory worker wages.

• Indirect. Relating indirectly to the production of your products, like the cost of maintaining factory equipment.

Product costs can also be either fixed or variable. Fixed product costs do not change regardless of the quantity of items manufactured or sourced. They include things like warehouse leases and salaries for permanent employees. Variable costs fluctuate depending on the quantity of products produced, such as packaging costs.

Some common categories of product costs for small businesses include:

Direct materials

Direct materials are those used in the manufacturing process that become an essential part of the product, including raw materials. That may mean wood for a furniture business, or goods from a wholesale manufacturer if you run an ecommerce boutique.

Direct labor

Labor costs for manufacturers, wholesalers, and retailers fall into two major categories: direct labor costs and indirect labor costs. Salaries, employee benefits, and insurance for employees who produce goods or services are all considered direct product costs.

Payroll costs for those not involved in the production process, including marketing teams or executives, do not qualify as product costs on your balance sheet.

Supply

A supply cost includes any expenses related to moving or storing products. These might include the price of shipping products from a factory to warehouse, tariffs associated with transporting goods, and the cost of storing your inventory in your warehouse. Supply costs are considered indirect costs, since they can’t be directly linked to the production process.

Manufacturing overhead

Manufacturing overhead costs are all indirect costs related to the manufacturing process that can’t be connected to specific products. That includes expenses like factory rent and utilities, wages for employees like security guards and maintenance crews, and essential supplies like factory equipment. Ultimately, manufacturing overhead includes anything that helps the manufacturing space, factory, or warehouse run.

How to calculate product costs

1. Determine the reporting period
2. Tally direct material costs
3. Add up indirect costs
4. Calculate the total product cost
5. Determine the product cost per unit
6. Consider marginal cost

Here are the steps for calculating total product cost and per-unit product cost. 

1. Determine your reporting period

First, decide on your time frame. Depending on your company’s accounting cycle, you can calculate product cost by month, fiscal quarter, or year. Product cost is considered an asset on a company’s balance sheet until the units are sold, at which point they are considered income as cost of goods sold (COGS).

If you’re running a fast-growing business or are considering exploring alternative production processes, you may opt for a shorter reporting period. This can give you the information you need to make informed decisions about accurately pricing products and choosing efficient production methods. 

2. Tally direct material costs 

Add up your company’s direct material costs during the time frame you specified. This includes:

• Raw materials. Such as flour for a bakery, beads for an ecommerce jewelry business, or paper and ink for a handmade stationery company.

• Direct labor costs. Like salaries for bakers, jewelry makers, and calligraphers.

3. Add up indirect costs 

These are your supply and manufacturing overhead costs. In addition to indirect labor costs, the price of essential supplies, and factory-to-warehouse shipping costs, you’ll also need to account for things like insurance, legal fees, and equipment maintenance and repairs. 

4. Calculate the total product cost

Add your direct costs and indirect costs to arrive at the total product cost.

Direct material costs + Direct labor costs + Indirect costs such as supply costs and manufacturing overhead = Total product cost

5. Determine product cost per unit

To calculate how much each unit costs to make or to supply, divide the total product cost by the number of units manufactured or sourced in that period. That’s your product cost per unit.

Knowing your per-unit cost can help you determine your pricing strategy, since you’ll now know how much you need to charge in order to earn back the money you spent on product costs.

6. Consider marginal cost

Another term to know is marginal cost. That’s the cost of making one more unit of a given good, and it can help you make supply and sales pricing decisions. That’s because as you make more products, the per-unit product cost can come down.

For example, if you’re buying raw materials in bulk, you might get a lower raw material price when you order more. If you’re shipping products from your factory to your warehouse, you might be able to add more products to the shipment at no additional cost.

Here’s how you’ll calculate it for product cost:

Marginal product cost = Change in total product cost / Change in total product quantity 

Knowing product cost per unit and marginal cost can help an ecommerce business conduct a profitability analysis. This helps you determine your profit potential and avoid running the business at a loss. For an ecommerce company, comparing product costs of similar items can help evaluate the supply chain and set prices.

An example of product costs

Let’s say an ecommerce company embroiders and sells custom pet collars to consumers. The company sources pet collars wholesale, then embroiders them with names of customer’s pets. The business has made 800 pet products over the past month and is calculating its product cost.

This pet business has several different product costs, both direct and indirect. Direct material costs include the wholesale cost of the collars from the manufacturer and the cost of embroidery thread. Direct labor costs are the wages and benefits for employees who embroider the collars. The indirect product costs are shipping costs to deliver the collars to the warehouse, warehouse rent, utilities and insurance, and the cost of maintaining and repairing the sewing machines on the assembly line.

What can’t be considered product costs? The wages of the sales representatives, shipping costs to consumers, an office building rental for the administrative team, and the cost of online ads. That’s because they don’t relate directly to the production of the product. Those are considered period costs.

In this example, the company’s total product cost is:

$2,800 direct product costs + $1,000 indirect product costs = $3,800 total product cost

To calculate the product cost per item, the company does the following calculation:

$3,800 total product cost / 800 products = $4.75 per product