What are the 3 main categories of cost in product costs?

Product costing and cost-accounting are commonly utilized to assist with determining production process financial requirements. Both costing methods are valuable for a range of business activities, from generating accurate financial statements to making pricing decisions for finished products.

Challenges of Product Costing

What are the 3 main categories of cost in product costs?

Product costing is defined as the accounting process used to calculate business costs incurred during the production process. Costs associated with the production process range from direct labor to manufacturing overhead fees.Costing methods are facing increased challenges as a result of modernization. For example, previously required components of the production process such as inventory space for holding products are becoming increasingly obsolete due to lightning fast delivery speeds.The ability for businesses to create and deliver products to customers so swiftly has changed the production process completely. As a result, calculating short term product cost and long term projections are more difficult than ever before.

One potential solution to product costing challenges is the use of the cost accounting method. Due to its focus on separate production phases, cost accounting does not need to amend long term projections in response to modern manufacturing challenges.

3 Different Product Cost Types

There are 3 primary types of product costs that all business professionals should be aware of. Calculating these product costs is necessary for achieving optimal accuracy for financial statements and inventories.

These product cost categories include-

1. Direct Labor

What are the 3 main categories of cost in product costs?

Direct labor costs consist of both employee wages and any additional costs associated with their benefits. Direct labor costs are only calculated for employees that work within the manufacturing and production process such as assembly line workers.

2. Direct Material

Raw materials and component costs are referred to as direct material costs. For example, a pottery company would classify their direct material costs by factoring in any clay and glaze used during the production process.

What are the 3 main categories of cost in product costs?

There are both direct costs and indirect costs included when calculating manufacturing overhead costs. Indirect costs incurred during the production process range from the labor costs of factory security guards to any cleaning supplies used by the janitor.

Although indirect labor and materials contribute to the production process, they are not classified as direct labor or direct material costs and must be accounted for separately. Alternatively, direct costs associated with manufacturing overhead range from machinery operating costs to direct materials purchased.

6 Different Product Costing Systems

The 6 product costing systems are job order costing, process costing, hybrid costing, standard costing, backflush costing, and activity-based costing. These 6 different process costing methods are crucial for businesses to become familiar with-

1. Job Order Costing

What are the 3 main categories of cost in product costs?

The job order costing method is especially useful for businesses that have a customized production process or smaller product quantity. A cost per unit figure is determined by factoring in labor, overhead, and material fees.

In the job order costing system, orders are commonly referred to as jobs, lots, or batches. A job order cost sheet will clearly list labor, material, and overhead costs for easy future reference.

2. Process Costing

As opposed to the job order costing method, the process costing system does not determine costs by batches. Instead, process costing calculates the costs associated with each separate production process or department.

The process costing method is widely used by companies that undertake mass production initiatives. This method is also very useful for businesses that have very limited product customization options available.

3. Hybrid Costing

What are the 3 main categories of cost in product costs?

Hybrid costing occurs when businesses use a combination of process costing and job order costing methods. For example, while an enterprise may utilize process costing for overhead fees, they may alternatively use job-order costing for raw materials procured.

Hybrid costing is a great way to receive the benefits of both costing methods or for businesses that have both mass production and customization initiatives occurring simultaneously.

4. Backflush Costing

Backflush costing is a great costing method option for businesses that use the just-in-time inventory system. The just-in-time inventory system consists of keeping a low to nonexistent inventory.

Instead of spending money on costs associated with maintaining inventory, some companies prefer to order raw materials strictly based on immediate production process needs. As a result, backflush costing does not need to incorporate the many costs incurred by inventory management.

5. Standard Costing

What are the 3 main categories of cost in product costs?

The standard costing process calculates costs using projected estimates. As a result, cost estimates must be revised when actual costs incurred are made available.

Alternative costing methods are generally used in tandem with the standard costing process.

6. Activity-Based Costing

The activity-based costing process utilizes cost drivers, also referred to as bases, in order to calculate costs per activity performed. Activities that are factored into this costing process range from ordering raw materials to packaging finished goods.

While standard costing uses only one basis, the alternative costing method incorporates several cost drivers.

Key Takeaways

What are the 3 main categories of cost in product costs?

  • Cost accounting and product costing help businesses determine their financial requirements and production processes.
  • The 3 primary product cost types are direct labor, direct material, and manufacturing overhead.
  • Different product costing systems range from job order costing to activity-based costing.

4 Min. Read

What are the 3 main categories of cost in product costs?

The costs involved in creating a product are called Product Costs. These costs include materials, labor, production supplies and factory overhead. The cost of the labor required to deliver a service to a customer is also considered a product cost. Product costs related to services should include things like compensation, payroll taxes and employee benefits.

Since product costs include manufacturing overhead that is required by both GAAP and IFRS, product costs should appear on financial statements. To eliminate overhead costs, a manager may modify product cost when making short-term product and unit pricing decisions. Alternatively, managers might decide to focus on the impact of a product on a bottleneck operation with their main focus being on the direct materials cost of a product and the time it spends in the bottleneck operations.

Product cost appears in the financial statements since it includes the manufacturing overhead that is required by both GAAP and IFRS. However, managers may modify product cost to strip out the overhead component when making short-term production and sale-price decisions. Managers may also prefer to focus on the impact of a product on a bottleneck operation, which means that their main focus is on the direct materials cost of a product and the time it spends in the bottleneck operation.

This article will also discuss:

What Are the Types of Product Costs?

What Is an Example of a Product Cost?

How Do You Determine Product Cost?

NOTE: FreshBooks Support team members are not certified income tax or accounting professionals and cannot provide advice in these areas, outside of supporting questions about FreshBooks. If you need income tax advice please contact an accountant in your area.

What Are the Types of Product Costs?

Costs incurred to produce a product intended to sell to a customer is called Product Costs.

Product cost includes:

Direct material: raw materials bought that go directly into producing the products. For example, the metal to make a car is a direct material cost for a car manufacturer.

Direct labor: the wages, benefits, and insurance that are paid to employees directly involved in manufacturing and producing the goods. For example, workers on the assembly line or those who use the machinery to make the products.

Manufacturing overhead: indirect factory-related costs that are incurred when producing a product. Manufacturing overhead costs include:

  • Indirect material: materials used in the production process but are not directly traceable to the product. Examples include glue, oil, tape, cleaning supplies, etc. are classified as indirect materials because it would be difficult to determine the exact cost of the materials that go into the production.
  • Indirect labor: the cost of wages for the labor of those who are not directly involved in the production like security guards, supervisors, and quality assurance workers in the factory.
  • Other costs such as factory lease, utilities and insurance.

What Is an Example of a Product Cost?

Let’s look at an example of Product Cost. Company XYZ is a manufacturer of tables.

Its product costs can include:

Direct material: wood used to create tables

Direct labor: wages and benefits for the carpenters

Manufacturing overhead (indirect material): nails used to hold the tables together

Manufacturing overhead (indirect labor): wages and benefits for the security guards to overlook the manufacturing facility

Manufacturing overhead (other): factory rent and cost of factory utilities

How Do You Determine Product Cost?

Typically, the cost of a product on a unit basis is derived by accumulating the costs associated with a batch of units that were produced as a group and dividing by the number of units manufactured.

The formula for Product Cost is:

Product unit cost = (Total direct labor + Total direct materials + Consumable supplies + Total allocated overhead) ÷ Total number of units

Let’s take another look at our table making company from the example above.

Company XYZ produced 1,000 tables.

To produce 1,000 tables, the company incurred costs of:

  • $12,000 on wood
  • $2,000 on wages for the carpenters and $500 on wages for the security guards to overlook the manufacturing facility
  • $100 for a bag of nails to hold the tables together
  • $500 for factory rent and utilities

Total product costs: $12,000 (direct material) + $2,000 (direct labor) + $100 (indirect material) + $500 (indirect labor) + $500 (other costs) = $15,100 total product cost.

So, Company XYZ incurred total product costs of $15,100 to produce 1,000 tables, or a unit product cost of $15,100 / 1,000 = $15.10.