Production Costs: Definitions, Formulas, and How to Control Them
Small businesses need to know exactly what each specific product costs to make. Not just the factory floor expenses. Everything. Production costs and manufacturing costs aren’t the same thing, even though people mix them up constantly. Get this wrong, and your pricing suffers, along with cost control. Your financial statements won’t tell you what’s really happening.
What are production costs?
Production costs are every expense you incur when manufacturing and delivering a product. Raw materials and labor are obvious. However, there are also indirect costs, such as administration, office utilities, logistics, and others – including time and money spent on product design and quality assurance.
Production costs go beyond the factory floor.
Manufacturing costs cover what happens inside your plant. Production costs take a wider view. They include everything it takes to get your product to customers.
Most manufacturers track what it costs to build their products. That’s it.
But if that’s all you’re measuring, you’re missing half the picture. Production costs include general business overheads, eating into your margins. These expenses don’t show up on the shop floor. They still need to be paid. And they will affect the selling price of your product.
Understanding the whole cost structure helps you price more accurately so you won’t get blindsided when monthly financials arrive.
Manufacturing cost vs production cost
Manufacturing costs simply cover direct expenses required to build a product inside your facility. Raw materials, direct labor costs, and manufacturing overhead costs. The latter includes all kinds of indirect costs associated with the manufacturing process itself, such as machine depreciation, plant utilities, and hourly shop floor supervision.
Production costs cast a wider net. They include everything in manufacturing costs, plus selling, general, and administrative expenses (SG&A), and research and development (R&D). These general costs and overheads occur outside the factory walls but still need to be covered for a functioning business and, therefore, for your product to reach customers.
The accounting treatment matters. Manufacturing costs get capitalized into inventory. They become part of your product’s value on the balance sheet. Production costs include additional expenses that hit your income statement as period costs. That difference affects how you track profitability and report financial health.
Types of production costs
Costs don’t all behave the same way. Some stay steady regardless of production volume. Others move up and down. Understanding these differences helps you manage costs more effectively and make smarter financial decisions.
Fixed costs
Fixed costs stay the same no matter what your production processes’ outputs look like. Make ten units or ten thousand—your rent doesn’t change. Neither do salaried labor, equipment depreciation, or insurance premiums.
These costs are predictable. But they still impact pricing and profitability because they get spread across every unit you produce. It’s important to know the total fixed costs, regardless of the level of production you manufacture.
Variable costs
Variable costs move with your production volume. Make more units means you’re spending more money on raw materials, packaging, storage or shipping, and hourly labor costs.
Variable costs directly impact scaling decision-making and forecasting accuracy. When you’re planning production runs or building budgets, these numbers need to be accurate.
Average (unit) cost
Average cost (or unit cost) is straightforward. Divide your total production costs by the number of units you made. That’s what each finished product unit costs on average.
You need this number for pricing decisions and margin analysis. Particularly when comparing different product lines.
Marginal cost
Marginal cost shows what one additional unit costs to produce.
This matters because if you can make and sell one more unit for more than it costs, you should probably do it. But watch for spikes. When marginal costs jump due to overtime, rush orders on materials, or capacity constraints, that’s a signal to reconsider your approach since the overall cost per unit increases.
Production costs example
Here’s a quick look at how the aforementioned cost types can converge when calculating production costs.
Let’s say a bicycle manufacturer produced 400 bicycles which incurred $65,000 in variable costs, along with the fixed costs of $15,000 per month. That means the total cost of production is $80,000. The average production cost per unit would then be $80,000 / 400 = $200.
As a production capacity increase would only affect variable costs, the average variable cost per unit in this scenario would be $65,000 ÷ 400 = $162.50. That means producing one more bicycle would cost an extra $162.50, which is noticeably lower than the average cost.
Let’s say the manufacturer is thinking about producing 500 units next month. Thanks to ordering more materials, the supplier offers the company a discount. This leaves the company with a projected total cost of $95,000. The marginal cost in that case would be:
Change in costs = $95,000 – $80,000 = $15,000
Change in quantity = 500 – 400 = 100
Marginal cost = $15,000 ÷ 100 = $150
Therefore, it would be economically viable to produce more bicycles, as long as demand remains. At some point, however, the marginal cost curve will turn upward, and each additional unit becomes more expensive to produce than the previous one. The takeaway? Either raise your selling price or reduce the volume of production in order to control costs.
How to calculate production costs?
You need to know your numbers to make good financial decisions. Pricing, production planning, profit margin management—all of it depends on accurate cost data.
Three metrics matter above all: Total Manufacturing Cost, Cost of Goods Manufactured (COGM), and Cost of Goods Sold (COGS). Get these right and you’ll understand what’s really happening with your costs.
Total Manufacturing Cost (TMC)
TMC = Direct Materials + Direct Labor + Manufacturing Overhead
This is the foundation. Everything spent inside the factory walls to produce goods. Steel, machine operators, electricity that powers your CNC line. In other words, items used in or because of your manufacturing process.
Manufacturing cost isn’t just a BOM and direct labor hours – it includes waste, downtime, and route inefficiencies.
Cost of Goods Manufactured (COGM)
COGM = TMC + Beginning WIP Inventory – Ending WIP Inventory
COGM shows the total value of goods you completed during a period. It adjusts for work-in-process (WIP), so you’re measuring only the total number of units that were actually completed.
This matters most for job order or batch manufacturing, particularly when work carries across multiple accounting periods.
Cost of Goods Sold (COGS)
COGS = COGM + Beginning Finished Goods Inventory – Ending Finished Goods Inventory
COGS represents the cost of everything you managed to sell in a fiscal period. It connects the production floor to the income statement, making it one of the most watched metrics in your financials.
Accurate inventory tracking and cost allocation are essential for valid COGS reporting.
Strategies for reducing production costs
Reducing production costs means finding manufacturing waste and eliminating it. Five areas give you the best return.
Tighten up the manufacturing process
Process wastes cost money. Lean practices like 5S (Sort, Set in order, Shine, Standardize, Sustain) or value stream mapping help you cut excess motion, scrap, and setup time. Value stream mapping often reveals that products spend most of their time waiting between operations, not actually being worked on.
Look at your bills of materials and yields as well. If your BOM calls for 10 feet of steel but you’re consistently using 10.5 feet, that extra half-foot is disappearing somewhere, e.g., offcuts, measurement errors, or poor nesting. It’s not contributing to your product, but it still eats up raw material budget. Start with your highest-volume products or most expensive materials. That’s where waste hurts most, and small improvements add up fast.
Make improvement part of the job
Cost-cutting campaigns fade because they come from the top down and end when the pressure lifts. What works is weaving continuous improvement into your culture. It sticks because it comes from the people doing the work. Look for ongoing savings that are sustainable in the long term.
Kaizen, Six Sigma, or even a simple suggestion program gives your team ownership and generates ongoing savings. A machine operator who spots a recurring setup issue can save more money in a month than a consultant’s report gathering dust on a shelf. When your employees feel a sense of ownership, they begin looking for ways to improve the process on their own.
Start small. Weekly five-minute team huddles where people share one thing that slowed them down. That’s enough to get the ball rolling.
Track real costs, not estimates
Estimates hide problems. If you’re pricing products based on standard costs, you might be leaving money on the table. Or losing it without knowing. Standard costs from last year don’t account for this year’s material price increases, wage adjustments, or efficiency changes. The gap compounds over time.
Track actual material, labor, and overhead costs. Actual cost tracking means capturing what you really spent—not what you budgeted. Every material purchase. Every hour logged. Every utility bill allocated to production. Create a clear, complete list of manufacturing costs and document it. That’s how you see what’s really happening.
Review your cost standards at least quarterly, but monthly is even better if you’re in an industry with volatile material prices.
Cut overhead where it doesn’t hurt
Production costs include more than the factory floor. Look at administrative expenses, marketing and sales costs, and other overheads. That approval workflow that touches five people before a $200 purchase order goes through? That’s overhead. The three different systems your team uses to track the same job? More overhead.
Take a step back and look at your system: how and what kinds of workflow processes can you streamline further? Eliminate steps that don’t add value. If someone reviews a document just to pass it to the next person without making decisions, that’s a step you can cut. Maybe you can also consolidate some supply chain vendors? Reduce redundant approval cycles? Automate order tracking to enhance access to sales data?
These extra operating costs eat into margins just like material waste does. But they’re easier to overlook because they aren’t always immediately visible. Small inefficiencies compound. Ten minutes of unnecessary meetings per person per day equals 40+ hours of lost productivity per employee per year.
Use software that shows real numbers
As useful as spreadsheets are, they often limit access to relevant insights. They break down when multiple people need the same data. Version control becomes guesswork. By the time you reconcile three different Excel files, the numbers are already outdated.
Manufacturing software tracks actual costs as they happen. Materials, direct labor costs, and overhead. When you can see real numbers instead of estimates, you make better decisions faster. Should you accept that rush order? With real costs visible, you know instantly whether overtime and expedited materials will kill your margin or if there’s room to make it work.
Real-time cost tracking means spotting problems while you can still fix them. A material cost spike is instantly reflected in your finances, not three weeks later when you’re already committed to customer pricing. You can calculate the total production cost accurately during the workday.
Control your production costs with MRPeasy
Most manufacturers don’t know their true production costs. They’re working with estimates and spreadsheets, guessing at margins. That creates problems when you need to quote a job or figure out which products actually make money.
MRPeasy automates cost tracking and provides real-time access to your financial data. It’s built for manufacturers and distributors who’ve outgrown spreadsheets but don’t want a massive ERP system with six-figure implementation costs. The software includes a built in standard accounting module and syncs natively with Xero and QuickBooks.
Think accurate, one-click cost and lead time estimating based on real manufacturing data could be helpful? Knowing how much a product actually costs to manufacture is one of the biggest advantages an ERP system brings to a small manufacturer. When you can see a product’s real costs before you ship it, pricing gets easier and so does cash flow management. You stop guessing and start working with real numbers.
Key takeaways
- Production costs encompass all business expenses required to produce and sell goods. Raw materials and labor, yes, but additionally, there are administrative overhead, sales costs, logistics, and other expenses. Manufacturing costs are narrower—they only cover direct costs and plant overhead.
- Fixed costs stay constant. Variable costs move with volume. Average costs show per-unit expenses. Marginal costs reveal the cost of producing one more unit. Understanding how these interact helps you price accurately and scale smartly.
- Three formulas matter most: Total Manufacturing Cost, Cost of Goods Manufactured, and Cost of Goods Sold. They show you real production efficiency. And real profitability.
- Cut production costs by eliminating waste and streamlining your production processes, not cutting corners. Lean practices like 5S or value stream mapping can help. So do continuous improvement programs and accurate automatic cost tracking. Overhead reduction helps too, but only if you’re measuring actual costs – estimates don’t cut it.
- Manufacturing ERP software that tracks real production costs as they happen gives you better data for decisions. When you can see actual material, labor, and overhead costs in real time, you price better and protect your margins more effectively.
Frequently asked questions (FAQ)
Production costs are calculated by adding all expenses required to make and sell a product. That includes direct manufacturing costs (materials, labor, factory overhead) plus selling, administrative, and other general business expenses. The result reflects the full cost of getting a product into a customer’s hands, not just what happens on the shop floor.
Production cost is what it costs your business to make and deliver the product. Price is what you charge your customers. You set the price above production cost to generate profit and cover future operating needs. So in essence, the unit price is production cost plus margin.
Manufacturing costs only include the expenses inside your plant: raw materials, direct labor, and manufacturing overhead. Production costs include all of those plus wider business expenses like sales, marketing, administration, and R&D. For example, assembling a bicycle might cost $200 in materials and labor, but by the time you add design costs, warehousing, and sales salaries, the full production cost might be $260.
Tracking production costs is crucial because it informs the true profitability of product pricing. If you only track manufacturing costs, you may underprice and hurt your margins without realizing it. Accurate production cost data leads to smarter pricing, better margins, and more informed decision-making on how to scale.
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