Product calculation and product cost calculation

Correct product costing enables cost transparency and provides the basis for defining optimal sales prices. It also shows cost reduction and margin potentials. In practice, however, costs are frequently only rough estimates. Even the setting of prices does not always follow a systematic calculation structure. This not only leaves opportunities untapped. Fundamental errors sometimes even lead to losses. Because of all these reasons, a comprehensive, systematic costing is absolutely necessary.

In this article you will learn how to calculate prices correctly and which errors should be avoided is at the core of product costing or product cost calculation. Manufacturing costs, cost of goods sold and the purchase prices of each individual part listed in bills of materials are the basis of any costing structure. They must be considered separately in every product costing.

The term “product costing” or product cost calculation describes an economic business procedure for summarising cost information of a product (cost unit). It thus makes it possible to determine the costs of individual units of manufactured and sold products. Therefore, the synonym cost unit accounting is often used. In addition, costing is indispensable for pricing new products. If market prices already exist, costing can be used to check the extent to which a product can be sold at all in a cost-covering or profitable manner.

Especially start-up companies often overlook important aspects in product calculation, which can threaten their existence sooner or later. Thus, due to the overall pricing, it must be possible to cover not only the direct costs of a product, but also the overhead costs of the company and to generate an adequate profit. Let us therefore at first deal with the question of which fundamental aspects must be taken into account in price calculation and/or general costing.

Anyone who launches new products has to consider numerous aspects when calculating product costs. It is by no means sufficient to simply add up all the product costs incurred on the basis of parts lists with the help of Excel and add a certain factor as profit. If the price is set too low, the company misses out on profit, because customers might have been willing to pay significantly more for the product. If the price is too high, on the other hand, there will be slow sellers. To summarise, a price has to meet the following requirements:

• It has to cover all costs
• It has to be competitive
• It has to encourage customers to buy the product
• It has to allow for a reasonable profit margin

In order to meet all these requirements, it is advisable to proceed in several steps, which we would like to outline below.

Considerations on pricing must not take place only when a product is completed. Product costing has to take place already in the development phase in order to be able to assess at this early stage whether the product and the corresponding product costs can earn money in the future at all. Estimates alone are not sufficient to be meaningful by themselves. It’s mor sensible to determine the price willingness of potential buyers as precisely as possible. Larger companies use professional service providers and market research for this purpose. SMEs and new companies that do not have the budget for such measures can survey customers on their own. Possible wordings are:

• Is this product of interest to you?
• What do you like about this product?
• Would you buy it for a price of x currency?
• Why would you buy it at this price or why not?

The second most important factor besides the buyers’ willingness to pay is the costs incurred. Companies must be able to break these down the cost precisely in controlling in order to determine an exact cost price. Basically, two types of costs have to be distinguished:

• Direct costs: These can be assigned directly to a product
• Overhead costs: These have to be allocated proportionately to all products, as they cannot be allocated directly

For new products in particular, companies often base their product calculations on margins that are customary in the industry. This means that all costs are added up first, then a usual industry mark-up is added. However, this method often does not allow the full profit potential to be exploited. Instead, it is advisable to proceed the other way round. Let’s look at a simplified example to make this clear:

An entrepreneur has developed a product and knows what the total costs (product costs) are. They amount to 50 euros. The profit mark-up that is customary in the industry is 100 %. If the entrepreneur follows the industry average, he would set the sales price at 100 currency (50 currency costs + 50 currency profit). The customers are willing to pay this price.

Let us now imagine that the entrepreneur would optimise his production, which would reduce his costs to 25 of the currency per piece. If he were to apply the industry-standard mark-up (100%) in this case again, the sales price would only be 50 currencies. He would therefore have to lower his price, although customers would have certainly paid the original price.

A number of typical mistakes are made again and again in the context of product costing. For example, demand of the product is often overestimated. But lower unit numbers mean that the overhead costs are distributed among fewer units. At a certain point, the product slips into the loss zone. The remedy is to estimate sales quantities as realistically and conservatively as possible.

Another controlling mistake is to leave market risks out of the product calculation. These risks include, for example, bad debt losses or new competitors who are aggressively priced, which means that the company’s own discounts have to be increased.

Another pitfall is to be guided too much by one’s own costs when setting prices. The customer benefit also has to be kept in focus so as not to offer the product too cheaply. Of course, the products, on the other hand, must not be too expensive. This situation can arise, among other things, if a product is equipped with too many features. Innovation- and technology-driven companies in particular fall into this trap. The high number of features leads to a price that the customer no longer wants to pay. In this case, it may make sense to downsize the product in its basic configuration and offer further features as an additional option and price.

One of the most significant pitfalls in product costing, nonetheless, is an unstructured approach or subjective pricing. Let’s take a look at the existing calculation models and how they contribute to an objective calculation.

There are several methods of product costing. Which calculation structure is useful in the context of controlling depends on several aspects. For example, production companies utilise different calculation models than trading companies. Likewise, companies with a wide range of products also utilise a different approach than companies that only offer a few similar products. Essentially, the following methods can be distinguished:

• Division costing: For homogeneous and slightly differing products
• Equivalence costing: Products have similar characteristics and the cost structure can be expressed by a simple ratio
• Overhead costing: For heterogeneous product portfolio
• Couple costing: Costing method that is used in production processes in which different products (co-products) are inevitably created for procedural reasons

In addition, a distinction can be made with regard to the point in time:

• Preliminary costing: costing before the service is provided, particularly relevant for quotation costing in make-to-order production
• Post-cost calculation: Serves to compare with the preliminary costing in order to avoid costing errors in the future

Division costing is the simplest costing structure of cost unit accounting. It is suitable for companies that only manufacture one type of product or products with a similar cost generation. In the simplest form of application (single-level division costing), only the total costs are divided by the quantity produced. However, there are also multi-level calculation variants in which different production levels can be taken into account. This allows also the possiblity to separate sales and administration costs.

In general, total costs in division costing are differentiated according to material costs, manufacturing costs, administrative costs and distribution costs. If sales quantity and manufacturing quantity do not coincide in controlling, the administrative costs and distribution costs have to relate to the quantity sold.

Calculation with equivalence numbers is an extended variant of division costing. It can be used when similar products are manufactured whose costs have a constant ratio to each other. This could be, for example, sheet metal in different thicknesses or screws with different lengths.

The equivalence numbers (also called ratios) are utilised to show the cost differences between the product variants. This allows product costing to be done with a simple division calculation. The definition of equivalence numbers is difficult in practice. Both qualitative and quantitative characteristics of the product or its manufacture can be used as reference points. For sheet metal, for example, the characteristic “material thickness” could be used to determine the equivalence numbers. A sheet with a thickness of 1 mm can serve as a baseline grade (equivalence number = 1). A sheet with a thickness of 2 mm would receive the equivalence number 2.

Overhead costing is suitable for businesses with complex product portfolios and is therefore the most common costing structure. It distinguishes between direct costs and overheads. It allows to allocate direct costs of a product directly, while overhead costs are calculated using overhead rates based on historical values. Once these percentage overhead rates are fixed, they can be used for unit costing as well as for quotation costing. The following cost types are used in overhead costing for production companies:

• Direct material costs: Material consumption, valued at cost price
• Material overheads: e.g., costs of storage and procurement
• Direct production costs: Production labour costs
• Production overheads: non-material resources, e.g., energy, auxiliary and operating materials
• Administrative overheads
• Sales overheads

If all these costs are added up, the result is the so-called cost price. In order to obtain the sales price, a defined overhead rate for the profit has to be added.

In the context of so-called co-production, further products of different nature are inevitably created within a simultaneous production process. A distinction is often made between a main product and sub-products (by-products, waste). The problem is that the variable overhead costs incurred cannot be allocated to sub-products according to the originator principle or the identity principle. Only the costs of further processing can be recorded on a cost unit basis. Two methods of joint costing have therefore become established:

• Residual value method: Costs of the input are allocated to the main product, value of the subsidiary products is deducted, residual value corresponds to the value of the main product
• Distribution method: Used when there are several main products; characteristics of the sub-products are used for distribution (e.g., market price); methodology corresponds to the calculation of equivalence figures

Preliminary costing is mostly used for products that are not yet in production (production costs). It is often used to create an offer. It therefore always refers to a production order or a defined service unit. The basis of all calculations is the operational accounting sheet. In order to complete the offer calculation, surcharge rates for profit, rebate, cash discount and commissions must also be added.

Post-cost calculation fulfills the purpose of cost determination and cost control. It provides a means of reviewing completed production orders and the general principles of product costing. In case of discrepancies between target and actual costs, the causes should be determined so that the quotation costing will be even more accurate in the future.

It is possible to have the product calculation or cost estimate (manufacturing costs) conducted by external specialists and service providers. This procedure can be particularly useful in the case of innovations and limited experience. Estimates and detailed calculations by experts are suitable, for example, for mechanical and electronic hardware products as well as for software developments.

In order to estimate or calculate the costs of products, several pieces of information are required. This includes the project type, the quality, the area of application, the desired level of detail, the batch and process size and the country of manufacture. Optionally, an item bill of materials, a work breakdown structure or documents such as graphics and technical drawings can be supplied.