No manufacturing business will be successful for long without keeping a very close eye on costs. While there are a host of business functions, each with its own costs, the number that matters most in terms of profitability is the Total Manufacturing Cost. This provides a basis for setting prices, and a way of seeing whether production operations are under control, becoming more efficient, or in need of remedial action.
This blog reviews how to calculate the Total Manufacturing Cost in a reporting period. It begins by answering the question, “What is Total Manufacturing Cost?” Then it reviews the various formulas used and explains how to perform the calculation. Finally, there are some tips to make the calculation a little easier and some cautions regarding things that can go wrong.
Components of Total Manufacturing Costs
Clearly, manufacturing any physical object requires raw materials and, to an extent, labor. (However, rising levels of automation mean fewer people are needed to make more things each year.)
The sum of these expenses is the Total Direct Manufacturing Cost. This fluctuates as production quantities go up and down. All the other costs incurred in making the product, including providing the factory, the machines inside it and the power and other services needed to run them, are part of the Manufacturing Overhead Cost.
Costs such as the payroll department or the legal team are excluded, because these exist whether anything is manufactured.
Drilling down deeper, direct material costs are the sum of the cost of all the materials used to make the product. However, this can’t be calculated from the Bill of Materials because that won’t reliably account for waste like set up pieces, offcuts and scrap. Instead, the approach is to look at the change in material inventory during the reporting period.
Direct labor is the cost of the time of the people that perform value-adding work on a product. This includes machine loading and unloading but excludes inspection and supervision. Direct labor cost is calculated by first establishing an average hourly cost.
Manufacturing overhead costs include indirect labor and materials, plus all the other costs incurred in providing and maintaining a factory full of machinery. This includes equipment depreciation, utilities and property taxes or rent. Some will vary in proportion to production levels while others are fixed.
Indirect manufacturing costs are the labor and material needed for production, but that don’t add value to or end up in the products directly. Inspection, maintenance and supervisors are all indirect labor. Indirect material includes consumables as well as maintenance and service items.
Formulas for calculating Total Manufacturing Costs
At the top level, Total Manufacturing Cost = Total Material Cost + Total Direct Labor Cost + Total Factory Overhead
The formula for Total Material Cost = opening inventory + purchases – closing inventory
For Total Direct Labor Cost, the formula = total labor hours to make the product produced in the reporting period x hourly rate
Manufacturing Overhead Costs = Total Indirect Manufacturing Cost + depreciation + utilities + insurance + property taxes/rent
Where Total Indirect Manufacturing Cost = total indirect labor + total indirect materials
How to calculate Total Manufacturing Costs
Calculating the Total Manufacturing Cost for a period requires access to the cost data in various company systems. Most, such as inventory values and purchases, will be in the ERP system while others will require accessing payroll, finance and the Computerized Maintenance Management System (CMMS).
Having obtained access, there are four, or optionally five, steps to follow:
Step 1: Calculate direct materials cost
Obtain the inventory valuations at the start and end of the period under review. Then determine how much inventory was purchased over this same period. The difference between opening inventory plus purchases, less the closing inventory, is the value of inventory used for production in that period, or in other words, the total direct material cost.
Step 2: Calculate direct labor cost
Direct labor costs include all the various taxes and benefit costs incurred. This may vary by personnel grade and length of service, so for highest accuracy, obtain actual numbers for each of the direct employees. However, should that be impractical, work with the HR and, if separate, payroll to come up with an hourly cost of direct labor.
Separately, obtain the number of direct hours worked in the period under review. Given that direct employees are mostly paid hourly and use some form of timeclock, this should be available from payroll. Multiply hours worked by average hourly rate for the total cost of direct labor.
Step 3: Calculate manufacturing overhead
Work with finance for depreciation numbers and the cost of utilities, insurance and rent or property taxes. From HR obtain costs for indirect employees. Review the CMMS for information on machine maintenance costs.
Total these for the period under review to arrive at a total for manufacturing overhead.
Step 4: Allocate manufacturing overhead
While this step isn’t necessary to arrive at the Total Manufacturing Cost, sharing out overhead between the various production departments or product lines is an essential part of determining product line profitability. (The alternative is to aggregate everything at a high level, which limits the extent to which costs can be analyzed.)
Businesses often debate the most equitable way of allocating overheads. Before automation was widespread it was often done on the basis of direct labor hours. This meant the lines with the most people carried the most overhead. As direct headcounts have fallen, businesses have switched to metrics like machine hours or floorspace occupied.
If the Total Manufacturing Cost study has the goal of determining the true cost of individual products, it will be necessary to work with the finance department to understand the preferred allocation method.
An alternative cost measure that’s easier to arrive at is Overhead Percentage Rate. This is manufacturing overhead costs as a percentage of sales. It provides an indication of business efficiency in that a lower number shows the business is controlling manufacturing overhead costs and is particularly valuable when viewed as a trend.
Step 5: Sum all costs
Having established total direct and overhead costs, calculating Total Manufacturing Cost is simply a matter of adding these together.
Tips for accurate cost calculation
Costs can change with little notice, so it’s prudent to put systems in place for collecting data at a frequency that enables corrective action to be taken before trends take the business in the wrong direction. Production volumes are obviously a major driver of changes in direct costs, but while overheads are more stable, they can change too. A modified preventive maintenance program may for example increase the cost of consumables used in one period, but reduce overtime worked to make up for unplanned downtime in the next.
Two tips for ensuring cost numbers remain accurate are:
- Monitor and update regularly
- Use cost management software
Material prices can change at short notice, labor costs will rise on an annual basis or when a new contract is agreed. These and all other inputs to the total cost calculation should be tracked and the calculations updated frequently.
In a small business, it may be possible to do this with a spreadsheet. That quickly becomes impractical as the number of inputs grows, so consider using specialized software written specifically for accurate and efficient cost tracking.
Common pitfalls and how to avoid them
While the formulas used to determine Total Manufacturing Cost are straightforward, obtaining the data for them is often not so easy.
One major challenge is data that’s either inaccurate or missing completely. Address this by setting up automatic reports, which may require help from IT, rather than relying on someone to do the calculations for you. Where human resources are needed, schedule this on a calendar and follow up regularly. Also, look for any sudden changes between periods as these may indicate problems with the data.
Overhead allocations can be a source of friction between departments as they can make one product line look highly profitable, while another appears at best highly marginal. (Given the decisions that may be made based on such numbers, a degree of sensitivity is understandable!) Address this head-on by ensuring the allocation basis is transparent and logical.
Focus on costs, let ATS help manage maintenance expense
In every manufacturing business understanding the total cost of production is key to maintaining control over operations and expenditures. It’s also a powerful tool for guiding resource allocation decisions and monitoring the effectiveness of improvement programs such as new approaches to preventive maintenance.
This blog has explained how to calculate Total Manufacturing Cost. Data collection methods, the importance of data accuracy and overhead allocations were also covered. For many manufacturers, especially those that are particularly asset-intensive, maintenance is a significant manufacturing overhead. ATS helps manufacturers in many industries to drive down maintenance costs while improving effectiveness. Contact us for more details.
