This post explains how to determine the cost of your products. Properly costing your products will help you set prices that maximize your profits. If you are in a service business that doesn’t sell physical products (such as a law practice or a dog-walker), I will write a separate post for you sometime in the future.
For purposes of product costing, there are two types of businesses: retailers and manufacturers. Retailers buy finished products from other companies. (This category includes so-called “wholesalers” who buy finished products from other companies and then resell them to other businesses.) On the other hand, manufacturers create products to sell to their customers.
|by The U.S. National Archives, on Flickr
Product costing for retailers is easy. The cost is usually whatever you paid your supplier. Add any shipping costs you paid and subtract any discounts received from your supplier.
For manufacturers, product costs include three elements:
- Direct materials – the costs of raw materials used to make a product. For example, suppose that your company makes and sells hand-knitted sweaters. This is the cost of the yarn.
- Direct labor – the costs of paying workers to make your products. For your sweater-knitting operation, this is how much you pay grandmothers to knit the sweaters.
- Manufacturing overhead – these are other costs necessary to produce your products. For example, this may include the cost of supplying grandmothers with proper knitting needles and rocking chairs.
Make sure you include all relevant costs of your products. Include any costs necessary to sell the product. Failure to do so could cause you to underprice your products – and sometimes even to sell products at a loss.