What it means
Accounting draws a hard line between costs that attach to a product and costs that attach to a stretch of time. Product costs are the three inputs needed to turn raw material into something saleable: direct materials, direct labour and manufacturing overhead.
Overhead covers the factory costs you cannot trace to one specific item, such as machine depreciation, factory rent and the supervisor's wages. The distinction matters because product costs are not expensed when you pay them, they are parked in inventory until the goods leave the building.
A month of heavy production and light sales can therefore show a comfortable profit even though cash has poured out of the door, which is one of the most common reasons a profitable looking business runs short of money. Managers use the product cost per unit to set prices, decide which lines are worth keeping and value stock at the year end.
Because overhead has to be spread across units using some allocation basis, such as machine hours or direct labour hours, two sensible accountants can arrive at slightly different unit costs for the very same item. Service businesses have an equivalent idea, usually called cost of service delivery, and software firms capitalise part of their development spending on a similar principle.
The test is always the same: does this cost help create the thing the customer buys, or does it simply keep the business running for another month? A common variant is variable costing, which treats only materials, direct labour and variable overhead as product costs and expenses fixed factory overhead immediately.
External reporting rules require the full absorption version, but plenty of management teams run variable costing internally because it stops reported profit moving purely because inventory levels changed.
In practice
Real-world examples.
Example
A craft brewery calculates that malt, hops, bottling labour and brewery overhead come to $1.40 per bottle. When a supermarket asks for a price of $1.25, the finance manager can say no in seconds because the offer sits below product cost before a single delivery van has moved.
Example
A cosmetics manufacturer builds stock ahead of a Christmas launch and reports a strong October profit. The controller explains at the board meeting that $600,000 of product costs are simply sitting in inventory and will land in cost of sales once the goods actually sell.
Example
An electronics assembler reallocates factory overhead from labour hours to machine hours after automating a line. The unit product cost of its high volume board falls from $18 to $14, and the sales team finally has room to win a contract it had been losing on price.
Think of it
“Product costs are like the ingredients baked into a cake. They're part of the cake's value until someone buys it-then they become an expense.
Formula
Calculation
Product costs = direct materials + direct labour + manufacturing overhead
Unit product cost = total product costs / units produced
A furniture workshop spends $450,000 on timber and fabric, $260,000 on the wages of the people who build the chairs, and $290,000 on factory rent, machine depreciation and supervision during the year. Total product costs are $450,000 + $260,000 + $290,000 = $1,000,000. It produced 50,000 chairs, so the unit product cost is $1,000,000 / 50,000 = $20 per chair.
If 40,000 chairs are sold, cost of sales is 40,000 x $20 = $800,000, and the remaining 10,000 chairs sit in closing inventory at 10,000 x $20 = $200,000. The showroom rent and sales commissions of $340,000 are period costs, so all $340,000 hits this year's profit and loss account no matter how many chairs were sold.Case study
Seen in the real world.
What follows is an illustrative and entirely fictional example. Brackenford Ceramics, an invented tableware maker, sold three ranges and believed all three were profitable because it costed every plate at materials plus a flat 60% mark up. Nobody had asked whether the flat mark up actually reflected the factory time each range consumed.
A new finance manager rebuilt the numbers using proper product costs, splitting direct materials, direct labour and factory overhead, and allocating overhead by kiln hours rather than by revenue. The hand painted range, which occupied the kiln for three times as long per piece, turned out to cost $31 a plate against a selling price of $28, while the plain white range was quietly earning twice the margin management assumed.
Brackenford's fictional board raised the hand painted price by 20%, lost a fifth of that range's volume and still improved group profit by roughly $210,000 in a year. The lesson in this illustrative case was not that the old numbers were dishonest, only that a single blended mark up hid two very different products.
Watch out
Common mistakes.
- Treating all business costs as product costs, so sales commissions and head office salaries end up inflating the value of unsold stock.
- Assuming product cost equals the price paid to a supplier, which ignores the labour and factory overhead needed to make the item saleable.
- Reading a rising profit figure as good news when the real driver is a build up of unsold inventory carrying product costs into next period.
Questions
People also ask.
Are product costs the same thing as cost of goods sold?
Not quite, they become cost of goods sold only when the units are sold, and until then they sit in inventory on the balance sheet.
Does a business that only sells services have product costs?
It has a direct equivalent in the staff time and materials consumed delivering the work, though the accounting label is usually cost of sales rather than product cost.
Why do two accountants sometimes report different unit costs for one item?
Because overhead has to be allocated on a chosen basis, and switching between labour hours, machine hours or units produced moves cost between products.
From the founder's library
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