Total production cost is the total cost of the entire production line and includes the costs of the three major components involved in manufacturing a product: direct materials, direct labor, and overheads. The exact formula is:
Total production cost = direct materials + direct labor + overheads
Each component of the formula has to be calculated in its own way:
Direct materials refers to all of the raw materials needed to create the final product, and is calculated by adding the cost of all raw materials purchased in a given time period to the cost of the beginning inventory and then subtracting the cost of the ending inventory.
Total direct materials = beginning inventory + materials purchased – ending inventory
Direct labor is simply all of the costs related to the labor that goes into production, including salaries, benefits, workers compensation insurance, and payroll taxes. It is calculated in 3 steps: first, calculate the direct hourly labor rate to account for variable pay rates and end up with one number that represents the cost of an hour of labor.
Direct hourly labor rate = (salaries + taxes + benefits)/total number of hours worked
Next, calculate the number of hours of labor required to produce one unit:
Direct labor hours = number of units produced/number of hours worked
The last step is to calculate the actual cost of direct labor by multiplying the hourly rate by the number of hours worked:
Total direct labor = direct hourly labor rate * direct labor hours
Overheads include costs like rent or mortgage on the factory, electricity and other utility bills, repair and maintenance costs, depreciation, salaries of managers and other non-assembly line workers, etc. Because many of these costs are fixed amounts or unconnected to the number of products made, a calculation is needed to assign a proportion of the cost to the number of products manufactured.
This calculation is made by adding up the total overhead costs and determining what percentage of the company’s monthly revenue goes to cover the overhead costs:
Overhead rate = overhead costs / sales revenue * 100
It’s important to know this overhead rate to get an indication of how efficiently the factory is using its resources – a lower overhead rate indicates better efficiency as a lower amount of revenue is being used to cover the overhead costs.