Running a small to mid-size manufacturing business is no small feat. Amid fluctuating market demands, rising material costs, and competitive pressure, understanding and managing your costs is essential for profitability.
Manufacturers that meticulously track, analyze, and optimize their cost structures gain a significant advantage — not just in managing day-to-day operations but in making strategic decisions that move their businesses forward.
Knowing how is the first step. In this article, we’ll show you actionable insights you can take to identify cost components, calculate total manufacturing cost, and better manage production expenses in your plant.
The Importance of Understanding Manufacturing Costs
Any manufacturer whose company has been through ups and downs knows all too well that profitability is not solely determined by revenue. It’s a function of the costs you incur to produce and deliver each finished product.
Without a clear and current understanding of these costs, you risk underpricing products, overestimating profit margins, or missing opportunities to improve efficiency. That’s why understanding your cost structure — especially as costs fluctuate — is so important. It enables you to:
- Accurately price products: Ensure pricing reflects actual production costs and desired profit margins.
- Minimize inefficiencies: Identify where costs are unnecessary or excessive.
- Plan better: Make informed decisions about scaling operations, investing in equipment, or managing labor.
Let’s break down some manufacturing costs to help you take control of your operations.
What Manufacturing Costs Include
Manufacturing costs are generally divided into direct costs and indirect costs, both of which play distinct but critical roles in your overall expenses.
1.Direct Manufacturing Costs
Direct costs are tied to the production of a specific product and typically fluctuate based on production volume. These include:
- Direct materials: Raw materials and components that are directly part of the finished product.
- Direct labor: Wages paid to employees physically producing the goods.
- Third-party services: Fees for external services like plating, painting, or heat-treating.
- Indirect Manufacturing Costs
2. Indirect costs support manufacturing operations, but are not directly tied to any specific product. These include things like:
- Indirect labor: Maintenance staff, material handlers, and supervisors.
- Facilities costs: Utilities, property taxes, and depreciation.
- Equipment expenses: Maintenance, repairs, supplies and depreciation.
Total Manufacturing Cost Formula
Once you’ve accurately captured your expenses, you can build a stronger foundation for calculating your total cost of production and ultimately managing it. Here’s an overview of the steps involved:
Step 1: Develop an Accurate Cost of Production
Start by identifying the total cost of production, or cost basis, for each product. You can approach this calculation by looking closely at the following:
- Bill of Materials (BOM): Itemize all components required to manufacture your product. Account for yield or waste to avoid underestimating material usage.
- Production Routing: Map out every step of the production process and the labor required for each step.
- Costing Method: Determine whether standard, actual, or average costing provides the best lens for cost analysis.
Tip: The more thorough you can be here, the more clear and realistic the picture of your cost basis will be.
Step 2: Optimize Labor and Total Manufacturing Overhead
Ensure labor rates are competitive and factor in overhead expenses like utilities and equipment costs. Assess production efficiency to determine whether you’re operating at optimal capacity. Could adding a shift or upgrading equipment improve performance?
Tip: Regularly comparing labor and overhead costs to benchmarks and industry standards can help you identify opportunities for improvement.
Step 3: Analyze Inventory Management Costs
Inventory is a critical area where costs can spiral out of control if not carefully managed. Balancing inventory is a fine art.
- Avoid Overstocking: Excess inventory ties up cash, increases storage costs, and runs the risk of obsolescence.
- Prevent Stockouts: Insufficient inventory can disrupt production and damage customer trust. If you depend on materials and products from suppliers overseas, be vigilant in tracking how the greater issues, such as changes in tariffs, might interrupt or slow supply chains, requiring you to account for longer lead times or adjust for higher costs.
- Focus on Inventory Turnover: Monitor key metrics like inventory turns to optimize stock levels. Sell or liquidate slow-moving inventory to free up resources.
Tip: Ensure your Enterprise Resource Planning (ERP) system is optimized to help you analyze purchasing patterns, sales forecasts, and inventory alignment with demand. Unsure? Click here to learn how to determine whether your current ERP system needs some tweaks or your manufacturing operation needs a new ERP system.
Step 4: Perform Ongoing Cost Analysis
Adopt analytical tools to assess the performance of your cost structure. Include:
- Margin Analysis: Evaluate product profitability by subtracting costs from revenue. Use this insight to decide which product lines to expand or discontinue. Don’t overlook the impact different pricing for different customers has on individual product margins. If you’re charging your largest customer too little, for example, what might appear to be a margin issue for a certain product might instead be a pricing issue for a particular customer.
- Variance Tracking: Monitor discrepancies between estimated and actual costs. This enables you to pinpoint inefficiencies in materials, labor, or processes.
- Volume Tracking: Consider, too, if your actual volume aligns with your estimates. If volume is falling short of projections, you’ll want to reevaluate those costs to account for the disparity and increase your burden rate, which will have an impact on product selling price.
- Tip: By quantifying performance at every stage, you can make better operational decisions, such as whether to outsource production or invest in new equipment.
Understand & Manage Your Manufacturing Costs with Confidence
Understanding and managing your costs won’t only benefit your bottom line — it will empower your business for long-term success. Small and mid-size manufacturers that take a strategic, data-driven approach to costs are better positioned to withstand economic fluctuations, improve efficiency, and invest confidently in growth opportunities.
You don’t have to face the complexities of cost management alone. Whether you need support in analyzing costs, managing inventory, or optimizing your processes, Rehmann has the experts and tools ready to help you succeed. To learn how we can help with inventory management and product costing, reach out to Melissa C. Rood at 248.458.7922 or [email protected].