Lecture

18
Product Costing

Dr. Janakarajan Ramkumar
Professor
Department  of Mechanical & Design Program 
IIT Kanpur,  India.
 Contents
 Introduction
 Cost and Price Structure
 Information Need Sources
 Estimating Direct and Indirect Costs
 Design and Manufacturing Costs
 Ways to Model Manufacturing Costs
Introduction
•The ratio of perceived quality to its cost is called the value of a
product.

•Thus, the goals of design activities are to create a product that

satisfies the customers’ requirements and to maximize profit.

•The difference between the price at which the product is sold and
the cost of providing the product to the customer is called as Profit.

•Profit is required for a business enterprise to remain viable.

•As Cost is the most accessible and universally understood measure of

resource consumption so Cost is also important.

•Cost can be readily used as an important metric on which to base

engineering design decisions.
Introduction
Engineering Economics and Cost Analysis

•Engineering economics is the application of accumulated knowledge

in engineering and economics.

•It is used to identify alternative uses of resources and to select the

best course of action from an economics point of view.

•The cost analysis is necessary for determining the manufacturing and

life cycle costs of specific products.

•Cost estimation, and thereby profitability, is necessary for determining

the economic advantage of the business, which determines the ability
of a company to be competitive.
Cost And Price Structure
• Direct Labour Cost + Materials = Prime Cost/Operational Cost.

• Direct labour cost : cost of actual labour used to produce the

product.
• The direct materials cost comprises the cost of raw or semi‐
finished materials that can be directly attributed to the product.

• Factory Overhead + Prime Cost = Cost of Goods Manufactured /

Manufacturing cost

• Overhead Cost:
• Indirect materials cost (factory supplies and lubricants),
indirect labour costs (cost of supervision and inspection and
the salaries of factory clerks), and fixed and miscellaneous
costs such as rent, insurance, taxes, depreciation,
maintenance and repair, utilities, and small tools.
Information Needs and Sources
• Accurate estimation of costs requires reliable information.
• The flow of information should be uninterrupted, timely, consistent,
thorough, and simple.

• Usually, three kinds of information are important:

• historical,
• measured, and
• policy.

• The information from internal reports is historical and typically

included in accounting reports.
• Measured information generally is in dollar or time dimensions, such
as material quantities calculated from drawings.
• Policy information is fixed in nature and includes information such as
union‐management wage settlements, Social Security tax, and liability
insurance.
Sources of Information

Internal
• Accounting Department
• Personnel Department
• Operating Departments
• Purchasing Department
• Sales and Marketing

External
• Government Agencies
• International Agencies
• Business Firms
• Trade Associations
• Publications
Estimating Direct and Indirect Costs
• Structuring cost information: It is a process of grouping like facts
about a common reference on the basis of similarities, attributes,
or relationships.

• Once the cost information is classified, it is summarised.

• Sometimes, a master list of cost codes are used.

• Materials, supplies, equipment costs, and the like are assigned

costs from the original documents and given the appropriate code
number.
Estimating Direct and Indirect Costs
Direct Labour Costs

• Two things are required to determine the direct labour cost:

1. The time it takes to complete the task and
2. The wage rate

• The procedure used in determining time it takes to complete the task

is described in the next slide.
Estimating Direct and Indirect Costs

Observe the task being performed and record the time it takes to complete the 
entire cycle of the task.

Time for number of task cycles is recorded and averaged and this average cycle 
time is called observed time.

Normal Time = Observed Time x Rating (pace at which the operator being observed 
works)

Standard Time/Job Standard = Normal Time + Allowances (personal needs, 
unavoidable delays and fatigue)
Estimating Direct and Indirect Costs

• The PDF allowances are the fraction of the normal time devoted to
personal needs, unavoidable delays, and recovery from fatigue.

• The standard time may be expressed in seconds, minutes, or hours.

• The standard time may be used to determine output per hour in

terms of number of pieces as follows:
 Estimating Direct and Indirect Costs
• From the preceding, the direct labour cost can be calculated as 
follows:

• NOTE: Wage rate may or may not include the cost of fringe benefits.

• If such cost is not included, the wage rate must be modified to

accommodate it. The actual wage rate in that case is
Estimating Direct and Indirect Costs
Where
F = FICA fraction
U = Unemployment compensation fraction
W = Workers compensation fraction
H = Health and other insurance compensation fraction

Sometimes, it is necessary to modify the time per unit to account for

the effect of learning. This may be done as follows:

Where
P = Cumulative production
T0 = Time to make the first unit
n = The learning rate
Estimating Direct and Indirect Costs

Direct Material Costs
•The bill of materials is essential for determining the quantities of
materials required, as it generally contains the pounds, cubic or
square yards, board feet, square feet, gallons, or linear feet of the
required materials.

•The next step is to apply the appropriate material unit price or

cost to this quantity to develop the material cost as follows:
Estimating Direct and Indirect Costs
Where
W = Weight in pounds for a unit, or in dimensions compatible to
price P
P = Price per pound of material, or per unit length or volume
R = Unit price of salvaged material per unit ($)
L1 = Losses due to scrap, in fractions
L2 = Losses due to waste, in fractions
L3 = Losses due to shrinkage, in fractions

To determine the material cost, one can use several rules: first
in/first out cost; last in/first out cost; current cost; or actual cost.

The actual price method requires calculating equivalent cost and

works as follows:

where i (the lot number) = 1 to n;
and A is the unit in dimensions compatible to cost C
Estimating Direct and Indirect Costs
Overhead or Indirect Costs

• Overhead costs are the portion of the costs that cannot be clearly
associated with particular operations, products, or projects
• It must be prorated among all the product units on some basis.
• Overhead costs include:‐
1. Labour costs for persons who are not directly involved with a
specific manufacturing process such as managers and secretaries
2. Various facilities costs such as utilities and mortgage payments on
the buildings
3. Noncash benefits provided to employees such as health
insurance, retirement contributions, and unemployment
insurance;
4. And other costs of running the business such as accounting, taxes,
furnishings, insurance, sick leave, and paid vacations.
Estimating Direct and Indirect Costs
Overhead or Indirect Costs
• When overhead is allocated based on direct labour hours, it is
often called a burden rate and is used to determine either the
overhead cost COH or a burdened labour rate LRB as, respectively,

Where
b = Labour burden rate (typical range: 0.3 ≤ b ≤ 2)
LR = Labour rate (often expressed in dollars per hour), which, when
converted to an annual basis, is an employee’s gross annual wage
Estimating Direct and Indirect Costs
Hidden Costs

•Hidden costs are those costs that are difficult to quantify.

•Examples for Hidden Costs include:
1. Product’s gain or loss of market share.
2. Company’s stock price changes.
3. Position in the market for future products.
4. Impacts on competitors and their response.
5. Future value of engineering, manufacturing, and support
experience associated with using new technologies or
materials in the current product.
6. Long‐term health, safety, and environmental impacts that may
have to be resolved in the future.
Design and Manufacturing Costs
Manufacturing Costs
• Manufacturing costs form the basis for determining the actual 
recurring cost of making a product.
• Manufacturing costs are generally the sum of the costs from 
four primary sources:‐

1. Recurring labour costs:‐ Labour costs refer to the cost of the 
people required to perform specific activities. The labour cost per 
unit associated with an activity performed during manufacturing is 
determined from either
or
or         
where
NL = Number of people associated with the activity: it can have a 
value < 1
T = Length of time taken by the activity
Np = Number of units that can be treated simultaneously by the 
activity
Design and Manufacturing Costs
Design and Development Costs
• Design and development costs are referred to as nonrecurring
costs as they are a one‐time charge no matter how many units of
the product are manufactured.
• The specific elements of design and development costs that must
be included are:‐
1. Development of the product specification.
2. Conceptual design.
3. Intellectual property acquisition and protection such as licensing 
costs and patent filing costs.
4. Design of the product including the creation of engineering 
drawings.
5. Software development.
6. Creation of prototypes.
7. Functional testing.
8. Environmental testing to determine or verify reliability.
9. Product qualification and certification.
Design and Manufacturing Costs
Manufacturing Costs
2. Recurring material costs:‐The cost of the materials associated with
an activity is given by

where
UM = Quantity of the material consumed as indicated by its count,
volume, area, or length
Cm = Unit cost of the material per count, volume, area, or length

3. The allocation of nonrecurring tooling:‐

Tooling costs are nonrecurring costs associated with activities that
occur only once or only a few times.

Examples of tooling costs are programming and calibration costs for

manufacturing equipment, and training of people
Some other examples may be the purchase or manufacture of
product‐specific tools, jigs, stencils, fixtures, masks, etc.
Design and Manufacturing Costs
Manufacturing Costs

4. Capital Costs

Capital costs are the costs of purchasing and maintaining the

manufacturing equipment and facilities. In general, capital costs
associated with an activity are determined from

where 
T = Length of time taken by the activity
Np = Number of units that can be treated simultaneously by the 
activity
Ce= Purchase price of the capital equipment or facility
Top = Operational time of the equipment or facilities expressed as the 
number of hours per year
Td= Depreciation life in years
Ways to model manufacturing costs
Process Flow Model:‐
• Manufacturing processes can be modelled as a sequence of
process steps that take place in a specific order.

• The steps and their order are referred to as a process flow.

• In process flow models, a product unit accrues cost as it moves

through the sequence of process steps.

• Each process step starts with the state of the unit after the
preceding process step.

• The current step then modifies the unit and its output is a new
unit state, which forms the input to the next process step.
Ways to model manufacturing costs
Cost of Ownership (COO) Model:‐
• COO calculates an effective total cost of ownership for each piece
of equipment in the manufacturing process and then charges
each unit a fraction of that cost based on the portion of the
lifetime of the equipment used up by the unit.

Activity Based Cost (ABC) Model:‐

• Activity‐based costing is a method of assigning an organization’s
resource costs through activities to the products and services
provided to its customers.
• Once activities and their associated cost drivers are identified, an 
activity rate AR (with units of cost per activity) is determined from 
the relation
Ways to model manufacturing costs

where the activity cost pool is the total amount of overhead

required by the activity during some period of time and the activity
base is the number of times the activity was performed on all
products during that period of time.

The total cost of the ith activity for a single product is determined by

where NAi is the number of times the activity must be performed to

manufacture one unit of a product. The product ARi NAi in the above
equation is the overhead allocated to one unit of the product by the
activity.
The sum of CAi over all activities associated with the manufacture of
a product gives the manufacturing cost of one unit of the product.
Ways to model manufacturing costs
Parametric Cost Model:‐
• Parametric cost models form the basis for many top‐down cost 
models that seek to establish an estimate of the cost of a product 
from high‐level design parameters that define the product’s 
performance, functionality, and physical attributes. 
• The relationship between design parameters and costs is called a 
cost estimating relationship (CER).
Ways to model manufacturing costs
Technical Cost Modeling (TCM):‐
• The process of predicting the primary cost contributions from
the physical parameters associated with a manufacturing
process and product‐specific details is called technical cost
modeling (TCM).

• Technical cost modeling can be used in conjunction with any of

the modeling approaches that have been discussed so far.
Task for students
Thanks