How to calculate the calculation

The word «cost calculation» sounds rather serious to a person who is far from economics.

Cost calculation items, direct and indirect expenses, allocation of overhead costs, consumption rates...

In fact, the idea itself is very simple.

A cost calculation is needed to answer one main question: how much does it cost us to produce one unit of a product?

For example, a company produces chairs.

One chair is sold for 100 rubles.

But how much does it actually cost the company?

50 rubles?

70?

90?

And how much of these costs actually increases when producing each new chair, and how much will the company incur even when it produces no chairs at all today?

This is exactly what a cost calculation is needed for.

Let's start with the simplest case

Imagine a small production facility that manufactured 100 chairs in one month.

The following were required for production:

• wood;
• varnish and glue;
• electricity;
• workers' wages;
• foreman's salary;
• rent of the premises;
• equipment repairs;
• depreciation of machinery;
• accounting;
• transportation and other expenses.

We can simply add all of this together.

Suppose we get:

10,000 rubles of expenses for the month.

If the company manufactured 100 chairs, a very simple question arises:

10,000 / 100 = 100 rubles per chair.

It seems that the cost calculation is ready.

But this is where we have already fallen into the first trap.

Because not all 10,000 rubles are equally related to the production of these 100 chairs.

Why you cannot simply divide all expenses

Imagine that tomorrow production makes not 100 but 200 chairs.

Approximately twice as much wood will be needed.

The same applies to glue and varnish.

A piece-rate worker will most likely earn more because they produced more output.

More electricity directly related to operating the machinery will also be required.

But the accountant's salary will practically not change depending on the number of chairs produced.

The rent of the premises will also remain the same.

The workshop foreman may receive the same salary.

Equipment depreciation for the month will not become twice as large simply because we produced twice as many products.

So we get an interesting result.

Some costs follow the product, while others exist regardless of the quantity produced.

That is why, when calculating costs, expenses must first be properly broken down.

Step 1. Determine what exactly we are calculating

This seems obvious, but this is where everything begins.

For example:

Cost calculation for one chair.

Or:

• 1 tonne of cement;
• 1 kg of cookies;
• 1 metre of fabric;
• 1 service;
• 1 hour of machine operation;
• 1 car repair.

In other words, we first determine the costing unit.

Until we know exactly what we want to determine the cost of, there is no cost calculation yet.

Step 2. Calculate direct costs

Now let's look at what is directly required to manufacture one chair.

Suppose:

Wood — 30 rubles.

Glue and varnish — 5 rubles.

Machine electricity — 3 rubles.

Worker's wages — 12 rubles.

We get:

30 + 5 + 3 + 12 = 50 rubles.

This is already a very important figure.

50 rubles are the direct costs of producing one chair.

Why direct?

Because we can quite easily say:

this wood went into this chair;

this amount of working time was required to manufacture it;

this amount of electricity was consumed by the production process.

In other words, we can directly link the costs to a specific product.

Step 3. But a company consists of more than just a machine and a worker

This is where things get really interesting.

To manufacture a chair, the company needs not only to buy wood and pay the worker.

It also needs to:

• maintain the premises;
• pay the foreman;
• repair equipment;
• light the workshop;
• heat it;
• maintain the administration;
• pay the accountant;
• pay for banking services;
• pay for communications;
• service the equipment.

But how do we determine how much of these expenses relates specifically to one chair?

For example, the accountant receives 2,000 rubles per month.

What part of their salary should one specific chair "pay"?

At first glance, the question seems strange.

But this is exactly what cost calculation does.

Step 4. Allocate common expenses

Suppose that during the month the company incurred 5,000 rubles in overhead costs.

They are related not to one specific chair, but to the production activity as a whole.

The company manufactured:

100 chairs.

If, in our very simple example, we use the quantity of products as the allocation base, we get:

5,000 / 100 = 50 rubles per chair.

Now we can put the cost calculation together.

Direct costs:

50 rubles.

Allocated overhead costs:

50 rubles.

Total:

100 rubles per chair.

And there we have our cost calculation.

But there is an important nuance

We should not treat the formula:

All company expenses / quantity of products = unit cost

as a universal rule.

It works only in a very simple case where all products are approximately the same.

Now imagine that the company produces simultaneously:

• a simple chair;
• an armchair;
• a large dining table.

Their production processes are completely different.

One requires more wood.

Another requires more labour time.

The third requires more machine time.

Therefore, simply taking all overhead costs and dividing them equally among all products would be unfair.

This is where the allocation base comes in

To allocate common expenses among different products, we need to choose an allocation base.

Simply put:

what criterion will we use to determine what share of the common expenses should be assigned to each product?

For example, expenses can be allocated proportionally to:

• production volume;
• direct costs;
• wages of production workers;
• labour intensity;
• machine time;
• cost of raw materials;
• standardized energy consumption.

The choice of allocation base depends on the nature of production.

The main principle here is very simple:

costs should be allocated as fairly as possible from the perspective of their economic relationship with the product.

A simple example of cost allocation

Suppose a company produces two products:

A chair and a table.

During the month, overhead costs amounted to:

10,000 rubles.

At the same time, direct costs were:

• chairs — 20,000 rubles;
• tables — 30,000 rubles.

Total:

50,000 rubles.

Chairs accounted for:

20,000 / 50,000 = 40%

of all direct costs.

Tables therefore accounted for:

60%.

Then overhead costs can be allocated as follows:

Chairs:

10,000 × 40% = 4,000 rubles.

Tables:

10,000 × 60% = 6,000 rubles.

This is what cost allocation is.

No magic.

Just a simple proportion.

Step 5. Calculate the cost per unit of product

Now imagine that during the month the company produced:

100 chairs.

Direct costs for them amounted to:

20,000 rubles.

Allocated overhead costs:

4,000 rubles.

Total production costs for the chairs:

24,000 rubles.

Then the cost calculation for one chair is:

24,000 / 100 = 240 rubles.

We get:

240 rubles is the calculated production cost of one chair in our example.

And now the most important part

Suppose the chair is sold for 300 rubles.

We get:

300 − 240 = 60 rubles.

At first glance, it seems:

Great! We earn 60 rubles from each chair.

But an economist will not stop the calculation here.

Because those 240 rubles consist of costs that are different in nature.

For example, if:

200 rubles are variable costs,
and 40 rubles are fixed and allocated costs,

then when deciding whether to produce another 100 chairs, the economics will look completely different.

This is why a cost calculation is needed not only to determine the cost of a product.

It is needed to make decisions.

What happens if we increase production?

Imagine that the company already maintains the workshop, equipment, foreman and administration.

In other words, a significant portion of fixed costs already exists.

We produce 100 chairs — these costs exist.

We produce 200 — they may hardly change.

As a result, when production volume increases, fixed costs begin to be allocated across a larger quantity of products.

For example:

With 100 chairs:

5,000 rubles of fixed costs / 100 = 50 rubles per chair.

With 200 chairs:

5,000 / 200 = 25 rubles per chair.

The equipment, premises and accountant did not become twice as cheap.

It is simply that their cost is now distributed across a larger number of products.

That is why production volume is extremely important for the cost per unit of product.

What if production decreases?

Everything happens in reverse.

With 50 chairs:

5,000 / 50 = 100 rubles of fixed costs per chair.

So we get:

• 200 chairs → 25 rubles of fixed costs per unit;
• 100 chairs → 50 rubles;
• 50 chairs → 100 rubles.

This is why you cannot look at the cost of one unit of a product separately from the production volume.

So what does a cost calculation ultimately consist of?

If we simplify it greatly, the logic looks like this:

Cost calculation = direct costs + allocated share of common expenses.

Direct costs, in turn, may include:

raw materials + materials + energy + direct labour + other directly attributable costs.

Common expenses are what ensure the operation of production as a whole:

management + maintenance of premises + servicing + depreciation + repairs + other expenses.

Depending on the specific company, the composition of costing items will differ.

And where do consumption rates come in?

This is where cost calculation connects with planning.

Suppose that manufacturing one chair requires:

5 kg of wood.

The price of wood is:

4 rubles per kg.

Then the cost of wood in the calculation is:

5 × 4 = 20 rubles.

If 0.5 hours of machine operation are required and the cost of one machine hour is 10 rubles:

0.5 × 10 = 5 rubles.

If the worker has a piece-rate of 15 rubles per chair:

labour = 15 rubles.

And this is how the production cost of one unit is gradually built up.

Therefore, resource consumption standardization is essentially the foundation of planned cost calculation.

The more accurate the consumption rates, resource prices and production volume, the more accurately the future cost will be calculated.

Actual and planned cost calculation

There is another important distinction here.

A planned cost calculation answers the question:

How much should the product cost us under the planned conditions?

We take:

• planned production volume;
• consumption rates;
• raw material prices;
• energy costs;
• labour rates;
• planned overhead costs.

And we calculate the expected cost.

An actual cost calculation answers a different question:

How much did the product actually cost us?

After the period ends, we look at:

how much raw material was actually used, how much energy was consumed, how much was paid to workers, what expenses were incurred, and how much product was actually produced.

And we compare:

plan → actual.

And this is where cost calculation becomes a management tool

Suppose we planned the cost of a chair at:

240 rubles.

In reality we got:

270 rubles.

Simply stating:

«The cost increased by 30 rubles»

is practically useless.

We need to ask the next question:

Why?

For example:

• wood became 10 rubles more expensive;
• wood consumption increased by 5 rubles;
• energy became 3 rubles more expensive;
• wages increased by 4 rubles;
• production volume was below plan, so more fixed costs had to be allocated per unit — another 8 rubles.

And now we understand the economics of the process.

We get:

270 − 240 = +30 rubles of variance.

And these 30 rubles can be broken down by cause.

This is where the real value of cost calculation lies.

A cost calculation is not just a table

You can create a beautiful twenty-line table and get a cost figure.

But if it is unclear:

why this amount is assigned specifically to this product,

then such a cost calculation provides little value for management.

A good cost calculation should allow you to answer at least several questions:

• How many resources are required per unit of product?
• Which costs increase together with production volume?
• Which expenses does the company incur regardless of production volume?
• What share of common expenses is attributable to a specific product?
• What happened to the cost compared with the plan?
• What caused the change in cost?

And most importantly:

does it make sense to produce this product at the current price at all?

Therefore, a proper cost calculation does not start with division

If we reduce the entire calculation to a few steps, the logic is as follows:

• Determine the product and the costing unit.
• Determine resource consumption rates for that unit.
• Determine resource prices.
• Calculate direct costs.
• Collect expenses that cannot be directly attributed to one product.
• Choose a reasonable basis for allocating them.
• Allocate common expenses among the products.
• Determine the total costs for each type of product.
• Divide the costs of a specific product by its production volume.

And we get:

the calculated cost per unit of product.

The simplest formula

If we make it very short:

Unit cost =

(direct costs for the product + allocated indirect expenses) / quantity of products manufactured.

But it is important to remember:

the main difficulty is not the division.

The main difficulty is correctly determining:

which costs are directly attributable to the product and which need to be allocated.

And even more importantly — how exactly to allocate them.

Because ultimately this affects not only the cost figure, but also the conclusion about which product is profitable to produce, which generates more results, where losses arise, and how the company can improve its economics.

That is why cost calculation is not simply a calculation of production cost.

It is a way to see what the economics of a product actually consists of.