Cost Accounting: How to Calculate Product Cost and Set Your Prices

What you'll learn

How to classify costs: direct or indirect, fixed or variable, product or period.
How to calculate a product's unit cost with absorption costing.
When to use variable costing, for example to accept or reject a special order.
How to allocate overhead among several products with a sensible base.
How to set a price with a margin on the selling price, and why markup is not margin.

Plenty of small businesses price like this: "ingredients times two." It works until it doesn't. They sell a lot, work long hours and still end the month with nothing left. The reason is almost always the same: a product's real cost includes much more than its materials. Cost accounting gives you the method to calculate it, and with it, a price that actually leaves a profit.

How costs are classified

Direct vs. indirect

Direct costs trace to each unit; indirect costs (overhead) are shared.

In a bakery: the flour and chocolate in each cake are direct; the oven's gas, which bakes everything, is indirect.

Variable vs. fixed

Variable costs move with volume; fixed costs don't, within a range.

In a bakery: ingredients and boxes are variable; kitchen rent, oven depreciation and a salaried baker are fixed.

Product vs. period

Product costs become part of inventory; period costs are expensed in the month.

In a bakery: everything in the kitchen is product cost; advertising and the bookkeeper are period costs.

A manufactured product's cost has three components:

Direct materials (DM): what physically becomes the product.
Direct labor (DL): the people who make it, at their full employer cost, as you calculated in lesson 14.
Manufacturing overhead (MOH): everything else in production, such as utilities, equipment depreciation, kitchen or workshop rent, maintenance and supervision.

1. Is the salary of the person who runs the bakery's social media part of the cost of each cake?

Yes, as direct labor
Yes, as manufacturing overhead
No: it's a selling expense (a period cost), expensed in the month and covered by the margin

Only production costs go into product cost. Selling and administrative expenses must be covered by your margin, but they aren't part of unit cost or inventory.

Unit cost with absorption costing

Brightside launches custom cakes to order. Data for a normal month, with 400 cakes produced:

Component	Detail	Per cake
Direct materials	Ingredients for each cake	$18.00
Direct labor	Baker's full employer cost of $4,800 a month ÷ 400 cakes	$12.00
Variable overhead	Oven energy and cake box	$2.00
Fixed overhead	$2,000 a month (kitchen rent share $1,000, oven depreciation $600, maintenance $400) ÷ 400 cakes	$5.00
Unit cost		$37.00

Unit cost of $37: direct materials $18 (48.6%), direct labor $12 (32.4%), variable overhead $2 (5.4%) and fixed overhead $5 (13.5%). "Ingredients times two" would price the cake at $36, below its cost.

This is called absorption costing (or full costing) because each unit absorbs a share of fixed production costs. It's the method GAAP requires for valuing inventory in financial statements, the same inventory you costed with FIFO and LIFO in lesson 6.

Volume changes unit cost

In a slow month with only 320 cakes, the fixed costs are spread over fewer units: labor rises to $15.00 per cake and fixed overhead to $6.25, so unit cost climbs to $41.25. That's why you calculate cost at a normal volume, not an exceptional month. Otherwise you'd raise prices in the low season, exactly when you're selling the least.

Variable costing: the view for decisions

For short-term decisions, such as accepting a special order at a discount, use variable costing, which charges the product only with costs that change with volume: $18 + $2 = $20 per cake. The baker's salary and the $2,000 of fixed overhead are paid with or without the order. If a hotel wants 50 extra cakes at $30 and the kitchen has spare capacity, each cake leaves $10 of contribution margin, and the order adds $500 to profit, even though $30 is below the $37 absorption cost. Just make sure it doesn't undercut the price your regular customers pay.

2. With spare capacity, should you ever accept a special order priced below absorption cost?

Never: it's selling at a loss
It can make sense if the price is above variable cost, because fixed costs are already covered
Always: more volume is always better

Any price above variable cost adds contribution margin. Watch that it doesn't cannibalize regular prices or use capacity you could sell at full price.

Several products: allocating overhead

When the kitchen also bakes cookies, fixed overhead must be shared using an allocation base that reflects which product uses more of it. In a bakery, the oven is the big consumer of resources, so oven hours are a good base:

Fixed overhead for the month:   $2,000
Oven hours:    cakes 120 h · cookies 80 h · total 200 h
Rate:          $2,000 ÷ 200 h = $10 per oven hour
Cakes:         120 h × $10 = $1,200 → $1,200 ÷ 400 cakes = $3.00 per cake
Cookies:        80 h × $10 = $800

Had all the overhead been loaded onto cakes, their cost would be inflated ($5.00 instead of $3.00 of fixed overhead per cake) and cookies would look more profitable than they are. A poor allocation base leads you to raise the price of the wrong product or promote the one that's losing money.

Activity-based costing (ABC)

When you have many products and large overhead, use several bases at once: machine hours for energy, number of orders for purchasing, number of batches for setup time. It's more precise, and it often reveals "star" products that aren't profitable at all, such as highly customized items that eat up setup and design time.

From cost to price

There are two ways to add profit to cost, and mixing them up is one of the most expensive mistakes a business can make:

Markup on costPrice = Cost × (1 + %)

$37 cake, "40%": $37 × 1.40 = $51.80
Real margin: $14.80 ÷ $51.80 = 28.6% of the price
Watch out: A 40% markup never gives a 40% margin.

Common trap

Margin on pricePrice = Cost ÷ (1 − %)

$37 cake, "40%": $37 ÷ 0.60 = $61.67
Real margin: $24.67 ÷ $61.67 = 40.0% of the price
Why use it: Margins are how your P&L, and every buyer, measures you.

Hits the target

In Excel or Google Sheets: =B2/(1-C2), with cost in B2 and target margin in C2. In the U.S., menu and shelf prices are normally shown before sales tax, which is added at checkout (lesson 13), so a $61.67 cake rings up at $66.76 in Austin. Unlike VAT countries, you don't have to squeeze the tax into your listed price, but customers still feel the total.

3. A product costs $60, and you want a 25% margin on the selling price. What price do you set (before sales tax)?

$60 ÷ (1 − 0.25) = $80. Check: ($80 − $60) ÷ $80 = 25%. At $75 (a 25% markup), the margin would be only 20%.

4. A supplier says it uses a 50% markup on cost. What gross margin is that on its selling price?

33.3%
50%
25%

If cost is $1, price is $1.50, and the margin is $0.50 ÷ $1.50 = 33.3%. Margin = markup ÷ (1 + markup).

Cost isn't the only thing that sets a price

Cost tells you your minimum sustainable price. The final price also depends on how much customers value what you sell and on what competitors charge. If the market won't pay more than $55 for a cake like Brightside's, the margin drops to ($55 − $37) ÷ $55 = 32.7%. If the market won't even pay your minimum price, the answers are lowering costs, raising volume to spread fixed costs or changing the product, not selling below cost and hoping to "make it up on volume."

Practice exercise: pricing handmade candles

Emma makes soy candles in Asheville, North Carolina: 1,000 a month. Each candle uses $4 of wax, wick and jar, plus $1 of label and box. Her part-time helper costs $2,680 a month in total, and the workshop's fixed costs are $1,320 a month (rent $1,000 and equipment depreciation $320).

Calculate the absorption unit cost.
Set her wholesale price for a 50% margin on price.
A gift shop wants to resell the candles at "keystone," the classic U.S. retail practice of doubling the wholesale price (a 50% margin on its own price). What will shoppers pay, before sales tax?
How many candles must Emma sell each month to break even at her wholesale price?

See solution

1) Unit cost
   Materials and packaging (variable)     $5.00
   Helper: $2,680 ÷ 1,000                 $2.68
   Fixed overhead: $1,320 ÷ 1,000         $1.32
   Unit cost                              $9.00

2) Wholesale price: $9.00 ÷ (1 − 0.50)   = $18.00

3) Retail price:    $18.00 ÷ (1 − 0.50)  = $36.00 (plus sales tax at checkout)

4) Fixed costs: $2,680 + $1,320           = $4,000
   Contribution margin: $18 − $5          = $13 per candle
   Break-even: $4,000 ÷ $13 = 307.7       → 308 candles a month

From workshop to shopping bag

Emma's cost$9.00

Wholesale price$18.00

Retail price$36.00

The shopper pays four times Emma's cost. That's how distribution works: if Emma ignores the retailer's margin when she prices, her candles will either reach shelves too expensive or she'll have to give up most of her own margin.

Summary

Product cost = direct materials + direct labor + manufacturing overhead.
Selling and administrative expenses are period costs: they're not in unit cost, but your price must cover them.
Calculate fixed cost per unit at a normal volume and allocate overhead with a base that reflects real use.
For special orders, compare the price with variable cost.
Price with a margin on price, cost ÷ (1 − margin); a markup on cost always yields a lower margin.

Next lesson: Business Valuation: Discounted Cash Flow (DCF) and Multiples. In the final lesson, you'll estimate what Brightside is worth to an investor.