What Is Cost Unit? (Definition, Calculation and Examples)
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The success of both product-based and service-based businesses depends on the profits they earn. To find out if their business is profitable, companies often calculate if their production costs are lower than the price of each product unit they sell. By knowing how to use the cost per unit calculation for this purpose, you can adjust product prices and meet your sales goals. In this article, we answer, "What is cost unit?", why it is important, how to calculate it and look at an example of cost unit calculation.
What is cost unit?
Cost unit, also known as the cost per unit, the cost of goods sold or the cost of sales, is the amount of money that a company invests in manufacturing a single unit of a saleable product. The cost of unit calculation appears in the company's financial statement. It helps the company determine if its production costs are lower than the sales revenue and whether it is profiting from its product sales. Cost per unit calculations are often used by businesses that are dependent on product sales, but service-based companies may also use them.
Why is cost per unit important?
Cost per unit calculation is important because it can inform the company about the efficiency of its business operations. Then, if necessary, it can take appropriate steps to make operational improvements. Cost per unit also helps the company decide what to charge for each product so they can be sure they are making a profit. To be profitable, the company must ensure that its production cost is lower than the price at which it sells it to the customer.
Given the importance of cost unit calculations in determining business profits, most companies assign an individual or a team to handle their cost accounting. The designated person or team may consider the different factors that are necessary for calculating the cost per unit and analyse these. They may attempt to find out how they can reduce the overall production costs or at least avoid incurring any increased or additional expenses. By lowering its production costs and not incurring any further expenses, the company can expect to gain more profit.
How to calculate cost per unit
You can calculate cost per unit by taking the following steps:
1. Determine your fixed costs
The costs that remain the same over a long period are known as fixed costs. Your unit production does not affect them. Fixed costs do not change if you produce few or more units or if the market demand for your product decreases or increases. Some examples of items that come under fixed cost include the rent you pay for your office space, the cost of buying or renting your equipment, the property tax you pay and the business insurance you get.
While fixed costs do not generally change drastically from one production cycle to another, there can be instances in which they increase. That is known as step cost. It can occur when your production requirements increase, and you may have to spend additional money to fulfil the orders. For instance, you might need to rent more warehouse space for storing new product units. In such cases, you must account for the additional expenses by calculating a new fixed cost.
2. Identify your variable costs
The expenses that depend on the production output and can change very frequently are variable costs. They may change daily, monthly, quarterly, annually or between production. Variable costs are dependent on the number of units produced and can change when that number changes. To calculate the variable costs of products, you may need to add your labour costs, material costs, utility bills, advertising expenses and any credit card fees.
The labour costs can include direct labour costs, such as salaries and benefits paid to employees who work directly in the production, hourly pay for contract workers and freelance rates. Additionally, they can include direct material costs for buying raw materials and the costs of processing these materials. To lower your total variable cost per unit, you can find materials that cost less, use machines that work more efficiently and hire employees who can get more work done in a short span.
3. Know how many units you are producing
To calculate cost per unit, you need to know the exact number of units you are producing in a specific production period. For example, you could manufacture 100 soaps per month, 300 soaps in a quarter and 1200 soaps annually. So, the number of units you are manufacturing are 100 in a month, 300 in a quarter and 1200 in a year.
4. Use the cost per unit formula
To calculate your cost per unit, you must add up your fixed and variable expenses and divide that sum by the number of units you produce. It is essential to use the same units of measurement in the formula. So, if you calculate the cost unit for a quarter, the figures for the number of units, fixed costs and variable costs must be from the same quarter.
Example of cost per unit calculation
Here is an example of a cost per unit calculation:
Classy Kurtas is a company that makes and sells women's kurtas to customers. They pay ₹10,000 a month to rent its workshop, and their monthly electricity bill is ₹800. This means they have a monthly fixed cost of ₹10,000 + ₹800 = ₹10,800. The company may buy 2,500 metres of 200gsm cotton cloth at ₹25 per meter from a cotton cloth manufacturer every month, which costs them ₹62,500. They may also hire a seamstress for ₹20,000 per month to stitch 50 kurtas as per a given design. So the company's variable cost for a month is ₹62,500 + ₹20,000 = ₹82,500.
To get their monthly cost per unit, the company can add their monthly fixed cost of ₹10,800 with their monthly variable cost of ₹82,500. That amounts to ₹10,800 + ₹82,500 = ₹93,300. Now they can divide this amount by the number of kurtas the seamstress makes per month. So, it is ₹93,300 / 50 = ₹1,866. This is their cost per unit. The company can use this number as a reference to set the selling price of each kurta. The selling price has to be more than ₹1,866 if Classy Kurtas wants to make a profit.
Unit cost on financial statements
Companies that manufacture goods or provide services report the unit cost in their financial statements. The way they report them may differ for different companies, with goods-producing companies having more exact cost unit calculations than service providers. Although, in all cases, these reports help the management to analyse the business operations and make vital decisions to improve them. Generally, the economies of scale lower the production cost per unit for large companies, and it can help maximise their profits.
Accounting for unit costs
The financial reporting statements for public and private companies use a reporting method known as generally accepted accounting principles or GAAP. During production, these companies keep an accurate record of their unit costs on their inventory sheet and then match it to the sale of each unit in their income statement. They can then find their gross profit, which is the amount they get after subtracting the unit cost or the money spent in the production of that unit from the revenue or the money they made in selling it.
The direct costs section in the income statement displays the revenue, unit costs and gross profit. Dividing the gross profit by the sales amount gives you the gross profit margin. The metrics of gross profit and gross profit margin are invaluable for cost-efficiency analysis. A higher gross profit margin is a good sign. It means that the company is earning more on every unit it sells.
The cost unit calculation can help companies with breakeven analysis. They can use the unit cost as the breakeven point. That is, the company cannot sell the unit below this price. It must maintain the unit cost as its minimum price per unit. Otherwise, the company cannot make a profit and may incur losses, instead. The amount it makes above the breakeven unit cost is its profit.
In the Classy Kurtas example, the company's breakeven unit cost is ₹1,866, and it must sell each kurta to customers at a higher price than that. If it sells each of the 50 kurtas it produces every month for ₹3,000, then the company gets ₹3,000 - ₹1,866 = ₹1,134 in profit. If the company were to price each kurta at ₹1,800, it would incur a loss of ₹66 per unit.
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