Own production cost

What it means

Production cost is the valuation basis for assets a company creates itself, such as finished goods, work in progress, a building constructed by its own staff or software it develops. The Accounting Act lists it as one of the basic methods of asset valuation.

Production cost comprises the direct costs of production, meaning materials, wages and other costs directly related to the output. The company may also include a share of indirect costs relating to production, that is production overheads.

Administrative overheads, selling costs and costs of unused capacity must not be included. They remain expenses of the period in which they arise and are not carried into the value of inventory or assets.

How it works in practice

For manufacturing clients we set up production cost calculations by product and rules for allocating production overheads. We describe the method in the accounting policy, because it determines both the inventory value on the balance sheet and the profit.

For assets built in-house, such as a hall constructed by the company’s staff, costs are first recorded as period expenses and then transferred to the asset under construction through capitalisation. When complete, the asset is put into use and depreciation begins.

For self-produced inventory, changes in value flow through the change in inventory within income. For the result to make sense, production cost must be calculated the same way at the start and end of the period.

What to watch out for

Including administrative overheads or excessive costs in production cost overstates inventory and pushes costs into the future. The current year’s result then looks better than it really is.

If production cost exceeds a product’s net realisable value, meaning the price at which it can be sold, an impairment allowance is needed. Inventory must not be shown on the balance sheet at a value the company cannot recover.