What Is Unit Cost?
A unit cost is a total expenditure incurred by a company to produce, store, and sell one unit of a particular product or service. Unit costs are synonymous with cost of goods sold (COGS).
This accounting measure includes all of the fixed and variable costs associated with the production of a good or service. Unit cost is a crucial cost measure in the operational analysis of a company. Identifying and analyzing a company's unit costs is a quick way to check if a company is producing a product efficiently.
Variable and Fixed Unit Costs
Successful companies seek ways to improve the overall unit cost of their products by managing the fixed and variable costs. Fixed costs are production expenses that are not dependent on the volume of units produced. Examples are rent, insurance, and equipment. Fixed costs, such as warehousing and the use of production equipment, may be managed through long-term rental agreements.
Variable costs vary depending on the level of output produced. These expenses have a further division into specific categories such as direct labor costs and direct material costs. Direct labor costs are the salaries paid to those who are directly involved in production while direct material costs are the cost of materials purchased and used in production. Sourcing materials can improve variable costs from the cheapest supplier or by outsourcing the production process to a more efficient manufacturer.
- Generally, unit costs represent the total expense involved in creating one unit of a product or service.
- Goods-centric unit cost measures will vary between businesses.
- A large organization may lower the unit cost through economies of scale.
- The cost is useful in gross profit margin analysis and forms the base level for a market offering price.
- Companies seek to maximize profit by reducing unit costs and optimizing the market offering price.
Unit Cost on Financial Statements
A company's financial statements will report the unit cost. These reports are vital for internal management analysis. The reporting of unit costs can vary by type of business. Companies that manufacture goods will have a more clearly defined calculation of unit costs while unit costs for service companies can be somewhat vague.
Both internal management and external investors analyze unit costs. These individual item expenses include all of the fixed and variable expenses directly associated with a product's production such as workforce wages, advertising fees, and the cost to run machinery or warehouse products. Managers closely monitor these costs to mitigate rising expenses and seek out improvements to reduce the unit cost. Typically, the larger a company grows, the lower the unit cost of production becomes. This reduction is because of economies of scale. Production at the lowest possible cost will maximize profits.
Accounting for Unit Costs
Private and public companies account for unit costs on their financial reporting statements. All public companies use the generally accepted accounting principles (GAAP) accrual method of reporting. These businesses have the responsibility of recording unit costs at the time of production and matching them to revenues through revenue recognition. As such, goods-centric companies will file unit costs as inventory on the balance sheet at product creation. When the event of a sale occurs, unit costs will then be matched with revenue and reported on the income statement.
The first section of a company's income statement focuses on direct costs. In this section, analysts may view revenue, unit costs, and gross profit. Gross profit shows the amount of money a company has made after subtracting unit costs from its revenue. Gross profit and a company's gross profit margin (gross profit divided by sales) are the leading metrics used in analyzing a company's unit cost efficiency. A higher gross profit margin indicates a company is earning more per dollar of revenue on each product sold.
The unit cost, also known as the breakeven point, is the minimum price at which a company must sell the product to avoid losses. As an example, a product with a breakeven unit cost of $10 per unit must sell for above that price. Revenue above this price is company profit.
The calculation of the unit cost of production is a breakeven point. This cost forms the base level price that a company uses when determining its market price value. Overall, a unit must be sold for more than its unit cost to generate a profit. For example, a company produces 1,000 units that cost $4 per unit and sells the product for $5 per unit. The gain is $5 minus $4, or $1 per unit in revenue. If a unit were priced at $3 per unit, there would be a loss because $3 minus $4 (cost) is a loss of $1 per unit.
Companies consider a variety of factors when determining the market offering price of a unit. Some companies may have a high amount of indirect costs which requires higher pricing to more broadly cover all of the company's expenses.
Real World Example
Unit cost is determined by combining the variable costs and fixed costs and dividing by the total number of units produced. For example, assume total fixed costs are $40,000, variable costs are $20,000, and you produced 30,000 units. The total production costs are the $40,000 fixed costs added to the $20,000 variable costs for a total of $60,000. Divide $60,000 by 30,000 units to get $2 per unit production cost (40,000 + 20,000 = $60,000 ÷ 30,000 = $2 per unit).