Manufacturing costing means working out what each product really costs to make: the materials, the labour and a fair share of overheads, and then making sure those costs reach your accounts. Xero and MYOB's small-business accounting record what you spend, but they don't turn materials, labour and overhead into the cost of finished goods, or track work in progress (WIP), on their own. That usually happens in a manufacturing system (an MRP), a spreadsheet or an ERP, and then has to be posted to the ledger. The gap between the two is where product costs, cost of goods manufactured and margins go wrong.
If you're still working out where your bills of materials should live, start with our guide to bills of materials with Xero or MYOB. This article is about the costing that sits on top of them.
What goes into the cost of a manufactured product
Every product cost has three parts:
- Materials. The components and raw materials in the bill of materials, at what they cost you (ideally including freight and duty).
- Direct labour. The time people spend making the product, at a cost per hour that includes on-costs such as super and leave, not just the pay rate.
- Overhead. Factory costs that can't be traced to one product: rent, power, machine depreciation, supervisors, consumables. These are shared out using a rate, usually per labour hour or per machine hour.
Most small manufacturers get materials roughly right. Labour is often a guess, and overhead is often left out of product cost altogether, so it sits in the profit and loss as an expense and every product looks more profitable than it is.
Allocating labour and overhead
Labour
The cleanest way is to record time against production orders or jobs: start and stop on a tablet, a timesheet with job codes, or time pulled from machines. The cost per hour should be a loaded rate. Your accountant can help you work out what to include.
Overhead
A simple approach that works for many small manufacturers:
- Total up a year's factory overhead from your accounts.
- Estimate the year's labour or machine hours.
- Divide one by the other to get an overhead rate per hour.
- Apply that rate to the hours recorded on each production order.
- Compare what was applied with the actual overhead each month or quarter, and adjust the rate when they drift apart.
For example, if your work is seasonal, overhead and hours swing through the year, and a monthly check of applied against actual overhead stops the error building up.
Standard costing or actual costing
Standard costing sets an expected cost for each product (materials, labour and overhead) and uses it for stock and cost of goods. The differences between standard and actual are recorded as variances, such as material price variance or labour efficiency variance. It's good for repeat products, and the variances tell you where costs are moving.
Actual costing builds each product's cost from what was actually used on each run or job. It suits made-to-order and job-shop work, where no two runs are the same.
Many manufacturers use a mix: standard costs for regular lines, actual costs for custom jobs. The important thing is that whichever you use, the variances or the actual costs are posted to the ledger, not left in the MRP.
Cost of goods manufactured and WIP
Cost of goods manufactured is the total cost of the products you finished in a period: materials, labour and overhead put into production, adjusted for what was already in progress at the start and what's still in progress at the end.
Work in progress (WIP) is the value of products started but not finished. At month-end it belongs on the balance sheet as an asset. If your accounts don't record it, costs of half-made products hit the profit and loss as if they were spent, and the month looks worse than it was. Next month, when those products are sold with no cost attached, it looks better.
In a well-connected set-up the flow in the ledger looks like this:
- Materials issued to production move from raw materials to WIP.
- Labour and overhead applied to production move into WIP.
- Finished goods move from WIP to finished goods stock.
- Sales move finished goods to cost of goods sold.
Xero and MYOB can hold these accounts, but something has to post the movements.
What an MRP does and doesn't send to the ledger
This is the question to ask before you assume costing is handled. Manufacturing apps that connect to Xero or MYOB vary a lot in what they post. Common patterns:
- Usually sent: sales invoices, purchase bills, customers and suppliers. Some also post stock value or cost of goods sold.
- Sometimes sent: a journal when production is completed, moving material cost into finished goods.
- Often not sent: labour and overhead applied to production, WIP at month-end, and variances between standard and actual.
MRPeasy, which sells a manufacturing system, says Xero on its own can't allocate overhead and direct labour to finished goods or calculate cost of goods manufactured, and that this needs a manufacturing system connected to Xero (MRPeasy). Even with one connected, check the app's integration notes for exactly which journals it creates. If labour, overhead and WIP aren't on the list, they're probably being done by hand in a spreadsheet, or not at all.
Questions to ask your MRP vendor or partner
- Which transactions does the integration post to Xero or MYOB, and to which accounts?
- Does it post WIP at month-end, or only when an order is finished?
- Does labour time from the shop floor reach product cost?
- How is overhead applied, and does that reach the ledger?
- If we use standard costs, are variances posted?
When an app is enough, and when it isn't
If you make a small range of standard products and your MRP posts stock, production and cost of goods to Xero or MYOB correctly, you may only need a sensible overhead rate and a monthly check. Your MRP partner can set that up.
It gets harder when labour comes from a separate timesheet or payroll system, products are made to order, you need WIP at month-end, or margin by product and customer depends on costs held in two places. That's the work our manufacturing job costing service covers: getting shop-floor time, materials and overhead into product cost and into the ledger. See also our page for manufacturing businesses.
Frequently asked questions
Can Xero do manufacturing costing?
Not on its own. Xero records purchases and sales but doesn't build product costs from materials, labour and overhead or track WIP. Manufacturers usually use a connected MRP, an ERP or a spreadsheet, and post the results to Xero.
What is cost of goods manufactured?
The total cost of products finished in a period: materials, labour and overhead put into production, plus WIP at the start, minus WIP at the end.
What's the difference between standard costing and actual costing?
Standard costing uses an expected cost per product and records the differences as variances. Actual costing builds the cost from what was really used on each run or job. Repeat products suit standard costing; made-to-order work suits actual costing.
How should a small manufacturer allocate overhead?
A common approach is a single overhead rate per labour or machine hour, worked out from a year's overhead and hours, then checked against actual overhead regularly. Your accountant can help choose the right base.
Do I need to value WIP at month-end?
If production runs over month-end and the amounts are material, yes, or your monthly profit swings around. Check with your accountant how detailed it needs to be.
If you're not sure what your products really cost, or your MRP and your accounts tell different stories, book a free initial chat. We'll tell you honestly whether your current systems can do it with better set-up or what's missing.