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close this bookFinancial Management of a Small Handicraft Business (Oxfam, 1988, 43 p.)
close this folderI. Cost calculations in the handicraft industry
View the document(introduction...)
View the documentI. 1. Production costs
View the documentI.2. Overhead apportionment
View the documentI.3. Selling and distribution costs
View the documentI.4. Ways to reduce costs


The first thing a producer must know is—how much do the products cost to produce? Two types of costs are involved in production: Direct costs are those attributable specifically to the finished product; the main direct costs in handicrafts are labour and raw materials. Indirect costs (also called overheads) are all other costs incurred in the production unit, for example rent of workshop, administrative salaries, bank interest etc. Obviously all costs, both direct and indirect, have to be covered if a production unit is not going to make a loss. First, it is necessary to consider two questions: what are all the costs involved in production? And, how should the indirect costs be allowed for in the cost of each product?

I. 1. Production costs

(i) Direct costs

There is usually little difficulty in ascertaining precisely the direct costs of a product, but some considerations to be borne in mind are not necessarily obvious.

Materials: It is a straightforward calculation to divide the cost of materials purchased by the number of products it can be used for, giving the unit cost. It should be remembered:

· to include all the materials—trimmings, thread adhesives, dyes etc.

· if transport charges are paid, these should normally be considered as part of the cost of the material

· there may be wastage; the cost of material purchased but unable to be used must be included. For example, if tanned leather has typically 15% wastage because of quality defects or non-usability of corner sections, then the material cost for each item must be surcharged by 15%.

Labour: It is normal in the handicrafts industry to pay piece-rate wages, the rate per piece being the unit labour cost. The calculation of the rate would be based on an average production time for the product multiplied by the remuneration per hour or day. It can sometimes be helpful to impose a production limit so that artisans do not rush the work in order to earn more but thereby produce an unacceptable quality. Where fixed daily wages are paid, there needs to be an accompanying productivity agreement, so that the unit labour cost remains constant. Production of any one item might involve a number of people doing different processes. A precise calculation must be made of the cost of all of them. If artisans are given paid leave, then this is a labour wastage, and an appropriate percentage addition must be added to the labour cost.

Other direct costs: If any machinery is employed in the production process, then the power source is a direct cost to the product. Often, there would be no other direct costs than labour and materials, but labelling and packaging would be one, if labels are used and a product is boxed for sale.

At this stage, we can produce the first half of an essential piece of paper, the product costing sheet (Figure 1).

Figure 1. Fibre Mat Costing Sheet {Direct Costs)

Direct costs

Money unit


Fibre, 2.1 kg at 5 per kg

(2 kg used; 0 1 kg wastage)




Edging material





Fibre sorting and washing






Edging and labelling


Other direct costs



Printed label


Total direct costs

35 on

(ii) Indirect costs

In order to calculate the indirect costs, it is necessary to add up all the other costs incurred in the production unit. These will vary considerably according to the type of unit. Typical overheads might be:

· artisan provident, savings or pension scheme—employer contributions
· wages of administrative and supervisory personnel
· rent of buildings—workplace, office, etc.
· service and maintenance charges—electricity, telephone, etc.
· administrative expenses—stationery, postage
· interest on bank loan
· product development and design, for example, one person might be employed to develop new designs—the salary, and cost of materials used, are overheads
· depreciation of fixed assets—typewriter, furniture, machinery, etc.

An existing production unit would make reference to its previous year's accounts in order to estimate current year overheads, allowing for any additional expenses planned and price increases. A new business must make estimates of what overhead expenses it will incur. When the exercise is completed, a figure will be arrived at for its total indirect costs.

A number of social production units will run special programmes for the benefit of artisans. Provision of a creche, a medical scheme, or a training programme would be examples. Generally speaking, it is unrealistic to include these in the production overheads. Costing provides the basis for pricing, and if costs are included which have no direct relationship to the production activity, then there would be little hope of achieving a competitive price. For this reason, it is preferable to keep a quite separate account for artisan benefit schemes, and it seems reasonable to seek grant assistance if possible to run them. There are many examples of well-meaning enterprises who have tried to fund welfare schemes out of profits but have not generated sufficient profits to meet the cost. Because of inadequate accounting systems, they have often been unable to separate their different costs, and have failed to identify where their difficulties lie, and whether production itself is profitable.

It is assumed here that the production activity will have the objective of at least breaking even. Businesses with a social purpose might be able to attract funding to cover certain overheads, or might have the services of people, or use of buildings, free of cost—for example, a volunteer designer. Ultimately, though, a production unit has to stand on its own two feet. If it cannot cover its production costs by sales revenue, it is not a viable income-generation programme. It would then either close down or become dependent on perpetual subsidy from a charitably-minded agency. Agencies are much more likely to fund specific social programmes running alongside a viable production activity.

I.2. Overhead apportionment

(i) Fixed and variable costs

All direct costs of production are variable costs, because obviously the total expenditure incurred varies according to which product, and how much, is being produced. The same is true of some indirect costs. For example, the supplier of one raw material might demand cash on delivery, necessitating the provision of a bank loan, while others might give 3() days credit. Supervisory staff may be employed for some production processes but not for others. Large baskets might require transportation from a producer's home to the collection centre, which other products might not. It is helpful if a business can distinguish these variable costs from fixed overheads, which will not change whatever the production activity: such things as the rent of the workshop, the telephone bill etc.

The purpose of the costing exercise is to obtain as accurate a record as possible of how much products cost to produce. This is for the purpose of not only pricing, but also monitoring the efficiency of production, gaining knowledge of the different profitability of products, and making decisions about what to produce.

Variable overheads should be allocated to the cost of the product in just the same way as direct costs, by identifying as closely as possible the relationship between quantity of production and expenditure incurred, to yield a unit variable overhead cost (Figure 3).

(ii) Overhead absorption rate

It is the apportionment of the fixed overheads which gives most difficulty. Here the objective is to treat as part of the cost of the product all of the other expenditure incurred in the production unit, although this has no direct relation to the product itself. The method used is the calculation of what is called an

overhead absorption rate:

Overhead absorption rate = ( Fixed overhead cost ) / ( Level of production activity )

Whilst this is the same basis as the calculation of direct and variable indirect costs, there are two difficulties:

Production level: The recovery of all fixed costs is critically dependent on attaining the estimated production level. If this falls below estimate, the fixed costs would clearly not be covered. There is no solution to this difficulty, which is more acute for a new business without sales experience. The only possible approach is to make the best estimates of what will be produced over the accounting period for which the fixed costs are identified, and to keep a careful watch on results. In a small handicrafts unit, fixed overheads are generally low. Indeed there can be no better advice for a new enterprise than to keep them absolutely as low as possible.

Individual product apportionment: It is unrealistic to apportion the same amount of overhead to each product, regardless of its variable cost. Therefore a suitable basis has to be found for individual apportionment. In the handicrafts industry, this is probably the number of labour hours taken in the production of each item. Thus the estimated level of production activity in the total period would be expressed in terms of labour hours, and the formula above would yield the overhead absorption rate. This rate would then be multiplied by the number of hours taken to make each item to give the individual product fixed overhead apportionment (figure 2)

Figure 2. Apportionment of Fixed Overheads to Fibre Mat

Money unit


Estimated fixed overheads in financial year


Estimated variable production costs


Estimated labourcost


Labour rate per hour


Labour hours in estimated production


Overhead absorption rate = (Fixed overhead cost ) / (Level of production activity (labour hours)) =

( 20,000 ) / (16,000) = 1.25

No. of labour hours to produce fibre mat4

Fixed overhead apportionment = 4 X 1.25 = 5

The advantage of this method is that it does not matter which products arc produced. As long as overall production reaches the estimated level, the fixed costs will be covered.

I.3. Selling and distribution costs

Income-generation occurs only when there is sales revenue, a consideration obvious enough, but nevertheless often overlooked by agencies which fund production units without undertaking a market feasibility study. In order to achieve sales, costs will be incurred. These will depend on what the selling method is. There may be promotional leaflets or catalogues, travel expenses to visit customers or sell in the marketplace, a commission payable to a sales agent etc. When selling overseas, there will certainly be further costs: cartage to port, additional packaging, documentation, customs clearance perhaps levies, certainly extra running around.

Selling and distribution costs are part of the overheads of a production unit. They may be variable, for example, a sales commission, or fixed, such as the bus fare to the weekly bazaar. The important thing to remember is to calculate them and include them in the coatings analysis in the same way as other overheads. Very often small businesses overlook them, because they have not evolved a selling strategy, and then find they cannot afford to incur the expenditure necessary for marketing. The onus to sell products is on the production unit; it should not wait for people to visit, but rather go out and find the customers, confident that there is some margin in the costing for doing so.

At this stage the costing sheet might be looking like this (Figure 3):

Figure 3. Fibre Mat Costing Sheet (Direct & Indirect Costs)

Direct costs

Money unit

As per Figure. 1


Variable overheads

Employment of porters and casual labour


Fixed overheads

Apportionment as per Figure 2


Distribution and selling costs

Apportionment of transport costs


Total cost


I.4. Ways to reduce costs

The objective of a social production unit is to maximize the earnings of the artisans. This emphasises the need to seek all possible means to keep other costs to a minimum. A number of possibilities might exist, and should be considered.

(i) Materials

Prices of raw materials tend to fluctuate according to the season. Cost might be saved by buying up stock at times of low prices and storing it. Price will also normally vary according to quantity purchased; again, bulk purchase might be beneficial.

Production units usually appreciate these factors, but sometimes lack the capital to finance stocks of materials. It should be checked whether this difficulty could not be overcome by taking a bank loan, which might be worthwhile, even at a high interest rate (Figure 4).

Figure 4. Decision Making on Bulk Purchase of Materials

Problem: Fibre costs 6 money units per kg for 9 months of the year, but for 3 months the price drops to 4.5. Production requires 200 kg per month. Storage is not available and would have to be rented at 0.05 money units per kg per month. Moreover, the production unit is short of capital, and would have to borrow money at the rate of 2% per month. At present, it buys its requirement month by month. Should it instead buy up all the fibre at the lower price and store it for the rest of the year?

Solution: N.B. ignore the 3 months when material is anyway bought at the lower price.

1. Present monthly cost of material for 9 months

Purchase price: 9 x 200 x 6 = 10,800

2. Monthly cost of material for 9 months on bulk purchase basis (assume purchase during last month of low price)

Purchase price: 9 x 200 x 4.5 = 8,100


Reducing per month by 450

200 kg, from 1800 kg in first.month


8100 money units loan

808 required payed back evenly over 9 months

Total cost

= 9,358

Therefore it is preferable to purchase in bulk when the price is low if loan finance can be obtained.

One further consideration regarding materials is whether wastage can be either used to make other small items, or alternatively sold. This option would not normally be available in fibre or grass products, but might well be in leatherware or woodwork.

If full allowance for the material has already been made in the costing of products for which it is principally used, then other small items could be made from the wastage at zero material cost.

(ii) Organization of work

The method by which production is organized should be carefully examined for efficiency. In some handicrafts production units artisans make the complete article; in others, a part only. Where division of labour applies, the artisan does not have the benefit of seeing the finsihed product but total output might be greater. The major objective being to generate income for the producers, there is rarely justification for producing in an inefficient way unless as part of a training programme.

The work location should be examined. Often, handicrafts work is done in the home, and it may be that communal working is impracticable. However, the relative advantages of each should be looked at financially. There may be good reason to place financial considerations below social ones, but at least production units should always know the cost of doing so. They might even be able to attract funding to cover the identified additional cost of operating inefficiently for worthwhile social reasons. It could work either way. It might be more expensive to run on a home industry basis because of transport costs for distributing and collecting materials and finished products; yet this could be necessary in order not to disrupt the other activities of the artisans. By contrast, it might be more expensive to build a communal work area; yet this might serve as a centre for education, awarenessbuilding, medical care etc which could not be built into the enterprise if the artisans worked at home.

It is often true that small handicrafts units do not run in the most efficient way, and that there is scope for cost saving if analysis of the costs and work patterns is undertaken. Whilst the motivation for production might not be profit-orientated, nevertheless the production activity must be controlled as in any business, precisely in order to enable it to fulfil the income-generation objective. Human concern and the business mentality need not be incompatible.

It might finally be possible to complete the costing sheet on the basis of different levels of production (Figure 5).

Figure 5. Fibre Mat Costing Sheet According to Production Level
Money unit

Per piece

Per 100 pcs

Per 1000 pcs

Direct costs

As per Figure 1




Material saving



Labour surcharge (overtime)


Variable overheads

As per Figure 3




Fixed overheads

Apportionment as per Figure 2




Distribution & selling costs

Apportionment of transport





Saving on bulk orders



Total cost




Less sale of waste fibre




Final production cost


41 20