What is Cost of Production?
Cost of production refers to the total cost incurred by a business to produce a specific quantity of a product or offer a service. Production costs may include things such as labor, raw materials, or consumable supplies. In economics, the cost of production is defined as the expenditures incurred to obtain the factors of production such as labor, land, and capital, that are needed in the production process of a product.
For example, the production costs for a motor vehicle tire may include expenses such as rubber, labor needed to produce the product, and various manufacturing supplies. In the service industry, the costs of production may entail the material costs of delivering the service, as well as the labor costs paid to employees tasked with providing the service.
Types of Costs of Production
There are various types of costs of production that businesses may incur in the course of manufacturing a product or offering a service. They include the following:
1. Fixed costs
Fixed costs are expenses that do not change with the amount of output produced. This means that the costs remain unchanged even when there is zero production or when the business has reached its maximum production capacity. For example, a restaurant business must pay its monthly, quarterly, or yearly rent regardless of the number of customers it serves. Other examples of fixed costs include salaries and equipment leases.
Fixed costs tend to be time-limited, and they are only fixed in relation to the production for a certain period. In the long term, the costs of producing a product are variable and will change from one period to another.
2. Variable costs
Variable costs are costs that change with the changes in the level of production. That is, they rise as the production volume increases and decrease as the production volume decreases. If the production volume is zero, then no variable costs are incurred. Examples of variable costs include sales commissions, utility costs, raw materials, and direct labor costs.
For example, in a clothing manufacturing facility, the variable costs may include raw materials used in the production process and direct labor costs. If the raw materials and direct labor costs incurred in the production of shirts are $9 per unit and the company produces 1000 units, then the total variable costs are $9,000.
3. Total cost
Total cost encompasses both variable and fixed costs. It takes into account all the costs incurred in the production process or when offering a service. For example, assume that a textile company incurs a production cost of $9 per shirt, and it produced 1,000 units during the last month. The company also pays a rent of $1,500 per month. The total cost includes the variable cost of $9,000 ($9 x 1,000) and a fixed cost of $1,500 per month, bringing the total cost to $10,500.
4. Average cost
The average cost refers to the total cost of production divided by the number of units produced. It can also be obtained by summing the average variable costs and the average fixed costs. Management uses average costs to make decisions about pricing its products for maximum revenue or profit.
The goal of the company should be to minimize the average cost per unit so that it can increase the profit margin without increasing costs.
5. Marginal cost
Marginal cost is the cost of producing one additional unit of output. It shows the increase in total cost coming from the production of one more product unit. Since fixed costs remain constant regardless of any increase in output, marginal cost is mainly affected by changes in variable costs. The management of a company relies on marginal costing to make decisions on resource allocation, looking to allocate production resources in a way that is optimally profitable.
For example, if the company wants to increase production capacity, it will compare the marginal cost vis-à-vis the marginal revenue that will be realized by producing one more unit of output. Marginal costs vary with the volume of output being produced. They are affected by various factors, such as price discrimination, externalities, information asymmetry, and transaction costs.
How to Calculate the Cost?
The first step when calculating the cost involved in making a product is to determine the fixed costs. The next step is to determine the variable costs incurred in the production process. Then, add the fixed costs and variable costs, and divide the total cost by the number of items produced to get the average cost per unit.
For the company to make a profit, the selling price must be higher than the cost per unit. Setting a price that is below the cost per unit will result in losses. It is, therefore, critically important that the company be able to accurately assess all of its costs.
CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)® certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below: