Cost of Production and Its Types
WHAT IS COST OF PRODUCTION
Cost of production is the amount that a business incurs in the production of goods or services. It therefore encompasses all the expenditures in manufacturing, which ranges from raw materials to labour, overhead, and other operational expenses. The cost of production is an important indicator in a business since it is used to derive various essential parameters relating to the product pricing, profitability, or even the general result.
Types of production costs
- Fixed Costs Overhead Costs
These costs occur irrespective of the level of production. They are independent of the number of units produced or sold. Fixed costs are incurred regardless of whether production is made or not.
Examples:
Rent of a factory space or office space
Wages of permanent employees
Depreciation of plant and machinery
Insurance charges
- Variable Costs
Variable costs varies directly with output. The more the units produced, the higher the variable costs. They vary with the volume of production.
Examples:
Hides and skins
Working wages (wages of the employees employed directly in the productive functions)
Electricity or other forms of energy
Packaging materials
- Semi-variable Costs (Mixed Costs)
These costs consist of a fixed and a variable component. Even though there is always a base cost that does not vary with the level of production, the cost increases with an increase in production.
Examples:
Telephone bill with a fixed monthly charge and charges based on usage
Salaries manager plus overtime compensation for extra work performed.
- Direct Costs
Direct costs are those costs directly associated with the manufacturing of specific goods or services. These costs are directly identifiable and can thus be traced back to the manufacture of a product.
Examples:
Raw materials
Direct labour, such as the wages of workers assembling the product
Manufacturing supplies
- Indirect Costs (Overheads)
Direct costs can be traced to a product but are not essential for the creation of the product. They are often duplicated between many products or activities and are absorbed by each product on a pro rata basis, using some assumptions or methods.
Examples
Factory rent
Utilities for the production facility
Salaries of administration
Office equipment depreciation
- Total Cost
The total cost is a summation of all the costs involved in production. It is a sum of fixed, variable, and semi-variable costs. The total cost formula is as shown below:
Total Cost
=
Fixed Costs
+
Variable Costs
Total Cost=Fixed Costs+ Variable Costs
- Marginal Cost
Marginal cost refers to the additional costs incurred by producing one more unit of a product. This forms an important metric for decision-making, especially on whether it is profitable to increase production.
Example: If producing one more unit of a good requires $5 worth of more raw material and labour, then the marginal cost is $5.
- Average Cost (Per Unit Cost)
Average cost is the sum of cost to produce an item divided by the number of products or units produced. It is handy for analysing cost efficiency of producing on various levels of output.
Average Cost
=Total Cost /Quantity of Output Average Cost= Quantity of Output /Total Cost
End
Opportunity cost is the value of the next best alternative that would have to be forsaken in order to take a decision. It is not a direct production cost but it does find use in cost accounting, if the resources available are always scarce.
Example: This will be the profit earned from producing Product B if a factory owner utilizes his machine to manufacture Product A instead of B.
- Fixed and Variable Cost Behaviour in the Short-Run and Long-Run
Short-run: In the short run, some costs (like rent, salaries) are fixed whereas others (like raw materials and direct labour) are variable.
Long-run: With passage of time, businesses can alter all factors of production which include fixed cost as well. Thus, greater room for managing of cost.
- Economic Costs
Economic costs would include explicit costs, which refer to direct financial expenses like wages, raw materials, etc. Implicit costs refer to the cost of opportunity, which comes in the form of what is foregone by using resources in one specific way as opposed to another way.
