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Cost of production

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Understanding Production Costs

For an expense to qualify as a production cost it must be directly connected to

generating revenue for the company. Manufacturers carry production costs

related to the raw materials and labor needed to create the product. Service

industries carry production costs related to the labor required to implement the

service and any materials costs involved in delivering the service.

Production incurs both direct costs and indirect costs. Direct costs for

manufacturing an automobile, for example, would be materials like plastic and

metal, as well as workers' salaries. Indirect costs would include overhead such

as rent, administrative salaries, and utility expenses.

Total product costs can be determined by adding together the total direct

materials and labor costs as well as the total manufacturing overhead costs. To

determine the product cost per unit of product, divide this sum by the number of

units manufactured in the period covered by those costs.

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. Costs of production relate to the different expenses that a firm faces in producing a good or service.

If the cost of producing a product exceeds the sale price, producers might first try

to lower their production costs. If they could not, then producers might shut down

operations, temporarily or permanently. For example, in late December 2018, the

selling price of a barrel of oil fell to 45 per barrel. 1 If production costs of oil varied

between 20 and 50 per barrel, then a cash negative situation would occur for

producers with steep production costs. Those producers could choose to stop

production until sale prices return to profitable levels.

Production Costs and Asset Recording

Once a product is finished, the company records the product's value as an asset

in its financial statements until the product is sold. Recording a finished product

as an asset serves to fulfill the company's reporting requirements, as well as

inform shareholders.

Types of costs

 Fixed costs – costs that don’t vary with output  Sunk costs – costs that cannot be recovered on leaving industry, e. advertising  Variable costs – costs relating to how much is produced (e. raw materials  Semi-variable costs – costs like labour which to some extent depend on output.  Marginal Cost: This is the cost of producing an extra unit.  Short-run costs (subject to diminishing returns)  Long-run costs (potential economies and diseconomies of scale.

Fixed Costs FC

These are costs that do not vary with output. However many goods are produced, fixed

costs will remain constant. For example, if a new factory costs £1 million, this cost is

unaffected by the number of goods produced.

Average fixed costs (AFC) = FC/Q. As more goods are produced, the average

costs will fall.

Variable Costs

In the short run, a firm will have fixed capital (it takes time to increase the size of factories). In the short run, the firm can vary the quantity of labour. However, in the short term, a firm is likely to experience diminishing marginal returns. This means as firms employ more workers, there will come a point where extra workers have a declining marginal product.

Diminishing Returns in the short run

As productivity (and marginal product) falls, the marginal cost of production will

increase.

Long Run Costs

In the long run, a firm can vary all factors of production, such as capital and

labour. Therefore, the firm will not face diminishing returns. However, as the

amount of capital can vary, the firm may experience economies or diseconomies

of scale.

 Economies of scale occur when increased output, leads to lower long-run

average costs

 Diseconomies of scale occur when increased output leads to higher long-

run average costs.

Factors affecting costs of production

 Wage costs. For labor intensive industry (service

sector/manufacturing of clothes) a small change in wage

costs has a big impact on the overall costs of firms.

 Labor productivity. New technology which improves output

per worker enables the firm to cut back on employing

workers, leading to lower costs.

 Exchange rate. A rise in the exchange rate makes imports

cheaper. If the firm needs to import raw materials, an

appreciation can reduce the cost of production (though

exports will be less competitive)

income tax purposes, the business will have less profit for its shareholders.

Businesses thus try to keep their COGS low so that net profits will be higher.

Cost of goods sold (COGS) is the cost of acquiring or manufacturing the products

that a company sells during a period, so the only costs included in the measure

are those that are directly tied to the production of the products, including the

cost of labor, materials, and manufacturing overhead. For example, the COGS

for an automaker would include the material costs for the parts that go into

making the car plus the labor costs used to put the car together. The cost of

sending the cars to dealerships and the cost of the labor used to sell the car

would be excluded.

urthermore, costs incurred on the cars that were not sold during the year will not

be included when calculating COGS, whether the costs are direct or indirect. In

other words, COGS includes the direct cost of producing goods or services that

were purchased by customers during the year.

As a rule of thumb, if you want to know if an expense falls under COGS, ask:

"Would this expense have been an expense even if no sales were generated?"

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