AIOU Solved Project 8404 Cost of Production
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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.
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.
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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.
The cost of production is an important factor in every company’s manufacturing or production processes. Understanding how to calculate, report, and control the cost of production is a crucial part of ensuring that a company’s products are cost-effective and profitable. To understand the cost of production, you will need to know what it is and how it affects a company’s success.
The term “cost of production” refers to all the costs that are involved when a company offers a service or manufactures a product. Production costs are comprised of various expenses, including the cost of materials, employee wages, factory maintenance, shipping costs, and more. State and federal taxes that are related to a company’s manufacturing processes or facilities can also be categorized as production costs.
Companies often calculate the cost of production in “cost per unit” which involves how much money it takes to create an individual item. To calculate the cost per unit, accountants take the cost of production and then divide it by the number of units manufactured. They can then consider the cost per unit and decide how to price the item for sale. Companies usually need to sell items for more than the cost of production to make a profit. If the cost of production is equal to or more than the sales price, the company runs the risk of operating at a loss.
The cost of production is an important factor for businesses to consider when assessing their financial health. If a product’s cost of production is consistently higher than the profits it earns, the company may need to cease production to stay within budget. Similarly, if the expenses involved in providing a particular service become too great, the company would need to either discontinue the service or find a way to cut costs.
Types of Production Costs
When manufacturing a product or offering a specific service, a business can incur multiple types of expenses. Let’s take a look at the most common types of costs of production:
Variable costs are expenses that change with production volume; these costs rise when production increases and fall when it decreases. With a production volume of zero, there are no variable costs associated with it. Variable costs include things like utilities, direct labor, raw materials, and commissions.
Unlike variable costs, fixed costs do not fluctuate with production volume; these costs remain the same whether there is zero production or running at full capacity. Fixed costs are generally considered time-limited, meaning that they are fixed to output for a specific period; most production costs vary from period to period. Employee salary, rent, and leased equipment are some examples of fixed costs of production.
The total production cost considers both variable and fixed expenses; all costs incurred during the production of a product or the offering of services are included in this calculation. Total cost is the sum of fixed and variable expenses; if a business’s fixed costs are $2,000, and the variable costs are $5,000, the total production cost would be $7,000.
Marginal cost determines how much it would take to produce one additional product unit, showing the total cost increase from that extra product. Variable expenses mainly affect the marginal cost, as fixed costs do not change with the level of output. Marginal costs are typically used to decide where resources should be allocated to optimize the profits of production. Marginal costs will vary with production volume and are affected by things like price discrimination, asymmetrical information, transaction costs, and externalities.
The average cost is essentially the expenses that occur from producing one unit or offering one service; this can be found in two ways: by dividing the total production costs by the amount of product created or by adding together the average variable and fixed costs. Average expenses are crucial when it comes to making decisions on how to price a product or service. Ideally, average costs should be minimized to increase the profit margin without increased expenses.
The Relationship Between Marginal and Average Cost
Marginal and average costs impact each other as production fluctuates:
- A decline in average expenses causes the marginal cost to be lower than the average.
- An increase in average costs causes the marginal cost to be greater than the average.
- When the average cost is at a minimum or maximum level, marginal costs equal the average.
Long-run costs accumulate when a business changes production levels in response to its expected profits or losses. Long-run expenses do not include any fixed production factors; labor, land, and goods all vary to reach these costs of offering a good or service. A long-run cost is efficiently sustained when a business produces the highest quantity of products and the lowest expense. Things like decreasing or expanding the company, changing the production quantity, and leaving or entering a new market all affect these costs.
Short-run costs can be seen in real-time throughout the production process. The only things that impact these costs are variable expenses and revenue. Short-run costs increase and decrease with varying costs and production rates. Managing short-run expenses is one of the best ways to succeed in reaching excellent long-run costs and a company’s overall goals.
Returns to Scale
Returns to scale show how the increase in production relates to the rise of inputs and varies between industries. Typically, a business will have increasing returns to scale at low production levels, decreased returns to scale at high production levels, and a constant somewhere in the middle. There are three stages of returns to scale:
Increasing returns to scale is the first stage and refers to when a production process increases the output of products while decreasing the average cost per unit. An example of this is when you can make a higher profit by producing more goods because you can obtain a higher quantity of materials at a lower price.
Constant returns to scale is the second stage and happens when there is no change in average cost while producing more units. If the output changes proportionally with the inputs, that means there are constant returns to scale.
Diminishing returns to scale is the third and final stage, referring to when the average cost of production increases with the volume of units produced; this is the exact opposite of increasing returns to scale. It can occur when the prices of raw materials rise over time without charging a larger amount per unit.
Measuring Production Costs
Measuring the production cost can be more challenging than it looks on the surface; how do you know what the costs are and how to maximize your profit? These are questions that people in every business ask regularly. Measuring production costs entails monetizing production times and the consumption of raw materials. How do you value the time and costs of workers, machines, and raw materials? Prod smart makes measuring production costs simple.
How to Calculate Cost of Production
To calculate production costs in the most straightforward way possible, you need to know two things: the fixed and variable costs associated with the production or service. By adding these costs together and dividing them by the number of units produced, you get the average cost per unit. The only way to profit from a good or service is to have a higher selling price than the production cost per unit.
Direct costs are expenses that be traced directly to specific products, services, customers or other production objects. A company’s accounting team records direct costs at every stage of the production process and then adds them together to find the total cost of production for each product. Direct costs are often variable, which means they may fluctuate depending on different factors. For example, the price of the oil that the manufacturing machines need to function might be higher or lower depending on the year. Similarly, a change in the state’s minimum wage might cause an entry-level employee’s hourly wage to increase. Direct costs include items like:
- Raw materials
- Manufacturing supplies
- Labor wages
Indirect costs are expenses that are associated with the production process but that cannot be traced directly to a product. Some indirect costs are impossible to factor into a specific product’s cost of production and must be considered a part of production overhead instead. Production overhead includes expenses that facilitate the production of a product or service without directly affecting the manufacturing process. Finding ways to identify, report and control indirect production overhead costs is one of the most efficient ways to lower a company’s cost of production. Examples of production overhead costs include:
- Office Supplies
- Building Utilities
- Supervisor or support staff salaries
- Maintenance costs
Several specific factors can greatly affect the cost of production for a given product or service. Here are several to consider:
- Exchange rate
- Cost of materials
- Tax rates
- Interest rates
As a company’s success grows, the demand for certain products will also increase. To fill customers’ orders, a company may need to buy more raw supplies, hire new laborers, expand the production facility or even open a second location. Ideally, a company can use the profits gained from new customers to offset the increased cost of production.
As technology continues to advance, some jobs which were traditionally accomplished by human laborers can now be done by automated machines. Many companies are choosing to use manufacturing robots instead of employees, thus lowering the costs associated with labor wages. Additionally, updating factory equipment, installing new computer systems or educating employees on the use of new digital interfaces can speed up the manufacturing process and also lower the cost of production.
If a company imports materials from overseas, exchange rates can greatly affect the cost of production. If the exchange rate rises, the materials the company needs to create its products become cheaper. However, a high exchange rate can also cause exporting companies to become less competitive and the costs may stay the same or even increase.
Cost of materials
The costs of the raw materials which are necessary for manufacturing can vary greatly depending on the year, the economy, and availability limitations. For example, the price of steel might rise or fall depending on the financial stability of the steel mill or on the costs of international transportation. The prices of oil and gasoline affect almost every industry due to their association with shipping and product delivery.
Taxes are an indirect production cost that can contribute significantly to a company’s annual overhead. Taxes may be higher or lower during a certain year depending on changes in the local or federal government. If a company hires several new employees, an increase in national insurance, or a tax on workers, can contribute to higher production costs.
Another indirect cost for companies is their loans. If a company borrowed funds from a bank or other entity to pay expenses, the loan’s interest rates can rise or fall. A rise in interest rate will increase the amount due for each regular loan repayment. When calculating the cost of production, companies must allow for fluctuation in interest rates to create accurate financial reports.
- William Baumol (1968), Entrepreneurship in Economic Theory. American Economic Review, Papers, and Proceedings.
- Stephen Ison and Stuart Wall (2007), Economics, 4th Edition, Harlow, England; New York: FT Prentice Hall.
- Israel Kirzner (1979), Perception, Opportunity and Profit, Chicago: University of Chicago Press.
- Lanen, W. N., Anderson, S., Maher, M. W. (2008). Fundamentals of cost accounting, McGraw Hill, ISBN978-0-07-352672-0