Cost of Production
Cost of Production
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.
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 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.
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.
2) Cost Structure
What is Cost Structure?
Cost structure refers to the various types of expenses a business incurs and is typically composed
of fixed and variable costs. Fixed costs are costs that remain unchanged regardless of the amount
of output a company produces, while variable costs change with production volume.
Operating a business must incur some kind of costs, whether it is a retail business or service
provider. Cost structures differ between retailers and service providers, thus the expense
accounts appearing on a financial statement depend on the cost objects, such as a product,
service, project, customer, or business activity. Even within a company, cost structure may vary
between product lines, divisions, or business units, due to the distinct types of activities they
perform.
Fixed Costs
Fixed costs are incurred regularly and are unlikely to fluctuate over time. Examples of fixed costs
are overhead costs such as rent, interest expenses, property taxes, and depreciation of fixed
assets. One special example of a fixed cost is direct labor cost. While direct labor cost tends to
vary according to the number of hours an employee works, it still tends to be relatively stable and,
thus, may be counted as a fixed cost, although it is more commonly classified as a variable cost
where hourly workers are concerned.
Variable Costs
Variable costs are expenses that vary with production output. Examples of variable costs include
direct labor costs, direct material cost, utilities, bonuses and commissions, and marketing
expenses. Variable costs tend to be more diverse than fixed costs. For businesses selling products,
variable costs might include direct materials, commissions, and piece-rate wages. For service
providers, variable expenses are composed of wages, bonuses, and travel costs. For project-based
businesses, costs such as wages and other project expenses are dependent on the number of
hours invested in each of the projects.
Cost Allocation
Cost allocation is the process of identifying costs incurred, and then accumulating and assigning
them to the right cost objects (e.g., product lines, service lines, projects, departments, business
units, customers) on some measurable basis. Cost allocation is used to distribute costs among
different cost objects in order to calculate the profitability of, for example, different product lines.
Cost Pool
A cost pool is a grouping of individual costs, from which cost allocations are made later. Overhead
cost, maintenance cost, and other fixed costs are typical examples of cost pools. A company
usually uses a single cost allocation basis, such as labor hours or machine hours, to allocate costs
from cost pools to designated cost objects.
A company with a cost pool of manufacturing overhead uses direct labor hours as its cost
allocation basis. The company first accumulates its overhead expenses over a period of time, say
for a year, and then divides the total overhead cost by the total number of labor hours to find out
the overhead cost “per labor hour” (the allocation rate). Finally, the company multiplies the
hourly cost by the number of labor hours spent to manufacture a product to determine the
overhead cost for that specific product line.
To maximize profits, businesses must find every possible way to minimize costs. While some fixed
costs are vital to keeping the business running, a financial analyst should always review the
financial statements to identify possibly excessive expenses that do not provide any additional
value to core business activities.
When an analyst understands the overall cost structure of a company, he/she can identify feasible
cost reduction methods without affecting the quality of products sold or service provided to
customers. The financial analyst should also keep a close eye on the cost trend to ensure stable
cash flows and no sudden cost spikes occurring.
Cost allocation is an important process for a business because if costs are misallocated, then the
business might make wrong decisions, such as overpricing/underpricing a product, or invest
unnecessary resources in non-profitable products. The role of a financial analyst is to make sure
costs are correctly attributed to the designated cost objects and that appropriate cost allocation
bases are chosen.
Cost allocation allows an analyst to calculate the per-unit costs for different product lines, business
units, or departments, and, thus, to find out the per-unit profits. With this information, a financial
analyst can provide insights on improving the profitability of certain products, replacing the least
profitable products, or implementing various strategies to reduce costs.
3) Product Costs
What are Product Costs?
Product costs are costs that are incurred to create a product that is intended for sale to customers.
Product costs include direct material (DM), direct labor (DL), and manufacturing overhead (MOH).
Product costs are the costs directly incurred from the manufacturing process. The three basic
categories of product costs are detailed below:
1. Direct material
Direct material costs are the costs of raw materials or parts that go directly into producing
products. For example, if Company A is a toy manufacturer, an example of a direct material cost
would be the plastic used to make the toys.
2. Direct labor
Direct labor costs are the wages, benefits, and insurance that are paid to employees who are
directly involved in manufacturing and producing the goods – for example, workers on the
assembly line or those who use the machinery to make the products.
3. Manufacturing overhead
Manufacturing overhead costs include direct factory-related costs that are incurred when
producing a product, such as the cost of machinery and the cost to operate the machinery.
Manufacturing overhead costs also include some indirect costs, such as the following:
Indirect materials: Indirect materials are materials that are used in the production process
but that are not directly traceable to the product. For example, glue, oil, tape, cleaning
supplies, etc. are classified as indirect materials.
Indirect labor: Indirect labor is the labor of those who are not directly involved in the
production of the products. An example would be security guards, supervisors, and quality
assurance workers in the factory. Their wages and benefits would be classified as indirect
labor costs.
Direct labor: The cost of wages and benefits for the carpenters to create the tables.
Manufacturing overhead (indirect material): The cost of nails used to hold the tables
together.
Manufacturing overhead (indirect labor): The cost of wages and benefits for the security
guards to overlook the manufacturing facility
Company A produced 1,000 tables. To produce 1,000 tables, the company incurred costs of:
$12,000 on wood
$2,000 on wages for carpenters and $500 on wages for security guards to overlook the
manufacturing facility
Period Costs
Product costs are costs necessary to manufacture a product, while period costs are non-
manufacturing costs that are expensed within an accounting period.
Definition Costs incurred to manufacture Costs that are not incurred to manufacture a product
a product and, therefore, cannot be assigned to the product
Examples Raw material, wages on labor, Marketing costs, sales costs, audit fees, rent on the
production overheads, rent on office building, etc.
the factory, etc.
Product costs are treated as inventory (an asset) on the balance sheet and do not appear on the
income statement as costs of goods sold until the product is sold.
For example, a company manufactures 50 units of widgets at a unit product cost of $5. On the
balance sheet, there would be a $5 x 50 = $250 increase in inventory. If the company sells 20 units
of widgets, $5 x 20 = $100 in inventory would be transferred to the cost of goods sold on the
income statement while the remaining $150 would remain in inventory on the balance sheet.
References:
https://corporatefinanceinstitute.com/resources/knowledge/finance/cost-of-production/
https://corporatefinanceinstitute.com/resources/knowledge/finance/cost-structure/
https://corporatefinanceinstitute.com/resources/knowledge/accounting/product-costs/