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How do you know if a production order made a worthwhile profit? You calculate the cost of production. Read on to learn the best way to track and manage your production costs.
What is the cost of production?
Cost of production is the total cost a business incurs to either produce a product or offer its services. Production costs typically include supplies and raw materials that are consumed during production, along with labor expenses.
Types of production costs
When manufacturing a product or offering a specific service, a business can incur multiple types of expenses. Here are the most common types of costs of production:
Variable costs are expenses that change with production volume. These costs arise when production increases and fall when it decreases. With a production volume of zero, there are no variable costs. 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 you’re running at full capacity. Fixed costs are generally time-limited, meaning that they are fixed to output for a specific period. Employee salary, rent, and leased equipment are some examples of fixed costs.
Total cost considers both variable and fixed expenses. All costs you incur during the production of a product or the offering of services are part of this calculation. Total cost is the sum of fixed and variable expenses. For example, 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. Thus 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. Price discrimination, asymmetrical information, transaction costs, and externalities all affect marginal cost.
Average cost is essentially the expenses that occur from producing one unit or offering one service. You can calculate the average cost in the following two ways:
- Dividing the total production costs by the amount of product created
- 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, you should minimize average costs to increase the profit margin without increasing 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. These 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 are seen in real-time through 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 the production rate. 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. This happens when the average cost does not change when 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. This refers to when the average cost of production increases with the volume of units produced. It’s 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.
How to Measure Cost of Production
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?
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 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.
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