Concept of Cost of Production:

Definition and Meaning:

By "Cost of Production" is meant the total sum of money required for the production of a
specific quantity of output. In the word of Gulhrie and Wallace:

"In Economics, cost of production has a special meaning. It is all of the payments or
expenditures necessary to obtain the factors of production of land, labor, capital and
management required to produce a commodity. It represents money costs which we want to
incur in order to acquire the factors of production".

In the words of Campbell:

"Production costs are those which must be received by resource owners in order to assume
that they will continue to supply them in a particular time of production".

Elements of Cost of Production:

The following elements are included in the cost of production:

(a) Purchase of raw machinery, (b) Installation of plant and machinery, (c) Wages of labor, (d)
Rent of Building, (e) Interest on capital, (f) Wear and tear of the machinery and building, (g)
Advertisement expenses, (h) Insurance charges, (i) Payment of taxes, (j) In the cost of
production, the imputed value of the factor of production owned by the firm itself is also
added, (k) The normal profit of the entrepreneur is also included In the cost of production.

Normal Profit:

By normal profit of the entrepreneur is meant in economics the sum of money which is
necessary to keep an entrepreneur employed in a business. This remuneration should be equal
to the amount which he can earn in some other alternative occupation. If this alternative return
is not met, he will leave the enterprise and join alternative line of production.

Types/Classifications of Cost of Production:

Prof, Mead in his book, "Economic Analysis and Policy" has classified these costs into three
main sections:

(1) Production Costs:

It includes material costs, rent cost, wage cost, interest cost and normal profit of the
entrepreneur.
(2) Selling Costs:

It includes transportation, marketing and selling costs.

(3) Sundry Costs:

It includes other costs such as insurance charges, payment of taxes and rate, etc., etc.

http://www.economicsconcepts.com/concept_of_cost_of_production.htm

In managerial accounting and cost accounting, production costs are the direct materials, direct
labor, and manufacturing overhead used to manufacture products. The production costs are
also referred to as manufacturing costs, product costs, a manufacturer's inventoriable costs, or
the costs occurring in the factory.
Production costs are often classified as direct or indirect product costs. For example, direct
materials and direct labor are direct product costs because they can be easily and economically
traced to the products being manufactured. On the other hand, manufacturing overhead costs
are indirect product costs because they are not easily or economically traceable directly to the
products. Instead, the manufacturing overhead costs must be allocated or assigned to the
products often through a predetermined overhead rate.
Production costs can also be classified as direct or indirect as to a factory department. For
example, the costs of the factory maintenance staff is a direct cost of the factory maintenance
department, while at the same time being an indirect product cost.

https://www.accountingcoach.com/blog/what-are-production-costs

Costs of Production

What It Means

The costs of production are the expenses to which a company is subject as it goes through the
process of generating, selling, and delivering goods and services to consumers. The various
resources on which the company relies to produce a product (the good or service) are known as
factors of production. These factors, which all represent costs to the company, can include
labor, equipment, real estate, machinery, technology, insurance, and other resources.

A company is concerned with the costs of production because, in general, it seeks to make a
financial profit on the sale of its products. The profit a company makes on its products is
calculated by subtracting the total cost of production from the total revenue the company
brings in (which is largely through sales of its products). If the company chooses not to raise
prices for its products, it can maintain (or increase) its level of profit only if it can keep steady
(or decrease) the costs of production. The more a company can lower its costs of production
while at the same time increasing its revenue (through increased numbers of sales), the more
profitable the company will be. For example, if a candle manufacturer produces and sells 1,000
candles a month and if the total costs of production are $3 per candle, the business can make a
profit only if it charges more than $3 per candle to consumers. To increase its profit, the
business must find a way to lower the costs of production per candle, to sell more than 1,000
candles per month, to get a higher price for the candles, or some combination of the three.

Determining the costs of production per product and understanding the sources of those costs
are important for several reasons. Foremost, a company can set a profit-making price on a
product if it knows how much the product costs to produce. Understanding the production
costs also makes it possible to determine what part of the total costs of, for example, an
organization, a manufacturing process, or a building lease is associated with a particular
product. Furthermore, understanding the production costs it possible to identify costs that are
too high and to make comparisons between the costs of different activities in the company.

When Did It Begin

The Scottish philosopher Adam Smith (1723–90) was the first person to develop the concept of
costs of production as an economic theory. Smith analyzed the role of the production of goods
in a market economy. In his most noted book, The Wealth of Nations (1776), he argued that,
although the free market (an economic market operating by free competition) appears
unrestrained, in actuality an “invisible hand” guides the market to produce the optimal amount
that will be consumed. For example, if there is a shortage of an essential good, its price
increases because its producers understand that consumers are willing to pay more to acquire
it. This encourages other producers to enter the market, which ultimately eliminates the
shortage. If there are more than enough producers of a certain good, the competition for the
consumer brings the price of the product down to what Smith called its “natural price,” which is
the cost of producing it. Even though a company makes no profit when a good is sold at the
price it costs to produce it, there is still an incentive to produce it because the selling price also
pays the company owner’s salary, which is included in the costs of production.

More Detailed Information

Because the costs of production are intimately tied to the ability of a company to generate a
profit, they are the subject of detailed analysis. In economics, cost is considered to be a
measure of the opportunities that are passed up when a company chooses one product or
activity over others. Consequently, the costs of production of any good or service can be
considered opportunity costs. For instance, by choosing any given production venture, a
company always foregoes the chance to choose another venture and, therefore, foregoes the
value of that alternative. The earnings that would have been made on taking another product
to market or making another investment are the opportunity costs.

A company’s opportunity costs of production can be divided into two main categories: explicit
costs and implicit costs. The implicit costs are essentially costs that are not transacted directly
in money, even though they are measured in money. For example, if the owner of a company
foregoes a salary that he could have made by working for someone else and, instead, works at
the company he owns for a lower salary, he never sees the amount of money he did not make,
but he knows what it is.

The explicit costs are more easily valued in money. They include direct payments for factors of
production such as wages, rent, and utilities. Economists usually take both implicit and explicit
costs into consideration, whereas companies and their accountants focus only on explicit costs.
To a business, the term costs of production refers to costs of producing and supplying goods for
which it is liable in the short term. Two different types of costs make up the explicit costs that a
firm incurs: fixed costs and variable costs.

Fixed costs are associated with the factors of production that remain unchanged no matter how
many units of the product are produced. Generally, they are all the costs of setting up a
business. Among the many different fixed costs are the rent paid for office or factory space, the
costs of salaries for full-time employees who work on the product, the costs paid for insurance
premiums that the business carries, and the property taxes on the land the business sits on.
Fixed costs also include the depreciation (the decline in value due to age and wear and tear
over time) of such things as plants and equipment.

The total amount of a fixed cost does not change as the level of production activity varies. For
example, if a company raises the number of units of a product it makes by 20 percent, the total
fixed cost of production remains the same.

The variable costs of production are subject to change according to the number of units of a
product made or with the scale of the company’s operation. Examples of variable costs include
the materials used to make the product and the wages paid to workers who are hired
specifically for the production of that good. For instance, the cost to an automaker for the sheet
metal that goes into its cars generally will increase in proportion to the number of cars it
produces; if it makes 10 percent more cars in a certain time period, its cost for sheet metal will
also increase by 10 percent. Likewise, if it costs the carmaker $10,000 to make one car, and
manufacturing activity doubles from a production rate of 100 cars a month to a rate of 200 cars
a month, then the total variable costs double from $1 million to $2 million. On the other hand,
the variable cost of making each car (the carmaker’s cost per unit) stays the same no matter
how much the activity increases. It costs the carmaker to $10,000 make each car, whether the
car is the first one manufactured in a given month, the 50th, or the 200th.

To better understand its costs of production, a company needs to trace as many costs as
possible directly to the activities that cause them to be incurred. Consequently, an important
distinction to be made is the difference between direct and indirect costs. A cost that can be
associated with a particular department or other specific segment of a company is called a
direct cost of that segment. For example, a salary of a television repair person is a direct cost of
the service department at a consumer electronics store. An indirect cost is one that cannot be
directly attributed to a particular segment. The costs of advertising for a large multinational
corporation are associated with all its divisions and departments. Similarly, the salary of a
company’s president or its chief financial officer is an indirect cost of the company as a whole.

https://www.encyclopedia.com/finance/encyclopedias-almanacs-transcripts-and-maps/costs-
production
Meaning and Definition
Cost of production refers to the total sum of money needed for the production of a particular
quantity of output. As defined by Gulhrie and Wallace, “In Economics, cost of production features a
special meaning. It is all about the payments or expenditures essential to get the factors of
production of land, labor, capital and management needed to produce a commodity. It signifies the
money costs which are to be incurred for acquisition of the factors of production.” In the words of
Campbell, “Production Costs are the costs which should be essentially received by resource owners
so as to presume that they will continue to supply them in a specific period of time.”
Elements of Production Cost
The key elements included in the production costs are as follows:
 Purchase of raw machinery
 Installation of plant and machinery
 Wages of labor
 Building rent
 Interest on capital
 Wear and tear of building and machinery
 Advertisement expenses
 Payment of taxes
 Insurance charges
 The imputed value of factor of production owned by the firm itself is also added in the
production cost.
 The production cost also includes the normal profit of the entrepreneur.
Formula for computing Production Costs
The general formula used for computing production cost is:
Production cost per item = Fixed Cost (FC) + Variable cost (VC) / No. of units produced
Calculating production cost
The key steps involved in computation of production cost are:
 Determine the fixed cost. These are the costs which do not alter on the basis of the number of
products produced. This includes the rent paid for building, salaries of the employees, and utility
costs.
 Estimate the variable costs. These are the costs that change with a change in the quantity of
production. For example, if you are making a cake, some of the variable costs would be flour,
eggs, and sugar.
 Add the fixed costs to the variable costs and divide this number by the number of items
produced thus reaching the production cost for one item.

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