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.

Recent Trends

Beginning in the last decades of the twentieth century, globalization (a process involving the merging of economies, governmental policies, political movements, and cultures around the world) has encouraged the opening up of information and communication channels and enhanced the sense of a global market. As one consequence of globalization, many companies based in the United States have transferred the tasks that once were done by American engineers to countries, such as India and the Philippines, where the costs of engineering production are significantly lower than in the United States. This activity is known as offshoring. Some companies have saved as much as 70 percent in their total costs of production by sending work to other countries, where in some instances the wages are as little as 10 percent of those paid to American engineers. Large multinational technology firms such as Microsoft, General Electric, and Google are among those who not only have offshored engineering jobs but also have built research and development centers in countries where labor is relatively cheap. Many start-up companies (fledgling businesses) also have made offshoring a part of the plans they have presented to venture capital firms (companies with funds available to invest in fresh enterprises).

As a result of this trend, an industry of offshoring companies has grown up and has become successful and important quite quickly. These businesses, of which many are Indian (although some are American with offices in India, the Philippines, and elsewhere), provide American companies with workers as well as human resources services, recruitment services, information technology, and even physical offices in low-cost countries.