Types of production costs

A manufacturing company's production department will need to consider the quality and quantity of a product in relation to cost. If a firm wants to make a profit, it has to know what it is spending as well as what it is earning. Here are some of the costs it needs to know to do this:

• Fixed
• Variable
• Total
• Marginal
• Average

Now look at each of these costs in more detail:

Fixed costs

These costs do not change however many units of a product are made. Factory rent, insurance premiums and administration salaries stay the same, whether the factory is working at full capacity or producing nothing. The owner of the business may have taken out a loan to buy equipment or refurbish a building. The loan will have to be repaid whether or not the business has customers.

Variable costs

Variable costs change as output [output: Whatever comes out of a system. In electronics, output components deliver a circuit's end result, while the output of a component is the size of electrical signal at its output terminal ] changes. For example, the amount of raw materials needed varies as the levels of output go up or down. Piece-work [Piece-work: The employee is paid according to the number of units produced. ] wages also fluctuate, depending on the employees' efficiency and the demand for the company's products.

Total costs

The fixed costs and the variable costs are added together to establish the total costs. The fixed costs remain constant, but the variable costs increase in direct proportion with output.

Marginal costs

Compact Discs

Using marginal cost [Marginal cost: The amount spent on producing one extra unit. It is the increase in total cost when one more unit is produced. ] is a way of measuring how much more it will cost a company to make one more individual item. Here is an example:

A company produces compact discs. It has produced 99 CDs and the total costs have amounted to £999. If the total costs increase to £1,000 when the hundredth CD is made the marginal cost of the last CD is £1.00.

The firm knows that now each CD should cost only £1.00 or less to produce. As the cost per unit usually decreases with a rise in output, it should become cheaper to produce each one. The firm may be able to offer a more competitive price to customers.

Average costs

The example of the CD shows the benefits of economies of scale, where mass production results in a lower unit cost. The reason is that the fixed costs do not change and are spread across a greater level of output.

Finding out the average cost of production [Average cost of production: The amount spent on producing each unit of output. It is calculated by dividing the total level of cost by the level of output. ] helps a firm to monitor its progress, and makes it easier to set prices. It is calculated by dividing total cost by total output.

Using the example of the compact disc firm above:

^{Total costs}/_{Total output} = Average cost of production

^£1,000/_{100 CDs} = £10 per CD

This might seem expensive, but if the firm produces another hundred units at a marginal cost of £1.00 per CD, its average cost will fall radically:

^{Total costs}/_{Total output} = Average cost of production

^£1,100/_{200 CDs} = £5.50 per CD

The firm can use this information to decide whether it is worth accepting a new order for goods.

Remember

The examiner will want to see that you understand what the different costs are, how they are calculated, and why it is important for a firm to work them out. You will be expected to apply your understanding to a real life situation.