What Is Cost Of Production? (With Factors That Affect It)
Updated 6 September 2023
All companies require to consider the cost of production to gain maximum benefits from their manufacturing or production processes. To ensure the cost-effectiveness and profitability of their products, companies calculate, report and control production expenses. By understanding the relevance of the cost of production for businesses, you can track its impact on your company. In this article, we define what is cost of production, learn about its importance, how to calculate it, the cost of production types and review the factors affecting the company's production costs.
What Is Cost Of Production?
To understand what is cost of production, it becomes necessary to record and calculate all the costs that a company bears in manufacturing products and providing services to consumers. The company production costs can cover the expenses of buying or leasing land, the prices of raw materials or parts, the salaries for the company employees, the charges for maintaining the manufacturing plant and the shipping costs. The taxes your company pays can also factor in the cost of production.
Why Is Cost Of Production Important?
Cost of production is important as it is a factor that can help companies to assess their financial health and find ways to cut expenses. For instance, if a company manufactures products having a higher cost of production than their sales profits, it may be necessary for the company to cease production or turn to another product that might be more budget-friendly and viable in the market. In the case of service provider companies, if the cost of dispensing the service exceeds the incoming revenue, they may want to limit some service features or discontinue some or all services.
How To Calculate Cost Of Production?
Many companies use the cost per unit measure to calculate their cost of production. The cost per unit is the amount of money that a company spends on manufacturing each product item or providing each service. The company can calculate the price of each unit by dividing the cost of production by the number of product units it manufactures or the services it provides. Once it knows how much it costs to produce one item, it can decide on a price that consumers may find affordable and which can also profit the company.
Generally, it is necessary to price items higher than what it took to produce them if you want to earn a profit. If the company's cost of production is the same as or higher than its product sales price, there is no profit. The company may find itself in financial trouble and at risk of closure if it continues to operate at a loss.
What Are The Types Of Cost Of Production?
The types of cost of production include the following:
Direct costs are the expenses that a company makes towards acquiring specific raw materials, parts, services and production equipment, paying employee wages and marketing to customers. Since the costs of these items can vary, direct costs are variable. These costs can occur at every stage of the production process, and the company's accounting team keeps an accurate and verifiable record of what the company spent, why and when. Afterwards, the accounting team can add up the direct costs to get the total cost of production for each product that the company manufactures.
Indirect costs are those expenses that occur during the production process but are not directly concerned with the product manufacturing. For example, the amount that the company spends on its office rent, supplies, utilities, maintenance and support staff wages. It can be problematic to factor such indirect costs into the total cost of production for a specific product. Most companies find it more convenient to include them in the production overhead costs. It may be possible to lower the cost of production by identifying, reporting and controlling production overhead costs.
Fixed costs are the production expenses that generally remain steady through the manufacturing process in a specific period. Examples of fixed costs include the salaries of the company employees and the price of the manufacturing equipment. These types of fixed costs do not change even if the company increases the rate of production.
Variable costs are the expenses in the production process that tend to increase or decrease as per the changes in the production volume. These costs are dependent on factors like market demands and trends, availability and shipping charges. If the market demand is high, the company may require to spend more on acquiring raw materials and on utility expenses to scale up the production.
What Are The Factors That Affect Cost Of Production?
The factors that can affect the cost of production include the following:
The market demand for specific products can determine whether a company continues to manufacture them and in what quantity. If the demand is high, the company can make and sell more products and earn more profit. For this, it may purchase more raw materials, expand its labour force and move operations to a larger production facility.
An increasing number of companies have adopted automation technology to do menial or repetitive tasks that traditionally required labourers. By using manufacturing robots for the work, the companies can continue their operations without hiring and paying labourers. They can also speed up the manufacturing process by using advanced computer systems and training employees to use digital interfaces. These things can significantly lower the cost of production related to wages and manufacturing.
Cost of materials
The cost of materials can vary greatly based on various factors, like their demand, availability, limitations, shipping, storage and the economic situation. The material prices, in turn, affect the cost of production. The increase in the prices of petrol and diesel, for example, can have a corresponding impact on the prices in other industries. That is due to their connection with electricity generation and the transportation and delivery of materials and products.
Labour costs are variable expenses that can affect the cost of production. These costs can differ according to the geographical location of the company. In some areas, the labour costs may be high, while, in others, they may be low. Labour costs are also dependent on the skills and training of the workers. If a company requires highly skilled workers for manufacturing complex products, it becomes necessary to have a higher production budget to cover the salaries.
Some companies may attempt to cut costs by hiring lower-skilled workers, but that is generally not advisable since it can impact the quality of the products and thus the brand reputation. It is more profitable in the long run to invest in well-trained technicians and operators to increase the value of the product and ensure customer satisfaction.
Some companies import raw materials and parts from abroad and pay the current exchange rate for their purchases. The exchange rate is the value of one national currency compared to another national currency. It can be free-floating and can rise or fall as per the fluctuations in the foreign exchange market, or it can be fixed and connected to the value of a specific national currency.
In the case of a free-floating exchange rate, the regular changes in its value can affect the cost of production of companies that import materials and parts. They may be able to obtain the materials and parts at a cheaper cost if the exchange rate rises and manufacture their products at a lower price. While that can be beneficial, it can also lead to less business competition and innovation. If the exchange rate falls, prices can increase, and production expenses are bound to go up.
Most companies include the taxes levied by the state and central governments in their production costs, and these can have an indirect effect on a company's cost of production. If it becomes necessary for the company to pay higher taxes in one year, its annual overhead can go up, and its cost of production is likely to be correspondingly high in that period. High tax rates can determine the production decisions that companies make. For example, they might use less expensive and lower quality raw materials to decrease the production costs and improve their profit margin.
It can sometimes be necessary for companies to take loans from banks or other financial institutions to pay for their business expenses. These loans can constitute indirect expenses and can have an impact on the cost of production. That is because it becomes necessary for the companies to set aside specific funds regularly to pay off the loan, and the interest payment rates on the loans can vary. If the interest rates rise, the companies pay more in loan repayments. It is essential to account for these rate fluctuations to maintain the accuracy of the company's financial reports.
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