Production Costs: What They Are and How to Calculate Them

What Are Production Costs?

Production costs refer to all of the direct and indirect costs businesses face from manufacturing a product or providing a service. Production costs can include a variety of expenses, such as labor, raw materials, consumable manufacturing supplies, and general overhead.

Understanding Production Costs

Production costs, which are also known as product costs, are incurred by a business when it manufactures a product or provides a service. These costs include a variety of expenses. For example, manufacturers have production costs related to the raw materials and labor needed to create the product. Service industries incur production costs related to the labor required to implement the service and any costs of materials involved in delivering the service.

Taxes levied by the government or royalties owed by natural resource-extraction companies are also treated as production costs. Once a product is finished, the company records the product's value as an asset in its financial statements until the product is sold. Recording a finished product as an asset serves to fulfill the company's reporting requirements and inform shareholders.

Total product costs can be determined by adding together the total direct materials and labor costs as well as the total manufacturing overhead costs. Data like the cost of production per unit or the cost to produce one batch of product can help a business set an appropriate sales price for the finished item.

To arrive at the cost of production per unit, production costs are divided by the number of units manufactured in the period covered by those costs. To break even, the sales price must cover the cost per unit. Prices that are greater than the cost per unit result in profits, whereas prices that are less than the cost per unit result in losses.

Types of Production Costs

Production incurs both fixed costs and variable costs. For example, fixed costs for manufacturing an automobile would include equipment as well as workers' salaries. As the rate of production increases, fixed costs remain steady.

Variable costs increase or decrease as production volume changes. Utility expenses are a prime example of a variable cost, as more energy is generally needed as production scales up.

The marginal cost of production refers to the total cost to produce one additional unit. In economic theory, a firm will continue to expand the production of a good until its marginal cost of production is equal to its marginal product (marginal revenue). This, in turn, will tend to equal its selling price.

Special Considerations

There may be options available to producers if the cost of production exceeds a product's sale price. The first thing they may consider doing is lowering their production costs. If this isn't feasible, they may need to reconsider their pricing structure and marketing strategy to determine if they can justify a price increase or if they can market the product to a new demographic. If neither of these options works, producers may have to suspend their operations or shut down permanently.

Here's a hypothetical example to show how this works using the price of oil. Let's say oil prices dropped to $45 a barrel. If production costs varied between $20 and $50 per barrel, then a cash-negative situation would occur for producers with steep production costs. These companies could choose to stop production until sale prices returned to profitable levels.