Read this blog till the end to learn about the cost of production. Read all the important terms related to the cost of production and also about its importance.
Whenever you purchase an article from the market, you buy it at the maximum retail price, MRP. The original manufacturing cost of the product is quite less than the maximum retail price of the product. The huge margin between MRP and manufacturing price is further filled with the production costs and profit of the traders.
How is the cost of production of an article determined? What are its types? And why is it different from the manufacturing costs? Read the blog to the end to get your answers with real-life examples.
What is the Cost of Production?
The Cost of Production is also called production costs or cost price. It is the total cost sustained by a business to produce a specific quantity of a product. It includes all direct and indirect costs of manufacturing the product.
(Suggested read - Inflation)
Or in simple words, the cost of production is the original cost of the product without adding profits of wholesalers, shopkeepers, and other intermediaries.
Read - 18 cost of production
What does the cost of production include?
The cost of production includes various direct and indirect costs that come in between the process of manufacturing. The cost of production includes following secondary costs:
Cost of raw material
Cost of labor required for the process of manufacturing
Cost of storage
Cost of technology used
Maintenance cost of equipments and infrastructure used
Cost of land and capital invested
(Suggested blog: Big Data Analytics)
Explanation of cost of production with example
Now let us understand the meaning of the cost of the production with few real-life examples:
Ram is a cobbler, and he makes a pair of shoes by purchasing a piece of leather at 200 INR. Here the cost price of shoes is 200 INR plus the labor charges of Ram.
Sam purchases a sewing machine for 5000 INR, he spends 300 INR on transporting the machine to his home. Here the cost of production of sewing machines for Adi is 5300 INR, i.e., original cost of sewing machine plus the cost of transportation.
Now, let us consider a big scale example,
Henry wants to set up a cup manufacturing unit. For the first month, he set a target of 1000 cups. He purchased a mold for making cups of 1000 INR. 20 cups require 1 kg of clay, which costs 200 INR.
Further, a labor asks 5 INR for making one cup. The charge of baking is the same as the charge of making. Later a painter demands 2 INR for painting each cup. After that, Henry spends 500 INR on petrol on his motor, for delivering the cups to the market.
Now, the total cost of production of cups is the total cost of mold, clay, labor, baker, painter, and transportation charges. The cost of production for 1000 cups here is 4200 INR.
These examples have cleared the meaning of cost of production in your mind.
( Read blog, Fiscal policy )
How can the cost of production be calculated?
Cost of production or cost price or production costs can be calculated by adding all direct and indirect costs of a manufacturing unit. Here is the formula of calculating cost of production.
Total cost of production= Cost of labor Cost of raw materials ie Overhead costs on manufacturing.
What is the importance of the cost of production?
Cost of production is an important term of economy, because of the following reasons:
It helps in estimating the net profit or net loss on the product sales.
It helps the manufacturer to set the maximum retail price of his products.
It helps the government to decide the price ceiling and price floor, and also the minimum support price of a product.
What are the types of cost of production?
Types of Cost of Production
Production costs or cost price can be of different types. The major types of the cost of production are as follows:
Fixed costs include those prices which don't change with time. Fixed costs as the name shows remain fixed throughout the time. These costs don’t depend on the amount of production.
(Recommended blog - Pricing Strategies)
Producers have to pay fixed costs for it even when there is zero production or no profits. For example,
- If a person opens a school. He has to rent a big building for the purpose. One year his school got 1000 admission and the other year he got only 100 new admissions. But for both years he has to pay the same rental charges for the building.
A farmer purchased a field for agriculture on loan. In one season he earns a good harvest and profits, and in the next season his crops fail. But still, he has to pay the interest of his loan rate, despite his profits or loss.
Variable costs are production dependent costs. As the name shows, variable costs change at different levels. It doesn’t stay the same all the time. Variable cost directly depends on production sales. If production sales increase, the variable costs also increase and vice-versa. For example,
- The variable cost for a restaurant owner is raw materials and vegetables. It depends on the number of customers it entertains.
- For a textile mill, the variable cost is raw fabrics, if its production decreases the cost of raw fabric will also decrease, thus decreasing the final variable costs.
The total cost is the sum of fixed costs and variable costs. For example,
- The cost of raw material for a textile mill is 50,000 INR and the mill pays 4000 INR as monthly rent. The total cost for the textile mill is 54,000 INR.
The average cost of production is defined as the total cost of production per unit produced. In simple words, average cost comes when the total cost of production is divided by the number of product units produced. For example,
- The total cost of production of cups in the above -mentioned example was 4200 INR, and a total of 100 units of cups were produced. So, the average cost of the cup production is 4.2 INR.
Each company produces some additional goods for meeting accidental damages or causes. The expenditure in manufacturing an additional quantity is called marginal costs. Marginal costs don’t affect fixed costs. But it increases the variable cost. For example,
- The marginal cost of the cup in the above example is 4.2 INR.
Marginal costs are either equal to or less than to the average cost.
What is the difference between cost of production and manufacturing costs?
Sometimes people misinterpret the cost of production or production costs as manufacturing costs. But there is a difference between Production and manufacturing cost. While the cost of production is an aggregated cost of different costs. Manufacturing costs are a part of the production costs or the cost of production.
While the cost of production includes all immediate costs expended for manufacturing and marketing of the product, the manufacturing costs include the essential cost that was required for the building of the product.
(Related blog - 4 Ps of Marketing)
For example, the rental expenditure of a building is included in the cost of production, but not in manufacturing costs. Both manufacturing costs and production costs include the expenditure related to law material and labor.
Again, the cost of transportation and marketing promotional expenditure is included in the cost of production but not in manufacturing costs.
A way forward
Cost of production is an important part of the manufacturing process. The cost of production is responsible for deciding the final price on commodities. The cost of production helps in deciding the price ceiling and price floor too. Thus, the role of cost of production becomes more vital in controlling market flow.
The government of India has launched many roles in order to reduce the cost of production for producers. This might be a result of free service or setting up free infrastructure for the producer.
The scheme ‘PM MITRA parks’ is one of the most recent steps of the government for reducing the cost of production of textile industries. Controlling the cost of production in an effective manner, can develop the market in an effective way.