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Business Studies
Production costs
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This Revision Bite will help you understand the different types of production
costs and how to calculate them.

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 changes. For example, the amount of raw materials
needed varies as the levels of output go up or down. Piece-work 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 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 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.

A company will always incur costs, no matter how efficient it is. Wages, raw
materials, transport and power all have to be paid for. The company needs
to establish all its costs to ensure it doesn't lose money.

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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

Piece-work
The employee is paid according to the number of units produced.

Marginal cost
The amount spent on producing one extra unit. It is the increase in total cost when one
more unit is produced.

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.

raw materials
Raw materials are anything naturally occurring in or on the earth / in the sea before
being processed. These are obtained through primary activities such as mining, fishing,
forestry and farming.