Costs of Production

Costs of production overview

The costs of production overview will explain the different types of costs that firms incur when producing goods or services and how they can be categorized into fixed and variable costs in both short-run and long-run production.

What is short-run production?

Short-run production in microeconomic theory is when at least one of the factors of production (land, labour, capital, or technology) is fixed and can’t be changed.

The company can produce more output in the short run by adding more variable factors to the fixed factors of production.

What is long-run production?

Long-run production in microeconomic theory is the period where the scale of all factors of production is variable and can be changed.

In the long run, the company can benefit from economies of scale as the scale and capacity of production can increase. For example, a company can increase the quantity of its labour force while simultaneously increasing the quantity of capital.

Types of production costs

There are many types of production costs:

• fixed cost
• variable cost
• total costs
• average cost
• marginal cost

Fixed costs

A company has to pay fixed costs whether the output level increases or decreases. Fixed costs are also costs that a company incurs when the output level is zero. The higher the fixed costs are in a company, the higher the output must be for the business to break even.

Other examples of fixed costs include:

1. Maintenance costs of a factory or an office building.

2. Rent.

3. Interest on loans.

4. Advertising.

5. Business rates.

Variable costs

Variable costs relate directly to the production or sale of a product. The marginal cost of an extra output unit determines the variable cost as more variable inputs are integrated into production. If a company increases its output in the short run, its total variable costs will rise.

Other examples of variable costs include:

1. Wages.

2. Basic raw materials (such as wood, metal, iron.)

3. Energy costs.

4. Fuel costs.

5. Packaging costs.

Total costs

A company’s total costs are made up of the fixed costs and variable costs added together, as shown in this formula:

\(\hbox{Total Costs (TC) = Fixed Costs (FC) = Variable Costs (VC)}\)

When a company produces more and increases its output, the company’s total cost of production will increase.

Costs of production example

Consider this simple table to understand a basic costs overview and their calculation process.

Table 1. Total costs calculation - StudySmarter.

In Table 1 you can see we have a certain set of units labeled as ‘Output’ as well as fixed costs and variable costs in ‘$.’

As we now know, the fixed costs remain constant. Hence, for every unit produced the fixed costs are $10,000.

As we said before, the variable costs change for every unit of output produced.

To calculate the total costs of production we can follow the formula that we discussed above. We simply add the fixed and variable costs. The sum of each total for every unit produced is illustrated in the fourth column.

Average cost of production

We calculate the average cost of production (also known as the unit cost) by dividing the firm’s total cost of production by the quantity of output it produced.

\(\hbox{Average Cost (AC)}=\frac{\hbox{Total Costs (TC)}}{\hbox{Level of Output (Q)}}\)

Let’s calculate the average costs with an example from Table 2 below. Consider the following units:

Table 2. Average costs calculation - StudySmarter.

We can also illustrate the average costs for each output level on an average total cost curve as in the figure below.

Average cost curve

In Figure 1 the cost of production is depicted on the y axis and the level of produced output is depicted on the x axis.

We can conclude that when initially the company’s costs of production (C) fall, the number of units of output produced (Q) increases. When the company produces at Q1, the average output cost is at C1. However, if for some reason the company increases its output from Q1 to Q2, we can see that the average cost per unit falls from C1 to C2. For higher output levels, the average costs the company incurs usually rise. You can see that when output increases from Q2 to Q3 and the average cost rises from C2 to C3.

In microeconomic theory, the average total cost curves in the short run are U-shaped. They initially show unit costs falling and then rising as output increases.

At low output levels, the average costs are high because there are more average fixed and variable costs. As the output level increases, the average costs fall due to the combined effect of declining average fixed and variable costs resulting from the internal economies of scale. However, as the output level continues to increase and the average cost continues to decline it eventually reaches a minimum.

This minimum point is the average-cost-minimising output level and the productively efficient output level or the optimum output level a firm can produce at the given cost. On the graph above, it is the lowest point of the average cost curve, at the intersection of C2 and Q2.

Once a firm reaches the optimum level and continues to produce more output, the average costs will start rising again. This can happen if the company decides to increase the quantities of variable factors such as machinery. This would lead to diseconomies of scale in production and diminishing returns causing the average costs to rise rapidly.

We can divide average production costs or average total costs into average fixed costs and average variable costs.

\(\hbox{Average Total Costs (ATC)}=\hbox{Average Fixed Costs (AFC)}+\hbox{Average Variable Costs (AVC)}\)

Average fixed costs curve

The average fixed cost curve is a negatively sloped curve that illustrates the relationship between the average fixed cost incurred by a company when producing goods and services of a certain output level in the short run. The curve shows the relation between the average fixed cost and the output level while keeping other variables like technology or capital constant.

We can illustrate the average fixed costs for each output level on an average fixed cost curve as in the figure below.

Average fixed cost curve

As you can see in Figure 2, the average fixed cost is relatively high at C1 and a low output level at Q1. However, as the production of output of the company starts to increase from Q1 to Q2, the average cost gradually declines from C1 to C2. This is because the fixed costs are spread over an increasingly larger quantity of output.

Average variable costs curve

The average variable cost curve is a U-shaped curve that illustrates the relationship between the average variable cost incurred by a firm producing goods and services at a certain output level in the short run.

Figure 3 below shows a firm’s variable cost curve of the production of labour factor.

Average variable cost curve

As you can see in Figure 3, labour becomes more productive as more workers are employed. Labour reaches its highest productivity, thereby minimising the average costs for the firm, at cost C and output level Q. However, if employment within the firm increased further, labour would eventually become less productive and the average cost would start rising again.

Average total costs curve

The average total cost curve illustrates the relationship between the average total cost incurred by a firm producing goods and services at a certain output level in the short run. The curve shows us the relation between the average total cost and output level while keeping production factors like technology and labour constant.

The average total cost curve is U-shaped and is usually illustrated alongside the average fixed cost curve and average variable cost curve.

Figure 4 below depicts the three curves alongside each other.

The average total cost curve

We obtain the average total cost curve by adding together the average fixed cost and the average variable cost at each output level.

These are the formulae:

Or

\(\hbox{Average Total Costs (ATC)}=\frac{\hbox{Total Costs (TC)}}{\hbox{Level of Output (Q)}}\)

The average total cost is high for small quantities of output, but as production increases, the average total cost starts to decline until it reaches a minimum value and then starts rising again.

The U-shape of the average total cost curve is a result of the underlying averages of both the average fixed and average variable costs. At low levels of output, both average fixed cost and average variable cost curves decline, which causes the average total cost curve to decline as well.

However, due to the law of diminishing marginal returns, the average variable cost curve eventually starts rising, outweighing the continued decline of the average fixed cost. This causes the average total cost to rise as well.

Long-run average costs

In the long run, the firm can change the size and scale of the factors of production it utilises. It can add or even subtract the assets such as factories or machinery to its production factors. In the long run, the costs are illustrated in the long-run average cost curve.

Figure 5 below depicts a long-run average cost curve:

The long-run average cost is essentially the long-run cost divided by the output level. The curve is U-shaped because the long-run average costs initially fall due to economies of scale as the firm expands its operations. Economies of scale is a phenomenon that occurs when a firm’s output increases whilst its long-run average costs decrease.

However, after the firm hits a certain point in its production process (illustrated at the intersection of C and Q in Figure 5 above), it starts experiencing diseconomies of scale. Diseconomies of scale is a phenomenon that occurs when a firm’s output increases whilst its long run average costs increase.

Costs of production example

Let's take a look at examples of costs of production for different types of companies.

Manufacturing company

Examples of production costs for a manufacturing company are:

• Fixed Cost: rent or lease of the factory, insurance premiums, salaries of administrative staff, wages of production workers
• Variable Cost: raw materials, electricity bills, cost of maintenance and repairs

Delivery service:

Costs of production examples for a delivery service company are:

• Fixed Cost: salaries of administrative staff, office rent or lease, phone and internet bills
• Variable Cost: gas for delivery cars, maintenance and repairs of vehicles, cost of packaging

Restaurant:

Here are examples of production costs for a restaurant:

• Fixed Cost: rent for the restaurant building, salaries of administrative staff, utilities (electricity, gas, water), fixed wages of kitchen and service staff
• Variable Cost: food ingredients, cost of beverages, cost of cleaning supplies and other operational expenses.

How can a firm reduce its costs of production?

There are several ways in which a firm can reduce its costs of production.

One way to reduce the costs of production would be to reduce direct costs as they make up a large portion of the total manufacturing costs. One technique is to use quotations from as many suppliers as possible. Another technique would be to offer cash payments in return for a cash discount. Many suppliers may be willing to trade off the discount for immediate payment.

A second way to decrease production costs would be to increase employees’ efficiency. A firm can do this by offering efficient training programs and by helping labour utilise cost-reducing techniques. It can also offer incentives to workers, such as a pay rise or a bonus premium.

Finally, tasks should be handed out to those that are specialised. In other words, if there is someone specialised in one field, the worker should be allocated to working in that particular field.