Production Costs

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.

KEY TAKEAWAYS

 Production costs refer to the costs a company incurs from manufacturing a

product or providing a service that generates revenue for the company.
 Production costs can include a variety of expenses, such as labor, raw
materials, consumable manufacturing supplies, and general overhead. 
 Total product costs can be determined by adding together the total direct
materials and labor costs as well as the total manufacturing overhead
costs. 
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.1

Taxes levied by the government or royalties owed by natural resource-extraction

companies are also treated as production costs.1  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.

 
To qualify as a production cost, an expense must be directly connected to
generating revenue for the company.

Total product costs can be determined by adding together the total direct
materials and labor costs as well as the total manufacturing overhead
costs.1  Data like the cost of production per unit 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.1

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.1

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.1

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.1

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. 

How Are Production Costs Determined?

For an expense to qualify as a production cost it must be directly connected to
generating revenue for the company. Manufacturers carry production costs
related to the raw materials and labor needed to create their products. Service
industries carry production costs related to the labor required to implement and
deliver their service. Royalties owed by natural resource-extraction companies
also are treated as production costs, as are taxes levied by the government.
How Are Production Costs Calculated?
Production incurs both direct costs and indirect costs. Direct costs for
manufacturing an automobile, for example, would be materials like plastic and
metal, as well as workers' salaries. Indirect costs would include overhead such
as rent and utility expenses. Total product costs can be determined by adding
together the total direct materials and labor costs as well as the total
manufacturing overhead costs. To determine the product cost per unit of product,
divide this sum by the number of units manufactured in the period covered by
those costs.1

How Does Production Costs Differ From Manufacturing Costs?

Production cost refers to all of the expenses associated with a company
conducting its business while manufacturing cost represents only the expenses
necessary to make the product. Whereas production costs include both direct
and indirect costs of operating a business, manufacturing costs reflect only direct
costs.