What are examples production costs?

By Indeed Editorial TeamUpdated March 23, 2021 | Published February 25, 2020Updated March 23, 2021Published February 25, 2020Cost of production is an important factor in every comp

What are examples production costs?

By Indeed Editorial Team

Updated March 23, 2021 | Published February 25, 2020

Updated March 23, 2021

Published February 25, 2020

Cost of production is an important factor in every company's manufacturing or production processes. Understanding how to calculate, report and control the cost of production is a crucial part of ensuring that a company's products are cost-effective and profitable. To understand the cost of production, you will need to know what it is and how it affects a company's success.

In this article, we will define cost of production, examine different types of production costs and discuss the factors that affect a company's cost of production.

Read more: The Value of Increasing Your Business Vocabulary

What is cost of production?

The term "cost of production" refers to all the costs that are involved when a company offers a service or manufactures a product. Production costs are comprised of various expenses, including the cost of materials, employee wages, factory maintenance, shipping costs and more. State and federal taxes that are related to a company's manufacturing processes or facilities can also be categorized as production costs.

Companies often calculate the cost of production in "cost per unit" which involves how much money it takes to create an individual item. To calculate the cost per unit, accountants take the cost of production and then divide it by the number of units manufactured. They can then consider the cost per unit and decide how to price the item for sale. Companies usually need to sell items for more than the cost of production to make a profit. If the cost of production is equal to or more than the sales price, the company runs the risk of operating at a loss.

The cost of production is an important factor for businesses to consider when assessing their financial health. If a product's cost of production is consistently higher than the profits it earns, the company may need to cease production to stay within budget. Similarly, if the expenses involved in providing a particular service become too great, the company would need to either discontinue the service or find a way to cut costs.

Related: Operation Management: Everything You Need To Know

Direct costs and indirect costs

The cost of production can be divided into two distinct categories, called direct costs and indirect costs:

Direct costs

Direct costs are expenses that be traced directly to specific products, services, customers or other production objects. A company's accounting team records direct costs at every stage of the production processes and then adds them together to find the total cost of production for each product. Direct costs are often variable, which means they may fluctuate depending on different factors. For example, the price of the oil that the manufacturing machines need to function might be higher or lower depending on the year. Similarly, a change in the state's minimum wage might cause an entry-level employee's hourly wage to increase. Direct costs include items like:

  • Raw materials
  • Manufacturing supplies
  • Labor wages
  • Commissions

Indirect costs

Indirect costs are expenses that are associated with the production process but that cannot be traced directly to a product. Some indirect costs are impossible to factor into a specific product's cost of production and must be considered a part of production overhead instead. Production overhead includes expenses that facilitate the production of a product or service without directly affecting the manufacturing process. Finding ways to identify, report and control indirect production overhead costs is one of the most efficient ways to lower a company's cost of production. Examples of production overhead costs include:

  • Office supplies
  • Building utilities
  • Supervisor or support staff salaries
  • Rent
  • Maintenance costs

Related: 16 Accounting Jobs That Pay Well

What factors affect cost of production?

Several specific factors can greatly affect the cost of production for a given product or service. Here are several to consider:

  • Demand
  • Technology
  • Exchange rate
  • Cost of materials
  • Tax rates
  • Interest rates

Demand

As a company's success grows, the demand for certain products will also increase. To fill customers' orders, a company may need to buy more raw supplies, hire new laborers, expand the production facility or even open a second location. Ideally, a company can use the profits gained from new customers to offset the increased cost of production.

Technology

As technology continues to advance, some jobs which were traditionally accomplished by human laborers can now be done by automated machines. Many companies are choosing to use manufacturing robots instead of employees, thus lowering the costs associated with labor wages. Additionally, updating factory equipment, installing new computer systems or educating employees on the use of new digital interfaces can speed up the manufacturing process and also lower the cost of production.

Exchange rate

If a company imports materials from overseas, exchange rates can greatly affect the cost of production. If the exchange rate rises, the materials the company needs to create its products become cheaper. However, a high exchange rate can also cause exporting companies to become less competitive and the costs may stay the same or even increase.

Cost of materials

The costs of the raw materials which are necessary for manufacturing can vary greatly depending on the year, the economy and availability limitations. For example, the price of steel might rise or fall depending on the financial stability of the steel mill or on the costs of international transportation. The prices of oil and gasoline affect almost every industry due to their association with shipping and product delivery.

Tax rates

Taxes are an indirect production cost that can contribute significantly to a company's annual overhead. Taxes may be higher or lower during a certain year depending on changes in the local or federal government. If a company hires several new employees, an increase in national insurance, a tax on workers, can contribute to higher production costs.

Interest rates

Another indirect cost for companies is their loans. If a company borrowed funds from a bank or other entity to pay expenses, the loan's interest rates can rise or fall. A rise in interest rate will increase the amount due for each regular loan repayment. When calculating the cost of production, companies must allow for fluctuation in the interest rates to create accurate financial reports.

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