Chapter 4 - Cost and Production

Introduction

In accounting, cost is the expenditure required to create and sell products and services, or to acquire assets. They are
known as explicit costs. An explicit cost is a direct payment made to others in the course of running a business, such as
wages, rent and materials, as opposed to implicit costs, which are those where no actual payment is made. In economics,
cost include both explicit and implicit costs. Costs and production are terms that go together. Hence we have production
cost or cost of production. Cost of production refers to the total cost incurred by a business to produce a specific quantity of
a product or offer a service. Production costs may include things such as labor, raw materials, or consumable supplies. In
economics, the cost of production is defined as the expenditures incurred to obtain the factors of production such as labor,
land, and capital, that are needed in the production process of a product. For example, the production costs for a motor
vehicle tire may include expenses such as rubber, labor needed to produce the product, and various manufacturing
supplies. In the service industry, the costs of production may entail the material costs of delivering the service, as well as
the labor costs paid to employees tasked with providing the service.

Types of Costs of Production

There are various types of costs of production that businesses may incur in the course of manufacturing a product or
offering a service. They include the following:

1. Fixed costs - Fixed costs are expenses that do not change with the amount of output produced. This means that the
costs remain unchanged even when there is zero production or when the business has reached its maximum production
capacity. For example, a restaurant business must pay its monthly, quarterly, or yearly rent regardless of the number of
customers it serves. Other examples of fixed costs include salaries and equipment leases. Fixed costs tend to be time-
limited, and they are only fixed in relation to the production for a certain period. In the long term, the costs of producing a
product are variable and will change from one period to another.

2. Variable costs - Variable costs are costs that change with the changes in the level of production. That is, they rise as the
production volume increases and decrease as the production volume decreases. If the production volume is zero, then no
variable costs are incurred. Examples of variable costs include sales commissions, utility costs, raw materials, and direct
labor costs. For example, in a clothing manufacturing facility, the variable costs may include raw materials used in the
production process and direct labor costs. If the raw materials and direct labor costs incurred in the production of shirts are
$9 per unit and the company produces 1000 units, then the total variable costs are $9,000.

3. Total cost - Total cost encompasses both variable and fixed costs. It takes into account all the costs incurred in the
production process or when offering a service. For example, assume that a textile company incurs a production cost of $9
per shirt, and it produced 1,000 units during the last month. The company also pays a rent of $1,500 per month. The total
cost includes the variable cost of $9,000 ($9 x 1,000) and a fixed cost of $1,500 per month, bringing the total cost to
$10,500.

4. Average cost - The average cost refers to the total cost of production divided by the number of units produced. It can also
be obtained by summing the average variable costs and the average fixed costs. Management uses average costs to make
decisions about pricing its products for maximum revenue or profit. The goal of the company should be to minimize the
average cost per unit so that it can increase the profit margin without increasing costs.

5. Marginal cost - Marginal cost is the cost of producing one additional unit of output. It shows the increase in total cost
coming from the production of one more product unit. Since fixed costs remain constant regardless of any increase in
output, marginal cost is mainly affected by changes in variable costs. The management of a company relies on marginal
costing to make decisions on resource allocation, looking to allocate production resources in a way that is optimally
profitable. For example, if the company wants to increase production capacity, it will compare the marginal cost vis-à-vis the
marginal revenue that will be realized by producing one more unit of output. Marginal costs vary with the volume of output
being produced. They are affected by various factors, such as price discrimination, externalities, information asymmetry,
and transaction costs.

How to Calculate the Cost

The first step when calculating the cost involved in making a product is to determine the fixed costs. The next step is to
determine the variable costs incurred in the production process. Then, add the fixed costs and variable costs, and divide the
total cost by the number of items produced to get the average cost per unit. Average Cost Per Unit – Formula is:

For the company to make a profit, the selling price must be higher than the cost per unit. Setting a price that is below the
cost per unit will result in losses. It is, therefore, critically important that the company be able to accurately assess all of its
costs.

Average Cost Concept

Average cost is defined as the total costs (fixed costs + variable costs) divided by total output. It is a key performance
measure in producing a good or service and reflects the cost on a per unit basis. Fixed costs and variable costs make up
the two components of total cost. Hence, average cost is likewise composed of variable and fixed cost and varies with
production volume.

 Fixed Cost - In accounting and economics, fixed costs, also known as indirect costs or overhead costs, are
business expenses that are not dependent on the level of goods or services produced by the business. They tend
to be recurring, such as interest or rents being paid per month. Since fixed costs do not increase with quantity
produced, the portion of the average cost attributable to fixed cost is very high for small production volumes but
declines rapidly and then levels off as the volume increases.

 Variable Cost – These are costs that change as the quantity of the good or service that a business produces
changes. Variable costs are the sum of marginal costs over all units produced. They can also be considered normal
costs. The portion of average cost related to the variable cost usually changes less dramatically. In fact, the
average variable cost would remain the same per unit whether the operation sold a small volume or large volume.
However, in actual production environments, average variable cost may fluctuate with volume. The variable cost
can be inefficient at very low and very high production volumes. At very low production volumes, resources may not
be used efficiently, so the variable cost per unit is higher. For example, suppose the ice cream bars are purchased
wholesale from a vendor who delivers them in a truck with a freezer. Since the vendor’s charge for ice cream bars
must cover the cost of the truck driver and truck operation, a large delivery that fills the truck is likely to cost less per
ice cream bar than a very small delivery. At the same time, pushing production levels to the upper limits of an
operation’s capability can result in other inefficiencies and cause the average variable cost to increase. For
example, in order to increase production volume in a factory, it may be necessary to pay workers to work overtime
at a rate 1.5 times their normal pay rate. Another example is that machines may be overworked to drive higher
volume but result in either less efficiency or higher maintenance cost, which translates into an increase in average
variable cost.

 Capacity - Note that even with the continued decline in the average fixed cost, there is a production volume where
the average cost per unit is at its lowest value. Economists called this production volume the capacity of the
operation. In the economic sense of the word, we might think of capacity as the volume level where we have the
most efficient operation in terms of average cost. Where demand is great, firms may realize more profit by operating
 over capacity than at the capacity point where total average cost is at its lowest. However, no system can operate
at full capacity for a prolonged period. Conversely, if demand is weak the firm will probably do better by operating
below capacity. However, if a firm that is operating above or below capacity does not see this as a temporary
situation, the discrepancy suggests that the firm’s capacity is sized either too small or too large. The firm may be
able to improve profits in future production periods by resizing its operations, which will readjust the capacity point.
If the firm operates in a very competitive market, there may even be little potential for profit for firms that are not
operating near their capacity level.

Short & Long-Run Average Cost and Scale

In the previous chapter, we observed how customers demand could change in the short-run compared to the long-run. In
the short run, consumers were limited in their choices by their current circumstances of lifestyles, consumption technologies,
and understanding. A long-run time frame was of sufficient length that the consumer had the ability to alter his lifestyle and
technology and to improve his understanding, so as to result in improved utility of consumption.

We see a similar effect in the production decisions made by businesses in the short and long run. In the short run,
businesses are somewhat limited by their facilities, skill sets, and technology. In the long run, businesses have sufficient
time to expand, contract, or modify facilities. Businesses can add employees, reduce employees, or retrain or redeploy
employees. They can change technology and the equipment used to carry out their businesses. Determining a short run
period from a long run period for a particular business can be very tricky. the period varies by the kind of organization or
industry. The following indicators may help to distinguish short run from long run production decisions:

 The Short Run Period – In this period firms are only able to influence prices through adjustments made to
production levels. In the short run, there are fixed costs and variable costs. In a decidedly short-run time frame, the
firm’s capacity or point of lowest average cost is effectively fixed. The firm may elect to operate either under or
slightly over their capacity depending on the strength of market demand but cannot readily optimize production for
that selected output level. The classification of short-run planning is more an indication of some temporary
constraint on redefining the structure of a firm rather than a period of a specific length. In fact, there are varying
degrees of short run. In a very brief period, say the coming week or month, there may be very little that most
businesses can do. It will take at least that long to make changes in employees and they probably have contractual
obligations to satisfy. Six months may be long enough to change employment structures and what supplies a firm
uses, but the company is probably still limited to the facilities and technology they are using.

 The Long Run Period – Is a time in which all factors of production and costs are variable. In the long run, firms are
able to adjust all costs, in the long run, since the firm has the flexibility to change anything about its operations
(within the scope of what is technologically possible and they can afford), all costs in long-run production decisions
can be regarded as variable costs. In the long run, the firm is able to make decisions that alter its capacity point by
resizing operations to where the firm expects to have the best stream of profits over time. Average cost curves for
long-run planning are flatter than short-run average cost curves due to the ability of businesses to readjust all
factors of production. The production level at which the long-run average cost curve flattens out is called the
minimum efficient scale. It is also the point at which the firm can achieve necessary economies of scale for it to
compete effectively within the market

 Economies of Scale - In microeconomics, economies of scale are the cost advantages that enterprises obtain due
to their scale of operation, and are typically measured by their production output. The increase in capacity needed
to achieve minimum efficient scale varies by the type of business. A bicycle repair shop might achieve minimum
efficient scale with a staff of four or five employees and be able to operate at an average cost that is no different
than a shop of 40 to 50 repair persons. At the other extreme, electricity distribution services and telephone services
that have very large fixed asset costs and low variable costs may see the long-run average cost curve decline even
for large production levels and therefore would have a very high minimum efficient scale. Businesses that are able
to lower their average costs by increasing the scale of their operation are said to have economies of scale. Firms
 that increase their scale but see their average costs increase will experience diseconomies of scale. Businesses
that have achieved at least their minimum efficient scale and would see the long-run average cost remain about the
same with continued increases in scale may be described as having constant economies of scale.

 Return to Scale - Returns to scale refers to the rate by which output changes if all inputs are changed by the same
factor. For example, if a soap manufacturer doubles its total input but gets only a 40% increase in total output, then
it can be said to have experienced decreasing returns to scale. If the same manufacturer ends up doubling its total
output, then it has achieved constant returns to scale. When the output increases in a greater proportion than the
increase in input, there is an increasing return to scale. Returns to scale are related to the concept of economies of
scale, yet there is a subtle difference. The earlier example of gained productivity of labor specialization when the
labor force is increased would contribute to increasing returns to scale. Often when there are increasing returns to
scale there are economies of scale because the higher rate of growth in output translates to decrease in average
cost per unit. However, economies of scale may occur even if there were constant returns to scale, such as if there
were volume discounts for buying supplies in larger quantities. Economies of scale mean average cost decreases
as the scale increases, whereas increasing returns to scale are restricted to the physical ratio between the
increase in units of output relative to proportional increase in the number of inputs used.

Economies of Scope and Joint Products

Economies of scope describe situations where, producing two or more goods together results in a lower marginal cost than
producing them separately. Economies of scope differ from economies of scale, in that the former means producing a
variety of different products together to reduce costs while the latter means producing more of the same good in order to
reduce costs by increasing the level of production efficiency. Economies of scope can result from goods that are joint-
products or complements in production, goods that have complementary production processes, or goods that share inputs
to production. Joint products are two or more products that are generated within a single production process. They can't be
produced separately and will incur undifferentiated joint costs. In some cases, two or more products may be natural by-
products of a production process. For example, in refining crude oil to produce gasoline to fuel cars and trucks, the refining
process will create lubricants, fertilizers, petrochemicals, and other kinds of fuels. Since the refining process requires heat,
the excess heat can be used to create steam for electricity generation that more than meets the refinery’s needs and may
be sold to an electric utility. When multiple products occur as the result of a combined process, they are called joint products
and create a natural opportunity for an economy of scope. Of course, not just any aggregation of goods and services will
create economies of scope. For significant economies of scope, the goods and services need to be joint products that are
similar in nature or utilize similar raw materials, facilities, production processes, or knowledge. Joint products produce the
following cost advantages:

A) Shared fixed cost - For example, suppose we have a company that expands from selling one product to two similar
products. The administrative functions for procurement, receiving, accounts payable, inventory management,
shipping, and accounts receivable in place for the first product can usually support the second product with just a
modest increase in cost.

B) Reducing unit variable costs - If multiple goods and services require the same raw materials, the firm may be able
to acquire the raw materials at a smaller per unit cost by purchasing in larger volume. Similarly, labor that is directly
related to variable cost may not need to be increased proportionally for additional products due to the opportunity to
exploit specialization or better use of idle time.

As with economies of scale, the opportunities for economies of scope generally dissipate after exploiting the obvious
combinations of goods and services. At some point, the complexity of trying to administer a firm with too many goods and
services will offset any cost savings, particularly if the goods and services share little in terms of production resources or
processes. However, sometimes firms discover scope economies that are not so obvious and can realize increased
economic profits, at least for a time until the competition copies their discovery.
Approaches to Production Planning

Production planning and control ultimately aims to increase productivity through efficiency enhancement while also being
economical. Increased productivity is successfully achieved through optimizing the use of existing production resources and
labor resources while eliminating wastage of materials. Two approaches to production planning are discussed below.

A) The Cost Approach -The cost approach or conventional approach to production planning is to start with the goods
and services that a firm intends to provide and then decide what (level) production configuration will achieve the
intended output at the lowest cost. Once output goals are set, the expected revenue is essentially determined, so
any remaining opportunity for profit requires reducing the cost as much as possible. The cost approach is often
easier to conduct, particularly for a firm that is already in a particular line of business & can make incremental
improvements to reduce cost. Although this principle of cost minimization is simple, actually achieving true
minimization in practice is not feasible for most ventures of any complexity. Rather, minimization of costs is a target
that is not fully realized because the range of production options is wide and the actual resulting costs may differ
from what was expected in the planning phase.

The decision about whether to provide a good or service and how much to provide requires an assessment of
marginal cost. Due to scale effects, this marginal cost may vary with the output level, so firms may face a circular
problem of needing to know the marginal cost to decide on the outputs, but the marginal cost may change
depending on the output level selected. This dilemma may be addressed by iteration (repetitions) between output
planning and production/procurement planning until there is consistency. Another option is to use sophisticated
computer models that determine the optimal output levels and minimum cost production configurations
simultaneously. Among the range of procurement and production activities that a business conducts to create its
goods and services, the firm may be more proficient or expert in some of the activities, at least relative to its
competition.

B) The Resource Approach - The resource approach encourages more out-of-the-box thinking that may lead a
business toward a major restructuring. For example, a firm may be world class in factory production but only about
average in the cost effectiveness of its marketing activities. In situations where a firm excels in some components of
its operations, there may be an opportunity for improved profitability by recognizing these key areas, sometimes
called core competencies in the business strategy literature, and then determining what kinds of goods or services
would best exploit these capabilities. This is the resource approach to the planning of production. Wernerfelt (1984)
wrote one of the key initial papers on the resource-based view of management.

Conceptually, either planning approach will lead to similar decisions about what goods and services to provide and
how to arrange production to do that. However, given the wide ranges of possible outputs and organizations of
production to provide them, firms are not likely to attain truly optimal organization, particularly after the fact.
However, in solving the problem of how to create the goods and services at minimal cost, there is some risk of
myopic focus that dismisses opportunities to make the best use of core competencies.

Marginal Revenue Product & Derived Demand

In economics, the profit maximization rule is represented as MC = MR, where MC stands for marginal costs, and MR stands
for marginal revenue. Companies are best able to maximize their profits when marginal costs (the change in costs caused
by making a new item) are equal to marginal revenues. This means that the optimal output level for goods and services
occur when marginal revenue equals marginal cost. This principle can be applied in determining the optimal level of any
production resource input using the concepts of marginal product and marginal revenue product.

 Marginal Product - is the amount of additional output that would be created if one more unit of the input were
processed. For example, if an accounting firm sells accountant time as a service and each hired accountant is
 typically billed to clients 1500 hours per year, this quantity would be the marginal product of hiring an additional
accountant.
 Marginal Revenue Product (MRP) - is the added revenue created from the marginal product or additional output.
The marginal revenue product would be the result of multiplying the marginal product times the marginal revenue of
the output. For the example in the previous paragraph, assuming that the marginal revenue from an additional billed
hour of accountant service is $100. The marginal revenue product of an additional accountant would be 1500 times
$100, or $150,000.

To determine if a firm is using the optimal level, the marginal revenue product can be compared to the marginal cost. If the
marginal revenue product exceeds marginal cost, profitability can be improved by increasing input & output. On the other
hand, If marginal cost exceeds marginal revenue product, profitability can be improved by decreasing input & output. When
the marginal revenue product and marginal cost are equal, the optimal level is considered attained. Marginal revenue
usually decreases as output levels increase. In the same way, the marginal revenue product also decreases as output
levels increase. This phenomenon is called the law of diminishing marginal returns. Hence, for the accounting firm, suppose
the marginal cost to hire an additional accountant is $120,000. The firm would improve its profit by $30,000 by hiring one
more accountant. However, although they may realize an additional $30,000 in profit by hiring one more accountant, it does
not automatically follow that they would realize $3,000,000 more in profits by hiring 100 more accountants. This is explained
by the law of diminishing marginal returns.

In economics, derived demand occurs when there is a demand for a good or factor of production resulting from demand for
an intermediate good or service. Example – mobile phones and lithium batteries. The rise in demand for mobile phones and
other mobile devices has led to a strong derived demand for lithium batteries.

Marginal Revenue vs. Marginal Cost for a Derived Demand

One difficulty in comparing marginal revenue product to the marginal cost of an input is that the mere increase in any single
input is usually not enough in itself to create more units of output. For example, simply acquiring more bicycle frames will
not result in the ability to make more bicycles, unless the manufacturer acquires more wheels, tires, brakes, seats, and such
to turn those frames into bicycles. In cases like this, sometimes the principle needs to be applied to a fixed mix of inputs
rather than a single input.

For the accounting firm in the earlier example, the cost to acquire an additional accountant is not merely the salary he is
paid. The firm will pay for benefits like retirement contribution and health care for the new employee. Further, additional
inputs in the form of an office, computer, secretarial support, and such will be incurred. So, the fact that the marginal
revenue product of an accountant is $150,000 does not mean that the firm would benefit if the accountant were hired at any
salary less than $150,000. We need to consider all the additional inputs of benefits, office expense, secretarial support, and
not just the salary.

Marginal Cost of Inputs and Economic Rent

In cases where inputs are in high supply at the current market price and the market for inputs is competitive, the marginal
cost of an input is roughly equal to the actual cost of acquiring it. So, in such a situation, the principle described earlier can
be expressed in terms of comparing the marginal revenue product to price to acquire the input(s). If the number of
accountants seeking a job were fairly substantial and competitive, the actual per unit costs involved in hiring one more
accountant would be the marginal cost.

If the market of inputs is less competitive, a firm may have to pay a little higher than the prevailing market price to acquire
more units because they will need to be hired away from another firm. In this situation, the marginal cost of inputs may be
higher than the price to acquire an additional unit because the resulting price increase for the additional unit may carry over
to a price increase of all units being purchased.
Suppose the salary required to hire a new accountant will be higher than what the firm is currently paying accountants with
the same ability. Once the firm pays a higher salary to get a new accountant, they may need to raise the salaries of the
other similar accountants they already hired just to retain them. In this instance, the marginal cost of hiring one more
accountant could be substantially more than the cost directly associated with adding the new accountant. As a result of the
impact on other salaries and associated costs of the hire, the firm may decide that the highest salary for a new accountant
that the firm can justify may be on the order of $50,000, even though the resulting marginal revenue product is substantially
greater.

If inputs are available in a ready supply, or there are close substitutes available that are in ready supply, the price of an
additional unit of input typically reflects either the opportunity cost related to the value of the next best use of that input or
the minimum amount needed to induce a new unit to become available. However, there are some production inputs that
may be in such limited supply that even further price increases will not attract new units to become available, at least not
quickly. In these cases, the marginal revenue product for an input may still considerably exceed its marginal cost, even after
all available inputs are in use. The sellers of these goods and services may be aware of this imbalance and insist on a price
increase for the input up to a level that brings marginal cost in balance with marginal revenue product.

Economic Rent - The difference between the amount the seller of the limited input supply is able to charge (actual price)
and the minimum amount that would have been necessary for him to sell (selling price) the unit to the firm is called
economic rent. Example: Suppose a contracting firm was hired to do emergency repairs to a major bridge. Due to the time
deadline, the firm will need to hire additional construction workers who are already in the area. Normally, these workers may
have been willing to work for $70 per hour. However, sensing the contracting firm is being paid a premium for the repairs,
meaning the marginal revenue product of labor is high, and there are a limited number of qualified workers available, the
workers can insist on being paid as much as $200 per hour for the work. The difference of $130 would be economic rent
caused by the shortage of qualified workers available on short notice.

Economic rent can occur in agriculture when highly productive land is in limited supply or in some labor markets like
professional sports or commercial entertainment where there is a limited supply of people who have the skills or name
recognition needed to make the activity successful.

Productivity and the Learning Curve

Resource Approach - The resource approach to production management is to make sure that all resources employed in the
creation of goods and services are used as effectively as possible. Smart businesses assess the productivity of key
production resources as a means of tracking improvements and in comparing their operations to those of other firms. In
retail stores, a key resource is the amount of floor space. The productivity of a store could be measured by the total revenue
over a period divided by the available square footage. This measure could be compared to the same measure for other
stores in the retail chain or with similar competitor stores. Even sections within the store can be compared for which types of
goods and services sold are most effective in generating sales, although given that costs vary too, a better productivity
measure here may be profit contribution (revenue minus variable cost) per square foot.

Marginal Product - Earlier in this chapter we introduced the concept of marginal product. This measure reflects how
productive an additional unit of input would be in creating additional output. However, even for some inputs, there are
differences in marginal productivity. For example, in agriculture an acre of land in one location may be capable of better
yields than an acre in another location. Therefore, firms will seek to employ first those units with the highest marginal
product before other inputs that produce less output.

Ratio of Average Productivity - In looking at the collective performance of a production operation, we need a measure of
productivity that applies to all inputs being used rather than the last unit acquired. One means of doing this is using the ratio
of average productivity, which is a ratio of the total number of units of output divided by the total units of an input. An
alternative measure of average productivity would be the total dollars in revenue or profit divided by the total units of an
input. Computations of average productivity make sense for key inputs around which production processes are designed. In
the example of the accounting firm used in this chapter, the number of accountants is probably a good choice. Average
productivity could be in the form of labor hours billed divided by accountants hired. If a firm managed to sell 1600 billable
hours in 1 year, but only 1500 billable hours in another year, the earlier year indicated higher productivity.

Learning Curve - Improvements due to productivity gains will usually result in decreased average costs. The relationship
between cumulative production experience and average cost is called the learning curve. Even if the firm continues to
produce at the same rate each period, it will see declines in the average cost per unit of output, especially in the initial
stages of operation. One numerical measure of the impact of learning on average cost is called the doubling rate of
reduction. The doubling rate is the rate of reduction in average cost that occurs each time cumulative production doubles. If
the average cost declines by 15% each time cumulative production doubles, that would be its doubling rate.

The productivity of firms may change over time. In the case of labor, the productivity of individual workers will rise as they
gain experience and new workers can be trained more effectively. There is also an improvement in overall productivity from
the increased knowledge of management in how to employ productive resources better. These productivity gains from
experience and improved knowledge are sometimes called learning by doing The economics of learning by doing was
introduced by Arrow (1962).

In addition to the increased profit potential of improved productivity, new firms or firms starting new operations need to
anticipate these gains in deciding whether to engage in a new venture. Often a venture will not look attractive if the
assumed costs of production are based on the costs that apply in the initial periods of production. Learning improvements
need to be considered as well. In some sense, decreased profits and even losses in the initial production periods are
necessary investments for a successful long-term operation.

Effect of Cumulative Production on Average Cost

Note that the number of units required to double cumulative production will get progressively higher. For example, if
cumulative production now is 1000 units, the next doubling will occur at 2000 cumulative units, with the next doubling at
4000 cumulative units, and the following at 8000 cumulative units. Thus, the doubling rate or rate of decline in average cost
for each successive unit of production will diminish as cumulative production increases.