Edited by Paul Elegbeleye, Re-edited by Olorundare Oluwapelumi
Monetary value of resources including expenses incurred during the cost of production is referred to as st Concepts.
Definition of Cost of Production
Cost of production refer to the total expenses a firm or producer incurs in the process of producing goods or services. These expenses arise from the use of different factors of production such as labour, land, capital, and entrepreneurship.
In order to produce goods, firms must pay for items like raw materials, workers’ wages, rent for buildings, electricity, machinery maintenance, and transportation. All the payments made for these resources together make up the cost of production.
For example, a baker who produces bread must purchase flour, yeast, sugar, and other ingredients needed for baking. The baker must also pay workers who assist in the bakery, cover electricity used by ovens and mixers, and pay rent for the bakery shop.
When all these expenses are added together, they represent the total cost the baker incurs in producing bread. This total amount is known as the cost of production.
Basic Cost Concepts
Economists classify costs into different types to help firms understand production expenses.
a. Fixed Cost (FC): Fixed cost refers to expenses that remain constant regardless of the level of production in the short run. These costs do not change whether a firm produces many goods, few goods, or even nothing at all.
Fixed costs are usually associated with long term commitments or assets that the firm must pay for regularly. Examples include rent for a factory building, salaries of permanent staff, insurance payments, and interest on loans.
For instance, a furniture factory may pay ₦300,000 monthly for its building rent. This amount must be paid even if the factory produces only a few chairs or no chairs during that month. Because the cost does not vary with output, it is called a fixed cost.
b. Variable Cost (VC): Variable cost refers to expenses that change according to the level of production. As a firm increases production, variable costs increase because more inputs are required. When production decreases, variable costs also decrease.
These costs are directly related to the quantity of goods or services produced. Examples include raw materials, wages of casual labourers, electricity used in running machines, packaging materials, and transportation of goods.
For example, if a bakery produces more loaves of bread, it will need more flour, yeast, and sugar. As production rises, the cost of these materials increases, making them variable costs.
c. Total Cost (TC): Total cost refers to the overall cost incurred by a firm in producing a certain level of output. It is obtained by adding fixed cost and variable cost together.
(Total Cost = Fixed Cost + Variable Cost).
Total cost therefore represents the complete cost of production faced by a firm at a particular level of output.
For example, if a small soap manufacturing business spends ₦50,000 on factory rent and machinery maintenance as fixed costs and ₦120,000 on raw materials and wages as variable costs, the total cost of production will be ₦170,000.
Total cost helps producers determine the overall expense involved in producing goods and is useful when calculating profit or loss.
d. Average Cost (AC): Average cost refers to the cost of producing one unit of output. It is also called unit cost. Average cost is calculated by dividing total cost by the number of units produced
(Average Cost = Total Cost ÷ Quantity Produced).
This concept helps firms determine how much it costs, on average, to produce each item. For example, if a company spends ₦10,000 to produce 200 notebooks, the average cost per notebook will be ₦50. Knowing the average cost helps firms set appropriate prices for their products and assess whether production is efficient.
Production: Factors Determining Volume And Specialisation
e. Average Variable Cost (AVC): Average variable cost refers to the variable cost incurred in producing one unit of output. It is obtained by dividing total variable cost by the number of units produced.
(Average Variable Cost = Variable Cost ÷ Output).
This concept helps producers understand how much of the cost per unit is due to variable factors such as raw materials and labour.
For example, if a firm spends ₦5,000 on raw materials and labour to produce 100 units of a product, the average variable cost will be ₦50 per unit. Average variable cost is important in short run production decisions because it shows how efficiently variable inputs are being used.
f. Average Fixed Cost (AFC): Average fixed cost refers to the fixed cost allocated to each unit of output. It is calculated by dividing total fixed cost by the number of units produced.
(Average Fixed Cost = Fixed Cost ÷ Output).
Unlike many other costs, average fixed cost always decreases as production increases because the fixed cost is spread over more units of output.
For example, if a factory has a fixed cost of ₦10,000 and produces 100 units, the average fixed cost will be ₦100 per unit. If production increases to 200 units, the average fixed cost falls to ₦50 per unit. This decline occurs because the same fixed cost is shared among more units of production.
g. Marginal Cost (MC): Marginal cost refers to the additional cost incurred when one extra unit of a good is produced. It measures how much total cost increases when output increases by one unit.
Marginal cost is calculated by dividing the change in total cost by the change in output.
(Marginal Cost = Change in Total Cost ÷ Change in Output).
For example, if producing 20 bags of rice costs ₦40,000 and producing 21 bags costs ₦41,200, the marginal cost of the 21st bag is ₦1,200.
Marginal cost is very important in production decisions because it helps firms determine whether increasing production will increase or reduce profit. If the marginal cost of producing an additional unit is lower than the price of the product, the firm may decide to increase production.
Summary
- Cost of production refers to expenses incurred in producing goods and services.
- Costs include fixed, variable, total, average and marginal costs.
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