What are the costs of production?

In economic theory, production costs are the costs incurred by an industrial organization when it engineers a project or provides a service that generates revenue and benefits. Labor costs, raw materials, consumable manufacturing costs, and general overhead sum up, accounting for production costs. Total cost data is calculated by combining total direct costs of materials, labor costs, and total production costs.

Engineering economic production costs

Engineering economics measures the revenues and total costs of engineering projects for a detailed estimate to see if they have enough profit and benefit to justify their investment in capital budgeting. Cost engineering economic analysis entails decision-making using engineering design and analysis techniques to create parametric goods and services that benefit customers at a reasonable price. The cost engineer who evaluates material selection and construction project costs should be familiar with various elements as prerequisites of engineering economics.

Types of costs

Direct costs

A direct cost is a cost incurred in the production of a certain good or service. Direct cost data can be linked to a cost object such as a service or department. Direct costs factor any expenditures incurred in the creation of a good, even if they are merely a part of the total cost given to the manufacturing subcontractor. Labor, raw materials, construction costs, and wages are all examples of direct costs.

Indirect costs

Indirect costs are those that cannot be directly linked to a finished product. Materials, salvage value, electricity, production managerial pay, and machine maintenance factors are some of these costs. Indirect manufacturing expenses are pooled into an overhead expenses band and assigned to the units produced in a financial quarter clipboard, resulting in some absorption of these expenses into the asset account.

Implicit costs

Any expense which has already been incurred but is not shown or documented as a standalone expense is considered an implicit cost. It's an opportunity cost that occurs when a corporation risks the alternative to gain money through the utilization of resources elsewhere in return for a financial transaction.

Explicit costs

Explicit costs have dollar values that are clearly stated and pass through to the financial statement information during a business cycle. Wages, rental bills, electricity, materials, and other direct costs are instances of explicit costs.

Life cycle cost

Research department, development research, planning, engineering, training, production, installation, management, service, and phase out are all part of a project's workflow. The term "life-cycle costs" refers to all cost calculations that occur throughout a product's life cycle.

Average cost curves

The price per unit produced is represented by the average total cost (ATC). The number of variable expenses that can be attributed to a single production unit is a small percentage of the total cost. The remaining component is the allocation of fixed expenses to each production unit.

The average cost (ATC), along with its components, average fixed cost (AFC), and average variable cost (AVC), is depicted in the diagram below. The graph depicts previous instances of variable cost inefficiency at extremely low and extremely large production volumes as short-run costs. Even while the average fixed cost continues to fall, there is a production level (marked Q3) where the average total cost is at its lowest. The capacity of an operation is defined by economists as the level of production function at which the average cost is the lowest.

We can think of capacity in the economic costs as the volume level at which we have the most efficient production in regards to average cost. Many businesses can operate at full capacity up to a certain effective physical limit, but they will pay a higher price for that extra production volume because they will need to recruit either more costly or less productive resources, causing production to slow down, or overusing resources, leading to higher servicing costs per unit.

Production costs during times of epidemic

The world has witnessed various pandemic outbreaks that spread to more than one continent. During the times of such pandemic outbreaks, the governments of each of the affected nations had to interfere to provide medical assistance to their citizens. Even the neighboring nations that were not affected during the outbreak have to provide aid to the affected nations. Existing medications were being repurposed to treat disease, which was critical to lowering mortality and managing the epidemic public policy. To assure equity and access, particularly among low and middle-income nations by the government, bulk accessibility at economical pricing was essential for monetary policy as well. The production costs for life-saving medicines are kept at an affordable rate so as to increase their accessibility to lower and middle-class households. Even the government provides aid to the manufacturing facilities to keep the production rate higher and costs lower. 

Context and Applications

This subject is particularly important to graduate students, university students, and job market candidates for studying the fundamentals of economics. It is studied by students undergoing courses such as Bachelor of Science in Industrial-Organizational Psychology​, Bachelor of Science in Electrical Engineering, and Master of Science in International Trade Relations.

Practice Problems

1. Which of the following statements define implicit costs?

1. The overall fixed costs are equal to the whole fixed costs.
2. American Economic Review
3. "Payments" for resources that are self-employed.
4. Short-run gains are always greater than long-term gains.

Answer: c

Explanation: Implicit costs are the opportunity costs forgone where the firm could have gained profits, to utilize self-employed resources.

2. Which of the following identifies as implicit cost for a firm?

1. Regarding the firm's employee earnings and salaries
2. The firm was reimbursed for the cost of leasing a building.
3. Paid for the firm's production supplies
4. Of wages foregone by the firm's owner

Answer: d

Explanation: Implicit costs are the opportunity costs forgone where the firm could have gained profits.

3. Which curve reaches its lowest in Q3?

1. Average fixed cost
2. Average total cost 
3. Average variable cost
4. All of the above

Answer: b

Explanation: In the diagram given in the article, in Q3, the average total cost (ATC) reaches its minimum. This is the point where the marginal cost (MC) curve intersects ATC.

4. Which of the following is not a fixed cost?

1. A cost of insurance of $50 per year, given last month
2. A lawyer's fee of $50,000 per year
3. A laborer's wages of $15 per hour 
4. A one-year lease of $1,000.

Answer: d

Explanation: Fixed costs do not increase or decrease with the consumption of every unit of product, service, or hour.

5. In the graph given above when is the average total cost the lowest?

1. Q1
2. Q3
3. Q2
4. Market failure

Answer: b

Explanation: The average total cost curve (ATC) hits its minimum in Q3 as shown in the graph. The ATC is also interested in the marginal cost curve (MC) from underneath at this point.

Related Concepts

• Game theory
• Adam Smith’s theory of labor value
• Keynesian economics
• Fundamentals of MACRS