Cost of Production Theory - Paper Example

Introduction

The Cost-of-production theory is a theory of value that states that the value of a condition or an object is determined by the amount of the cost of the funds which were used in manufacturing it. The cost may include any of the elements of production such as capital, labor, or land as well as taxation (Dorfman, 2016). The theory of illustrates how output fluctuates with variations in inputs.

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Production Costs

The production costs fall under the Cost-of-production theory. These are the costs which are incurred by an organization when providing services to its customers or when it is manufacturing goods is known as the production cost. Production costs comprise various expenses which are linked to the way a firm's functions as well as what the company does to deliver the merchandise into the client's hands. Producers usually are concerned with manufacturing costs since they handle factors like utilities, labor, raw materials, equipment, general overhead, and consumable manufacturing materials (Gueye, 2018). Also, taxes charged by royalties allocated by natural resource extracting corporations or the government are also counted as production costs. Nonetheless, organizations have discovered that it is better to separate these manufacturing costs into various groups to analyze them closer. These categories are; implicit and explicit costs or variable and fixed costs.

Implicit Costs

The cost which has already been incurred but has not been reported or shown as a separate expense is known as the implicit cost. This cost signifies the opportunity cost which occurs once an organization distributes the internal resources towards a task without any compensation for the use of the resources (Sexton, 2015). It implies that whenever a business allots its funds, it regularly forgoes the capacity to make money from the utilization of the resources somewhere else.

Implicit costs may also be identified as implied, imputed, or notional values. Companies do not essentially document implicit costs for bookkeeping purposes since cash does not change hands. The costs symbolize the loss of possible revenue and not profits. A business might choose to incorporate these expenses as the cost of transacting business because they signify potential sources of revenue.

The loss of interest profits on resources as well as the depreciation of equipment for a capital project are examples of implicit costs. Also, they may be intangible costs which are not accounted for, for instance in circumstances where the owner distributes time toward the upkeep of a business, instead of allotting those hours somewhere else (Sexton, 2015). Occasionally, implicit costs are not documented for bookkeeping purposes.

Explicit Cost

The explicit cost involves monetary transactions and tangible assets and ensues in real business opportunities. It is also defined as the cost which occurs, can be easily recognized, and can also be accounted for in financial statements or business documents. The exact value signifies apparent, clear cash outflows which decrease the organization's bottom-line productivity. Items for instance rent, wage expenses, or lease costs are some examples of explicit costs (Sexton, 2015). It usually is quite easy to detect the causes of those cash outflows as well as the business' undertakings to which the expenditures are attributed.

The net income of an organization reveals the residual income which remains once every exact cost has been paid. The only costs which are majorly significant in calculating the business' accounting profits are the explicit costs. Furthermore, expenditures which are related to supplies, inventory, advertising, purchased equipment, and utilities are also examples of explicit costs. The expense incurred when an asset depreciates also considered an explicit cost since it is associated with the cost of the primary asset which the organization owns, even though the devaluation of an asset is not an action which can be traced tangibly.

Explicit costs are also utilized in the calculation of opportunity costs, which is the cost of the top alternative that has not been accepted (Sexton, 2015). Additionally, they are used in the computation of economic profit, which is the total return a corporation collects according to every cost incurred to achieve that income.

Variable Costs

Variable costs are business expenses which change in quantity with the output of production. These costs decrease or increase based on a corporation's volume of production (Previte and Hoffman, 2014). The variable cost of production is a constant amount per unit produced. When the size of output and production increases, the variable costs will also rise. Equally, when fewer products are manufactured, the variable costs related to the production will accordingly decrease. Some variable costs consist of the utility costs, sales commissions, cost of raw materials used in production, and direct labor costs.

Fixed Costs

Fixed costs are costs or expenses which do not change when the number of services or goods manufactured or sold decreases or increases (Previte and Hoffman, 2014). A fixed cost is an expense which has to be paid by an organization, despite any commercial activity. Together with the variable cost, the fixed cost is the total cost of managing a business and also play a significant role in verifying its profitability. Furthermore, fixed costs are generally utilized in break-even analysis to determine the level of production and sales as well as pricing under which an enterprise makes neither loss nor profit.

Fixed costs include interest expense, insurance, utility expenses, property taxes, and depreciation of assets. Moreover, when a business pays salaries annually to its workers irrespective of the number of worked hours, the wages are regarded as fixed costs. A business's lease on a building is also a fixed cost which can absorb substantial funds.

Factors Affecting Production Costs

Cost is a critical factor when deciding on the right manufacturer of the product, and the location where it should it produce, therefore businesses must adequately evaluate the elements which drive the production costs of their ventures. Some of these factors include:

Raw Materials

The material an entrepreneur chooses impacts the value of his or her enterprise. Cheap raw materials mean cheaper merchandise however it could lack quality or durability. On the other hand, expensive materials instantly increase the production costs yet give a product which is of high quality and lasts longer.

Quality

When it comes to production, an entrepreneur pays for quality. When an organization works with a reliable producer, it generally means that she or he invests in quality control. As much as this increases the final price of the manufactured product, it assists in ensuring that the product is produced using the appropriate material and sticks to the firm's requirements (Industrial Systems Research, 2013). Investing in the product's quality saves the organization some money in the end as it will only experience fewer problems and evade non-conformity.

Location

The location of a business' manufacturing associate may affect the cost of the firm's venture for several reasons. According to the 2016 Deloitte Global Manufacturing Competitiveness Index, China is considered the perfect location for manufacturing products and parts to fully developed producing infrastructure and economical pricing (Xing, 2018). It is worth noticing that an entrepreneur discovers quite a variety of pricing choices when producing commodities in China based on other considerations like the material used and the quality.

Lead Time

When an entrepreneur wants something immediately, it can affect the cost depending on the venture. Producing a commodity faster is more costly compared to a longer lead-time. It is all about the management of resource for the producer. A faster turnaround involves committing more resources, equally regarding machinery and workforce, which may undoubtedly be a bit expensive compared to lengthier turnaround time. Nonetheless, there are always restrictions on how fast the products can be manufactured. Though distributing more resources can accelerate the process of manufacturing it should not compromise the quality of the final product.

Equipment and Facilities

Innovating intricate designs needs a combination of hardware, skills, and knowledge. Nevertheless, the intricacy of the model can also influence the firm's production costs. When the designs are advanced, the firm will probably need more sophisticated equipment that comes at a greater price. Producers who work with advanced machinery is more likely to satisfy all the manufacturing requirements of a business, but their financing in high-end equipment may also have affected the firm's final price as a client (Industrial Systems Research, 2013). State-of-the-art equipment certainly offers a variety of opportunities which can lead to more improved manufacturing experience.

The Proximity of the Market

Most importantly, the successful production of a commodity is not satisfactory. It is similarly essential that the product should have a ready market. Furthermore, the merchandise must also be sold at an appropriate price to make a reasonable profit. Thus, this is only possible if the identified market is near. The proximity of the market guarantees that the transportation cost is reduced and ensures a minimum wastage.

Conclusion

In conclusion, manufacturing costs tend to behave differently; therefore it is quite significant for companies to gain a better understanding of the connection between costs and factors which influence them. This will give a company the capacity to provide substantial future costs which are essential for making decisions. Furthermore, before establishing a new business, entrepreneurs have to know that every choice has a close bearing on the production cost of the commodities in the long run. Thus, they must analyze the various factors or forces that may influence the cost behavior.

References

Dorfman. R. (2016). Theory of Production. Encyclopaedia Britannica. Encyclopaedia Britannica, Inc. Accessed on November 26, 2018. https://www.britannica.com/topic/theory-of-production.

Gueye, G. (2018). COSTS OF PRODUCTION [Ebook]. AUBURN UNIVERSITY. Retrieved from https://gueyenono.github.io/files/econ2020/5.pdf

Industrial Systems Research. (2013). Manufacturing in Britain: A Survey of Factors Affecting Growth and Performance. Industrial Systems Research.

Previte. J & Hoffman. R. (2014). Essential Financial Mathematics. Lulu.com.

Sexton. L.R. (2015). Exploring Economics. Seventh Edition. Cengage Learning.

Xing. L. (2018). Mapping China's 'One Belt One Road' Initiative. Springer.