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Running a business

What are production costs and the best practices for controlling them?

Production costs are the total amount a business spends to produce a specific product or service. It accounts for raw materials, labour, and nearly everything else needed to get a product ready for sale.

The cost of production is one of the essential concepts in managerial accounting, and an important consideration to evaluate current operations and find opportunities for greater efficiency and profitability.

What are production costs?

Production costs are the total expenses incurred by a business in producing a product or service. Production cost factors typically include labour, raw materials, equipment, rent, and other supplies or overhead.

Although production costs are generally associated with businesses like manufacturers with high inventory levels, they affect all types of businesses. Distributors, retailers, and service-based businesses also need to track the cost of offering goods to customers.

Production costs are directly connected to generating revenue and are often the largest expense of a business.

For an expense to be listed as a production cost, it has to be incurred while producing the product or service for sale. A manufacturer, for example, may include raw materials, machinery, labour, and rent in its production costs. On the other hand, a software company may list software licenses, third-party applications, web or application hosting, and labour.

These expenses naturally impact a business’ pricing structure, cash flow, and resulting profit or loss. All else remaining the same, an increase in production cost means a decrease in the amount of cash you have on hand.

Decreased production costs, however, don’t automatically lead to more profit in the long run. Cutting on expenses like labour or raw materials may also result in lower-quality products and services.

The ability to balance production costs with the projected revenue generated by those products and services is a key to success for any business.

Five types of production costs

While the exact expenses depend on the business and industry, there are five main types of production costs:

1. Fixed costs

Fixed costs (also referred to as overhead or indirect costs) remain the same, regardless of how many products or services a business produces.

They are not dependent on production volume but are usually recurring and time-based. Examples of fixed costs are monthly salaries or rent.

2. Variable costs

Variable costs are expenses that change in direct proportion to any changes in production. They increase when production volume rises and decrease when production volume falls. Examples of variable costs are raw materials, packaging, or shipping costs.

3. Total cost

Total cost is the sum of both fixed and variable costs accrued during production. In other words, it’s the total cost of production and changes according to production volume.

4. Average cost

Average cost is the total cost of production divided by the total unit of output.

The average cost (or unit cost) is how much it costs a business to produce a single unit and helps determine its selling price.

5. Marginal cost

Marginal cost is the incremental increase in total cost when one additional unit is produced.

As fixed costs aren’t changed by production volume, marginal costs mostly have to do with variable costs.

Calculating marginal costs helps a business determine its optimal level of production. When the marginal cost to produce one additional unit is lower than the average cost-per-unit, the business has reached economies of scale and an increased potential to maximise profit margins.

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How are production costs calculated?

Production costs are calculated by adding together all the fixed costs and variable costs incurred while producing a product or service.

The formula for calculating total production costs is:

Fixed costs + Variable costs = Production cost

Take, for example, a furniture manufacturer that makes patio sets. Its fixed costs include warehouse rent, equipment and asset depreciation, labour, utilities, and insurance, amounting to $75,000 a month. Its variable costs for production that same month include raw materials, packaging, freight, and credit card processing fees, totalling $100,000.

Its total production cost for the month is $75,000 + $100,000 = $175,000.

The formula to calculate the average cost per unit is:

(Fixed costs + Variable costs) / Total number of units produced = Production cost per unit

If our furniture manufacturer made 350 patio sets that month, its production cost per unit is $175,000 / 350 = $500.

Note: You can also calculate for average fixed costs or average variable fixed costs separately using the formulas below:

Fixed costs / Total number of units produced = Average fixed cost

Variable costs / Total number of units produced = Average variable cost

The formula for marginal cost is:

Change in total cost / Change in quantity = Marginal cost

In the months before summer, the manufacturer sees a growth in demand for patio sets and increases production to 500 units a month. It hires two new employees and purchases more raw materials.

Its marginal cost per additional unit is ($200,000 – 175,000) / (500 – 300) = $125.

Production costs vs. manufacturing costs

It’s easy to confuse production costs with manufacturing costs; both have to do with producing a product for sale.

The two calculations give businesses a clear picture of all their costs and help set the optimal price to ensure long-term profitability. But while production costs cover all the expenses of operating a business during production, manufacturing costs factor in only costs related to the product.

Manufacturing costs don’t account for the standard fixed costs described in the previous sections. Instead, they look at the following three types of expenses:

Direct material costs: The expense for all the raw materials and other inventory types that directly go into the final product. Examples of direct material costs are fabric for apparel or aluminium and rubber for bicycles.

Direct labour costs: The salaries paid to anyone directly involved in making the product or service for sale. It’s important to note that direct labourers are only those who actively work on the product, such as the engineer who designs a car, or a bottler of packaged beverages. Department managers or employees dedicated to repairing products are not included in direct labour costs.

Manufacturing overhead costs: All other indirect costs incurred during production are considered as part of overhead. In comparison, direct material and direct labour costs are tied to specific product units, while overhead accounts for the manufacturing process as a whole.

Examples of manufacturing overhead costs are warehouse rent, utilities, equipment depreciation, and maintenance and repairs. It also includes the salaries of management or maintenance staff, but not salaries for any administrative, sales, or other business functions.

Note: Direct and variable costs sound similar, as they’re expenses accrued during production. However, direct costs can also include fixed costs, such as labour and rent, while variable costs can also include indirect costs, like credit card fees and shipping.

Best practices to control production costs

An ongoing goal of every business is to reduce production costs without sacrificing the quality of their product or service.

There are several ways to do this, most of which require looking at previous numbers and assessing each step of the production process.

1. Keep track of production numbers

Applying the production cost formulas in the sections above will give a clear breakdown of what’s being spent to get your product or service ready for customers.

It’s best to calculate production costs at regular intervals (i.e., per quarter, per month, per season) so you can detect any changes in total expense and analyse its effect on business sales and profit.

2. Reduce cost of materials and supplies

Raw materials and parts make up a significant percentage of production costs. And more often than not, suppliers are willing to negotiate favourable terms to retain a good client.

Ask about any available discounts in exchange for longer contracts, larger orders, or cash payments. It’s also good to get quotes from other suppliers or consider testing alternative materials that don’t compromise on quality.

3. Streamline the production process

Review the steps and resources used to manufacture your product, talk to your production team, and look for opportunities to streamline the process. Check for tasks that seem overly time-consuming or unnecessary, and develop ways to improve or update workflows.

If needed, conduct A/B tests, measure improvement metrics such as production output or saved resources, and reassess any changes regularly.

4. Eliminate any unnecessary costs

Are there any expenses you can cut that wouldn’t make a big difference to the final product or service? For instance, many businesses spend heavily on packaging, which leads to heavier packages, higher shipping rates, and waste.

In a D.S. Smith packaging survey in August 2020, “93% of respondents reported receiving a box with wasted space [and] 73% of respondents indicated receipt of a box that was twice the size or more than needed.”

Other areas that can offer potential savings include consolidating deliveries, optimising the quantity of on-hand inventory, and scheduling routine equipment maintenance to prevent malfunctions and downtime.

5. Leverage automation and software tools 

When it comes to repetitive tasks common to most business production, automation goes a long way in reducing labour and increasing efficiency.

Common areas of automation within production include processing orders, tracking shipments, managing resources, scheduling payroll, and the like. Business management software like QuickBooks Enterprise can also organise all production data on one platform and simplify data tracking throughout the business.

Final thoughts

Production costs are at the core of every business, impacting its selection of suppliers and the type of products and prices it offers to customers.

Calculating production costs also informs strategic decision-making, revealing potential areas of improvement, whether a production change can achieve economies of scale and the best way to maximise profit.

While every care has been taken to ensure the accuracy of the information presented as at 01 May 2023, Intuit is not providing you with professional advice and we recommend you obtain your own professional advice. Intuit is not liable for your use of the information presented.

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