What are Costs of Production? What is thEIr role?
Simply put, the costs of production is the money spent for a business/firm to produce their goods or services. Prodcution costs arre used to cage production levels, make pricining decisions, extrapolate profitability. There are two types of production costs:
- Explicit costs, also called out-of-pockets expenses, are tangible and include costs such as wages, insurance, rent, and utilities.
- Implicit costs or opportunity costs are a lot less tangible. They include lost potential returns, lost savings interest, and lost money from a job. For example, if Sue is an IT Manager, she gives up her $150,000 salary to start her business baking cakes. That $150,000 plus the potential bonuses or raises are called implicit cost because, Sue gave up that future earning potential to start her business.
Profit, what every business wants
Profit is the money a business has left over after subtracting total cost from total revenue. The profit calculation equation is below.
Profit = Total Revenue (TR) - Total Costs (TC)
There are two types of profit, accounting profit, and economic profit. Accounting profit looks only at explicit costs. It is the money that you are spending, the money out. Generally, accounting for profit is included on a business’s balance sheet and adheres to GAAP. Meanwhile, economic profit combines both your explicit and opportunity or implicit costs. Economic profit will always be lower than opportunity costs. When total revenue is enough to cover both implicit (oppotunity) and explicit (out-of-pocket) costs you have zero ecomic profits. Kepp in mind this does not mean a business will have no accoutning profits, it simply means a business was able to cover both types of costs.
Accoutning Profit = Total Revenue (TR) - Explicit (Out-of-Procket) Costs
Economic Profit = Total Revenue (TR) - Implicit (Opportunity) Costs
Fixed Costs, Variable Costs, Marginal Costs, Oh My!
- Fixed Costs – are expenses that do not change with the increase in production. Examples of these types of costs are rent, equipment depreciation, and business insurance. Fixed costs influence the price of a good or service
- Variable Costs – are expenses that change based on the level of production output. These costs include raw materials, direct labor (wages), and shipping. This type of cost also influences the price paid for a product or service.
- Marginal Costs – how much it costs to produce an additional unit of a product or service. This type of cost is key to determining production levels. A business has reached maximum production if it takes $5 to produce 5 units but $10 to produce 6 units. Any units beyond 5 will result in diminished revenue.
Formula for MaximiZIng Profit and Revenue
The profit maximization rule is a goal businesses strive to achieve by making as much total revenue as possible while keeping total costs low. Maximizing profit is done by cutting operational costs, optimizing production, adjusting price, factoring in opportunity costs, and looking for alternative investments. The table below shows how a business might calculate maximum profit. Row 3 of the chart indicates that maximum profit has been achieved. Any more units produced after three will incur a significant manufacturing cost, thus lowering total revenue.
- Quantity (Q) – Number of goods or services sold
- Total Revenue – is the price of the good or service multiplied by the quantity sold
- Total Costs – is fixed costs plus variable costs
- Profit- equals total revenue minus total costs.
- Marginal Cost is the change in total costs divided by the change in quantity. Change is denoted by ▲.
A | B | C | D | E | F | G | |
Quantity (Q) | Total Revenue (TR = P * Q) | Total Cost (TC=FC+VC) | Profit (TR-TC) | Marginal Revenue | Marginal Cost (MC=▲TC/▲Q) | Change in Profit (MR-MC) | |
0 | 0 | $0 | $2 | -$2 | $0 | $0 | $-2 |
1 | 1 | $5 | $4 | $3 | $5 | $4 | $1 |
2 | 2 | $10 | $6 | $4 | $5 | $3 | $2 |
3 | 3 | $15 | $8 | $7 | $5 | $4 | $1 |
4 | 4 | $20 | $14 | $6 | $5 | $3.5 | $1.5 |
5 | 5 | $25 | $20 | $5 | $5 | $4 | $1 |
6 | 6 | $30 | $26 | $4 | $5 | $4.33 | $.67 |
More Sources On Costs and Profits
- Explicit and Implicit Costs, and Accounting and Economic Profit via OpenStax
- Profit Definition Plus Gross, Operating, and Net Profit Explained via Investopedia