The Costs of Production

Key words: direct costs, depreciation, indirect costs, overheads, fixed costs, variable costs, cost unit, marginal cost, under-recovery, average cost.

Identifying business costs

In most cases, running a business is all about making decisions on how best to use scarce resources in order to make a profit, where:

Profit = Sales Revenues – Costs

Every business decision, whether to launch a new product, change advertising methods, or to expand production, has cost implications. Because the primary purpose of most private-sector firms is to make a profit, it is essential that businesses are able to keep a tight control on their costs. Cost control is equally important to public-sector organisations and charities who do not seek to make a profit, but will nonetheless want to minimise the cost of their operations.

In order to control costs, it is first necessary to be able to identify business costs, calculate how much these costs are, and then to set targets for future cost levels.

Classifying costs

There are two main ways in which costs can be classified and calculated in order to assist managers in planning and controlling the operation of their business:

Direct and indirect costs are definitions used for accounting purposes to calculate the level of profit before tax for a particular good or service

Fixed and variable costs are classified according to how they vary as the level of output of a good or service is varied.

Direct costs

Costs which can be directly identified with a particular product or activity are known as direct costs or prime costs. These will include:

· Direct materials: the raw, or semi-finished materials used to make a product

· Direct labour: the wages of employees directly involved in making or assembling a product

· Direct design costs: costs incurred at the product planning stage

· Other direct costs: including the costs of power used in production, hire charges for machinery specifically employed in the production process, and the costs of any work subcontracted to other businesses

· Depreciation: an allowance made to cover a fall in the value of fixed assets, such as machinery, vehicles, computers, etc., due to wear and tear.

Each year a business must work out how much depreciation to allow for each fixed asset. That is, it must put aside a certain amount of money each year so that, when the asset wears out, it will have saved up enough to buy a replacement.

There are two main methods used by businesses to work out depreciation. These are:

The straight line method: this divides the cost of the asset by the number of years it is expected to remain in service. For example, if a machine costs 1,000 pounds and is expected to last 5 years, then the value of that machine will depreciate by 200 pounds each year.

The reducing balance method: this assumes that the depreciation charge in the earlier stage of the expected life of an asset will be greater than in later years. The value of the asset is therefore depreciated by a constant percentage each year. For example, if the value of the 1,000-pound machine is depreciated over 5 years at 25% each year, then the depreciation charge in the first year will be 250 pounds, in the second year 187.50 (i.e. 25% of 750), in the third 140.60 – and so on, until all that remains after 5 years is the expected scrap value of the asset.

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