Production costs refer to the total amount that a manufacturer spends on his product or service in the manufacturing process. If you are a business owner or manager you would have at some time found yourself in the position asking yourself: , “What will be the costs of production? ” must have hit you upon a business idea or after seeing a product.
From raw materials to labor, to allocation of resources, in short, everything that goes into a product until it’s all set for sale, accounts for the total production costs.
This might be something really simple to understand, but what if your production costs exceed your budget and your profit margin dips or even becomes negative? Controlling them will definitely have popped into your mind as a top priority, and that is what we’ll talk about besides production costs.
So, let’s get started!
Production Costs: Understanding the Concept
Here’s a more detailed description of the concept. Production costs are the costs or expenditures that a business puts in until the final product is all set for sale.
As discussed earlier, it involves the costs accounting for raw materials, labor, and every minor and major process behind bringing a product into its final shape and form.
Service providers also incur these costs in the labor responsible for the provision of the service. Taxes by the government or royalties owned by natural resources companies are also counted as product costs.
Calculating Production Costs:
Calculating the production cost involves a few steps and some important considerations.
- Determine total product costs by adding together the total direct material plus labor costs, and also the total manufacturing overhead costs, also called the variable and fixed costs.
- The product costs for a particular batch or a unit can be determined by dividing production costs by the number of units manufactured in a particular period.
Maintaining data like production cost per unit facilitates manufacturers in setting a price for the finished product.
Types of Production Costs:
The five production cost examples are listed below.
1. Fixed costs:
Also known as overhead or indirect costs, fixed costs don’t change and remain the same irrespective of the production volume in units or profit margin.
Instead of being dependent on production volumes, the fixed costs are recurring and unavoidable. Rent and salaries fall in this category.
2. Variable Cost:
These costs are directly proportional to production volumes! The greater the volume, the greater the variable costs. For example, if you produce a voluminous batch, your variable costs will increase proportionally, or decrease incase of a small-scale production.
Raw material, packaging, and shipping costs account for variable costs.
3. Total Cost:
Total Cost = Fixed Costs + Variable Costs
In simpler words, total cost refers to the sum of both fixed and variable costs. It’s the total cost of production and changes according to production volume.
4. Average Cost:
Another name for average cost is Unit Cost. It represents the cost a business has to bear when producing a single unit and helps the manufacturer determine the selling price. It’s the total cost of production divided by the total unit output.
Average Cost = Total Cost / Number of Units Produced
5. Marginal Cost:
Imagine one additional batch is produced that will incur manufacturing cost and that’s the marginal cost. This is an incremental increase in the total cost when an extra batch is produced.
This helps businesses evaluate their capacity and determine an appropriate production level as marginal cost of production usually increase as capacity utilization reaches 100% .
Benefits of Controlling Production Costs:
As discussed earlier, production costs must be controlled in order to avoid being less competitive or losses for the busines. This is one main benefit of practicing control. Let’s explore other benefits that make controlling production costs worth it.
More money ends up in the business’ pocket, leading to a profit surge if costs are kept in check
When production costs are controlled properly, businesses become stronger and can be in a position to offer attractive prices and become competitive in the marketplace.
Businesses with controlled production costs can stay more focused and offer strong competition in the market.
Controlled costs can help businesses identify areas best for investment, thus maximizing growth and efficiency.
Efficient cost control helps minimize unnecessary spending, saving money on materials and labor.
Best Practices for Controlling Production Costs:
The fFollowing are the few best practices that help manufacturers control production costs and become competitive:
Maintain a Record of Production Stats:
Documenting the production of units on a regular basis helps manufacturers understand and evaluate their expenditures. Keeping a track record of the variable costs and production costs will give them a clear idea of what and how much has gone into producing a product or a batch.
By doing so, manufacturers can also spot fluctuations in the production costs among various units, and analyze the effect on business and sales.
Minimize the Supplies and Material Cost:
Raw materials are often costly and secure a big share in the total cost of production, potentially increasing the overall price. The best practice to avoid it is to reduce the cost of supplies and raw materials.
It can be easily done by researching or reaching out to a supplier who agrees to a discount or better purchasing conditions offer. This can also be done through negotiations by agreeing upon a long-term partnership, cash payments, or bulk orders.
Getting quotes from various suppliers also gives manufacturers a good picture of reasonable raw materials prices in the market and their availability.
Streamline the Production Process:
Watching every step from the very start of the production helps you streamline the whole process, and ultimately control the costs. This may include;
- Monitoring and reviewing the steps and resources utilized during the whole process
- Discussions with the production team
- Finding opportunities and devising strategies to streamline the process
- Eliminating unnecessarily time-consuming steps
- Developing ways to update the workflow
- Conducting A/B testing if needed
- Measuring various metrics like production output
- Regularly reevaluating changes
Ditch Unnecessary Costs:
The D.S Smith Packaging Survey is a great tool to understand this practice. Conducted in August 2020, the study revealed 93%respondents, who revealed receiving unnecessary waste in the packaging. Also, 73 % of respondents talked about recipes twice the size or more than what was needed.
This pinpoints the “unnecessary costs” that can be easily controlled. Some businesses spend a great fortune on packaging, particularly fancy items to make them look more attractive. These practices result in heavier packages, and more shipping charges, surging the overall costs.
Employing Automation Tools and Software
Automation has been a lifesaving hack for businesses with repetitive tasks. It tends to increase efficiency while reducing the business’s reliance on labor, which ultimately cuts production costs.
Automation and software can provide efficiency gains and margins in areas like;
- Processing orders
- Tracking Shipments
- Resource management
- Payroll Scheduling
Inventory Management Tools, Supply Chain Management, and other such tools are a great help in this regard.
Conclusion
What are the costs of production? The expenses that a business has to endure in making a product until it’s ready for sale. Fixed, Variable, Average, Total, and Marginal, each represent the production cost example, we’ve already discussed above.
The best way to control production costs requires manufacturers to follow certain practices, exercise care and good management to see the difference.
Check out the best practices enlisted above and observe your competitive advantage build over time !
