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The Cost of Production

2 Broad Agents of Market
  • Consumer : Who demands via consumption. Objective of a consumer is to maximize his/her utility.
  • Producer : Who supplies via production. Objective of a producer is to maximize his/her profits.

The important factor that affect 'Supply' is 'Cost of Production

Based on the cost of production, several supply decisions can be arrived at like what goods to produce , how much goods to produce , to which segment to pitch the product to, etc.

Types of Costs

Historical Cost and Replacement Cost

  • Historical Cost : It is the actual cost when purchasing an asset.

    Example

    • Cost of Machinery while setting up a plant.
    • Purchasing land for setting up a factory.

  • Replacement Cost : The price that is needed to replace a certain asset based on the current market price, let's say Rs. 1 Cr

    Example

    The cost of machinery today replacing the outdated one(which was purchased and put at time of setting up of the plant) at current market price let's say 2 Cr

    What is a Depreciation Reserve?

    A firm bought machinery for a cost of 5 Cr, after 15 years the exact machinery needs to be replaced by a new one. But the cost of the same machinery today 15 years later is 15 Cr. To compensate this a firm starts a depreciation reserve, which accommodates a certain specific amount into this reserve, let's say 1 Cr per year and after 15 years, new machinery is bought from this reserve without any additional burden on the firm

Fixed Cost and Variable Cost

  • Fixed Cost : All costs incurred that are unaffected by the company's production output or sales.

    Example

    • Interest to be paid to bank is independent of firm's sales being up or down
    • Rent to be paid is independent on firm's sales

  • Variable Cost: All the costs that are associated with the firm that increase or decrease with respect to the production volume/output. Those costs which increase with increase in production volume and decrease with decrease in production volume.

    Example

    Cost of trolley autos increases with increase in production volume

Real Cost and Prime Cost

  • Real Cost : It accounts for physical quantities of various non-monetary factors that are in materialistic terms.

    Example

    Cost of number of nails, cost of cubic per feet and etc

  • Prime Cost: It is the direct cost incurred in terms of material and labour involved in the production excluding fixed cost. Prime costs help determine the selling cost of a commodity to earn profit.