Cost of production – What is cost of production, definition and concept?

The cost of production (or operating cost) is the expense required to manufacture a good or to generate a service.

In this way, the cost of production is linked to those necessary expenses, leaving out others such as financial ones. It usually includes raw materials and supplies, direct and indirect labor, and other management costs, such as depreciation, rent, or consulting expenses.

Production cost elements

As mentioned, there are three key elements in the cost of production. We explain each of them below:

  • One is raw materials and supply. The first are those materials that are transformed in the production process. An example would be flour and salt in bread. The second is those that are not processed, but are needed, such as bags in which some goods are sold.
  • The second, as important as the first, is labor. In this case, only direct labor is included, ie that involved in the production process, for example, employees working in the production chain.
  • The third is the other indirect production costs. Here we include indirect work, which is necessary, even if it is not involved in the process. For example, the staff of the administration department. We also need to add the rest of the necessary expenses, such as depreciation, rent or taxes.

How to calculate the cost of production

The form of calculation depends on which of the three cost aspects we are interested in. Let’s look at each of them:

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  • For raw materials and consumables, all necessary expenses must be included. These can be transport, insurance, customs, non-deductible taxes and the like. For the calculation it is convenient to know the cost per unit produced.
  • For work, gross salary and other social costs must be included. For example, the contributions that the company pays to social insurance for unemployment, training or pensions. For the calculation it is convenient to know the cost per hour.
  • Finally, in relation to indirect costs, which must include the rest. In this case, we need to include everyone except the financial ones.

Example of production cost

Let’s imagine a company that, for simplicity, produces a single product. The raw material required for each unit manufactured is also one unit. Purchases are calculated by their total amount. For direct labor, we consider a production of 5 units for each hour of work. The indirect one is the salaries of the administration. Finally, 1500 pieces are produced. at 30 monetary units (mu) each.

Production cost 1

Unit costs are calculated by dividing the total by the units produced. Once we have them all, we add them up and calculate the total unit cost of production. The difference between the selling price and this cost is the gross unit margin or profit. Multiplication with production gives the company’s gross profit. After calculating the financial result, we obtain the net profit, which we did not include in the example.