Cost of Production

The cost of producing a firm’s output depends on how much labour and physical capital the firm uses. A list of the costs involved in producing cars looks very different from the costs involved in producing computer software or haircuts or fast-food meals. However, the cost structure of all firms can be broken down into some common underlying patterns. When a firm looks at its total costs of production in the short run, a useful starting point is to divide total costs into two categories: fixed costs that cannot be changed in the short run and variable costs that can be changed.

Fixed and variable costs

After you have worked through this section of the learning unit, you should be able to:

  • distinguish between fixed and variable costs

Fixed costs are expenditures that do not change regardless of the level of production, at least not in the short run. Whether you produce a lot or a little, the fixed costs are the same. One example is the rent on a factory or a retail space. Once you sign the lease, the rent is the same regardless of how much you produce, at least until the lease runs out. Fixed costs can take many other forms: for example, the cost of machinery or equipment to produce the product, research and development costs to develop new products, or even an expense like advertising to popularise a brand name. The level of fixed costs varies according to the specific line of business: for instance, manufacturing computer chips requires an expensive factory, but a local moving and hauling business can survive with almost no fixed costs at all if it rents trucks by the day when needed.

Variable costs, however, are incurred in the act of producing – the more you produce, the greater the variable cost. The cost of labour is treated as a variable cost, since producing a greater quantity of a good or service typically requires more workers or more work hours. Variable costs would also include the cost of raw materials.

Consider the following cost items for a barbershop called Best Barber and identify the fixed costs and the variable costs:

Fixed cost Variable cost
Wages for barbers o o
Rent for the premises o o
Cost of equipment o o
Electricity o o
Advertising o o

Variable cost varies with output, and in this example, it would probably be wages for barbers and electricity.

 Fixed cost does not vary with output, and in this example, it would probably be rent for the premises and advertising.