Production Cost and Its Types

Production cost refers to the total cost incurred by a firm in the process of producing goods or services. It includes all the expenses associated with the production process, such as raw materials, labor, and overhead costs. Understanding production costs is vital for businesses as it helps them determine the pricing of goods and services, identify inefficiencies, and make decisions about production levels.

The different types of costs include fixed costs, variable costs, semi-variable costs, marginal cost, opportunity cost, economic cost, accounting costs, sunk cost, among other types of costs.

Now that we understand the general types of production costs, let’s dive deeper into some specific types using examples: 

1. Implicit Costs

• Definition: Implicit costs are the opportunity costs of using resources owned by the firm. These are not actual cash expenses but represent what the firm sacrifices by using its resources in a certain way.
• Example in Indian Context:
  • Suppose an entrepreneur in India, Sita, owns a textile factory and decides to run the business herself instead of hiring a manager. The salary she could have earned if she worked elsewhere is the implicit cost.
  • Similarly, if she uses her factory space for her own business rather than renting it out, the potential rental income she forgoes is another implicit cost.

2. Explicit Costs:

• Definition: Explicit costs are direct, out-of-pocket payments made by a business for purchasing or using resources needed for production. These are the actual monetary expenses a business incurs to carry out its activities. Unlike implicit costs, explicit costs involve actual cash transactions.
• Examples: Wages, rent, raw materials, utilities, and other direct payments related to the production process.

3. Marginal Cost

• Definition: Marginal cost is the additional cost incurred when producing one more unit of output. It is important for determining whether it is profitable to increase production.
• Example in Indian Context:
  • Consider an Indian automobile manufacturer like Tata Motors. If they are producing 10,000 cars a month and the total production cost is ₹50 crore, and if producing one additional car raises the total cost to ₹50.2 crore, the marginal cost of producing that additional car is ₹20,000.
  • In this case, Tata Motors would use marginal cost calculations to determine whether it is worthwhile to increase production.

4. Incremental Cost

• Definition: Incremental cost refers to the additional cost incurred when there is a specific change in the production process, such as expanding production or launching a new product.
• Example in Indian Context:
  • Imagine a small IT startup in Bengaluru decides to expand its operations and hire 10 more employees for a new project. The incremental cost would include the salary of those 10 new employees, additional office space rent, and equipment.
  • If the incremental cost to expand operations is ₹5 lakh per month, the company would evaluate whether the added revenue from the new project justifies the extra expense.

5. Sunk Cost

• Definition: Sunk costs are costs that have already been incurred and cannot be recovered. These costs should not affect future decision-making since they are past expenses that cannot be changed.
• Example in Indian Context:
  • Suppose an Indian film production company, like Yash Raj Films, has already spent ₹15 crore on producing a movie. Unfortunately, the film flops at the box office. The ₹15 crore spent on production is a sunk cost because it cannot be recovered, and the company should not base any future decisions (like additional investments in the same movie) on it.
  • Future decisions about production or marketing should only focus on future costs and expected revenue, not the sunk cost.