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What is 'Production Cost'

Production cost refers to the cost incurred by a business when manufacturing a good or providing a service. Production costs include a variety of expenses including, but not limited to, labor, raw materials, consumable manufacturing supplies and general overhead. Additionally, any taxes levied by the government or royalties owed by natural resource extracting companies are also considered production costs.

BREAKING DOWN 'Production Cost'

Also referred to as the cost of production, production costs include expenditures relating to the manufacturing or creation of goods or services. For a cost to qualify as a production cost it must be directly tied to the generation of revenue for the company. Manufacturers experience product costs relating to both the materials required to create an item as well as the labor need to create it. Service industries experience production costs in regards to the labor required to provide the service as well as any materials costs involved in providing the aforementioned service.

In production, there are direct costs and indirect costs. For example, direct costs for manufacturing an automobile are materials such as the plastic and metal materials used as well as the labor required to produce the finished product. Indirect costs include overhead such as rent, administrative salaries or utility expenses.

Deriving Unit Costs for Product Pricing

To figure out the cost of production per unit, the cost of production is divided by the number of units produced. Once the cost per unit is determined, the information can be used to help develop an appropriate sales price for the completed item. In order to break even, the sales price must cover the cost per unit. Amounts above the cost per unit are often seen as profit while amounts below the cost per unit result in losses.

If the cost of producing a product outweighs the price that is paid for it, this may lead producers to consider temporarily ceasing operations. For example, in January 2015, the selling price of a barrel of oil fell to $40 a barrel. With product costs varying from $20 to $50 a barrel, a cash negative situation occurs for those with production costs on the higher end. Those producers may choose to cease production efforts until sale prices return to profitable levels which lowers the amount of supply available within the market and may encourage oil prices to rise based on the shifting supply and demand models.

Production Costs and Asset Recording

Once a product is complete, it can be recorded as a company asset until the product is sold. This allows the value of the product to be accounted for within financial statements and other accounting documents, and provides a way to keep shareholders informed and reporting requirements to be met.

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