In economics, production costs involve a number of costs that include both fixed and variable costs. Fixed costs are costs that do not change when output changes. Examples include insurance, rent, normal profit, setup costs and depreciation. Another name for fixed costs is overhead. Variable costs, also called direct costs, depend on output. A change in output causes a change in variable costs.
For example, for a boat manufacturing company, the total fixed cost is the sum of the premises, machinery and equipment needed to make boats. This cost is not affected by the number of boats made. However, the total variable cost is dependent on the number of boats produced.
Since total fixed costs do not change with increased output, a horizontal line is drawn on the cost curve as opposed to an upward curve drawn to show total variable costs. The upward curve of total variable costs shows the law of diminishing marginal returns. To calculate the total cost, total fixed costs are added to total variable costs.
Average fixed cost and average variable cost can also be calculated to help analyze production cost. To calculate the average fixed cost, the total fixed cost is divided by output. An increase in production reflects a downward trend on average fixed cost, consequently reflecting a downward slope on the curve. The average variable cost is calculated by dividing total variable cost by output. The curve for average variable cost is U-shaped, because it first shows a downward fall until it reaches the minimum point before it rises again, based on the principle of proportions.