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What is 'Production Cost'

Production costs refer to the costs incurred by a business when manufacturing a good or providing a service. Production costs include a variety of expenses, such as labor, raw materials, consumable manufacturing supplies, and general overhead. Additionally, 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 production 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 regard to the labor required to provide the service as well as any materials costs involved in providing the service.

In production, there are direct costs and indirect costs. For example, direct costs for manufacturing an automobile are materials, such as plastic and metal materials and the labor required to produce the finished product. Indirect costs include overhead, such as rent, administrative salaries, and 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. To break even, the sales price must cover the cost per unit. Prices exceeding the cost per unit result in profits, whereas prices below the cost per unit result in losses.  

If the cost of producing a product exceeds the price, producers may consider temporarily or permanently ceasing operations. For example, in January 2015, the selling price of a barrel of oil fell to $40 a barrel. With production 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. 

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 in financial statements and other accounting documents, and it keeps shareholders informed and reporting requirements met.

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