Cost of Production

5. PRODUCTION, INPUTS,
AND OUTPUTS
TECHNOLOGY: LABOR INTENSIVE
OR CAPITAL INTENSIVE
SHORT RUN VS. LONG RUN
THE PRODUCTION FUNCTION
TOTAL, AVERAGE, AND
MARGINAL PRODUCTS
THE LAW OF DIMINISHING
RETURN
THE THEORY OF COST
TOTAL FIXED COST, TOTAL
VARIABLE COST, AND TOTAL COST
AVERAGE COST
MARGINAL COST
THE CONCEPT OF PROFIT
MAXIMIZATION

6. Production
Producing something is the act of creating something out of
components or raw resources. To put it another way, production uses
inputs to produce an output that is fit for consumption, a good or
product that provides value for a customer or end-user.
Inputs
Taking something in is the act of input. The resources that go into
producing a good or service are referred to, including labor and fuel.
An input, for instance, is something that a business receives when it
purchases raw materials to produce completed goods.
Outputs
Output is the exact opposite of input, which is the finished item that is
produced using a combination of input resources. An example of an
output would be when a business ships a finished product to a
consumer.

7. CAPITAL INTENSIVE
Capital intensive refers to a business process or
industry that requires significant investment to
generate a good or service and has a high
percentage of fixed assets, such as real estate,
machinery, and equipment. High levels of
depreciation are frequently an identifying feature of
businesses in capital-intensive industries.
LABOR INTENSIVE
Labor intensive is a process or industry that uses
a lot of work to create its products or services.
The quantity of capital needed to create the goods
or services is often used to calculate the degree
of labor intensity; the more capital is needed, the
more labor-intensive the business. Restaurants,
hotels, agriculture, mining, as well as the
healthcare and caregiving sectors, are all labor-
intensive enterprises.

8. SHORT RUN LONG RUN
The short run is a period
of time in which the
quantity of at least one
input is fixed and the
quantities of the other
inputs can be varied.
The long run is a period of time in
which the quantities of all inputs
can be varied. There is no fixed
time that can be marked on the
calendar to separate the short run
from the long run. The short run
and long run distinction varies
from one industry to another.

9. THE PRODUCTION FUNCTION
A production function gives the technological relation between quantities of physical inputs
and quantities of output of goods. The production function is one of the key concepts of
mainstream neoclassical theories, used to define marginal product and to distinguish
allocative efficiency, a key focus of economics. One important purpose of the production
function is to address allocative efficiency in the use of factor inputs in production and the
resulting distribution of income to those factors, while abstracting away from the
technological problems of achieving technical efficiency, as an engineer or professional
manager might understand it.

11. The total quantity of output
produced by a firm.
FORMULA: Average Product
(AP) x Labor (L)
The total quantity of output per unit of
labor (the variable input)
This tell us how much output each unit
of labors produces on average.
FORMULA: Average Product = Total
Product (TP)/ Variable Inputs (L)
The extra or additional output resulting
from one additional unit of labor (the
variable input)
This tell us how much output increases
when we add one more unit of labor.
FORMULA: change in total product
(ΔTP)/ change in labor (ΔL)

12. Let’s say we are running an ice cream factory and we care about how much our ice cream production per day
varies as a function of the number of people working in the factory.
QUANTITY OF LABOR (WORKERS) TOTAL PRODUCT
GALLONS OF ICE CREAM
(OUTPUT) PER DAY
0
10
18
24
28
30
0
1
2
3
4
5

13. QUANTITY OF
LABOR (WORKERS)
TOTAL PRODUCT
MARGINAL
PRODUCT
0 0
1 10
2 18
3 24
4 28
5 30
FORMULA: change in total product (ΔTP)/
change in labor (ΔQL)
0
10
8
6
4
2
10 - 0 / 1 - 0 = 10
18 - 10 / 2 -1 = 8
24 - 18 / 3 - 2 = 6
28 - 24 / 4 - 3 = 4
30 - 28 / 5 - 4 = 2

14. QUANTITY OF
LABOR
(WORKERS)
TOTAL
PRODUCT
MARGINAL
PRODUCT
AVERAGE
PRODUCT
0 0 0
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
FORMULA: Average Product = Total
Product (TP)/ Variable Inputs (L)
0
10
9
8
7
6
10 / 1 = 10
18 / 2 = 9
24 / 3 = 8
28 / 4 = 7
30 / 5 = 6

15. QUANTITY OF
LABOR
(WORKERS)
TOTAL
PRODUCT
MARGINAL
PRODUCT
AVERAGE
PRODUCT
0 0 0
1 10 10
2 8 9
3 6 8
4 4 7
5 2 6
FORMULA: Average Product (AP) x
Labor (L)
0
10
18
24
28
30
10 × 1 = 10
9 × 2 = 18
8 × 3 = 24
7 × 4 = 28
6 × 5 = 30

16. Mr. Perez is running a chocolate factory and he care about how much his chocolate production per day varies as a
function of the number of people working in the factory.
QUANTITY OF LABOR
(WORKERS)
TOTAL PRODUCT MARGINAL PRODUCT AVERAGE PRODUCT
0 0 0
1 20 20
2 16 18
3 48 12
4 56 14
5 60 4
0
20
36
16
8
12

18. LAW OF DIMINISHING RETURNS STATES THAT IN THE SHORT RUN WHEN VARIABLE FACTORS OF PRODUCTION
ARE ADDED TO A STOCK OF FIXED FACTORS OF PRODUCTION, TOTAL/MARGINAL PRODUCT WILL RISE AND THEN
FALL.

19. SHORT-RUN PRODUCTION IN A TOY TRUCK
QUALITY OF LABOR QUANTITY OF CAPITAL TOTAL PRODUCT (TP) MARGINAL PRODUCT (MP)

20. -2
-1
0
1
2
3
4
5
QL 1 2 3 2 1 -1
MARGINAL
PRODUCT
QUANTITY OF LABOR
MARGINAL PRODUCT OF LABOR IN THE SHORT-RUN

22. NOTIFICATION
1

24. The theory of cost is the costs of a business
highly determine its supply and spendings. The
modern theory of cost in Economics looks into
the concepts of cost, short-run total and
average cost, long-run cost along with economy
scales. The cost function varies concerning
factors such as operation scale, output size,
price of production, and more. The theory of
cost production needs to be understood in
detail by economists to run their company and
increase its profit and productivity.

25. TYPES OF COST
THESE ARE COSTS THAT A FIRM DIRECTLY PAYS
FOR AND CAN BE SEEN ON THE ACCOUNTING
SHEET.

26. TYPES OF COST
THESE ARE COSTS THAT A FIRM DIRECTLY PAYS
FOR AND CAN BE SEEN ON THE ACCOUNTING
SHEET.
THESE ARE OPPORTUNITY COSTS, WHICH DO NOT
NECESSARILY APPEAR ON ITS BALANCE SHEET
BUT AFFECT THE FIRM.

27. TYPES OF COST
THESE ARE COSTS THAT A FIRM DIRECTLY PAYS
FOR AND CAN BE SEEN ON THE ACCOUNTING
SHEET.
THESE ARE OPPORTUNITY COSTS, WHICH DO NOT
NECESSARILY APPEAR ON ITS BALANCE SHEET
BUT AFFECT THE FIRM.
TOTAL COSTS MEANS AN ECONOMIC
MEASUREMENT OF THE ENTIRE AMOUNT
PAID TO PRODUCE A PRODUCT.

28. TYPES OF COST
IS THE AMOUNT OF POTENTIAL GAIN AN
INVESTOR MISSES OUT ON WHEN THEY
COMMIT TO ONE INVESTMENT CHOICE
OVER ANOTHER.
TOTAL COSTS MEANS AN ECONOMIC
MEASUREMENT OF THE ENTIRE AMOUNT
PAID TO PRODUCE A PRODUCT.
THESE ARE OPPORTUNITY COSTS, WHICH DO NOT
NECESSARILY APPEAR ON ITS BALANCE SHEET
BUT AFFECT THE FIRM.
THESE ARE COSTS THAT A FIRM DIRECTLY PAYS
FOR AND CAN BE SEEN ON THE ACCOUNTING
SHEET.

29. These costs are not related directly or identifiable to
any operation or service. Costs such as electric
power or water supply are some examples because
these expenses vary with output. They generally have
a functional relationship with production.
TYPES OF COST

30. TYPES OF COST
These costs are easily pointed out or identified
expenditures such as manufacturing costs. Such costs
cater to specific operations or goods.
These costs are not related directly or identifiable to
any operation or service. Costs such as electric
power or water supply are some examples because
these expenses vary with output. They generally have
a functional relationship with production.

31. TYPES OF COST
Such costs do not vary with output and are
fixed expenditure of the company. For
example, taxes, rent, interests are all fixed
costs as they do not vary within a constant
capacity. Any company cannot avoid these
costs.
These costs are easily pointed out or identified
expenditures such as manufacturing costs. Such costs
cater to specific operations or goods.
These costs are not related directly or identifiable to
any operation or service. Costs such as electric
power or water supply are some examples because
these expenses vary with output. They generally have
a functional relationship with production.

32. TYPES OF COST
Variable costs do change in the short-
run due to the fact that they vary with
output.
Fixed costs do not change in the short-
run and do not vary with output.
INDIRECT COSTS EXTEND BEYOND THE EXPENSES
YOU INCUR WHEN CREATING A PRODUCT; THEY
INCLUDE THE COSTS INVOLVED WITH
MAINTAINING AND RUNNING A COMPANY.
DIRECT COSTS ARE EXPENSES THAT A COMPANY
CAN EASILY CONNECT TO A SPECIFIC “COST
OBJECT,” WHICH MAY BE A PRODUCT,
DEPARTMENT OR PROJECT.

33. A fixed cost is an expense that a company is obligated to pay, and
it is usually time-related. An example of a fixed cost would be the
rent a company pays for office space and/or manufacturing
facilities on a monthly basis. This is normally a contractually
agreed-upon period that is fixed, unless both landlords and
tenants agree to re-negotiate a lease agreement.

34. Total variable cost is the aggregate amount of all
variable costs associated with the cost of goods
sold in a reporting period. It is a key component in
the analysis of corporate profitability. The
components of total variable cost are only those
costs that vary in relation to production or sales
volume. It is not compiled at the individual unit
level.
Formula: Total Variable Cost = (Total Quantity of
Output) x (Variable Cost Per Unit of Output)

35. Total cost is the entire amount of money that must be spent on something
to either produce, maintain, or own it. Production managers must be able to
accurately calculate total cost in order to know what they can and cannot
afford. Take the example of building a car. There are many different costs
that go into the process of building a car, and all of these costs together
form the total cost of production. Production managers must be able to
accurately calculate total cost in order to know what they can and cannot
afford.
Formula: Total Cost (TC) = Total Fixed Cost (TFC) +Total Variable Cost (TVC)

36. Average cost refers to the per-unit cost of production, which is
calculated by dividing the total cost of production by the total
number of units produced. In other words, it measures the
amount of money that the business has to spend to produce
each unit of output. It forms a fundamental component of
demand and supply that affects the supply curve.
Formula: Total Cost of Production / Number of Units Produced

37. Marginal cost refers to the increase or decrease in the cost
of producing one more unit or serving one more customer. It
is also known as incremental cost. Marginal costs are based
on production expenses that are variable or direct – labor,
materials, and equipment

38. Calculating the marginal cost helps a business determine the point at
which increasing the number of items produced will push the average
cost up. Costs can increase when volume increases if the company
needs to add equipment, move to a larger facility, or struggles to find a
supplier that can provide enough materials.
The formula for calculating marginal cost: Divide the change in total
costs by the change in quantity.

40. Profit maximization refers to a tendency of business firms to maximize
profits in the short or long run by using the most efficient methods and
equalizing the marginal cost and revenues. Its main purpose is to increase
the level of production of a firm or business that will grant it the maximum
profit on selling goods and services.
Formula: P = total revenue (TR) – total cost (TC)