5.1 Classification of production costs

Production costs are the payments a firm makes, and the sacrifices it bears, in order to produce goods or services: payments for raw materials, labour, rent, power, transport and the use of machines. Economists classify these costs according to how they behave when output changes, because that behaviour determines how much a firm should produce and at what price it can sell. For a procurement officer the classification matters too: it shows which purchases rise with every unit produced (materials, packaging) and which stay the same whatever the output (rent, insurance, salaried staff). Example: a furniture workshop pays the same rent each month whether it makes 10 or 50 chairs, but its spending on timber, glue and varnish rises with every chair made.

Worked cost schedule used in this topic

A small furniture workshop has the following weekly costs (Ksh):

5.1.1 Fixed costs

Fixed costs are costs that do not change with the level of output in the short run. They must be paid even when the firm produces nothing, which is why they are also called overhead, indirect or supplementary costs. In the schedule, the workshop's fixed cost is Ksh 20,000 a week at every level of output, including zero. Fixed costs exist only in the short run: in the long run the firm can change its premises, machines and contracts, so all costs become variable.

Examples of fixed costs

• Rent of premises: Paid monthly whatever the output.
• Salaries of permanent staff: Managers, accountants and storekeepers on fixed pay.
• Insurance premiums: On buildings, machines and stock.
• Depreciation of machines by time: The fall in value of equipment due to age.
• Interest on loans: Paid on borrowed capital regardless of output.
• Licences and permits: Annual business permits and similar charges.

Features of fixed costs

• Constant in total: Total fixed cost is the same at all outputs, so its graph is a horizontal straight line.
• Falling per unit: Fixed cost per unit falls as output rises, because the same amount is spread over more units.
• Unavoidable in the short run: They are incurred even when the firm shuts down temporarily.
• Short-run concept: All fixed costs can be changed in the long run.
• Basis for capacity decisions: High fixed costs encourage a firm to use its capacity fully.

5.1.2 Variable costs

Variable costs are costs that change directly with the level of output: they are zero when nothing is produced and rise as output rises. They are also called prime, direct or operating costs. In the schedule, variable cost rises from Ksh 0 at zero output to Ksh 120,000 at 50 chairs. Variable costs usually rise at a falling rate at first, as workers and machines are used more efficiently, and then at a rising rate as the fixed plant becomes crowded (the law of diminishing returns).

Examples of variable costs

• Raw materials: Timber, fabric, foam, nails and glue in the furniture example.
• Packaging materials: Cartons, wrapping and labels.
• Wages of casual and piece-rate workers: Paid according to work done.
• Power and fuel for machines: Electricity and fuel used in production.
• Transport of finished goods: Delivery costs that rise with quantity sold.
• Sales commission: Paid per unit sold.

Features of variable costs

• Zero at zero output: No variable costs are incurred if nothing is produced.
• Rise with output: Total variable cost increases as output increases.
• Controllable: Managers can reduce them by cutting output or buying more efficiently.
• Shape of the curve: The total variable cost curve starts at the origin and usually rises less steeply at first, then more steeply.
• Procurement link: Most of a firm's purchasing of materials and supplies is a variable cost, so better prices from suppliers directly lower the cost of each unit.

5.1.3 Total cost

Total cost is the sum of all the costs of producing a given level of output: total fixed cost plus total variable cost.

TC = TFC + TVC

At zero output total cost equals fixed cost (Ksh 20,000 in the schedule), and as output rises total cost rises by the amount of the extra variable cost. The total cost curve therefore starts on the vertical axis at the level of fixed cost and has the same shape as the variable cost curve, lying above it by the constant amount of fixed cost.

Example: at 30 chairs, TC = 20,000 + 66,000 = Ksh 86,000.

Uses of total cost

• Pricing: The firm must cover total cost in the long run to stay in business.
• Profit calculation: Profit = total revenue − total cost.
• Break-even analysis: The break-even output is where total revenue equals total cost.
• Average cost: Total cost divided by output gives the cost per unit (average cost, analysed in 5.2).
• Budgeting: Total cost at the planned output is the basis of the production and purchasing budget.

5.1.4 Opportunity costs

Opportunity cost is the value of the next best alternative that is given up when a choice is made. Because resources are scarce, using money, materials, labour or premises for one purpose means they cannot be used for another; the benefit lost from that other use is the real economic cost of the choice. Opportunity cost is often not paid in cash, so it does not appear in the accounts, but it must be considered in every economic decision.

Example: the owner of the workshop uses a room she owns as a store instead of renting it out for Ksh 15,000 a month. Although no rent is paid, the opportunity cost of using the room as a store is Ksh 15,000 a month.

Example from procurement: a firm ties up Ksh 2,000,000 in excess stock for a year when the money could have earned 10% a year in a fixed deposit. The opportunity cost of holding the stock is 10% × 2,000,000 = Ksh 200,000 a year.

Importance of opportunity cost

• Choice between alternatives: It shows what is sacrificed when one option is chosen.
• Use of owned resources: It reminds owners that their own premises, capital and time have a cost even when no payment is made.
• Investment and stockholding decisions: It explains why holding too much stock is costly.
• Economic profit: Economists deduct opportunity costs (implicit costs) as well as cash costs (explicit costs) when measuring profit.
• Government and household decisions: The same idea applies to public spending and personal choices.

Explicit and implicit costs

• Explicit costs: Actual payments to outsiders, such as wages, rent and purchases of materials.
• Implicit costs: The opportunity costs of resources the owner provides, such as the owner's own labour, premises and capital.

5.1.5 Marginal cost

Marginal cost is the addition to total cost from producing one more unit of output.

MC = change in total cost ÷ change in output = ΔTC ÷ ΔQ

Because fixed cost does not change with output, marginal cost depends only on the change in variable cost. In the schedule, increasing output from 20 to 30 chairs raises total cost from Ksh 70,000 to Ksh 86,000, so:

MC = (86,000 − 70,000) ÷ (30 − 20)

= 16,000 ÷ 10

= Ksh 1,600 per chair

Behaviour of marginal cost

• Falls at first: From Ksh 3,000 to Ksh 2,000 to Ksh 1,600 per chair, as workers specialise and machines are used more fully.
• Then rises: From Ksh 2,200 to Ksh 3,200 per chair, as the fixed workshop becomes crowded and diminishing returns set in.
• U-shaped curve: Plotted against output, marginal cost forms a U-shape.
• Not affected by fixed cost: A change in rent changes total cost but not marginal cost.
• Decision rule: A profit-maximising firm produces up to the output where marginal cost equals marginal revenue; producing an extra unit whose marginal cost is above the price it sells for lowers profit.

Example of a marginal decision

A buyer offers to purchase an extra 10 chairs at Ksh 2,500 each when the workshop is producing 30 chairs. Raising output to 40 chairs adds Ksh 2,200 per chair to cost (marginal cost from 30 to 40 chairs). Since Ksh 2,500 is greater than Ksh 2,200, the order adds 10 × (2,500 − 2,200) = Ksh 3,000 to profit, provided it does not affect the price paid by other buyers.

Chapter Summary

This chapter explored the classification of production costs, detailing fixed costs that remain constant regardless of output, variable costs that change with production levels, total cost as the sum of fixed and variable costs, opportunity costs representing foregone alternatives, and marginal cost as the expense of producing one additional unit. It then examined short run cost analysis where some inputs are fixed, contrasting with long run cost analysis in which all inputs are variable and firms can adjust all factors of production. The chapter also analyzed cost curves, illustrating relationships between output and various cost measures. Finally, it addressed the optimal size of the firm by discussing economies of scale, highlighting how increasing production can reduce average costs and improve efficiency. These concepts collectively provide a comprehensive understanding of how firms manage costs to maximize profitability.