Cost of production implies the expenses involved in producing a commodity. Cost of production influences the price determination of commodity. It always implies the money costs only. These money costs are divided into two types namely Fixed costs and variable costs.
Fixed costs : Costs which do not vary with the level of production are known as fixed costs. These costs are also known as supplementary costs or overhead costs. These costs are incurred by the producer irrespective of the changes in production. Even though production is stopped due to any reason the producers have to bear these costs.
Examples of Fixed Costs:
Costs (depreciation) incurred on equipment, machinery, buildings, etc. salaries of permanent staff, interest on capital, insurance premium etc come under the category of fixed costs.
Average fixed cost: Average Fixed cost is obtained by dividing the total fixed costs with the total output. It increases with a decrease in output. It decreases with an increase in output. The more the production, the less will be the average fixed cost:
Characteristics of Fixed Costs:
1) The total fixed cost remains constant even though total output increases or decreases.
2) It is the minimum expenditure on indivisible factors.
3) Some of the fixed costs like Machinery, buildings etc. are useful over a long period of time.
4) The Average Fixed cost is inversely related to the total quantity produced by a firm. It remains low at higher levels of output It will be greater at the beginning stages of production. The Average Fixed cost curve will be a rectangular hyperbola.
Variable costs : Variable costs are those which vary with the changes in production. In fact the producers are guided by these costs in determining the prices. Variable costs be high at higher levels of production. These costs will be less when production is low. Expenses incurred on raw-materials, power, fuel, wages paid to temporary staff, transport etc. are examples of variable costs. Variable costs will be nil when production is stopped. Variable costs are also described as prime costs or direct costs.
Average variable cost: Average variable cost is obtained by dividing the total variable cost with the total number of units produced. The average variable cost is subject to the Law of variable proportions. As production increases, economies of large scale production are secured. As a result the average variable cost will be less. After a stage Diminishing returns arise. This leads to an increase in average variable cost.
Characteristics of Variable costs :
1) Variable costs change with the level of output.
2) Raw-materials, fuel and some other variable factors lose their utility after a single use.
3) Variable costs are not incurred when production is stopped.
4) Change in production and changes in variable costs may not be proportional to each other. In the initial stages, changes in the rate of increase in output due average variable costs are less than the rate of increase in output due to the increasing returns. After a particular stage increase in variable costs will be greater than that of increase in output due to the diminishing returns. So the average variable cost curve will be a U shaped curve.
Examples of Variable Costs:
Utility expenses like electricity, gas, water etc, wages of daily labors, factory lubricants like diesel, petrol, octane etc are variable costs.