Definition: Cost of production is the total price paid for resources used to manufacture a product or create a service to sell to consumers including raw materials, labor, and overhead.
What Does Production Cost Mean?
What is the definition of cost of production? For a business owner, knowing their cost of production is a vital step in creating and maintaining a profitable business. By knowing the cost of every step in production, management can optimize production processes, delivery schedules, and general business activities in an effort to make better products more efficiently than in the past.
Management accountants analyze product processes and track this metric in order to properly price their goods and services to achieve an appropriate margin. For example, an orange juice company management will track the price of oranges, sugar, and other commodities used in the production of their juice. If any of these goods’ prices increase, the juice manufacturer will also have to increase their prices to maintain the same level of profits.
Let’s look at an example.
Example
Marcus is the Chief Operating Officer of a large manufacturing company that creates keyboards. Since he is in charge of the manufacturing, he knows every component of the keyboard: the plastic, the paint, metal, and electronics. He knows each supplier, and he wants to conduct his annual review of the firm’s costs of production.
He looks through the firm’s records, and finds the plastic for the keyboard costs $3.00 per board, while the paint costs $0.50. The electronics within the board costs the most, at $10.00 per keyboard, while the metal is a close second, at $8.00 per board. Summing up all of the costs, which include production, he sees that each keyboard costs ($3.00 + $0.50 + $8.00 + $10.00) = $21.50 to produce.
With keyboards selling at $30 in store, and even more for a custom-built keyboard, he sees that the firms still has a reasonable cushion for profit. Additionally, he decides that this cost of production method is the one he will continue to use, as it allows him to get detailed and specific answers to his questions.
Summary Definition
Define Cost of Production: Production costs are the resources used to create a good.
