Total costs

The total cost of producing all output. It is calculated by
FIXED COSTS + VARIABLE COSTS

Example:
A car manufacturer has the following costs. It makes 10 cars a week

- Rent £ 1000 per week
- Salaries £ 1, 000 per week
- Interest £ 500 per week
- Materials £ 100 per car
- Wages £ 50 per car
- Power £ 100 per car

Fixed costs are 1000 + 1000 + 500 = £ 2, 500

Variable costs are (100 * 10) + (50 * 10) + (100 *10) = £ 2, 500

Total costs are £ 2, 500 + £ 2, 500 = £ 5, 000

Costs are expenses the company has to pay during the production of its product. There are 3 main types of costs, these are: fixed costs, variable costs, and semi-variable costs:

• Fixed costs:

Costs that don't change over a period of time and don't vary with output. E.g. salaries, rent, tax, insurance, heating and lighting. Fixed costs can also be called indirect costs as they are not directly associated with the final product. Fixed costs have to be paid even if the company is not producing any goods.

• Variable costs:

Costs that vary directly with output so when output increases, variable costs also increase. E.g. raw materials, electricity. Variable costs can also be called direct costs as they are directly associated with production.

• Semi-variable costs:

These costs have fixed and variable elements. E.g. a person working for the company may have a fixed salary but may also earn commission on sales.

Total costs are calculated by adding together fixed, variable and semi-variable costs.

Costs can be variable, fixed, or mixed.

Variable Costs:

Variable costs vary in a linear fashion with the production level. However, when stated on a per unit basis, variable costs remain constant across all production levels within the relevant range. The following two charts depict this relationship between variable costs and output volume.

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A good example of a variable cost is materials. If one pair of pants requires $10 of fabric, then every pair of pants requires $10 of fabric, no matter how many pairs are made. The fabric cost is $10 per unit at every level of production. If one pair is made, the total fabric cost is $10; if two pairs are made, the total fabric cost is $20; and if 1, 000 pairs are made, the total fabric cost is $10, 000. Hence, the total cost is increasing and linear in the production level.

Fixed Costs:

Fixed costs do not vary with the production level. Total fixed costs remain the same, within the relevant range. However, the fixed cost per unit decreases as production increases, because the same fixed costs are spread over more units. The following two charts depict this relationship between fixed costs and output volume.

In this example, fixed costs are $50, 000. The first chart shows that fixed costs remain $50, 000 at all production levels from 100 units to 1, 000 units. The second chart shows that the fixed cost per unit decreases as production increases. Hence, when 100 units are manufactured, the fixed cost per unit is $500 ($50, 000 ÷ 100). When 500 units are manufactured, the fixed cost per unit is $100 ($50, 000 ÷ 500).

Relevant Range:

The relevant range is the range of activity (e.g., production or sales) over which these relationships are valid. For example, if the factory is operating at capacity, increasing production requires additional investment in fixed costs to expand the facility or to lease or build another factory. Alternatively, production might be reduced below a threshold at which point one of the company’s factories is no longer needed, and the fixed costs associated with that factory can be avoided. With respect to variable costs, the company might qualify for a volume discount on fabric purchases above some production level. The relevant range for characterizing fabric as a variable cost ends at that production level, because the fabric cost per unit of output is different when the factory produces above that threshold than when the factory produces below that threshold.

Mixed Costs:

If, within a relevant range, a cost is neither fixed nor variable, it is called semi-variable or mixed. Following are two common examples of mixed costs.

In this example, although the total cost line increases in production, it does not pass through the origin because there is a fixed cost component. An example of a cost that fits this description is electricity. A fixed amount of electricity is required to run the factory air conditioning, computers and lights. There is also a variable cost component related to running the machines on the factory floor. The fixed component in this example is $3, 000 per month. The variable cost component is $10 per unit of output. Hence, at a production level of 500 units, the total electric cost is $8, 000 [$3, 000 + ($10 x 500)].

The mixed cost illustrated in the above chart is called a step function. An example of such cost behavior would be the total salary expense for shift supervisors. If the factory runs one shift, only one shift supervisor is required. In order for the factory to produce above the maximum capacity of a single shift, the factory must add a second shift and hire a second shift supervisor, so that total shift supervisor salary expense doubles. If the factory runs three shifts, three shift supervisors are required.