TOTAL COST: FUNCTION, HOW IT IS CALCULATED AND EXAMPLE - DUDAS - 2025

The total cost is an economic measure that adds all expenses paid to produce a product, buying an investment or purchase equipment, which includes not only the initial outlay of cash, but also the opportunity cost of their choices.

Unlike cost accounting, total cost in economics includes the total opportunity cost of each factor of production as part of its fixed or variable costs.

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Total cost is the total economic cost of production. It is made up of a variable cost, which varies according to the quantity of a good produced, including inputs such as labor and raw materials.

In addition, it is composed of a fixed cost, which is a value independent of the quantity of a good produced. Includes expenses that cannot be varied in the short term, such as buildings, equipment, and machinery.

The rate at which total cost changes as the quantity produced changes is called marginal cost. This is also known as the variable cost of the marginal unit.

Importance

This is a fundamental concept for business owners and executives, because it allows you to track the combined costs of operations.

The meaning of this term varies slightly depending on the context. For example, when used to define production costs, it measures the total fixed, variable, and general expenses associated with the production of a good.

It enables people to make pricing and revenue decisions based on whether total costs increase or decrease.

Additionally, stakeholders can drill down into total cost figures by separating them into fixed costs and variable costs, and adjust operations accordingly to lower overall production costs. Management also uses this idea when considering capital expenditures.

In marketing, you need to know how total costs are divided between variable and fixed. This distinction is crucial in forecasting the revenue generated by various changes in unit sales and thus the financial impact of proposed marketing campaigns.

Total cost of production function

The cost function is the mathematical relationship between the cost of a product and its various determinants. In this function, the unit cost or total cost is the dependent variable.

Variable and fixed factors

During production, some factors are easily adjustable to synchronize with any change in production level. For example, a company employs more workers or buys more raw materials to increase production. These are the variable factors.

However, factors such as infrastructure, production equipment, etc., are not so easy to adjust. The company usually requires more time to make changes to them. These factors are the fixed factors.

Based on an understanding of variable and fixed factors, a look at short and long-term periods can be taken to better understand short-term total costs.

Short and long term periods

The short term is a period of time in which the company can increase production by making changes only in the variable factors, such as labor, raw materials, etc.

Also, the amounts of the fixed factors cannot be changed in the short term. Therefore, the short term is a period of time in which only the variable factors change, the fixed factors remain unchanged.

On the other hand, the long term is a period of time in which the company must make changes in all the factors in order to obtain the desired result. It can be said that, in the long run, all factors become variable.

It is important to bear in mind that these factors, fixed or variable, generate costs. It can be seen below:

Fixed costs

Fixed costs are those that do not vary with production and generally include rentals, insurance, depreciation, and setup costs. They are also called overhead.

In Figure 1, it can be seen that fixed costs are independent of production. That is, they do not change with any modification in the production output.

The company incurs these costs regardless of the size of production. The company must bear these costs, even if it closes its operations in the short term.

Generally, fixed costs include charges such as: rent, insurance premium, maintenance costs, taxes, etc.

Variable costs

Variable costs are costs that vary with production and are also called direct costs. Examples of typical variable costs include fuel, raw materials, and some labor costs.

In Fig. 2 it can be seen that variable costs change with modifications in production output. Variable costs include payments such as salaries, raw material expenses, energy consumption, etc.

If a company closes its operation in the short term, then it will not use the variable factors of production. Therefore, you will not incur variable costs.

Total cost curve

The total cost (TC) of a business is the sum of the total variable costs (CVT) and the total fixed costs (CFT). Therefore, we have: CT = CFT + CVT

The following graph represents the curves for total fixed cost, total variable cost, and total cost:

As can be seen, the CFT curve starts from a point on the Y axis, being parallel to the X axis. This implies that even if production is zero, the company will incur a fixed cost.

On the other hand, the CVT curve rises upward. This implies that CVT increases as production output increases.

This curve starts from the origin, which shows that there are no variable costs when the production output is zero.

Finally, it is observed that the total cost curve (TC) is obtained by adding the CFT with the CVT.

How is it calculated?

Add up the fixed costs of the business

In the business environment, fixed costs are often called overhead costs. These represent the amount of money the business needs to spend to simply keep operating.

More exactly, it could be said that fixed costs are costs that do not decrease or increase as the company produces less or more services and goods.

Fixed costs for a business are similar, though not entirely the same, as costs that are put into a personal budget.

Among the fixed costs of a company are: rent, utilities, leases of buildings, equipment, machinery, insurance premiums and labor that does not participate in the production of services and goods.

For example, suppose you own a tennis ball plant. The monthly fixed costs are as follows:

- Building lease = $ 4,000.

- Loan payments = $ 3,000.

- Insurance premiums = $ 1,500.

- Teams = $ 2,500.

In addition, $ 7,000 per month is paid for employees who do not directly affect the manufacture of the tennis balls: security guards, administrative assistants, etc. By adding all these values, you get a value for the fixed costs of: $ 4,000 + $ 3,000 + $ 1,500 + $ 2,500 + $ 7,000 = $ 18,000.

Calculate variable costs

Variable costs in businesses are a little different than personal budgets. The variable costs of a company are the expenses directly affected by the amount of services or goods produced.

That is, the more a company grows in relation to the services provided, goods produced, etc., the higher its variable costs.

Variable costs for a business include raw materials, personnel involved in the production process, shipping costs, etc.

Additionally, services can also be a variable expense, if they fluctuate with the company's production.

Examples

For example, suppose that a certain robotic car factory has a large consumption of electricity. The electricity you need will increase as you build more cars. That is why the different public services can be classified as variable cost.

Continuing with the example of the tennis ball plant, it can be said that the variable costs include:

- Rubber = $ 1,000.

- Shipping = $ 2,000.

- Factory worker wages = $ 11,000.

The factory also consumes natural gas in large quantities for the process that vulcanizes the rubber. This cost increases as production increases. The utility bill for this month was $ 3,000.

Adding all these expenses, you get a total variable cost of: $ 1,000 + $ 2,000 + $ 11,000 + $ 3,000 = $ 17,000.

Determine the total cost

The formula for calculating the total costs of a company turns out to be really quite simple: Total cost = fixed costs + variable costs.

Taking the example, since the fixed costs are $ 18,000 and the variable costs are $ 17,000, the total monthly cost for the plant is $ 35,000.

Business costs in financial statements

Most of the variable and fixed costs of companies can be found in the financial statements.

Specifically, the profit and loss statement must contain all the variable costs related to the production of the company's services and goods, together with important fixed costs, such as administrative staff salaries, rent, etc.

The profit and loss statement is a standard financial instrument. All companies that have some type of accounting exercise should have one.

Also, to see how much money the business needs for future payments, it may be necessary to analyze another financial statement, called a balance sheet.

The balance sheet contains, in addition to other important figures, the liabilities of a company, which is the amount of money owed to other entities.

This can help establish the financial health of the business. If you are making just enough money to cover the full cost and you have significant liabilities, the business may be in an unfavorable position.

Total cost formula

The total cost formula is used to derive the combined fixed and variable costs of a batch of goods or services.

The formula is the unit average fixed cost plus the unit average variable cost, multiplied by the number of units. The calculation is:

Total cost = (average fixed cost + average variable cost) x number of units.

For example, a company is incurring $ 10,000 of fixed costs to produce 1,000 units, giving an average unit fixed cost of $ 10, and its unit variable cost is $ 3. At the 1,000-unit production level, the total cost of production is:

($ 10 Average Fixed Cost + $ 3 Average Variable Cost) x 1,000 Units = $ 13,000 Total Cost.

Problems with the formula

There are several problems with the total cost formula. To correct these problems, it is necessary to recalculate the total cost each time the production volume changes by a quantity of material.

Limited range for average fixed cost

The definition of fixed cost is that it is a cost that does not vary with production volume, so the average fixed cost part of the formula should only be applied within a very narrow production volume range.

In reality, the same fixed cost is likely to apply across a wide range of production volumes, so the average fixed cost figure could vary greatly.

Variable purchase costs are based on volume

When purchasing raw materials and components for the production process, the cost per unit will vary based on volume discounts. Therefore, the more units ordered, the lower the variable cost per unit.

Direct labor cost is actually fixed

There are few cases where direct labor actually varies directly with production volume.

Rather, it takes a fixed number of people to staff a production line. That group can handle a wide range of production volumes. Therefore, direct labor should generally be considered a fixed cost.

Example

Jane is the COO of the world's largest automaker. The company has recently seen its total costs have been increasing 15% year over year. For this reason, Jane was tasked with analyzing this trend in an effort to fix it.

Overall, she realizes that the company's costs have risen from $ 100,000 to $ 132,250 in just two years, validating the extreme growth in total costs.

After reviewing the numbers, you notice, to your surprise, that fixed costs have not increased, but have decreased from $ 70,000 to $ 65,000.

In addition, you see that the variable costs of the company, specifically in salaries and benefits, have increased from $ 30,000 to $ 67,250.

She reasons that the opportunity cost of this $ 37,250 is too great and could be used elsewhere in the company.

Therefore, personnel are reduced and shifts are increased, spending the $ 37,250 on other investments for the company. This will eventually reduce your overall total costs.

References

1. Wikipedia, the free encyclopedia (2019). Total cost. Taken from: en.wikipedia.org.
2. My Accounting Course (2019). What is Total Cost? Taken from: myaccountingcourse.com.
3. Steven Bragg (2018). Total cost formula. Accounting Tools. Taken from: accountingtools.com.
4. Economics Online (2019). Costs of production. Taken from: economicsonline.co.uk.
5. Toppr (2019). Short Run Total Costs. Taken from: toppr.com.
6. Wikihow (2019). How to Calculate Total Cost. Taken from: wikihow.com.