Types of Costs and Levels of Production

A company's costs take two forms—fixed and variable. Fixed costs (also known as overhead) are costs that do not vary with production or sales revenue, such as payments for rent, heat, interest, salaries, and other bills that must be paid regardless of output.

In contrast, variable costs vary directly with the level of production. For example, each calculator produced by Texas Instruments (TI) involves a cost of plastic, microprocessing chips, packaging, and the like. These costs tend to be constant per unit produced, but they are called variable because their total varies with the number of units produced.

Total costs consist of the sum of the fixed and variable costs for any given level of production. Average cost is the cost per unit at that level of production; it is equal to total costs divided by production. Management wants to charge a price that will at least cover the total production costs at a given level of production.

To price intelligently, management needs to know how its costs vary with different levels of production. A firm's cost per unit is high if only a few units are produced every day, but as production increases, fixed costs are spread over a higher level of production results in each unit, bringing the average cost down. At some point, however, higher production will lead to higher average cost because the plant becomes inefficient (due to problems such as machines breaking down more often). By calculating costs for different-sized plants, a company can identify the optimal plant size and production level to achieve economies of scale and bring down the average cost.

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