To understand how profitable a business is, it’s important to understand the costs. There are two categories of costs, based on whether or not the costs change. These categories are variable and fixed costs.

Some costs - such as machinery tooling, building out a factory, or designing a new product - don’t change with the number of products produced. That makes them fixed costs.

Other costs - such as parts, labor, and shipping - do change based on how many products are produced. These are considered variable costs.

Production overhead costs

Any cost associated with producing or manufacturing a product that is neither the materials nor the cost of labor working directly with those materials is considered a production overhead cost.

Management salaries are considered a production overhead cost because managers don’t work on products directly.

Production overhead costs are part of the conversion costs for a business to convert raw materials into finished products. Production overhead costs are indirect costs. They are accounted for in the inventory account.

Costs for areas of the business such as sales and general administration (ie human resources employees) are not production overhead costs.

To get a full picture of the costs of operating a business, add up all the variable and fixed costs. This sum is called the total cost.

A business is profitable if the total revenue exceeds the total cost of operation. To maximize profits, businesses should produce products until Marginal cost is greater than marginal revenue (or the market price).

Average total cost (ATC) is a helpful metric when evaluating production costs. ATC= (total cost to produce all units)/(# units produced).

Due to fixed cost, the ATC is typically higher for low quantities of production. When selling fewer units, fixed overhead like rents and wages have a bigger impact on the Average total cost to produce each unit.

Production function

Increasing inputs generally results in increasing outputs. The increase in production in response to increasing an input (such as number of workers) is called marginal product.

However, marginal product doesn’t always increase linearly with increases in input (such as number of workers). When this happens, the input is no longer the only bottleneck. For example, adding more workers is efficient until all the machinery has an operator; afterwards adding workers is much less effective. Much like with marginal utility, there is a point where additional input has less utility than it used to. This is called diminishing marginal product.

Increasing the output has another benefit. Fixed costs are shared across all outputs, so fixed costs per unit go decrease when production increases.

Focus on the relationship between Marginal cost and average cost per unit. When Marginal cost is lower than the average cost, producing more units makes an operation more efficient.

When the Marginal cost of producing another unit is higher than the average cost to produce a unit, producing more units makes an operation less efficient.