Production Cost and Selling Cost

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PRODUCTION COSTCost-of-production theory of value

In economics, the cost-of-production theory of value is the theory that the price of an

o !ect or condition is determined y the sum of the cost of the resources that "ent intoma#in$ it% The cost can comprise any of the factors of production &includin$ la or,

capital, or land' and ta(ation %

The theory ma#es the most sense under assumptions of constant returns to scale and the

e(istence of !ust one non-produced factor of production% These are the assumptions of the

so-called non-su stitution theorem % Under these assumptions, the lon$-run price of a

commodity is e)ual to the sum of the cost of the inputs into that commodity, includin$

interest char$es%

Historical development of theory[ edit ]

*istorically, the est-#no"n proponent of such theories is pro a ly +dam Smith % Piero

Sraffa , in his introduction to the first volume of the Collected or#s of David Ricardo ,

referred to Smith.s addin$-up theory% Smith contrasted natural prices "ith mar#et price %

Smith theori/ed that mar#et prices "ould tend to"ard natural prices, "here outputs

"ould stand at "hat he characteri/ed as the level of effectual demand % +t this level,

Smith.s natural prices of commodities are the sum of the natural rates of "a$es, profits,

and rent that must e paid for inputs into production% &Smith is am i$uous a out "hetherrent is price determinin$ or price determined% The latter vie" is the consensus of

later classical economists , "ith the Ricardo-0althus- est theory of rent%'

David Ricardo mi(ed this cost-of-production theory of prices "ith the la or theory of

value , as that latter theory "as understood y 1u$en von 23hm-2a"er# and others% This

is the theory that prices tend to"ard proportionality to the socially necessary la or

em odied in a commodity% Ricardo sets this theory at the start of the first chapter of his

Principles of Political 1conomy and Ta(ation % *e also refutes the la or theory of valuein later sections of that chapter% This refutation leads to "hat later ecame #no"n as

the transformation pro lem% 4arl 0ar( later ta#es up that theory in the first volume

of Capital , "hile indicatin$ that he is )uite a"are that the theory is untrue at lo"er levels

of a straction% This has led to all sorts of ar$uments over "hat oth David Ricardo and
http://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Factors_of_productionhttp://en.wikipedia.org/wiki/Effect_of_taxes_and_subsidies_on_pricehttp://en.wikipedia.org/wiki/Constant_returns_to_scalehttp://en.wikipedia.org/w/index.php?title=Non-substitution_theorem&action=edit&redlink=1http://en.wikipedia.org/w/index.php?title=Cost-of-production_theory_of_value&action=edit&section=1http://en.wikipedia.org/wiki/Adam_Smithhttp://en.wikipedia.org/wiki/Piero_Sraffahttp://en.wikipedia.org/wiki/Piero_Sraffahttp://en.wikipedia.org/wiki/Principles_of_Political_Economy_and_Taxationhttp://en.wikipedia.org/wiki/Prices_of_productionhttp://en.wikipedia.org/wiki/Market_pricehttp://en.wikipedia.org/wiki/Classical_economicshttp://en.wikipedia.org/wiki/David_Ricardohttp://en.wikipedia.org/wiki/Labor_theory_of_valuehttp://en.wikipedia.org/wiki/Labor_theory_of_valuehttp://en.wikipedia.org/wiki/Eugen_von_B%C3%B6hm-Bawerkhttp://en.wikipedia.org/wiki/Principles_of_Political_Economy_and_Taxationhttp://en.wikipedia.org/wiki/Transformation_problemhttp://en.wikipedia.org/wiki/Karl_Marxhttp://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Factors_of_productionhttp://en.wikipedia.org/wiki/Effect_of_taxes_and_subsidies_on_pricehttp://en.wikipedia.org/wiki/Constant_returns_to_scalehttp://en.wikipedia.org/w/index.php?title=Non-substitution_theorem&action=edit&redlink=1http://en.wikipedia.org/w/index.php?title=Cost-of-production_theory_of_value&action=edit&section=1http://en.wikipedia.org/wiki/Adam_Smithhttp://en.wikipedia.org/wiki/Piero_Sraffahttp://en.wikipedia.org/wiki/Piero_Sraffahttp://en.wikipedia.org/wiki/Principles_of_Political_Economy_and_Taxationhttp://en.wikipedia.org/wiki/Prices_of_productionhttp://en.wikipedia.org/wiki/Market_pricehttp://en.wikipedia.org/wiki/Classical_economicshttp://en.wikipedia.org/wiki/David_Ricardohttp://en.wikipedia.org/wiki/Labor_theory_of_valuehttp://en.wikipedia.org/wiki/Labor_theory_of_valuehttp://en.wikipedia.org/wiki/Eugen_von_B%C3%B6hm-Bawerkhttp://en.wikipedia.org/wiki/Principles_of_Political_Economy_and_Taxationhttp://en.wikipedia.org/wiki/Transformation_problemhttp://en.wikipedia.org/wiki/Karl_Marx


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4arl 0ar( really meant % Nevertheless, it seems undenia le that all the ma!or classical

economics and 0ar( e(plicitly re!ected the la or theory of price 567&567'%

+ some"hat different theory of cost-determined prices is provided y the neo-RicardianSchool 587of Piero Sraffa and his follo"ers%

The Polish economist 0icha9 4alec#i 5:7 distin$uished et"een sectors "ith cost-determined prices &such as manufacturin$ and services' and those "ith demand-determined prices &such as a$riculture and ra" material e(traction'%

One mi$ht thin# of this theory as e)uivalent to modern theories of mar#up pricin$, full-cost pricin$, or administrative pricin$ % 1ver since *all and *itch, 587 economists 5citationneeded 7 have found that the evidence $athered in surveys of usinessmen support suchtheories%

0ost contemporary economists accept neoclassical economics or mainstream economics%The non-su stitution theorem is presented in $raduate-level microeconomics te(t oo#s asa theorem of mainstream economics% 0any mainstream economists also elieve they can

!ustify theories of full-cost pricin$ "ithin their theory% The ma!ority of mainstreameconomists "ould pro a ly then accept this theory as an element in their theory, "hichdoes not $ive ade)uate attention to issues of consumer demand and mar$inal utility %

Market price[ edit ]

Main article: Market price

0ar#et price is a familiar economic concept; it is the price that a $ood or service is

offered at, or "ill fetch, in the mar#etplace% It is of interest mainly in the study of

microeconomics% 0ar#et value and mar#et price are e)ual only under conditions of

mar#et efficiency, e)uili rium, and rational e(pectations%

In economics, returns to scale and economies of scale are related terms that descri e"hat happens as the scale of production increases% They are different, non-interchan$ea le terms%

Labor theory of value[ edit ]

Main article: Labor theory of value

The la or theories of value are economic theories accordin$ to "hich the true values ofcommodities are related to the la or needed to produce them%

There are many accounts of la or value, "ith the common element that the value of ane(chan$ea le $ood or service is, or ou$ht to e, or tends to e, or can e considered as,

e)ual or proportional to the amount of la or re)uired to produce it &includin$ the la or

re)uired to produce the ra" materials and machinery used in production'%
http://en.wikipedia.org/wiki/Production_cost#cite_note-Gordon-1http://links.jstor.org/sici?sici=0002-8282(195905)49%3A2%3C462%3AWWTLTO%3E2.0.CO%3B2-9http://en.wikipedia.org/wiki/Neo-Ricardianismhttp://en.wikipedia.org/wiki/Neo-Ricardianismhttp://homepage.newschool.edu/~het/schools/neoric.htmhttp://en.wikipedia.org/wiki/Piero_Sraffahttp://en.wikipedia.org/wiki/Micha%C5%82_Kaleckihttp://homepage.newschool.edu/~het/profiles/kalecki.htmhttp://en.wikipedia.org/w/index.php?title=Full-cost_pricing&action=edit&redlink=1http://en.wikipedia.org/w/index.php?title=Full-cost_pricing&action=edit&redlink=1http://en.wikipedia.org/w/index.php?title=Administrative_pricing&action=edit&redlink=1http://en.wikipedia.org/wiki/Production_cost#cite_note-HallHitch-2http://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Neoclassical_economicshttp://en.wikipedia.org/wiki/Marginal_utilityhttp://en.wikipedia.org/w/index.php?title=Cost-of-production_theory_of_value&action=edit&section=2http://en.wikipedia.org/wiki/Market_pricehttp://en.wikipedia.org/wiki/Rational_expectationshttp://en.wikipedia.org/w/index.php?title=Cost-of-production_theory_of_value&action=edit&section=3http://en.wikipedia.org/wiki/Labor_theory_of_valuehttp://en.wikipedia.org/wiki/Production_cost#cite_note-Gordon-1http://links.jstor.org/sici?sici=0002-8282(195905)49%3A2%3C462%3AWWTLTO%3E2.0.CO%3B2-9http://en.wikipedia.org/wiki/Neo-Ricardianismhttp://en.wikipedia.org/wiki/Neo-Ricardianismhttp://homepage.newschool.edu/~het/schools/neoric.htmhttp://en.wikipedia.org/wiki/Piero_Sraffahttp://en.wikipedia.org/wiki/Micha%C5%82_Kaleckihttp://homepage.newschool.edu/~het/profiles/kalecki.htmhttp://en.wikipedia.org/w/index.php?title=Full-cost_pricing&action=edit&redlink=1http://en.wikipedia.org/w/index.php?title=Full-cost_pricing&action=edit&redlink=1http://en.wikipedia.org/w/index.php?title=Administrative_pricing&action=edit&redlink=1http://en.wikipedia.org/wiki/Production_cost#cite_note-HallHitch-2http://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Wikipedia:Citation_neededhttp://en.wikipedia.org/wiki/Neoclassical_economicshttp://en.wikipedia.org/wiki/Marginal_utilityhttp://en.wikipedia.org/w/index.php?title=Cost-of-production_theory_of_value&action=edit&section=2http://en.wikipedia.org/wiki/Market_pricehttp://en.wikipedia.org/wiki/Rational_expectationshttp://en.wikipedia.org/w/index.php?title=Cost-of-production_theory_of_value&action=edit&section=3http://en.wikipedia.org/wiki/Labor_theory_of_value


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Different la or theories of value prevailed amon$ classical economists throu$h the mid-

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2usinesses that #no" their production costs #no" the total e(pense to the production

line, or ho" much the entire process "ill cost to produce the item% If costs are too hi$h,

these can e decreased or possi ly eliminated% Production costs can e used to compare

the e(penses of different activities "ithin the company% In production, there are direct

costs and indirect costs% >or e(ample, direct costs for manufacturin$ an automo ile are

materials such as the plastic, metal or la or incurred to produce such an item% Indirect

costs include overhead such as rent, salaries or utility e(pense%

The costs related to ma#in$ or ac)uirin$ $oods and services that directly

$enerates revenue for a firm% It comprises of direct costs and indirect costs % Direct costs

are those that are tracea le to the creation of a product and include costs

for materials and la or "hereas indirect costs refer to those costs that cannot e traced to

the product such as overhead %

Cost of production refers to the total sum of money needed for the production of a

particular )uantity of output% +s defined y ?ulhrie and allace, @In 1conomics, cost of

production features a special meanin$% It is all a out the payments or e(penditures

essential to $et the factors of production of land, la or, capital and mana$ement needed to produce a commodity% It si$nifies the money costs "hich are to e incurred for

ac)uisition of the factors of production%A In the "ords of Camp ell, @Production Costs

are the costs "hich should e essentially received y resource o"ners so as to presume

that they "ill continue to supply them in a specific period of time%A

Elements of Production Cost

The #ey elements included in the production costs are as follo"s;

Purchase of ra" machinery

Installation of plant and machinery

a$es of la or

2uildin$ rent

Interest on capital

ear and tear of uildin$ and machinery
http://www.businessdictionary.com/definition/costs.htmlhttp://www.businessdictionary.com/definition/maker.htmlhttp://www.businessdictionary.com/definition/acquirer.htmlhttp://www.businessdictionary.com/definition/goods-and-services.htmlhttp://www.businessdictionary.com/definition/revenue.htmlhttp://www.businessdictionary.com/definition/revenue.htmlhttp://www.businessdictionary.com/definition/comprise.htmlhttp://www.businessdictionary.com/definition/comprise.htmlhttp://www.businessdictionary.com/definition/direct-cost.htmlhttp://www.businessdictionary.com/definition/indirect-cost.htmlhttp://www.businessdictionary.com/definition/product.htmlhttp://www.businessdictionary.com/definition/material.htmlhttp://www.businessdictionary.com/definition/labor.htmlhttp://www.businessdictionary.com/definition/labor.htmlhttp://www.businessdictionary.com/definition/overhead.htmlhttp://www.businessdictionary.com/definition/overhead.htmlhttp://www.businessdictionary.com/definition/costs.htmlhttp://www.businessdictionary.com/definition/maker.htmlhttp://www.businessdictionary.com/definition/acquirer.htmlhttp://www.businessdictionary.com/definition/goods-and-services.htmlhttp://www.businessdictionary.com/definition/revenue.htmlhttp://www.businessdictionary.com/definition/comprise.htmlhttp://www.businessdictionary.com/definition/direct-cost.htmlhttp://www.businessdictionary.com/definition/indirect-cost.htmlhttp://www.businessdictionary.com/definition/product.htmlhttp://www.businessdictionary.com/definition/material.htmlhttp://www.businessdictionary.com/definition/labor.htmlhttp://www.businessdictionary.com/definition/overhead.html


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+dvertisement e(penses

Payment of ta(es

Insurance char$es

The imputed value of factor of production o"ned y the firm itself is also added

in the production cost%

The production cost also includes the normal profit of the entrepreneur%

Formula for computing Production Costs

The $eneral formula used for computin$ production cost is;

Production cost per item = Fixed Cost (FC ! "ariable cost ("C # $o% of units produced

Calculating production cost

The #ey steps involved in computation of production cost are;

Determine the fi(ed cost% These are the costs "hich do not alter on the asis of the

num er of products produced% This includes the rent paid for uildin$, salaries of the

employees, and utility costs%

1stimate the varia le costs % These are the costs that chan$e "ith a chan$e in the

)uantity of production% >or e(ample, if you are ma#in$ a ca#e, some of the varia le

costs "ould e flour, e$$s, and su$ar%

+dd the fi(ed costs to the varia le costs and divide this num er y the num er of

items produced thus reachin$ the production cost for one item%
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S1BBIN? COST

Cost of sales if said in a phrase then it basically is, manufacturing cost of units sold in a particular period or

simply cost.

On the other hand selling costs include such costs that are incurred to make things available for sale.

Important thing to understand here is that even after incurring cost of sales, you cannot sell the goods unless

business incurs selling costs.

Here it will be good we define finished goods also. here are many ways to define finished goods according the

production process and business practices in a particular situation. !ut going specific and ignoring e"ceptions

then finished goods are such goods that are completely manufactured.


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!ut being completely manufactured does not mean that goods are also in salable condition.

#et $eali%able &alue '#$&( means what business has realized on selling an inventory. It is calculated by

deducting selling costs from sales value. he reason why only selling costs are deducted out of the sales revenue

is that users of financial information might be interested in knowing that how much additional cost was incurred

before the revenue 'that business has generated( was actually made possible to be generated. )s without selling

costs, business might have not generated any revenue at a ll.

*or e"ample, to drive a car, you have to give ignition. +ithout ignition, you cannot drive a car. ame way, to

generate revenue and to earn profits ultimately, you have to incur selling costs. Otherwise, you will not be able to

get any profits out of the value you have added into the manufactured goods by incurring manufacturing costs.

+hile valuing the closing inventory for financial reporting purposes, we compare the cost 'manufacturing cost(

and #$& of the inventory and as per I) -, inventory is to be valued at lower of cost and #$&.

Cost of goods soldCost of goods sold or COGS refer to the carrying value of goods sold during a particular period.Costs are associated with particular goods using one of several formulas, including specific identification, first-infirst-out (FIFO , or average cost. Costs include all costs of purchase, costs of conversion and other costs incurredin !ringing the inventories to their present location and condition. Costs of goods made !y the !usiness includematerial, la!or, and allocated overhead. "he costs of those goods not yet sold are deferred as costs of inventoryuntil the inventory is sold or written down in value.

#any !usinesses sell goods that they have !ought or produced. $ hen the goods are !ought or produced, the costs associatedwith such goods are capitali%ed as part of inventory (or stoc& of goods . ' ) "hese costs are treated as an e*pense in the period the!usiness recogni%es income from sale of the goods. '+)

etermining costs re uires &eeping records of goods or materials purchased and any discounts on such purchase. In addition, ifthe goods are modified , ' ) the !usiness must determine the costs incurred in modifying the goods. Such modification costs includela!or, supplies or additional material, supervision, uality control and use of e uipment. /r inciples for determining costs may !e

easily stated, !ut application in practice is often difficult due to a variety of considerations in the allocation of costs.'0)

Cost of goods sold may also reflect ad1ustments. 2mong the potential ad1ustments are decline in value of the goods (i.e., lowermar&et value than cost , o!solescence, damage, etc.

$hen multiple goods are !ought or made, it may !e necessary to identify which costs relate to which particular goods sold. "hismay !e done using an identification convention, such as specific identification of the goods ,first-in-first-out (FIFO , or averagecost. 2lternative systems may !e used in some countries, such as last-in-first-out (3IFO , gross profit method, retail method, orcom!inations of these.

Cost of goods sold may !e the same or different for accounting and ta* purposes, depending on the rules of the particular 1urisdiction. Certain e*penses are included in COGS. 4*penses that are included in COGS cannot !e deducted again as a!usiness e*pense. COGS e*penses include5

"he cost of products or raw materials, including freight or shipping charges6 "he cost of storing products the !usiness sells6 irect la!or costs for wor&ers who produce the products6 and Factory overhead e*penses.

Importance of inventories [ edit ]

Inventories have a significant effect on profi ts. 2 !usiness that ma&es or !uys goods to sell must &eep trac& of inventories ofgoods under all accounting and income ta* rules. 2n e*ample illustrates why. Fred !uys auto parts and resells them. In +778,Fred !uys 9 77 worth of parts. :e sells parts for 987 that he !ought for 9 7, and has 9;7 worth of parts left. In +77


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remainder of the parts for 9 87. If he &eeps trac& of inventory, his profit in +778 is 9=7, and his profit in +77< is 9 7, or 9 >7 intotal. If he deducted all the costs in +778, he would have a loss of 9+7 in +778 and a profit of 9 87 in +77


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!ased on past e*perience and management 1udgment as to factual relationships. 2ctivity !ased costing attempts to allocate costs!ased on those factors that drive the !usiness to incur the costs.

Overhead costs are often allocated to sets of produced goods !ased on the ratio of la!or hours or costs or the ratio of materialsused for producing the set of goods. Overhead costs may !e referred to as factory overhead or factory !urden for those costsincurred at the plant level or overall burden for those costs incurred at the organi%ation level. $here la!or hours are used,a burden rate or overhead cost per hour of la!or may !e added along with la!or costs. Other methods may !e used to associate

overhead costs with particular goods produced. Overhead rates may !e standard rates, in which case there may !e variances, ormay !e ad1usted for each set of goods produced.

Daria!le production overheads are allocated to units produced !ased on actual use of production facilities. Fi*ed productionoverheads are often allocated !ased on normal capacities or e*pected production. ' 7) #ore or fewer goods may !e produced thane*pected when developing cost assumptions (li&e !urden rates . "hese differences in production levels often result in too much ortoo little cost !eing assigned to the goods produced. "his also gives rise to variances.

Identification conventions [ edit ]

In some cases, the cost of goods sold may !e identified with the i tem sold. Ordinarily, however, the identity of goods is lost!etween the time of purchase or manufacture and the time of sale. ' ) etermining which goods have !een sold, and the cost ofthose goods, re uires either identifying the goods or using a convention to assume which goods were sold. "his may !e referredto as a cost flow assumption or inventory identification assumption or convention. ' +) "he following methods are availa!le in many

1urisdictions for associating costs with goods sold and goods still on hand5

Specific identification. @nder this method, particular items are identified, and costs are trac&ed with respect to each

item. ' ) "his may re uire considera!le record&eeping. "his method cannot !e used where the goods or items areindistinguisha!le or fungi!le.

2verage cost. "he average cost method relies on average unit cost to calculate cost of units sold and ending inventory.

Several variations on the calculation may !e used, including weighted average and moving average. First-In First-Out (FIFO assumes that the items purchased or produced first are sold first. Costs of inventory per unit or

item are determined at the time made or ac uired. "he oldest cost ( i.e. , the first in is then matched against revenue andassigned to cost of goods sold.

3ast-In First-Out (3IFO is the reverse of FIFO. Some systems permit determining the costs of goods at the time

ac uired or made, !ut assigning costs to goods sold under the assumption that the goods made or ac uired last are soldfirst. Costs of specific goods ac uired or made are added to a pool of costs for the type of goods. @nder this system, the!usiness may maintain costs under FIFO !ut trac& an offset in the form of a 3IFO reserve. Such reserve (an asset or contra-asset represents the difference in cost of inventory under the FIFO and 3IFO assumptions. Such amount may !e differentfor financial reporting and ta* purposes in the @nited States.

ollar Dalue 3IFO. @nder this variation of 3IFO, increases or decreases in the 3IFO reserve are determined !ased on

dollar values rather than uantities. Eetail inventory method. Eesellers of goods may use this method to simplify record&eeping. "he calculated cost of

goods on hand at the end of a period is the ratio of cost of goods ac uired to the retail value of the goods times the retailvalue of goods on hand. Cost of goods ac uired includes !eginning inventory as previously valued plus purchases. Cost ofgoods sold is then !eginning inventory plus purchases less the calculated cost of goods on hand at the end of the period.

Example [ edit ]

ane owns a !usiness that resells machines. 2t the start of +77 * 7.= . She sells machine for 0=. :er cost for that machine depends on her inventory method. If she used
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FIFO, the cost of machine is + plus +7 she spent improving it, for a profit of . Eemem!er, she used up the two 7 cost itemsalready under FIFO. If she uses average cost, it is plus +7, for a profit of 0. If she used 3IFO, the cost would !e 7 plus +7 fora profit of =.

In year :, ane sells the last machine for : and )uits the usiness% She recovers the lastof her costs% *er total profits for the three years are the same under all inventory methods%Only the timin$ of income and the alance of inventory differ% *ere is a comparisonunder >I>O, +vera$e Cost, and BI>O;

Cost of GoodsSold

------ Profit ------

Year Sales FIFO Avg. LIFO FIFO Avg. LIFO

07 +7 ++ +0 +7 8 >

+ 0= + 7 0 =

8 + 7 > ; 8

"otal + 80 80 80 <

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Production Cost and Selling Cost