Since managers must determine the most efficient mix of labor and capital and the most efficient production process, they must study the costs of production. Here you will find that costs are different at different production levels. But why? Why does the cost to produce each item vary as output changes? To answer the question, you must examine the two different kinds of cost that go into producing a product.
Total Costs Equal Fixed Costs Plus Variable
Costs. Wally's Wooden Wagon Company of Wallace, Washington has been manufacturing its famous 'Wallywagon" forover 75 years.
The company operates a small factory with a capacity of 10,000 wagons a year. A firm's capacity is the maximum number of units it can produce. If Wally's Wooden Wagon Company wanted to produce more than 10,000 wagons, it could do so by adding to its floor space, buying new machines, building a new plant, or making some other improvements.
Fixed Costs. Wally's accountant says that the com-pany's fixed costs, or overhead costs as they are often called, are $120,000 a year. Fixed costs remain about the same regardless of the number of wagons the firm produces. Expenses such as rent, real estate taxes, a manager's salary, and interest on loans are examples of fixed costs.
Variable Costs. In addition to its fixed costs, Wally's Wooden Wagons will also have to pay certain variable costs. Variable costs increase and decrease with the volume of business. Hourly wages, power, and raw materials are examples of variable costs. When things are slow, WWW can lay off workers, shut down some of its machines, and buy fewer raw materials. When business picks up, those items of expense will increase.
One day, Walter W. Wally, Jr., the firm's owner, asked his accountant what his average costs were likely to be that year.
"It all depends upon how many wagons you are making," the accountant said. "What does production have to do with it? I just want to know my average costs. You know, the cost of each individual wagon," said Mr. Wally.
"I understand that Mr. Wally," the accountant replied. "Let me show you the results of a study we just completed. You'll see what I mean." Then the accountant showed the figures in Table 7-1.
"Hmm," Mr. Wally murmured after looking over the figures. "I think you had better tell me what all this means."
The accountant explained that total production costs are the sum of the fixed costs and the variable costs. If you want to know the cost of a single item, you can find it by calculating the average fixed cost and the average variable cost then adding the two together.
The table includes costs for six different levels of production. Production levels are shown in Column 1, Wagons Produced. Column 2 lists the total fixed costs. You can see that they remain the same at every production level. Total variable costs listed in Column 4, however, increase with the output.
Columns 3 and 5 list the average fixed and variable
costs. They are calculated by dividing the total costs in Columns 2 and 4bythenumberofwagons produced (Column I). Average total costs, Column 6, lists the cost of producing a single wagon at each of the six levels of production. They are found by adding Columns 3 and 5.
Did you notice that as production increased, it cost less to produce the wagons at first? Then, as output increased still further, so did the cost of each wagon? The reason has to do with another one of those "laws" of economics- the law of diminishing returns.
The Law of Diminishing Returns. Because total fixed costs remain the same at every level of production, average fixed costs must decrease every time the output increases. Why, then, did the average cost of a Wallywagon increase when the firm produced more than 6,000 annually?
The answer is related to average variable costs, which declined at first and then began to increase (see Column 5 of 7-1). To increase his output, Mr. Wally would need to hire more workers and keep his machines and other equipment running for longer and longer periods of time. Eventually the point would be reached where the workers would start to get in each other's way, and the machinery would begin to break down. This is the point of diminishing returns. The cost of producing each additional wagon is greater than the cost of producing the one before.
Economists state the law of diminishing returns this way: As variable inputs (items that add to variable costs) are applied to the fixed inputs (such as buildings and machinery), output per unit of input will increase. If the process continues, a point will be reached (the point of diminishing returns) where the output per unit of input will begin to decrease.
But now that Mr. Wally knows how much it costs to produce his Wallywagons, he still needs an answer to a very important question: How many wagons should he produce?
Remember, the plant has a capacity of 10,000 wagons. But when the plant is producing 6,000 wagons annually, average production costs are at the lowest level ($47 per wagon). Should Mr. Wally produce 6,000 wagons or as many as he can?
The number of wagons that Mr. Wally is likely to produce will depend on how many he can sell. Like every wise producer, Mr. Wally knows that the laws of supply and demand will determine how many wagons he should make.
The number of Wallywagons he can sell will depend, in part, on their price. In a recent market survey (Table 7-3) the Wallywagon staff learned the number of wagons they could expect to sell at each of several prices.
Applying this information to its earlier cost study, the accounting staff concluded a selling price of $70 per wagon and a production level of 6,000 wagons would give the firm the greatest profit - $138,000. So, we assume that this is the price and production level Mr. Wally would select.