Components and Example of Total Cost


Meaning of Total Cost

Total cost refers to the cost incurred in the final production of a particular product or given level of output. In simple terms, total cost is the sum of all cost elements associated with production of particular level of output. Total cost typically involves combination of two components: Fixed cost and variable cost. Fixed cost is the cost that remains fixed and does not vary with changes in the level of output produced such as the leasing cost of building, machinery, and lightning expenses.

On the other hand, variable cost is one that changes with the variations in the level of output produced like raw materials and labor cost. The variable cost rises with the increase in production and falls with the decrease in the level of production.

The economist more oftenly uses 2-factor inputs for the explanation of cost model i.e., Capital (K) and Labor (L). The capital comes under the category of fixed cost that remain stable irrespective of what level of production is carried out. The rental price (fixed cost) on a per unit basis is represented by ‘r’ and this way total fixed cost equates to ‘Kr’. The labor is considered as variable cost which changes as per the production level. ‘w’ is used for denoting wage rate and this way the total variable cost equals to ‘Lw’.

Symbolically, Total cost can be represented by the equation:

TC = FC + VC = Kr + Lw

Components of Total cost

The components of the total cost are well-explained in the points given below: – 

Direct Material

Direct materials include the cost of all those materials which are primarily used in the production of the finished products. These materials are necessarily required for the production of a specific product and in their absence, a product can’t be produced. Direct materials become an integral part of finished goods produced by brands. It is also easy to trace the per-unit cost of these materials used in the manufacturing process. Examples of direct materials include iron and steel used for making car bodies, raw cotton used in textile manufacturing, and the use of crude oil for making petrol.   

Direct Labor

Direct labor refers to the workers who are directly engaged in the production activities of a product. It is a cost of labor associated with the particular product or specific work activity performed. Direct labor included labor costs of assemblers and one who operates machinery. 

Direct Expenses

All expenses related to the production of a specific product and do not fall under the category of direct materials or direct labor are termed direct expenses. These expenses are traceable on a per unit basis and are charged as the prime cost of the product. Examples include cost paid for hiring special machinery or plant for production, surveyors and architect fees, and freight charges paid on special materials.

Factory Overheads

Factory overheads is a term that is composed of indirect labor, indirect material as well as indirect expenses. These are also termed as manufacturing expenses which are indirect in the way that they are not directly linked to the production of products.

Selling and Distribution/ Administrative overheads

Selling and distribution cost is a component that begins after the product is produced and ready for sale in the market. This cost comes after the end of factory cost. It comprises all those expenses which are incurred by the firm to facilitate or boost its selling activities. Salaries and commission of salesmen, advertising and packaging cost, sales administrative cost, and cost incurred on transportation and storage of goods comes under the category of selling and distribution expenses.

Example of Total cost

Mr. Jack Bone work as a chief operating officer with one of world-leading car manufacturer company. The management team of company is noticing that their total cost is rising by 17% year over year. Jack is asked to analyze the trend and provide with an appropriate recommendation plan. 

On carrying out various analyses, Jack found that costs have increased from $100000 to $136890 in just 2 years which obviously denotes an extreme rise in cost. On further evaluating these numbers, it was surprisingly found that fixed cost has in fact fallen from $80000 to $46000. The increase in cost is resulting out of rising in variable cost, particularly the salary and related benefits have sharply risen to $76480 from $38000.

Jack recommended to management that the opportunity cost of $38480 (rise in variable cost) is high and should be spend elsewhere. Eventually company reduces the staff numbers and increase the shift, and amount of $38480 was spend on doing investment for company. These actions eventually bring down the overall total cost of the organization.