It is a term in economics, which is equal to the sum of all costs incurred by a manufacturer or a provider producing a certain level of output.
Total Cost Details
The total cost calculates everything that the business spends and dividing the result by unit output. Total cost gives you insight into how profitable your business is and whether it would be better to adjust pricing, reduce costs, or diversify your product line to increase profit.
Generally, it expresses the combination of all fixed costs (expenses independent of the number of produced goods or services and usually represent machinery, salaries, and lease) and all variable costs, which change according to the volume of activity of an organization (direct labor and raw materials). Two calculation issues that appear are that if you have an order for more units, your variable cost will be lower and that the fixed cost can vary when it expresses the smaller or larger number of units produced. Therefore, there’s no long-term fixed cost, and it’s necessary to recalculate the total cost whenever the unit volume changes.
Example of Total Cost
The following formula represents how to calculate the total cost:
Total Cost = (Average fixed cost + Average variable cost) * Quantity of units
For example, a firm is incurring $200,000 of fixed costs from salaries and machinery rented to produce 400 units. The average fixed cost per unit is now $500 and if you want to produce 1,000 with a variable cost per unit is $10, the total cost of production becomes the following:
($500 Average fixed cost + $2 Average variable cost) x 1,000 Units = $510,000
Additionally, it’s helpful to know that “increasing returns to scale” refers to a production process where an increase in the number of units produced causes a decrease in the average cost of each unit (when raw materials are purchasable at a cheaper price). “Diminishing return to scale” refers to products for which the average costs of output increase as the level of production increases (for example, in the event a company is forced to import raw materials due to production increase).
Total Cost vs. Economic Cost
As you know, the average cost of a unit is the total cost divided by the number of units produced. The marginal cost of a given unit of output is the increase in the total cost required to produce that unit. And so, they both depend primarily on the total cost.
Another accounting term closely related to the total cost is economic cost. It represents the cost of a decision that a firm makes depending on the cost of the option chosen and the benefit that the best option may provide.
An economic cost is a forecasting tool, and just like total cost, it equals the sum of all the variable and fixed costs added to the opportunity costs. Calculating the economic cost involves total cost, variable cost, fixed cost, average cost, and marginal cost.
Significance of Total Cost
Knowing the total production cost of an item is crucial to a business’s pricing policy. In addition, companies often use their total cost calculations to measure their efficiency and identify where they could make savings, like buying materials from a cheaper supplier or moving into a factory with more affordable rent. The total cost can also apply when setting the product price, determining the marketing strategy, and identifying the product lines that need a redesign.
The main advantage of using the total cost is that it can be compared over time to help with analysis and strategy construction. It’s a benchmarking tool that evaluates the performance of a business compared to its competitors.
However, for larger businesses with several different products or services available, calculating the total cost can be very complicated. They produce a greater number of items, and their prices are much higher, so it becomes difficult to allocate the expenses effectively to calculate the total. Moreover, in a business where the cost of supplies varies constantly or seasonally, the variable cost in the formula needs to be continuously adjusted.