Many companies do not fully understand the cost of production. They believe that a product with a fixed cost is a product that is free from the variation with respect to demand, quantity and quality. This is not entirely true, because the cost of production varies depending upon the scale of production, the nature of the product itself, and the role of consumers or suppliers in maintaining the demand. To illustrate this, suppose that a given amount of widgets is produced in one year and that number of widgets has been constant over the years. The production function has been unchanged for all these years but now suppose that the number of widgets increases, so does the demand for them.
We can now identify two factors, the total number of units produced per year and the net change in production. We may assume that the overall value of the output, i.e., total sales less total cost of production is proportional to the output value of each unit. If we then take the sales volume of one company per year and divide it by the number of units produced, we get a measure of the company’s revenue. This would be the indicator of value added on the widgets that are sold. This process can also be used to measure the cost of production of a company’s output.
It is a mistake to think that the production process has any effects on the value of output other than those directly resulting from alterations in the variables of production. Economic theory maintains that there are two forces acting on the value of production: increases in the variables reflecting increased demand and decreases in the variables reflecting decreases in supply. There is therefore only one force acting on the value of a variable input, which is the returns to the firm. Thus, changes in output are not independent of changes in the prices or wages of labor and capital. In a production process oriented economy, changes in the rate of return on investment are the key forces determining value.
Another error regarding the representation of input-cost relations is the assumption that changes in scale of production are independent of changes in output due to scale differences. Although the distribution of inputs across scale does not affect the overall value of output, the nature of the inputs and the extent of inputs in the production system may affect the relative relationships among the prices of inputs, output and scale. A standard approach to solving the distribution problems is to assume that output and cost are independent of scale.
The assumption that the distribution of input costs is independent of changes in the output is usually a mistake because it leads to overpricing of various inputs and underpricing of other inputs. Output pricing and cost pricing are determined by various inputs affecting costs and the output quality. One example is found when firms with very similar products have different ways of measuring quality. Even if they use similar measuring methods, their outputs may be very different.
The tendency to mispricing can be checked by considering a firm’s profit margins as the measure of internal efficiency. An increase in profit and a decrease in cost of production are equivalent if the firm increases its output while maintaining constant at its average cost of production. If the firms produce more per unit input but at a higher cost of production, its profit margin will also decrease. This is because the firm is using variable inputs to increase its output but is charging more than the optimum price for that output. It is also possible to raise output at the expense of reducing the cost of production.
If the firm has constant inputs and constant costs, then the value of output and cost of production must be equalized over time, as firms attempt to maintain consistency in their production processes. However, if there is a substantial change in either input cost or output cost, then this may change the relationship of these variables. Input cost is determined by the fixed inputs in a production process. Output cost is determined by the variable inputs in a production process. Since both of these variables are in free-fall, a change in one of these factors will have an effect on the other. If the firm adjusts its fixed input costs according to a changing output cost, then it may cause a change in output.
Constant inputs and constant outputs are necessary for a firm to achieve its objectives. If one input is changed from constant to variable then this will change both the costs and the outputs. Thus, firm A may be optimizing one aspect of its production process and its end outcome, while failing to optimize another aspect. Since all the firm’s outputs are already determined according to its cost of production, it is difficult to determine which of these aspects is most important.