The factor cost represents the entire cost from each individual item needed to produce a good. These costs can include raw materials necessary to produce a good, labor needed to transform the raw materials to finished goods, and the indirect costs allocated to goods, such as electricity, rent or other fixed costs. Using the factor cost (also known as the cost for factors or production) for goods and services is quite different than allowing the market to dictate a price for products.
The factors of production consist of land, labor and capital. These items are necessary to produce goods and services, with most companies having to purchase or expend time or money to gather the factors of production. Under factor cost principles, a company can charge consumers the total cost of production when exchanging goods in an economic transaction. A major issue with this costing process is that companies can pass inefficiencies onto consumers. For example, a consumer may desire to purchase a widget at $5 US Dollars (USD). However, no company can produce a widget at less than $7 USD based on the current costs for the factors of production. If this cost increase is the result of a company’s poor production processes, then the consumer must pay for this inefficiency.
One benefit from the costing of goods using the factor cost process is the ability for consumers to avoid paying for indirect taxes. Many companies add the cost of doing business — such as business licenses, federal taxes or other unavoidable government taxes — to the goods and services they produce. These costs will unnaturally raise the cost of consumer products and result in consumers having less income to spend on goods and services. Government subsidies can also help lower the factor cost of goods and services. Subsidizing goods will help companies recoup some costs prior to selling the products to consumers. Through a subsidizing process, governments can attempt to offset the high costs associated with the factors of production, thereby extending the purchasing power of money held by consumers.
Factor cost as the base charge for goods and services often attempts to place a true economic value on goods produced. Profits are low or may be non-existent if a company is unable to control their costs. In this scenario, government subsidies are how a business will earn capital to continue the production of goods and services. New industries with emerging technology or other goods with little market demand may be difficult for companies to produce. Governments help further these technologies by giving by offsetting the factor costs associated with the factors of production.