Final answer:
For external reporting, production costs include both fixed and variable costs. Fixed costs are the consistent expenses irrespective of output, like rent, while variable costs vary with production levels, such as the cost of raw materials.
Step-by-step explanation:
When considering the cost classification required for external reporting, production costs encompass both direct and indirect costs. In the realm of finance and accounting, we often evaluate costs in terms of their behavior in relation to output levels. Fixed costs and variable costs are the primary components that makeup production costs.
Fixed costs are expenses that do not change regardless of the level of production within the relevant period. This typically includes costs such as rent on a factory or machinery and equipment that are necessary for the production process. These costs are incurred even before production begins and will not fluctuate with production volume, making these costs somewhat predictable.
On the other hand, variable costs fluctuate with the level of output. These costs increase as production rises and decrease when production is reduced. Variable costs experience diminishing marginal returns; as production increases, the marginal cost for each additional unit tends to rise.
Therefore, option d) 'They encompass both direct and indirect costs.' is correct in the context of the cost classification required for external reporting. Both fixed and variable costs need to be taken into account when calculating the total production cost, each playing a different role in the production and financial planning processes of an organization.