What exactly does upgrading the “Venom” augment of Caustic Quills do

At Heat Lvl 5 and 10 your weapons get a small but meaningful bonus, and yes if you took the time to look at a Lvl 1 item you see the blue bar and some dark blueish bar after that. Each level fills that up a bit. For crafting the higher tier items eg.Tempered Calibur it need the standard stuff plus a Calibur. An Acended Calibur requires a lvl 5+ Tempered Calibur. A rule of thumb is if you're not at the highest tier of gear and your stuff is lvl 10 get new stuff.

The Spiral Knights Wiki has the skinny on crafting:

Alchemy Machines are located in Haven, Moorcroft Manor, and Emberlight. Haven has several Alchemy Machines which can be found in Guildhalls, the Bazaar, Arcade, and the Town Square. The cost of crafting an item depends on its star level, and generally doubles with each additional star.

• Alchemy Cost:
• ★☆☆☆☆: 200 crowns/ 10 energy
• ★★☆☆☆: 400 crowns/ 50 energy
• ★★★☆☆: 1,000 crowns/ 200 energy
• ★★★★☆: 2,500 crowns/ 400 energy
• ★★★★★: 5,000 crowns/ 800 energy

Usually, crafting is much cheaper than buying the item pre-made from a vendor, and also gives the added possibility of creating a unique variant (see below). Pre-made items increase in price as their star level increases. Thus, items with a high star level are generally cheaper to craft than to buy pre-made.