6 COST Concepts

8/11/2019 6 COST Concepts

1/22

1

Concept of COST

For a manager the production decisions are not

possible without their respective cost considerations.Cost and revenues are two important factors with

which a producer has to determine the profit.

It is the difference between revenue and cost, which

determine firmsoverall profitability.

From the decision making point of view, the concept

of cost is more important than the revenue, because

the firm can influence cost easily than the revenue.More specifically, to know the profitability and

viability of the production process, one has to know the

cost side.


2/22

2

Moreover, for a managerial decision making, it is thefuture cost which matters a lot rather than the currentcosts.

The current cost is relevant only if the management is tocontinue with its past or present policies in future andthe environment in which the firm operates remainunchanged.

The future cost condition is necessary to meet thechanging environment and production process.

In the traditional economic theory, cost can be classifiedinto short-run and long run costs.

Short-run costs are the costs over a period during whichsome factors of production (capital and management)are fixed.

On the other hand, the long-run costs are the costs overa period which allows to change all factors of production.In the long run all factors become variable.


3/22

3

Both in short-run and long-run, the total cost is amulti-variable function, which is derived by manyfactors.

Symbolically, in thelong-run:TC= f (X, T, Pf)

In the short -run:

TC= f (X, T, Pf, K )

Where TC: Total Costs X: Output

T: Technology

Pf: Price of factors

K: Fixed factorsThe cost function can be written as

TC=f(X), ceter is par ibus, wh ich means, al l otherfactors remain ing constant , cos t is a func t ion of

output .


4/22

4

In a traditional short-run theory, the total cost of afirm is split into total fixed cost and total variablecost, i.e.

TC=TFC+TVCWhere Total Fixed Cost (TFC) inc ludes:

Salaries of administrative staff

Depreciation (wear and tear) of machinery

Expenses for land maintenance and depreciation ifany

Expenses for building depreciation and repairs

The Variable Cos t (TVC) inc ludes:

The raw materials The cost of direct labour

The running expenses of fixed capital, such asfuel, ordinary repairs and routine maintenance.


5/22

5

The concept of tota l cos t, total variable cos t and total

f ixed cost in the short- run can be better understood by

the following table:

No. of Units of

Output

Total Fixed Cost

(TFC)

Total Variable

Cost (TVC)Total Cost (TC)

0 50 0 50

1 50 20 70

2 50 35 85

3 50 60 110

4 50 100 150

5 50 145 195

6 50 190 240

7 50 237 287

8 50 284 334


6/22

6

Fixed costs are also known as over head costs,

which includes charges such as contractual rent,

insurance fees, maintenance costs, property tax,

administrative expenses etc.

Thus, fixed costs are those which are incurred in

hiring the fixed factors of production whose amount

can not be altered in the short-run.On the other hand, variable costs are also called

prime or direct costs, which are incurred on the

employment of variable factors of production whose

amount can be altered in the short-run.

Thus the total variable cost changes with changes in

output in the short-run, i.e. they increase or

decrease when the total output rises or falls.


7/22

7

The total fixed cost is graphically denoted by

a strait line parallel to the output axis, shown

as:

Output

Cost

TFC


8/22

8

The total variable cost in the traditional

theory of the firm has to broadly an Inverse-

S-Shape, which reflects the law of variableproportion, can be shown as follows:

TVC

Output

Cost


9/22

9

The total variable cost curve starts from theorigin which shows that when output is zero,the variable costs are also zero.

According to this law, at initial stages ofproduction, with a given plant, as more of thevariable factors are employed, its productivity

increases and the average variable cost falls.This continues till the optimal combination of

the fixed and variable factors is reached.

Beyond this point an increased quantities ofthe variable factors are combined with thefixed factors, the productivity of variablefactors decline.


10/22

10

The total cost (TC) curve has been obtained by

vertical summation of the total fixed cost (TFC)

and the total variable cost (TVC) curves can beshown as follows:

TC

TVC

TFC

Output

Cost


11/22


12/22

12

Average Fixed Cost (AFC):

Average fixed cost is the total fixed cost divided bythe number of units of output produced. Therefore,

AFC=TFC/q

Where, q is the number of units of outputproduced.

Since total fixed cost is a constant quantity, averagefixed cost will steadily fall as output increases.

Therefore, AFC slopes downward through out itslength.

As output increases, the TFC spread out over moreand more units and AFC becomes less and less.

When output becomes very large, average fixedcost approaches zero but will never be zero. This

can be shown by the following diagram as:


13/22

13

Cost

AFC

Output


14/22

14

It is seen from the diagram that AFC curvecontinuously falls through out.

Mathematically speaking, AFC curveapproaches both output and Cost axisasymptotically, i.e. the AFC curve gets verynearer to both the axis but never touches it.

Average Variable Cost (AVC): Average variable cost is the total variable cost

divided by the number of units of product

produced. Therefore:AVC=TVC/q

Where, q represents the number of output

produced.


15/22

15

Hence, the AVC is variable cost per units of output.

The AVC will generally fall as the output increases from zero

to normal capacity of the output due to the occurrence of

increasing returns. But beyond the normal capacity output, the AVC will rise

steeply because of operation of diminishing returns. This can

be shown by the following diagram as:

Cost

Output

AVC


16/22

16

From the diagram, it is clear that the AVC

which first falls, reach the minimum and then

rises.Average Total Cost (ATC):

The average total cost (ATC) or average cost

(AC) is the total cost divided by the number ofunits of output produced. Therefore:

ATC or AC = Total Cost/Number of Output

OrATC or AC = TC/q


17/22

17

Since, the total cost is the sum of total variable costand total fixed cost, the average total cost is also thesum of average variable cost and average fixed

cost.This can be proved as follows:

ATC = TC/q

Since,

TC= TFC+TVC

ATC = (TFC+TVC)/q

= TFC/q + TVC/q

= AVC+AFCSo, ATC = AFC+AVC

Average total cost is also known as unit cost, since itis cost per unit of output produced.


18/22

18

Marginal Cost (MC):

Marginal cost is an addition to the total cost causedby producing one more units of output. In other

words, marginal cost is the addition to the total costof producing nunits instead of n-1units, where n isany given number.

In symbol,

MCn = TCn

TC n-1Suppose the production of 5 units of productinvolves the total cost of Rs. 206. If the increase inthe production of 6 units raises the total cost to Rs.236, then the marginal cost of the sixth unit is 30 i.e.

(236-206) = 30.Since marginal cost is change in the total cost as a

result of unit change in output, it can also be writtenas:

MC = TC/q


19/22

19

The concepts of AFC, AVC, ATC, TC and MC can be

better understood by the following table as:1 2 3 4 5 6 7 8

Units of

Output

Total

Fixed

Cost

Total

Variable

Cost

Total

Cost

AFC

(2/1)

AVC

(3/1)

ATC

(4/1)

MC

(TCn-TC

n-

1)

0 50 0 0 0 0 0 -

1 50 20 70 50 20 70 -

2 50 35 85 25 17.50 42.50 15

3 50 60 110 16.66 20 36.66 25

4 50 100 150 12.50 25 37.50 40

5 50 145 195 10 29 39 45

6 50 190 240 8.33 31.66 40 45

7 50 237 287 7.11 33.85 40.96 47

8 50 284 334 6.25 35.50 41.75 47


20/22

20

The average cost curves can be shown in

one diagram as follows:

Cost

Output

MC ATC

AVC

AFC


21/22

21

The Relation between AC and MC: When marginal cost is less than average cost the average

cost falls and when marginal cost is greater than average

cost, the average cost rises.Example:Situation I:

For a producer: 1st Product: 50 rupees

2nd Product: 45 rupees

This implies thatAC falls as MC is less than AC.

Situation II: 1st Product: 50 rupees


This implies thatAC rises as MC is greater than AC.Situation III: 1st Product: 50 rupees


This implies thatAC is equal to MC or AC=MC.


22/22

22

This can be better understood by the following diagram as:

From the diagram it is clear that as long as short run marginal cost curve

(MC) lies below the short-run average cost curve (AC), the AC is falling. When marginal cost (MC) lies above the AC curve, the AC is rising.

At the point of intersection L,where MC is equal to AC, AC is neitherfalling nor rising. At the point Lwhere MC curve crosses the AC curveto lie above the AC curve, is the minimum point of AC curve.

So, the MC cuts AC at its minimum point.

Cost

Output

L

MC

AC

Documents

6 COST Concepts