COST CONCEPTS

By:Akshat. D. Yadav

Meaning, nature & kinds of costs• “ Cost means sacrifice” Mr.Cairnes• If we buy a product by paying some money then we sacrifice some thing which

could have been bought by that money.• Cost is determined by various factors like Output, technology & prices of inputs

& productivity of factors of production.

• These factors can be categorized as Uncontrollable & controllable factors. Mathematically we can represent Cost C =f ( Q, T, Pf & Pr f) where Q is output, T is technology & Pf is prices of factors of production & Prf is

productivity of factors of production. These are also known as “Determinants of Cost” . Prices of factors of production &

productivity of factors of production are uncontrollable determinants.

• Other things remain same each determinants have positive relation with Cost.

Kinds of costs• There may be different types of costs incurred by a firm under different

circumstances.• Costs may include money or may not be measurable in money terms. Few

important costs are as follows:- Accounting Costs :- Financial management recognizes only money cost or nominal

cost that can be recorded in the books of accounts. Hence they are also known as ACCOUNTING COSTS .These are those costs which can be identified, measured & accounted for. Few examples are a) cost of raw materials b) wages & salary etc. These are also known as “Explicit cost” for which explicit payments have been made in past.

Real Costs:- These costs can not be measured in terms of money. These are more or less social & psychological in nature. These can not be quantifiable in monetary terms. These costs do not cause any outflow of cash hence accountants do not attach any importance to it but Decision makers do consider it. E.g facilities provided to employees, comfort etc

Opportunity costs:- While taking a decision in favor of an alternative, opportunity of other alternatives have been foregone. If we invest some money in saving account, we get interest but we forego opportunity to invest that fund in equity. Such foregone costs are “opportunity costs”

Contd. Implicit Costs:- These are those costs that do not involve actual payment or cash

outflow. But those represent costs e.g Self owned resources by a firm or if the owner is also the manager who does not take salary. Other examples are interest foregone on use of own capital, rent foregone on use of own property. These costs are important for managerial decisions.

Explicit Costs:- Accounting Costs mentioned earlier are Explicit Costs. These costs are out of pocket costs and go to trading & P/L Account statement. Raw material costs, wages & salary etc are explicit costs.

Social Costs:- These are those costs that the society has to bear because of the firm’s activities. E.g pollution caused by the firm. These costs have two components a) Private costs of the firm ( as the resources it uses in its production activity could have been used elsewhere)

b) Social costs paid by society e.g pollution. Firm take up welfare activities to nullify these social costs. Corporate social responsibility concept has evolved because of this.

Replacement Costs:- Replacement costs are current price of buying or replacing any input at present. Buying a new machine to replace old one is replacement cost.

Contd.• Historic & Future Costs:-Historic costs are incurred at the time of purchase of

assets. They are also regarded as “Sunk Costs”. If a car is sold unused, it will not fetch original price.

Where as Future costs are budgeted or planned costs. These are those costs which are likely to occur in future

• Direct & Indirect Costs:- Direct Costs are those that can be assigned to any particular activity e.g wood required to make a table. Cost to purchase wood is direct cost.

Indirect cost are those which have to be distributed to many activities. E.g Electricity bill is indirect cost which has to be distributed to many activities.

Direct cost are fixed per unit of output whereas indirect cost are fixed per unit of time.

• Controllable & Uncontrollable Costs :- Controllable costs are those which can be regulated by management e.g fringe benefits, quality controls etc whereas uncontrollable costs are those which can not be regulated by management e.g minimum wages, raw material prices etc.

Contd.• Production & Selling Costs:- Production costs are those which are related to

production of the product where as Selling costs are related to those which are incurred in making those products available to consumers.

• Costs can also be classified on the basis of time. These can be of two types: COSTS IN SHORT RUN & COSTS IN LONG RUN COSTS IN SHORT RUN We know two types of costs a) Fixed costs & b) Variable Costs. Fixed costs are

those costs that can not be changed in short run whereas variable costs are those which can be changed in short run.

• As discussed, Short run costs have two components: a) Fixed costs & b) variable costs a) Fixed costs:- These are those costs which do not vary with outputs or production. Firms have to bear these costs even if there is no output. The shape

of Total Fixed Cost is a parallel line with x-axis , if we plot quantity on x-axis & cost on y-axis. It means that output can increase to any level without increase in Total Fixed Costs.

b) Variable Costs:- These are those costs which vary with output in short run.

Contd. variable costs are zero if there is no output production. Total Variable Costs (TVC)

as shown in figure, starts from origin therefore. As per law of variable proportion, as more inputs are added, total product increases at increasing return initially and later on declines . (As shown in Total product, average product & marginal product example).

It is because of this variable proportion, TVC is an inverse S in graph.

• (Relationship between TFC,TVC ,TC, AFC, AVC, AC & MC) i.e Total Fixed cost, Total variable cost, Total Cost, Average Fixed Cost, Average variable cost, Average cost & Marginal Cost). Let us take a numerical:-

Output TFC TVC TC(TFC+TVC)

AFC(TFC/OUTPUT)

AVC(TVC/OUTPUT)

AC MC

0 500 0 500 - - - -

1 500 50 550 500 50 550 50

2 500 80 580 250 40 290 30

3 500 105 605 166 35 201.6 25

4 500 129 629 125 32.2 157.2 24

5 500 150 650 100 30 130 21

6 500 180 680 83 30 113 30

7 500 225 725 71 32.1 103.1 45

8 500 280 780 62.5 35 97.5 55

9 500 360 860 55.5 40 95.5 80

10 500 450 950 50 45 95 90

11 500 545 1045 45.5 49.5 95 95

CONTD.• We can draw following conclusion from this caselette.:- 1) Fixed cost is 500/- per day. Upto unit 5th TVC is rising at a decreasing rate

( 30,25,24,21) and beyond that it increases at an INCREASING RATE (30, 45,55,80 & so on). This gives rise to LAW OF SCALE. More output brings down the variable cost per unit.

2) AFC at initial stages of production decreases at a very fast rate (250, 84,41,25 etc) but as the output increases, the sharpness of fall also goes down.

3) On the other hand, if we look at AVC, It decreases in the beginning, reaches a minimum of 30 at the 5th unit and then starts increasing.

4) If we look at MC, Then we find that MC decreases with increase in output(50,30 &25) but after reaching a minimum at the 5th unit of output, it increases with increase in output.

Assignment:- Show these curves graphically

Contd.• Numerical: Firm’s TC is given to be 100+ 50Q- 11Q2+ Q3

a) Find MC,AC & AVC b) Also prove that MC passes through minimum point of AVC.------------------------------------------------------------------------------------------------------------------Some mathematical formula must be kept in mind:- a) TC = TFC + TVC (Total fixed cost + Total variable cost) b) AFC = TFC/Q (Total Fixed cost/ Quantity) c) AVC = TVC/Q ( Total variable cost/ quantity) d) AC= TC/Q ( Total cost/ Quantity) = (TFC + TVC)/Q = AFC + AVC E) MC= Dtc/Dq i.e differentiation of TC / Quantity----------------------------------------------------------------------------------------------------------------

Solution:- a) MC = Differentiation of TC i.e 100+ 50q – 11Q2 + Q3

i.e 0 + 50 – 2x11 Q + 3 Q2

i.e 50 -22 Q + 3Q2 ---------(1) AC= TC/Q = (100+50Q-11Q2 + Q3)/Q = (100/Q +50 - 11 Q +Q2)---(2)

Contd. TC= 100+ 50Q -11Q2 +Q3 has two components TFC & TVC It consists of 100 as TFC & 50Q – 11Q2 + Q3 as TVC. AVC = TVC/Q i.e (50Q – 11Q2 +Q3)/ Q = 50 -11Q +Q2-------------(3)

b) Prove that MC passes through minimum point of AVC. Minimum point of AVC means differentiation of AVC should be zero i.e differentiation of (50- 11Q +Q2) =0 i.e 0- 11 +2Q=0 i.e Q = 11/2= 5.5 At Q = 5.5 , AVC = 50 -11Q + Q2 (put value of Q) i.e 19.75 ------(4) -------------------------------------------------------------------------------------------------------------- ASSIGNMENT NUMERICAL ABC Cola’s total variable cost TVC = 50q- 10Q2 + Q3 , where Q is output. 1) Find the level of output where MC is a minimum. 2) What is the level of output where AVC is a minimum. 3) What is the value of AVC & MC at the output of (2)ANS: MC = 50 – 20Q + 3Q2 , for MC to be minimum differentiation of MC =0 Q = 20/6 AVC = to be minimum Q = 5 At Q =5, AVC = MC = 25------------------------------------------------------------------------------------------------------------------

Costs In Long Run• All costs are variable in long run as all variables like factors of production,

technology, size of plants etc change in Long Run.• Long run costs function is often referred as “Planning Cost Function”.• Only Average cost curve is relevant in Long Run.• Long Run Costs consist of many short run costs.• LAC Curve is also known as “envelop curve”. graph:

Economies of scale• “Economies of scale mean lowering of costs of production by producing in bulk”• It is a situation in which the long run average costs of producing a good decrease

with increase in the level of output. E.g it might cost a manufacturer Rs.100 for one unit, Rs.180 for two units, Rs.240 for three units, and so on, such that the Average cost per unit decreases as the production volume increases.

• There can be two types of economies:- Internal economies:- Cost per unit depends on size of the firm & External economies:- Cost per unit depends on the size of the Industry, not the

firm Internal Economies External Economies

Specialization Technological advancement

Greater efficiency of machines Easier access to cheaper raw material

Managerial economies Financial institution in proximity

Financial economies Pool of skilled workers

Production in stages

Managerial Application of cost analysis• There are many applications of Cost Concept in managerial decision. Few are:-

Optimum Production output level:- In long run optimum quantity of production is where AC = MC.

Optimum inventory level:-Optimum level of inventory is defined as that size of stock for which the average cost of inventory held is at minimum.

To determine optimum size of plant:- optimum plant size can also be determined by cost analysis.

Break even analysis:- Cost curves help us to determine break even point of a firm.

EOQ :- Economic order quantity can also be determined with the help of cost curves.

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