UNIT – 3
The term cost simply means cost of production. It is the expenses incurred in the production of goods. It is the
sum of all money-expenses incurred by a firm in order to produce a commodity. Thus it includes all expenses
from the time the raw material are bought till the finished products reach the wholesaler.
A managerial economist must have a proper understanding of the different cost concept which are essential for
clear business thinking. The cost concept which are relevant to business operation and decision can be grouped
on the basis of their purpose under two overlapping categories:
1. Concept used for accounting purpose
2. Concept used in economics analysis of the business
Future and Past Costs
Futurity is an important aspect of all business decisions. Future costs are the estimates of time adjusted past or
present costs and are reasonably expected to be incurred in some future period or periods. Their actual incurrence
is a forecast and their management is an estimate. Past costs are actual costs incurred in the past and they are
always contained in the income statements. Their measurement is essentially a record keeping activity.
Incremental and Sunk Costs
Incremental costs are defined as the change in overall costs that result from particular decisions being made.
Incremental costs may include both fixed and variable costs. In the short period, incremental cost will consist of
variable cost — costs of additional labour, additional raw materials, power, fuel, etc. — which is the result of a
new decision being taken by the firm. Since these costs can be avoided by not bringing about any change in the
activity, incremental costs are also called avoidable costs or escapable costs. They are also called differential
costs.
Sunk cost is one which is not affected or altered by a change in the level or nature of business activity. It will
remain the same whatever the level of activity.
Example: The most important example of sunk cost is the amortisation of past expenses, e.g., depreciation.
Out-of-Pocket and Book Costs
Out-of-pocket costs are those that involve immediate payments to outsiders as opposed to book costs that do not
require current cash expenditure.
Example: Wages and salaries paid to the employees are out-of-pocket costs while salary of the owner manager.
If not paid, it is a book cost. The interest cost of owner's own fund and depreciation cost are other examples of
book costs. Book costs can be converted into out-of-pocket costs by selling assets and leasing them back from
the buyer.
Replacement and Historical Costs
Historical cost of an asset states the cost of plant, equipment and materials at the price paid originally for them,
while the replacement cost states the cost that the firm would have to incur if it wants to replace or acquire the
same asset now.
Example: If the price of bronze at the time of purchase, say, in 1974, was 15 a kg and if the present price is 18 a
kg, the original cost of 15 is the historical cost while 18 is replacement cost. Replacement cost means the price
that would have to be paid currently for acquiring the same plant.
Explicit Costs and Implicit or Imputed Costs (Accounting Concept of Cost and Economic Concept of Cost)
Explicit costs are those expenses which are actually paid by the firm (paid-out-costs). These costs appear in the
accounting records of the firm. On the other hand, implicit costs are theoretical costs in the sense that they go
unrecognised by the accounting system. These costs may be defined as the earnings of those employed resources
which belong to the owner himself.
Actual Costs and Opportunity Costs
Actual costs mean the actual expenditure incurred for acquiring or producing a good or service. These costs are
the costs that are generally recorded in books of account, for example, actual wages paid, cost of materials
purchased, interest paid, etc.
The concept of opportunity cost occupies a very important place in modern economic analysis. The opportunity costs
or alternative costs are the returns from the second best use of the firm's resources which the firm forgoes in order to
avail itself of the returns from the best use of the resources. To take an example, a farmer who is producing wheat can
also produce potatoes with the same factors. Therefore, the opportunity cost of a quintal of wheat is the amount of the
output of potatoes given up. Thus, we find that the opportunity cost of anything is the next best alternative that could be
produced instead by the same factors or by an equivalent group of factors, costing the same amount of money. Two
points must be noted in this definition. Firstly, the opportunity cost of anything is only the next best alternative foregone.
Secondly, in the above definition it is the addition of the qualification "or by an equivalent group of factors costing the
same amount of money".
Direct (or Separable or Traceable) Costs and Indirect (or Common or Non-traceable) Costs
There are some costs which can be directly attributed to the production of a unit of a given product. Such costs
are direct costs and can easily be separated, ascertained and imputed to a unit of output. This is because these
costs vary with the output units. However, there are other costs which cannot be separated and clearly attributed
to individual units of production. These costs are, therefore, classified as indirect costs in the accounting process.
Shut-down and Abandonment Costs
Shut-down costs are required to be incurred when the production operations are suspended and will not be
necessary if the production operations continue. When any plant is to be permanently closed down, some costs
are to be incurred for disposing off the fixed assets. These costs are called abandonment costs.
Private and Social Costs Notes
Economic costs can be calculated at two levels: micro-level and macro-level. The micro-level economic costs
relate to functioning of a firm as a production unit, while the macro-level economic costs are the ones that are
generated by the decisions of the firm but are paid by the society and not the firm. Private costs are those which
are actually incurred or provided for by an individual or a firm for its business activity. Social cost, on the other
hand, is the total cost to the society on account of production of a good. Thus, the economic costs include both
private and social costs.
Business Cost and Full Cost
Business cost include all the expenses which are incurred to carry out a business. It includes all the payments and
contractual obligations made by the firm together with the book cost of depreciation on plant and equipment.
These cost concepts are used for calculating business profits and losses and for filing returns for income- tax and
also for other legal purposes.
The concept of full costs, includes business costs, opportunity costs and normal profits. The opportunity cost
includes the expected earnings from the second best use of the resources, or the market rate of interest on the total
money capital and also the value of the entrepreneurs own services which are not charged for in the current
business. Normal profit is a necessary minimum earning in addition to the opportunity cost, which a firm must
get to remain in its present occupation.
Above are the some concepts of costs. But the important cost concepts which play crucial role in managerial
decision-making are as follows:
Fixed and Variable Cost:-
Fixed Cost: Fixed cost are those costs which do not vary with the volume of production. These costs remain
fixed or constant up to a certain level of production. Even if the production is zero, a firm will have to incur fixed
costs. Examples are rent, interest, depreciation, insurance, salaries etc. The fixed costs are also called
supplementary costs, capacity costs or period costs or overhead costs.
Average fixed cost (fixed cost per unit) changes with a change in the quantity of production. If the volume of
production increases, average fixed cost will decrease. If the quantity of production decrease, average fixed cost
will increase. Thus, there is an inverse relationship between fixed costs and quantity of production.
Average fixed cost is obtained by dividing total fixed cost by total output. Total fixed cost curve and average
fixed cost curve are shown below:
From the above graph it is clear that the total fixed cost curve is horizontal to the OX axis. On the other hand the
average fixed cost curve slopes from left to right. This implies that as the output increases, the average fixed cost
falls.
Variable Cost:
Variable costs are those costs, which change with the quantity of production. When the output increases, variable
cost also increases. When the output decreases, the variable cost also decreases. Thus, there is a direct relationship
between variable cost and volume of production.
Variable costs are also known as prime costs or direct costs. Examples are materials, wages, power, stores etc.,
Prime or variable cost consist of direct material cost, direct labour cost and other direct expenses.
Total, Average, and Marginal Costs
▪ The Total Cost (TC) refers to the total expenditure on the production of goods and services.
▪ It includes both explicit and implicit costs.
▪ The explicit costs themselves are made up of fixed and variable costs.
The Average cost (AC) is obtained by dividing total cost (TC) by total output (Q).
AC = TC/Q
Marginal Cost (MC) is the addition to total cost on account of producing one additional unit of a product.
It is the cost of the marginal unit produced.
MC = Change in TC/ Change in Q = ΔTC/ ΔQ
Short-Run and Long-Run Costs
Short-Run Costs are costs which change as desired output changes, size of the firm remaining constant. These
costs are often referred to as variable costs.
Long-Run costs, on the other hand are costs incurred on the firm’s fixed assets, such as plant, machinery,
building, and the like.
Short Run Costs
• Total Variable cost (TVC)
– Total amount paid for variable inputs
– Increases as output increases
• Total Fixed Cost (TFC)
– Total amount paid for fixed inputs
– Does not vary with output
• Total Cost (TC) = TVC + TFC
Short-Run Total Cost Schedules
Output Total Fixed Total Variable Total Cost
(Q) cost (TFC) cost (TVC) (TC=TFC+TVC)
0 6,000 0 6,000
100 6,000 4,000 10,000
200 6,000 6,000 12,000
300 6,000 9,000 15,000
400 6,000 14,000 20,000
500 6,000 22,000 28,000
600 6,000 34,000 40,000
Total Cost Curves
Average Costs
We have seen that we calculate average total cost by dividing total cost by the quantity of output produced.
Similarly, we can calculate average fixed cost by dividing fixed cost by the quantity of output produced. And
we can calculate average variable cost by dividing variable cost by the quantity of output produced. Or,
mathematically, with Q being the level of output, we have:
Average total cost = ATC = TC/Q
Average fixed cost = AFC = FC/Q
Average variable cost = AVC = VC/Q
Finally, notice that average total cost is the sum of average fixed cost plus average variable cost:
ATC = AFC + AVC.
Short Run Marginal Cost
Short run marginal cost (SMC) measures rate of change in total cost (TC) as output varies
SMC = ΔTC/ ΔQ = ΔTVC/ ΔQ
Average & Marginal Cost Schedules
Output Average fixed cost Average variable cost Average total cost Short-run marginal
(Q) (AFC=TFC/Q) (AVC=TVC/Q) (ATC=TC/Q= cost (SMC= TC/
AFC+AVC) Q)
0 -- -- -- --
100 60 40 100 40
200 30 30 60 20
300 20 30 50 30
400 15 35 50 50
500 12 44 56 80
600 10 56.7 66.7 120
Cost Output Relationship in Short Run
In the short-run a change in output is possible only by making changes in the variable inputs like raw materials,
labour etc. Inputs like land and buildings, plant and machinery etc. are fixed in the short-run. It means that short-
run is a period not sufficient enough to expand the quantity of fixed inputs. Thus Total Cost (TC) in the short-run
is composed of two elements – Total Fixed Cost (TFC) and Total Variable Cost (TVC).
TFC remains the same throughout the period and is not influenced by the level of activity. The firm will continue
to incur these costs even if the firm is temporarily shut down. Even though TFC remains the same fixed cost per
unit varies with changes in the level of output.
On the other hand TVC increases with increase in the level of activity, and decreases with decrease in the level
of activity. If the firm is shut down, there are no variable costs. Even though TVC is variable, variable cost per
unit is constant.
So in the short-run an increase in TC implies an increase in TVC only. Thus:
TC = TFC + TVC, TFC = TC – TVC, TVC = TC – TFC, TC = TFC when the output is zero.
The graph below shows Short-run cost output relationship.
Short-run Average Cost and Marginal Cost
The concept of cost becomes more meaningful when they are expressed in terms of per unit cost. Cost per unit
can be computed with reference to fixed cost, variable cost, total cost and marginal cost. The following Table and
diagram illustrates cost output relationship in the short-run, with reference to different concepts of cost.
Cost Output Relationship in the Long Run
In order to study the cost output relationship in the long run it is necessary to know the meaning of long run. As
known in the long run the size of an industry can be expanded to meet the increased demand for products as such
in the long run all the factors of production can be varied according to the need. Hence long run costs are those
which vary with output when all the input factors including plant and equipment vary.
As per the above figure suppose that at a given time the firms operate under plant SAC2 and produces output
OQ. If the firm decides to produce output OR and continues with the current plant SAC2 its average cost will be
uR. But if the firm decides to increase the size of the plant to plant SAC3 its average cost of producing OR output
would then be TR. Since cost TR is less than the cost on old plant uR, therefore new plant SAC3 is preferable
and should be adopted. Thus the long run cost of producing OR output will be TR which can be obtained by
increasing the plant size.
To draw long run average cost curve(LAC) we start with a number of short run average cost(SAC) curves, each
such curve representing a particular size of plant including the optimum plant. One can now draw a LAC curve
which is tangential to all SAC curves. In this connection following features are highlighted:
1- The LAC curve envelopes the SAC curves and is therefore called as envelope curve.
2- Each point of the LAC is a point of tangency with the corresponding SAC curve.
3- The points of tangency on the falling part of SAC curve for points lying to the left of minimum point of LAC.
4- The points of tangency occur on the rising part of the SAC curves for the points lying to the right of minimum
point of LAC.
5- The optimum scale of plant is a term applied to the most efficient of all scales of plants available. This scale
of plant is the one whose SAC curve forms the minimum point of LAC curve. It is SAC3 in our case which is
tangent to LAC curve at its minimum point at R.
6- Both LAC ad SAC curves are U shaped but the difference between the two U shapes is that the U shape of the
LAC curve is flatter or lesser pronounced from bottom. The main reason for this is that in the long run such
economies are possible which cannot be had in the short run, likewise some of the diseconomies which are faced
in short run may not be faced in the long run.
Economies and Diseconomies of Scale
Economies of scale may be defined as the cost advantages that can be achieved by an organisation by the
expansion of their production in the long run. Therefore, the advantages of large scale expansion are known as
Economies of Scale. The lower average cost per unit achieves the advantage in cost.
Economies of Scale are a long term concept which is achieved when there is an increase in the sales of an
organisation. Due to the lowering of production cost, the organisation can save more and invest it on buying a
bulk of raw materials which can again be obtained at a discount.
These are the benefits of Economies of Scale. When there is a massive expansion in an organisation, the cost per
unit may increase with the increase in output. Diseconomies of Scale may arise due to internal issues resulting
from technical, organisational, or resource constraints.
Types of Economies of Scale
The Economies of Scale may be divided into two categories- 1) Internal Economies and 2) External Economies.
1. Internal Economies of Scale: Internal Economies are the real economies which arise from the expansion
of the organisation. These economies are the result of the growth of the organisation itself.
2. External Economies of Scale: External Economics are the economies that originate from factors outside
the organisation. These economies result in the increase in the main organisation by the increase in the
quality of factors outside the organisation like better transportation, better labour, infrastructure, etc. Due
to the betterment of these external factors, the cost of production per unit of an item in the organisation
decreases.
Types of Diseconomies of Scale
Similar to the Economies of Scale, Diseconomies of Scale is of two types- Internal Diseconomies of Scale and
External Diseconomies of Scale.
Internal Diseconomies of Scale: Internal Diseconomies of Scale are the Diseconomies resulting from the
internal difficulties within the organisation. The Internal Diseconomies are the factors which raise the cost of
production of an organisation like lack of supervision, lack of management and technical difficulties.
External Diseconomies of Scale: External Diseconomies of Scale are the external factors which result in the
increase in the production per unit of a product within an organisation. The external factors that act as a restrain
to expansion may include the cost of production per unit, scarcity of raw materials, and low availability of skilled
labours.
Examples of Internal Economies
1. Technical Economies of Scale: This occurs when an organisation invests in modern technology which
helps in lowering the cost of production. It enables an organisation to produce a large number of goods in
a lesser period.
2. Financial Economies of Scale: This occurs when large organisations take a loan with a low rate of
interest. The banks easily give them loans since they have good credibility.
3. Managerial Economies of Scale: This occurs when large organisations employ people with a special
skill set which helps to maximize the profits of the organisation like an accountant or manager.
4. Marketing Economies of Scale: This occurs when large organisations increase their budget. They can
then spread their market by setting up branches or buy more raw materials in bulks with lesser price.
Cost Control & Cost Reduction
Cost Control
The definition of cost control states that it is a process which focuses on trying to control the total cost through
competitive analysis. Such practices help in aligning the original cost in agreement with the established costs.
Through this process, firms can ensure their production costs do not soar higher than the predetermined expenses.
The cost control process involves several stages, which begins with the budget preparation related to production.
Next, the actual performance is evaluated, followed by the calculation variances between the original cost and
the budgeted cost. The next task is to investigate the reasons for the same, and the final stage involves
implementing necessary actions to mend the discrepancies.
Standard costing and budgetary control are two techniques used in the cost control process. The process is a
continuous one and helps to analyse the causes for the variances. It involves:
• Determining the standards
• Comparing the standards and looking at the results
• Analysing the variances
• Establishing the action needed to be taken by the firm
Cost Reduction
The definition of cost reduction states it to be a process which aims to reduce the unit cost of a product or service
manufactured by the firm without harming its quality. A number of modern and improved techniques can be used
for this purpose which serves as an insight to the alternative methods to lower the production costs of every unit.
Cost reduction has a significant role in reducing the per unit costs of products and are thus essential for firms to
maximise their profits. This process helps in pointing out and reducing the unnecessary expenses during the
production process, storage, selling or distribution of the products. The cost reduction process emphasises the
following:
• Savings in every unit cost of production
• The product quality should not be compromised
• Non-volatile nature of the savings
The primary tools involved in cost reduction involve quality operation and research, better designs in products,
reducing variety and evaluating jobs amongst others.
Difference Between Cost Control and Cost Reduction
The importance of cost control and cost reduction are massive in businesses, but they have a few differences. The
key difference between cost control and reduction include:
• Cost control is a process which focuses on reducing the total cost of production. However, cost reduction
aims at reducing the per unit cost of a product.
• Cost control is a quick process by nature, while cost reduction is a more permanent process.
• The cost control process ends when the required target is met. On the other hand, the cost reduction
process is a continuous process which does not end after a certain time. It is primarily focused on
eliminating unnecessary costs.
• Cost control does not provide any promises regarding maintaining the quality of the products, but cost
reduction does not affect the quality of the product even slightly.
• The cost control process is more of a function to prevent the cost before their occurrence while the cost
reduction process is more of a function used to resurrect the expenses.
Thus cost control and reduction are an essential part of any organisation willing to boost their profits.
Indifference Curves and its Properties
An indifference curve may be defined as the locus of points. Each point represents a different combination of two
substitute goods, which yields the same utility or level of satisfaction to the consumer. Therefore, he/she is
indifferent between any two combinations of goods when it comes to making a choice between them. Such a
situation arises because he/she consumes a large number of goods and services and often finds that one
commodity can be substituted for another. This gives him/her an opportunity to substitute one commodity for
another, if need arises and to make various combinations of two substitutable goods which give him/her the same
level of satisfaction. If a consumer faced with such combinations, he/she would be indifferent between the
combinations.
Example: If a consumer is asked whether he prefers combination 1 of two goods X and Y (assuming that the
market price of X and Y are fixed) or combination 2, he may give one of the following answers:
1. he prefers combination 1 to 2
2. he prefers combination 2 to 1
3. he is indifferent about combinations 1 and 2.
The third answer implies that the consumer prefers 1 as much as 2. There may be some more combinations of
goods X and Y which are equally preferable to him. Suppose, there are five different combinations of X and Y,
that gives him the same level of satisfaction.
Figure below shows the indifference curve drawn on the basis of the figure give in table. It depicts, in general,
all combinations of two goods which yield the same level of satisfaction to the consumer. The consumer is
indifferent about any two points lying on this curve.
An indifference curve of a consumer represents a particular level of satisfaction for the consumer. A consumer
may, infact, identify a large number of such curves each representing a different level of satisfaction.
An indifference map gives a complete description of a consumer’s tastes and preferences as shown in Figure
below to show the different satisfaction levels.
Properties of Indifference Curve Notes
Indifference curves have the four basic characteristics:
1. Indifference curves have a negative slope
2. Indifference curves are convex to the origin
3. Indifference curves do not intersect nor are they tangent to one another
4. Upper indifference curves indicate a higher level of satisfaction.
Isoquants
Isoquants are a geometric representation of the production function. The same level of output can be produced
by various combinations of factor inputs. Imagining continuous variation in the possible combination of labour
and capital, we can draw a curve by plotting all these alternative combinations for a given level of output. This
curve which is the locus of all possible
combination is called the ‘isoquant’.
Any quantity of a good can be produced by using many different combinations of labour and capital (assuming
both can be substituted for each other). An isoquant or an iso-product curve is the line which joins together
different combinations of the factors of production (L, K) that are physically able to produce a given amount of
output.
Suppose isoquant refers to 100 Kg. of output. This output can be produced by a large number of different
combinations of labour and capital. All the different combinations for the same amount of output would lie on
the same isoquant.
Example: 10 units of capital and 5 units of labour (A) provide the same output as 3 units of capital and 20 units
of labour input (B). The firm can choose any one of these combinations (A or B) or any other combination which
lies on the same isoquant to get 100 Kg. of output. The isoquant does not tell us the combination of factor inputs
the firm actually uses; (that combination is based on process of the factors) but shows the technically possible
combinations of factor inputs that are required to produce a given level of output. Isoquant I has been drawn by
joining these combinations of labour and capital inputs which give out the same amount of total produce i.e., 100
Kg. Points like A which require more capital but less labour represent capital intensive methods of production.
Points like B, which require less capital and more labour represent labour intensive methods of production.
