COST

Introduction:

A production function tells us how much output a firm can produce with its existing plant and
equipment. The level of output depends on prices and costs. The most desirable rate of output is the
one that maximizes total profit that is the difference between total revenue and total cost.

Entrepreneurs pay for the input factors- Wages for labour, price for raw material, rent for building
hired, interest for borrowed money. All these costs are included in the cost of production. The
economist’s concept of cost of production is different from accounting.

This chapter helps us to understand the basic cost concepts and the cost output relationship in the
short and long runs. Having looked at input factors in the previous chapter it is now possible to see
how the law of diminishing returns affect short run costs.

Cost Determinants

The cost of production of goods and services depends on various input factors used by the
organization and it differs from firm to firm. The major cost determinants are:

 Level of output: The cost of production varies according to the quantum of output. If the
size of production is large then the cost of production will also be more.

 Price of input factors: A rise in the cost of input factors will increase the total cost of
production.

 Productivities of factors of production: When the productivity of the input factors is high
then the cost of production will fall.

 Size of plant: The cost of production will be low in large plants due to mass production with
mechanization.

 Output stability: The overall cost of production is low when the output is stable over a
period of time.
  Lot size: Larger the size of production per batch then the cost of production will come down
because the organizations enjoy economies of scale.

 Laws of returns: The cost of production will increase if the law of diminishing returns
appliesin the firm.

 Levels of capacity utilization: Higher the capacity utilization, lower the cost of production

 Time period: In the long run cost of production will be stable.

 Technology: When the organization follows advanced technology in their process then the
cost of production will be low.

 Experience: over a period of time the experience in production process will help the firm to
reduce cost of production.

 Process of range of products: Higher the range of products produced, lower the cost of
production.

 Supply chain and logistics: Better the logistics and supply chain, lower the cost of
production.

 Government incentives: If the government provides incentives on input factors then the cost
of production will be low.

Types Of Costs

There are various classifications of costs based on the nature and the purpose of calculation. But in
economics and for accounting purpose the following are the important cost concepts.

Actual cost/ Outlay cost/ Absolute cost / Accounting cost: The cost or expenditure which a firm
incurs for producing or acquiring a good or service. (Eg. Raw material cost)
Opportunity cost: The revenue which could have been earned by employing that good or service in
some other alternative uses. (Eg. A land owned by the firm does not pay rent. Thus a rent is an
income forgone by not letting it out)

Sunk cost: Are retrospective (past) costs that have already been incurred and cannot be recovered.

Historical cost: The price paid for a plant originally at the time of purchase.

Replacement cost: The price that would have to be paid currently for acquiring the same plant.

Incremental cost: Is the addition to costs resulting from a change in the nature of level of
business activity. Change in cost caused by a given managerial decision.

Explicit cost: Cost actually paid by the firm. If the factors of production are hired or rented then it
is an explicit cost.

Implicit cost: If the factors of production are owned by a firm then its cost is implicit cost.

Book cost: Costs which do not involve any cash payments but a provision is made in the books of
accounts in order to include them in the profit and loss account to take tax advantages.

Social cost: Total cost incurred by the society on account of production of a good or service.

Transaction cost: The cost associated with the exchange of goods and services.

Controllable cost: Costs which can be controllable by the executives are called as controllable
cost.

Shut down cost: Cost incurred if the firm temporarily stops its operation. These can be saved by
continuing business.
Economic costs are related to future. They play a vital role in business decisions as the costs considered in
decision - making are usually future costs. They are similar in nature to that of incremental, imputed
explicit and opportunity costs.

Determinants Of Short –Run Cost

Fixed cost: Some inputs are used over a period of time for producing more than one batch of goods. The
costs incurred in these are called fixed cost. For example amount spent on purchase of equipment,
machinery, land and building.

Variable cost: When output has increased the firm spends more on these items. For example the money
spent on labour wages, raw material and electricity usage. Variable costs vary according to the output. In
the long run all costs become variable.
Total cost: The market value of all resources used to produce a good or service.
Total Fixed cost: Cost of production remains constant whatever the level of output.
Total Variable cost: Cost of production varies with output.
Average cost: Total cost divided by the level of output.
Average variable cost: Variable cost divided by the level of output. Average fixed cost: Total fixed cost
divided by the level of output. Marginal cost: Cost of producing an extra unit of output.

Short Run Cost Output Relationship

The cost concepts made use of in the cost behavior are total cost, Average cost, and marginal cost.
Total cost is the actual money spent to produce a particular quantity of output. Total cost is the
summation of fixed and variable costs.

TC=TFC+TVC
Up to a certain level of production total fixed cost i.e., the cost of plant, building, equipment etc, remains
fixed. But the total variable cost i.e., the cost of labour, raw materials etc., Vary with the variation in
output. Average cost is the total cost per unit. It can be found out as follows.

AC= TC/Q
The total of average fixed cost (TFC/Q) keep coming down as the production is increased and average
variable cost (TVC/Q) will remain constant at any level of output.

Marginal cost is the addition to the total cost due to the production of an additional unit of product. It can
be arrived at by dividing the change in total cost by the change in total output.
In the short-run there will not be any change in total fixed cost. Hence change in total cost implies change
in total variable cost only.

Cost – output relations

Units of Total fixed Total Total cost Average Average Average Marginal
Output Q cost TFC variable (TFC + variable fixed cost cost (TC/Q) cost MC
cost TVC TVC) TC cost (TVC / (TFC / AC
Q) AVC Q) AFC

0 60 - 60 - - - -

1 60 20 80 20 60 80 20

2 60 36 96 18 30 48 16

3 60 48 108 16 20 36 12

4 60 64 124 16 15 31 16

5 60 90 150 18 12 30 26
 6 60 132 192 22 10 32 42

The above table represents the cost-output relation. The table is prepared on the basis of the law of
diminishing marginal returns. The fixed cost Rs. 60 May include rent of factory building, interest on
capital, salaries of permanently employed staff, insurance etc. The table shows that fixed cost is same at
all levels of output but the average fixed cost, i.e., the fixed cost per unit, falls continuously as the output
increases. The expenditure on the variable factors (TVC) is at different rate. If more and more units are
produced with a given physical capacity the AVC will fall initially, as per the table declining up to 3rd
unit, and being constant up to 4th unit and then rising. It implies that variable factors produce more
efficiently near a firm’s optimum capacity than at any other levels of output.

And later rises. But the rise in AC is felt only after the start rising. In the table ‘AVC’ starts rising from
the 5th unit onwards whereas the ‘AC’ starts rising from the 6th unit only so long as ‘AVC’ declines ‘AC’
also will decline. ‘AFC’ continues to fall with an increase in Output. When the rise in ‘AVC’ is more than
the decline in ‘AFC’, the total cost again begin to rise. Thus there will be a stage where the ‘AVC’, the
total cost again begin to rise thus there will be a stage where the ‘AVC’ may have started rising, yet the
‘AC’ is still declining because the rise in ‘AVC’ is less than the droop in ‘AFC’.

Thus the table shows an increasing returns or diminishing cost in the first stage and diminishing returns or
diminishing cost in the second stage and followed by diminishing returns or increasing cost in the third
stage.

The short-run cost-output relationship can be shown graphically as follows.

In the above graph the “AFC’ curve continues to fall as output rises an account of its spread over more
and more units Output. But AVC curve (i.e. variable cost per unit) first falls and than rises due to the
operation of the law of variable proportions. The behavior of “ATC’ curve depends upon the behavior of
‘AVC’ curve and ‘AFC’ curve. In the initial stage of production both ‘AVC’ and ‘AFC’ decline and
hence ‘ATC’ also decline. But after a certain point ‘AVC’ starts rising. If the rise in variable cost is less
than the decline in fixed cost, ATC will still continue to decline otherwise AC begins to rise. Thus the
lower end of ‘ATC’ curve thus turns up and gives it a U-shape. That is why ‘ATC’ curve are U-shaped.
The lowest point in ‘ATC’ curve indicates the least-cost combination of inputs. Where the total average
cost is the minimum and where the “MC’ curve intersects ‘AC’ curve, It is not be the maximum output
level rather it is the point where per unit cost of production will be at its lowest.
The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized up as follows:

1. If both AFC and ‘AVC’ fall, ‘ATC’ will also fall.

2. When ‘AFC’ falls and ‘AVC’ rises

a. ‘ATC’ will fall where the drop in ‘AFC’ is more than the raise in ‘AVC’.

b. ‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’

c. ‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in ‘AVC’
Relationship Between Marginal Cost And Average Cost Curve:

The marginal cost and average cost curves are U shaped because of law of diminishing returns. The
marginal cost curve cuts the average cost curve and average variable cost curves at their lowest
point. Marginal cost curve cuts the average variable cost from below. The AC curve is above the
MC curve when AC is falling. The AC curve is below the MC when AC is increasing. The
intersecting point indicates that AC=MC and that is the minimum average cost with an optimum
output. (No more output can be produced at this average cost without increasing the fixed cost of
production)

Graph – Relationship Between Average Cost And Marginal Cost

Optimum Output And Minimum Cost

The MC and AC curves are mirror image of the MP and AP curves.

It is presented in the graph below.

All organizations aim for maximum output with minimum cost. To achieve this goal they like to
derive the point where optimum output can be produced with the given amount of input factors and
with a minimum average cost. In the graph the MP=AP at maximum average production. On the
other hand MC = AC at minimum average variable cost. Therefore this is the optimum output to be
produced to achieve their managerial goals.
Graph – Optimum Cost and Output

The above set of cost curves explain the cost output relationship in the short period but in the long
run there is no fixed cost because all costs vary over a period of time. Therefore in the long run the
firm will have only average cost curve that is called as long run average cost curve (LAC). Let us
see how the average cost curve is derived in the long run. This LAC also slopes like the short
period average cost curve (U shaped) provided the law of diminishing returns prevails. In case the
returns to scale are increasing or constant then the LAC curve will have a different slope. It will be
a horizontal line, which is parallel to the ‘X’ axis.

Cost Output Relationship In The Long Run

In the long run costs fall as output increases due to economies of scale, consequently the average
cost AC of production falls. Some firms experience diseconomies of scale if the average cost
begins to increase. This fall and rise derives a U shaped or boat shaped average cost curve in the
long run which is denoted as LAC. The minimum point of the curve is said to be the optimum
output in the long run. It is explained graphically in the chart given below.
Graph – Long Run Average Cost Curve

In the long run all factors are variable and the average cost may fall or increase to A, B respectively
but all these costs are above the long run cost average cost. LAC is the lower envelope of all the
short run average cost curves because it contains them all. At point ‘E’ the SAC1 and SMC1
intersects each other, in case the organization increases its output from OM to OM1 they have to
spend OC1 amount. In case the organization purchases one more machine (increase in fixed cost)
then they will get a new set of cost curves SAC2, and SMC2. But the new average cost curve
reduces the cost of production from OC1 to OC2.That means they can save the difference of C1C2
which is nothing but AB. Therefore, in the long run due to business expansion a firm can reduce
their cost of production. During their business life they will meet many combinations of optimum
production and minimum cost in different short periods. In the long run due to law of diminishing
returns the long run average cost curve LAC also slopes like boat shape.

WHY AC IS U SHAPED?
In the short-run average cost curves are of U-shape. It means, initially it falls and after reaching the
minimum point it starts rising upwards. It can be on account of the following reasons:
1. BASIS OF AVERAGE FIXED COST AND AVERAGE VARIABLE COST
Average cost is the aggregate of average fixed cost and average variable cost (AC = AFC + AVC).
To begin with, as production increases, initially the average fixed cost and average variable cost
falls. But after a minimum point, average variable cost stops falling but not the average cost. It is
due to this reason that average variable cost reaches the minimum before AC.
The point, where AC is minimum is called the optimum point. After this point, AC begins to rise
upward. The net result is the increase in AC. Therefore, it is only due to the nature of AFC and
AVC that AC first falls, reaches minimum and afterwards starts rising upward and hence assume
the U-shape.
2. BASIS OF THE LAW OF VARIABLE PROPORTION
The law of variable proportion also results in U-shape of short run average cost curve. If in the
short period variable factors are combined with a fixed factor, output increases in accordance with
the law of variable proportions. In other words, the law of ‘Increasing Returns’ applies.
Similarly, if employ more and more variable factors are employed with fixed factors the law of
Diminishing Returns is said to apply. Thus, it is due to the law of variable proportions that the
average cost curve assumes the shape of U.

Economies Of Scale

Economies of scale exist when long run average costs decline as output is increased. Diseconomies
of scale exist when long run average cost rises as output is increased. It is graphically presented in
the following graph. The economies of scale occur because of (i) technical economies: the change
in production process due to technology adoption. (ii) Managerial economies (iii) purchasing
economies, (iv) marketing economies and (v) financial economies.

Economies of scale means a fall in average cost of production due to growth in the size of the
industry within which a firm operates.
Diseconomies Of Scale:
Arises due to managerial problems. If the size of the business becomes too large, then it becomes
difficult for management to control the organizational activities therefore diseconomies of scale
arise.

Graph – Economies of Scale and Diseconomies of scale

Factors Causing Economies Of Scale:
There are various factors influencing the economies of scale of an organization. They are generally
classified in to two categories as Internal factors and External factors.

Internal Factors:
Labour economies: if the labour force of a firm is specialized in a specific skill then the
organization can achieve economies of scale due to higher labour productivity.
Technical economies: with the use of advanced technology they can produce large quantities
with quality which reduces their cost of production.
Managerial economies: the managerial skills of an organization will be advantageous to achieve
economies of scale in various business activities.

Marketing economies: use of various marketing strategies will help in achieving economies of
scale.
Vertical integration: if there is vertical integration then there will be efficient use of raw material
due to internal factor flow.
Financial economies: the firm’s financial soundness and past record of financial transactions will
help them to get financial facilities easily.

External Factors:

Better repair and maintenance facilities: When the machinery and equipments are repaired
and maintained, then the production process never gets affected.
Research and Development: research facilities will provide opportunities to introduce new
products and process methods.
Training and Development: continuous training and development of skills in the managerial,
production level will achieve economies of scale.
Economies of location: the plant location plays a major role in cutting down the cost of
materials, transport and other expenses.

Factors Causing Diseconomies Of Scale:

Labour union: continuous labour problem and dissatisfaction can lead to diseconomies of scale.
Poor team work: Poor performance of the team leads to diseconomies of scale.
Lack of co-ordination: lack of coordination among the work force has a major role to play in
causing diseconomies of scale.
Difficulty in fund raising: difficulties in fund raising reduce the scale of operation.
Difficulty in decision making: the managerial inability, delay in decision making is also a factor
that determines the economies of scale.
Scarcity of Resources: raw material availability determines the purchase and price. Therefore
there is a possibility of facing diseconomies in firms.

Break Even Analysis

Break even analysis helps to identify the level of output and sales volume at which the firm ‘breaks
even’. It means the revenues are sufficient to cover all costs of production. Various managerial
decisions of firms are taken by the managers based on the break- even point.

It is a study of cost, revenues and sales of a firm and finding out the volume of sales where the
firm’s costs and revenues will be equal. There is no profit and no loss. The total revenue is equal to
the total cost of production. The amount of money which the firm receives by the sale of its output
in the market is known as revenue.
The above graph shows the break- even point of an organization. The total revenue curve (TR) and
total cost curve (TC) is given. When they produce 50 units the total cost and total revenue are equal
that is $ 150’000 which is at the intersecting point of the curves. Break even point always denotes
the quantity produced or sold to equalize the revenue and cost.

When the firm produces less than 50 units the revenue earned is less than the cost of production
(TR<TC) therefore in the initial period the firm incurs loss which is shown in the graph. Through
selling more than 50 units the revenue increases more than the cost of production therefore the
difference increases and provides profit to the organization (TR>TC). It can be calculated with the
help of the following formula.
TFC
Break even quantity = ------------------------
Selling Price - AVC

TFC + targeted profit

To decide a quantity to achieve a targeted profit = -------------------------
Selling price – AVC

Sales - BEP
Safety margin = ---------------------- X 100
Sale
Managerial Uses Of Break-Even Analysis:

1. Product planning: it helps the firm in planning its new product development. Decisions
regarding removal or addition of new products in their product line.
2. Activity planning: the firm decides the expansion of production capacity.
3. Profit planning: this helps the firm to plan about their profit well in advance and at the
same time it helps to identify the quantity to be sold to achieve the targeted profit.
4. Target capacity: the targeted sales quantity helps to decide the purchase, inventory and
management.
5. Price and cost decision: Decision regarding how much the price of the commodity
should be reduced or increased to cover their cost of production.
6. Safety margin: it helps to understand the extent to which the firm can withstand their fall
in sales.
7. Price decision: the selling price can be fixed based on its expected revenue or profit.
8. Promotional decision: the firm can decide the kind of promotion required and how
Distribution decision: Break even analysis helps to improve the distribution system and
for business expansion.
9. Dividend decision: firm can decide the dividend to be fixed for their shareholders.
10. Make or buy decision: break even analysis helps to decide on whether to make or buy
the product. It means outsourcing or in house production.

We can conclude that the break – even analysis is a useful tool for decision making at various
levels of a business firm in the short and long run. Therefore it is an essential tool to be used by the
Managers.