COST OF PRODUCTION

Cost is defined as the expenditure incurred by a firm or producer to purchase or hire factors of
production in order to produce a product. As you know, factors of production are land, labour,
capital and entrepreneurship. In the production process, the entrepreneur organises land, labour,
capital and raw materials to produce output. As a producer he/she has to pay rent for land,
wages to labour and interest to procure capital.
Wages, rent, interest, profit are called factor costs of production. Besides these, the producer
also incurs expenditure on raw materials, electricity, water, depreciation of capital goods such
as machines and indirect taxes etc. The producer also uses the services of certain factors
supplied by his/her own self. The imputed value of such inputs also form the part of cost.
TYPES OF COST
Explicit Costs (Money Costs)
A firm purchases the services of assets like building, machine etc. It pays hiring charges for
building, normally termed as rent. It employs workers, accountant manager etc. and pays wages
and salaries to them. It borrows money and pays interest on it. It purchases raw material, pays
electricity bills and makes such other payments. All such actual payments, on purchasing and
hiring different goods and services used in production are called ‘explicit costs’.
Implicit costs (Imputed costs):
Many a times, we find that all inputs are not always bought or hired by the producer from the
market. Some of the inputs are provided by the entrepreneur or producer himself. He may use
his own building. He may invest his own money in the business. He may be the manager of his
own firm. A farmer may cultivate his own land. If a producer had taken a building from another
production unit, he would have paid rent. In the same way, if he had borrowed money he would
have paid a certain amount of interest. Similarly, if he had engaged a manager he would have
paid him a salary. But he is not paying these amounts explicitely i.e. (rent for his building,
interest on his money and salary for his services) because he has contributed them for his own
business. So market value of these self-owned and self supplied inputs must be calculated. It
is, therefore, a cost to the producer. We can make an estimate of these costs on the basis of
their prevailing market prices. Let us term such costs as ‘implicit costs’ (to distinguish them
from explicit costs). These are also termed as imputed costs. One example of such cost is the
imputed rent of the self owned factory building. It can be taken as equivalent to the actual rent
paid for a similar type of building. Similarly, we can find out imputed interest and imputed
wages.
Opportunity cost
Economists define opportunity cost as the value of next best alternative foregone. What does
this mean? It is a common practicve that a person makes a list of several activities before
adopting a particular one to persue his/her goal. Similarly, in production a producer leaves
some alternatives before finally choosing to produce the particular output. So, while finally
choosing one, the producer did forego the alternative production. Let us take example of a
farmer. He can produce either rice or wheat on a piece of land. If he has decided to produce
wheat on this piece of land, he has to forego the produciton of rice for producing wheat. So,
value of rice foregone (next best alternative) is the opportunity cost of producing wheat.

Private Costs
While producing a commodity a firm has to pay for raw material; it has to pay wages of
workers; it has to pay rent of building. These are private costs for the firms. Thus private costs
are the expenditure of an individual firm in producing a commodity.
Social Cost
Factories emit large amount of smoke from their chimneys into the atmosphere. This may not
figure in the calculation of costs in their records. But the cost to the community may be in the
form of additional washing bills for clothes and the money spent by the community on medical
bills etc. These costs are social costs.
Cost in the short run: Fixed vs variable cost : In the short run two types of factors are
identified. One, fixed factors which cannot be changed and two, variable factors which can be
changed to increase output. Fixed costs are those costs which do not change with any changes
in the quantity of production or size of output during period. They remain constant during the
whole period at any level of output. Whether the production is zero or less or more. Then cost
are fixed in nature. Fixed costs are also known as supplementary cost. Let the rent of a factory
building paid by the producer is ` 1000 per month. Whether the producer produces the output
or not, he/she has to pay the rent after hiring the building.
On the other hand, variable cost are those cost which vary with the change in the quantity of
output or production. They do not remain constant and are variable in nature. There cost
increase with increase in output and decrease with a decrease in output. These costs are related
to variable factor of production. They are also known as direct cost or prime cost. For example,
labour is called variable factor in the short run. So, wage paid to labour is a variable cost. In
order to increase output, producer can hire more units of labour. So, the expenditure on wages
will increase. If output level is to be reduced, then producer can reduce the amount of labour
and accordingly less amount of wage will be paid. So variable cost varies with change in level
of output.
TFC Total expenditure on fixed factors is called total fixed cost (TFC)
TVC Total expenditure on variable factors is called total variable cost (TVC) TC
Sum of TFC and TVC is the total cost (TC)
TC = TFC + TVC
Total cost of a given volume of output is the sum of the explicit and implicit costs and normal
profit. In the previous section we have learnt that production costs are classified into fixed cost
and variable cost.
These two costs together make total cost i.e., TC = TFC + TVC
where TC stands for total cost, TFC for total fixed cost and TVC for total variable cost.
When a production unit is established but there is no production, total cost is the same as the
total fixed cost. As production takes place, variable cost is also incurred and so total cost
changes. Total cost increases as the quantity of output rises, The change in total cost equals the
change in total variable cost. This is because total fixed cost remains constant at all quantities
of output. Change in total cost is due to changes in variable cost only.
AVERAGE COST
Average Fixed Cost (AFC) :
Average fixed cost is obtained by dividing total fixed cost by the number of units of output
produced.

Average Variable Cost (AVC)

Average variable cost is obtained by dividing the total variable cost by the units of output
produced.

Average Total Cost (ATC) :

ATC is obtained by dividing the Total Cost (TC) by the total units of output.
MARGINAL COST
The concept of marginal cost is a very important concept in micro economics. The word
marginal should be taken to mean additional. For example, Marginal cost of producing a level
of output is the addition to the total cost or total variable cost caused by producing an extra unit
of output.

Relationship between AC and MC

(i) When MC is less than AC, AC falls with increase in the output
(ii) When MC becomes equal to AC, AC becomes minimum and constant.
(iii) When MC is more than AC, AC rises with increase in the output.