Cost of production (1)


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Cost of production (1)

  1. 1. INTRODUCTIONCost is normally considered from the producer’s orfirm’s point of view. A firm has to employ anaggregate of various factors of production such asland, labour, capital and entrepreneurship.
  2. 2. The cost of production of a commodity is theaggregate of price paid for the factors of productionused in producing that commodity. Cost ofproduction, therefore, denotes the value of thefactors of production employed.
  3. 3. The Cost of ProductionTotal revenue is the amount of a firm receives forthe sale of its output. Total cost is the market valueof the inputs a firm uses in production. Profit = total revenue minus total cost.
  4. 4. “Real cost of production” refers to the physicalquantities of various factors used in producing acommodity. Real cost, thus, signifies the aggregateof real productive resources absorbed in theproduction of a commodity (or a service).
  5. 5. The real cost of production signifies toils, troubles,sacrifice on account of loss of consumption forsavings, social effects of pollution caused by factorysmoke, automobiles, etc.
  6. 6. Real Cost –The real cost of production of a commodity refers tothe exertion of labour. Sacrifice involved in theabstinence from present consumption by the saversto supply capital and social effects of pollutioncongestion, etc.It’s an abstract idea. Its exact measurement is notpossible.
  7. 7. Opportunity Cost – The cost of something is whatyou give up to get it.The concept of opportunity cost is based on thescarcity and versatility characteristics of productiveresources. It is the most fundamental concept inEconomics.It is the cost measured in terms of forgone benefitsfrom the next best alternative use of a givenresource.
  8. 8. The concept of opportunity cost is based on thescarcity and versatility (alternative applicabilities)characteristics of productive resources. It is themost fundamental concept in economics.
  9. 9. Wants are multiple. When we choose the resource inone use to have one commodity for satisfying aparticular want, it is obvious that its other use assome other commodity that can be produced by itcannot be available simultaneously.This means,the second alternative use of theresources (or another commodity) is to be sacrificed tohave the resource employed in one particular way,
  10. 10. i.e. to get a particular commodity; because the sameresource cannot be employed in two ways at thesame time. The sacrifice or loss of alternative use ofa given resource is termed as “opportunity cost”.
  11. 11. Importance of the Concept of Opportunity Cost1. Determination of Relative Prices of Goods: The concept of opportunity cost is useful in explaining the determination of relative prices of different goods. For instance, if the same group of factors can produce either one car or six scooters, then the price of one car will tend to be at least six times more than that of one scooter.
  12. 12. 2. Determination of Normal Remuneration to a Factor: The opportunity cost sets the value of a productive factor for its best alternative use. It implies that if a productive factor is to be retained in its next best alternative use, it must be compensated for or paid at least what it can earn from its next best alternative use.
  13. 13. 3.Decision-Making and Efficient Resource Allocation:The concept of opportunity cost is essential in rationaldecision-making by the producer.It follows that a resource will always tend to move orwill be used in an occupation where it has a highopportunity cost. Thus, the concept of opportunitycost serves as a useful economic tool in analyzingoptimum resource allocation and rational decision-making.
  14. 14. Importance –(1) Determination of Relative prices of goods.(2) Determination of normal remuneration to a factor.(3) Decision making & efficient resource allocation.Money Cost – Cost of production measured in termsof money is called money cost. It is the monetaryexpenditure on inputs of various kinds – rawmaterial, labour, etc.
  15. 15. Money Cost“Money cost” is the monetary expenditure on inputsof various kinds – raw materials, labour etc., requiredfor the output, i.e., the money spent on purchasingthe different units of factors of production needed forproducing a commodity. Money cost is, therefore, thepayment made for the factors in terms of money.
  16. 16. Explicit & Implicit CostsExplicit cost are direct contractual monetarypayments incurred through market transaction.Explicit costs refer to the actual money outlay ofthe firm to buy or hire the productive resources.
  17. 17. It includes –(1) Costs of raw material(2) Wages & Salaries(3) Power Charges(4) Rent of business or factory premises(5) Interest payment of capital invested(6) Insurance premium
  18. 18. (7) Taxes like property tax, duties, license fees(8) Miscellaneous – Marketing & advertising expenses.
  19. 19. Implicit CostsImplicit money costs are imputed payments whichare not directly or actually paid out by the firm. Itarises when the firm or entrepreneur suppliescertain factors owned by himself.Implicit costs are as follows -1) Wages of labour rendered by the entrepreneur himself. Contd..2……..
  20. 20. 2) Interest on capital supplied by him.3) Rent of land and premises belonging to the entrepreneur himself.4) Normal returns of entrepreneur, a compensation needed for his management and organisational activity.The distinction between explicit and implicit moneycost is important in analysing the concept of profit.
  21. 21. Fixed Cost –Amount spent by the firm on fixed inputs in the shortrun known as supplementary costs or overhead costsit usually include –1) Payments of rent for building2) Interest paid on capital3) Insurance premium4) Depreciation and maintenance allowances5) Administrative expenses – salaries6) Property & business taxes, license fees, etc.
  22. 22. FIXED COST Recurrent Allocable(Rent, interest, (Depreciation insurance Charges) premium)
  23. 23. Variable Cost – (Prime Costs)These costs are incurred by the firm as a result ofthe use of variable factor inputs. They are dependentupon the level of output.It includes –o Prices of raw materialso Wages of Labouro Fuel & Power chargeso Excise duties, sales taxo Transport expenditure
  24. 24. The distinction between prime costs (variable costs)and supplementary costs (fixed costs) is, however, notalways significant. In fact,the difference between fixedand variable costs is meaningful and relevant only inthe short period. In the long run, all costs arevariable because all factors of production becomeadjustable in the long run. In the short period, onlythose costs are variable which are incurred on thefactors which are adjustable in the short period.
  25. 25. In the short run,however,the distinction betweenprime and supplementary costs is very significantbecause it influences the average cost behavior of theproduct of the firm. Thus, it has a significant bearingon the theory of firm. In specific terms, thesignificance of making this distinction between fixedand variable costs is that in the short period a firmmust cover at least its variable or prime costs if it isto continue in production.
  26. 26. Even if a firm is closed down, it will have to incurfixed or supplementary costs. The firm will sufferno great loss in continuing production, if it cancover at least its variable costs under theprevailing price.
  27. 27. Types of Production Costs & their measurementTotal Cost – Aggregate of expenditures incurred bythe firm in producing a given level of output. TC = TFC + TVCTFC – It is the total cost of fixed factors of productionemployed by the firm in the short run.
  28. 28. In economic analysis, the following types of costsare considered in studying cost data of firm:1. Total Cost (TC),2. Total Fixed Cost (TFC),3. Total Variable Cost (TVC),4. Average Fixed Cost (AFC),5. Average Variable Cost (AVC),6. Average Total Cost (ATC), and7. Marginal Cost (MC).
  29. 29. Total Fixed Cost (TFC)Suppose a small furniture-shop proprietor starts hisbusiness by hiring a shop at a monthly rent ofRs.1,000, borrowing loan of Rs.10,000 from a bank atan interest rate of 12%, and buys capital equipmentworth Rs.900. Then his monthly total fixed cost isestimated to be:Rs.1,000 + Rs.900 + Rs.100 = Rs.2,000. (Rent) (Equipment Cost) (Monthly Interest on the loan)
  30. 30. Definition: Total fixed cost is the total cost ofunchargeable,or fixed, factors of productionemployed by the firm in the short run.
  31. 31. Again, TVC = f (Q) which means, total variable cost isan increasing function of output.Suppose,in our illustration of the furniture-shopproprietor, if he was to start with the production ofchairs, he employs a carpenter on a piece-wage ofRs.100 per chair. He buys wood worth Rs.2,000,rexine-sheets worth Rs.3,000, spends Rs.500 forother requirements to produce 5 chairs.
  32. 32. Then his total variable cost is measured as:Rs.2,000(wood price)+Rs.3,000(rexine cost)+ Rs.500(allied cost)+Rs.500 (labour charges)= Rs.6,000.Definition: Total variable cost is the total costs ofvariable factors employed by the firm at each levelof output.
  33. 33. TVC - TVC = F (Q)It is the total cost of variable factors employed bythe firm at each level of output.AFC – Total fixed cost divided by total units of output (Q stands for the numbers of units of the product)
  34. 34. AVC-Total variable cost divided by total units of outputATC – Total cost divided by total units of outputMarginal Cost (MC) -It is the addition made to the total cost by producingone more unit of output.
  35. 35. Long run costs :Long run period is long enough to enable a firm tovary all its factor inputs. In the long run a firm canmove from one plant capacity to another. Firm canincrease or decrease plant capacity according tonature of demand.
  36. 36. Calculate CostsTP (Q) TFC TVC TC AFC= TFC AFC= TVC AFC = TC MC Q Q (1) (2) (3) (4) (5) (6) Q (8) (7) 0 100 0 100 - - - - 1 100 25 125 100 25 125 25 (125-100) 2 100 40 140 50 20 70 15 (140-125) 3 100 50 150 33.3 16.6 50 10 (150-140) 4 100 60 160 25 15 40 10 (160-150) 5 100 80 180 20 16 36 20 (180-160) 6 100 110 210 16.3 18.3 35 30 (210-180) 7 100 150 250 14.2 21.4 35.7 40 (250-210) 8 100 300 400 12.5 37.5 50 150 (400-250) 9 100 500 600 11.1 55.6 66.7 200 (600-400) 10 100 900 1000 10 90 100 400 (1000-600)
  38. 38. In the long run there is no dichotomy of total costinto fixed and variable costs as in the short run.Long run involves various short run adjustmentsvisualized over a period of time.Long run average cost curve is the envelope of thevarious short run AC curves.
  39. 39. Y SAC3 LAC SAC1 SAC2 C OUTPUT O S T X O Q1 Q2 Q3• LAC is the Locus of all these points of tangency.• LAC is enveloping to a number of plant sizes and the related sizes.• It is regarded as the long run planning device. A rational entrepreneur would select the optimum scale of plant.• It is flatter U shaped means in the beginning it slopes down gradually after a certain point it begins to slope upward.
  40. 40. Cost Leadership Introduced By Michel Porter towards Competitive Advantage Lowest cost of peration in the business by the firm Business Strategy of doing the business at the owest possible cost in a market AVIATION INDUSTRY MALAYSIA-Air Asia-Lowest COST –Largest profit
  41. 41. How to achieve cost leadership?Cost Control measuresAvoiding wastage ‘better supervision on the workersAccess to cheaper source of capital and required financeFocus on quantitative targets for the business expansionensuring that the cost is maintained at the minimum level
  42. 42. Contd .. Wall Mart has earned cost leadership reputation in retail trade Modern business follows two generic evel stretegies Product differentiation Cost leadership
  43. 43. Sources of cost leadership Economics of scale Reaching to a level of minimum efficient scale much earlier than the competing firms in the market Learning curve effect. Inter nationalization. Technological acquisition and improvement. Access to low cost inputs. Knowledge management.
  44. 44. Competitive threats by a firm Threat of new entry Threat of rivalry Threat of substitutes Threat of suppliers Threat of buyers