Historical costs: When cost are calculated for
a firm’s income tax returns, the law requires
use of historical costs or the actual cash
Current costs: current cost is the amount
that must be paid under prevailing market
Historical cost measure the market value of
an asset at the time of purchase. Current
cost measure market value at the present
cost is incurred at the time of
Replacement cost is necessary to replace inventory
Replacement cost: current costs for
computers and electronic equipment are
determined by what is referred to as
replacement cost or the cost of duplicating
Opportunity cost is the value that is forgone in
choosing one activity over the next best
Opportunity cost can be defined as the cost of any
decision measured in terms of the next best alternative,
which has been sacrificed. To illustrate the concept
better, let us assume that a person who has Rs. 100 at his
disposal can spend it on either of the three options: having
a dinner at a restaurant, going for a music concert or for a
movie. The person prefers going for a dinner rather than
to the movie, and the movie over the music concert.
Hence, his opportunity cost is sacrificing the movie, the
next best alternative once he goes for a dinner. If we carry
forward the same example at the firm level, a manager
planning to hire a stenographer may have to give up the
idea of having an additional clerk in the accounts
department. This is applicable even at the national level
where the country allocates higher defense expenditures
in the budget at the cost of using the same money for
infrastructural projects. In order to maximize the value of
the firm, a manager must view costs from this perspective
Extending the concept of opportunity costs discussed
above, total costs for a business should ideally include a
normal payment for all the factors of production,
including managerial and entrepreneurial skills and
capital provided by the owners of the firm. A normal
return to management or capital is the minimum
payment necessary to keep those resources from shifting
to other firms. Hence, economic cost refers to the
costs involved for all the factors of production
including those purchased from outside as well as
those owned by the firm. For example, an
entrepreneur wants to start a business with Rs. ten
lakh, which is presently invested in a fixed deposit in
a bank earning an interest of Rs one lakh per annum.
Hence, while calculating the total cost of the firm the
money earned as interest (Rs. one lakh) would be
treated as economic cost.
In most business decisions, the total opportunity
costs cannot be accounted for fully because of our
inability to include implicit costs. Implicit costs are
the value of forgone opportunities that does not
involve a physical cash payment. For example, an
entrepreneur who manages his firm has to forgo his
salary, which he could have earned if he had
worked elsewhere. Though implicit costs are not
included in books of accounts, they do play an
important role in a decision making process.
Explicit costs can be defined as the costs which
involves actual payment to other parties. Both
costs are equally important while making business
decisions, but sometimes implicit costs are ignored
as they are not as apparent as explicit costs.
There are two types of cost associated with time
Incremental cost is the total additional cost that a firm
has to incur as a result of implementing a major
managerial decision. For example, for Telco, a leading
truck manufacturer in India, the marginal cost of making
one additional truck in a defined production period
would be the labor, components, and energy costs
directly associated for making that extra truck.
Incremental costs in this case would be adding a new
product line, acquiring a company or hiring an in-house
legal staff. Thus, it can be said that marginal cost is a
subset of incremental cost.
Sunk costs are those costs which are incurred in the past
or that have to be incurred in the future as result of a
contractual agreement. The cost of inventory and future
rent charges for a warehouse that have to be incurred as
a part of a lease agreement are examples of sunk costs.
These costs are irrelevant while making decisions
because in any case they have to be borne by the firm.
Direct costs are the costs, which can be directly
associated to the production of a given product.
The use of raw material, labor input, and
machine time involved in the production of each
unit of that product can be determined.
On the other hand, there are certain costs like
stationery, office and administrative expenses
including electricity charges, depreciation of
plant and buildings, and other such expenses
that cannot be separated and directly attributed
to individual units of production.
Fixed costs are those costs, which do not vary with the
changes in the output of a product. They are associated with
the existence of a firm’s plant and, therefore, must be paid
even if the firm’s level of output is zero. Costs incurred as a
result of payment of interest on borrowed capital, contractual
rent for equipment or building, depreciation charges on
equipment and buildings, and the salaries of top level
management and key personnel are generally fixed costs. For
example, a firm which has entered into a lease agreement for
ten years for hiring the office space has to pay the same rent
whether the level of output of the firm doubles or even
becomes four times in that ten year period.
Variable costs are those costs that vary with the level of
output. They include payment for raw materials, charges for
fuel and electricity, payment of wages and salaries of
temporary staff, and payment of sales commission, etc. For
example, in the case of hotel industry there is a high variation
in occupancy rates according to different seasons. A hotel on a
hill station may report 100 percent occupancy in summers
while the situation changes dramatically in winters when the
occupancy rates are just 10-20 percent or even lower. Hence,
the industry hires lot of temporary staff during the period of
high occupancy, who are not retained during low occupancy
Average cost is the cost per unit.
Marginal costs can be defined as the change in
the total cost of a firm as a result of change in
one unit of output. These costs are important
in short-term decision making of the firm to
determine the output at which profits can be
Total cost (TC) is the cost associated with all
of the inputs. It is the sum of TVC and TFC.
A cost function determines the behavior of
costs with the change in output. The costoutput relationship gains importance when
the firm has to allocate resources and
determine a price for the output. The cost
function can be a schedule, graph or a
mathematical relationship showing the
minimum achievable cost for producing
various quantities of output. It indicates the
functional relationship between total cost
and total output. If C represents total cost
and Q represents the level of output, then
the cost function is represented as C = f (Q).
the total cost (C) for producing the output
level Q is given by
C=L w + K r or C= f (Q)
Short run cost functions help in determining the relationship
between output and costs in the short run. With a particular
change in production output, the change in total, average
and marginal costs can be determined for a given set of cost
functions for a firm. The short run average total costs
(SRATC) and average variable costs (AVC) are slightly Ushaped. The marginal cost (MC) curve intersects both the
average variable cost curve and short run average total cost
curve at their lowest points. The cost functions shown in the
figure are the representative of the short-run costs incurred
by majority of firms.
The level of output where the average total cost is minimum
is known as the short run capacity of a firm. This is also the
optimum level output since the average total cost is
minimized at this point .
Long run can be defined as a sufficiently long period that
allows the firm to adjust factors of production to meet
market demand. In the long run, the firm chooses the
combination of inputs that minimizes the cost of production
at a desired level of output. The firm identifies the plant
size, types and sizes of equipment, labor skills and raw
materials that on combination give the maximum output at
the lowest cost, considering the technology available and
the production methods used. As the inputs are chosen for
producing a desired level of output, all the inputs in the long
run are variable. If there is an unexpected rise in the
demand and the firm wants to increase the output from Q 1 to
Q2 (Ref Figure 5.2), the firm can increase variable inputs like
labor and raw material. In such circumstances, the short run
average cost will be high. If the demand lasts for a longer
period, then a larger investment in the plant and equipment
is required. This would reduce the per unit cost to C 2. A short
run average cost function like SAC2 can be determined for
the new set of inputs.
Revenue is the income received from the sale of
receipts or goods.
Concepts of revenue:
Total revenue is the sum of the income received from
the sale of total goods.
TR = price x quantity
Average revenue is the revenue per unit.
AR = TR / No. of units sold
Marginal revenue is the additional revenue obtained by
selling one more additional unit.
MR = change in TR / change in units sold
In perfect competition market AR = MR.
In imperfect Competition market, AR > MR
Break-even analysis is an important practical
application of the cost function. In business planning,
many decisions are taken on the basis of an
anticipated level of output. Break even analysis
studies the inter-relationships between the firm’s
revenues, costs and operating profit at various levels
of production. It is used to measure the effects of
changes in selling prices, fixed costs, and variable
costs on the output level that is to be achieved
before the firm starts earning operating profits.
Break even analysis is also used for evaluating the
financial viability of new marketing plans and product
lines. While conducting break even analysis, the level
of output that a firm must produce to reach a point
where the firm makes no profit or loss is known as
break even point.
The difference between the total revenue and the total
cost is the profit generated by the firm. In Figure 5.3, the
vertical distance between the curves of total revenue (TR)
and total cost (TC) determines total profits at any level of
production. The point where the total cost equals the total
revenue is known as the break-even point as explained
earlier. In Figure 5.3, the break-even points can be seen at
two different levels of production i.e. Q1 and Q3. Output
below Q1 will lead to losses, as the total revenues are less
than total costs. The firm earns profits between the Q1
and Q3 level of production, where the total revenue is
more than the total cost. The total profits are maximum at
point Q2 as the vertical distance between the total
revenue and the total cost is maximum at this point.
Therefore, to achieve the maximum level of profits, the
firm should retain the same price-output structure
A computer chip-manufacturing firm has incurred
a fixed cost of Rs 2,30,000. It sells each unit for
Rs 400. The variable cost per unit is Rs 65. What
will be the break-even quantity and revenue?
Quantity required to break even (Qb) = Fixed
cost/P – AVC
= 23, 0000/400 – 65
= 23, 0000/335
= 686.567 units Or 687 units
Total revenue at which the computer chip
break-even is equal to the product price and the break
=687 * 400= Rs 274800