The managerial economist concerned with making , managerial decisions. Different business
proposals are evaluated in terms of their cost and revenues. To know what costs are examined, it
is necessary to understand what „cost‟ is and how to analyse the same.
COST CONCEPT AND NATURE OF COST:
Cost refers to the expenditure incurred to produce a particular product or service. All costs
involve a sacrifice of some kind or other to acquire some benefit.
Ex: If I want to eat food , I should be prepared to sacrifice money.
Costs may be monetary, or non-monetary; tangible, or intangible; determined subjectively or
objectively. Social cost such as pollution or noise; psychic costs such as frustration or
dissatisfaction resulting from the stress and train of the modern industrial activities add another
dimension to the cost concept.
The cost of production normally includes the cost of raw materials, labour, and other expenses.
This is known as total cost(TC). This is compared with the total revenue (TR) realized on the
sale of the products manufactured. The difference between the total revenue and total cost is
termed as profit.
( TR-TC = PROFIT)
This is the financial accountant‟s interpretation of total cost, total revenue and profit. This may
provide base for several legal purpose.
In decision making, cost need to be analysed and in a wider perspective. Through this data for
studying the costs is obtained from financial records. But some times the financial records may
not provide the all the necessary information. But for business decision making we required
usually all related information of costs of the business. To get such information we have to
understood different or variations of the cost.
The following are the possible variations or different types of the cost:
Long-run Vs Short-run:
Long run is defined as a period of adequate length during which a company may alter all factors
of production with higher degree of flexibility. Long-run cost covers the cost of change in the
size and kind of plant. Here perfect flexibility in the size of plant, labour force, executive talent
and so on.,
Short-run is defined as the period relatively shorter when at least some of the factors of
production are fixed. In the short-run it covers the costs associated with the variation in the
utilization of fixed plant or other facilities. Degree of flexibility is lacking in the short-run.
Fixed Vs Variable Costs:
Variable costs are differentiated from the fixed costs based on the degree of their variability in
relation to the rate of output.
Fixed costs are those costs that are fixed in the short run. Whether the production is taken up or
not, we have to incur certain expenses such as rent for factory and office buildings, insurance,
telephone, electricity and so on.
Variable costs are those costs that vary with the volume of production. Variable costs comprise
the cost of raw materials, wages paid to the labour and soon.
Semi-fixed or semi-variable costs:
Semi-fixed or semi-variable costs refer to such costs that are fixed to some extent beyond which
they are variable. Telephone charges or electricity charges from good example for this. If we
have connection, we have to pay minimum charges. This is fixed charge. The more you use the
facility, the more you have to pay. This is semi variable cost.
Marginal cost refers to „the additional cost incurred for producing an additional unit‟.it equals the
change in the variable cost per unit. This change is due to a change in the level of output.
Outlay Cost & Opportunity Cost :
Outlay cost are those costs that involve cash outflow at sometime these are generally recorded in
the books of account.
Ex: Actual wages paid, cost of materials purchases, interest paid etc.,
Opportunity Costs refer to the „costs of the next best alternative foregone‟ we have scarce
resources and all these have alternative uses.
It is the minimum possible alternative earning that might have been earned if the productive
capacity& service has been put to some alternative use.
Ex : - Rs. 10,00,000 can be invested in
: We can get an interest @ 6% per annum only.
: We can get an interest @ 9% per annum only.
: We can get up to 30% interest on investment.
Incremental Cost and Sunk Cost : Incremental cost is the
Incremental costs are the „added cost due to a change in the level (or)nature of business
activity‟. It is also called “differential cost”
Ex :- Addition of a new product line, changing the channel of distribution, Adding a new
Machine, Replacing a machine by a better machine, expansion into additional markets etc., it
arises only when a change in contemplated in the existing business.
Sunk costs are those costs that have already been committed in the past. They do not affected the
Ex : -Deprciation.
A firm may have spent towards Rs 10,000 in connection with aproposal to purchase a new
machinery at a price of Rs 1,00,000. Later, suppose, it is offered another machine, of equally
good quality, for Rs 70,000 . the amount of Rs 10,000 spent in the connection with the first
proposal is a sunk cost.
Past and Future Costs :
Past costs are those costs that have been spent already in the past.they are also called committed
costs or historical costs.
Future costs are those costs that will be spent in the future. And these have to be well
Urgent and Postponable Costs :
This classification based on the cost that have priority.
Urgent costs those costs which must be incurred in order to continued operations of the firm are
called as urgent costs.
Ex:- the cost of materials and labour which must be incurred if production is to take place.
Costs, which can be postponed at least for some time are known as postponable costs.
Ex:- Maintenance relating to building & machines.
Out-of Pocket and Book Costs :
This distinction based on the traceability and variability with output.
Out of pocket costs refer to costs that involve an immediate outflow of cash. These are spend in
the day-to-day life of the business, such as purchase of raw materials, utility expenses, rent of the
premesis occupied. It is also called explicit costs.
Book cost are those, Such as depreciation do not require current cash expenditure. Book costs
can be converted in to out-of-pocket costs by selling the assets and leasing them back from thec
buyer. It is also called imputed costs.
Ex : the rental payment then replaces the depreciation charge and interest cost of own capital.
Escapable & Unavoidable Costs :
Escapable costs refers to the costs can be saved by reducing the scale of operations to a lower
Closing Unprofitable Branch House.
Reducing Credit Sales.
Escapable cost are different from controllable and discretionary costs.
Unavoidable costs are those that are essential for the substsance of the business activity and
hence they have to be incurred.
Replacement and Historical Costs :
Historical Costs means the costs that have been originally spent to acquire the assets. The
financial statements are generally based on the historical costs.
Ex: A plant price originally paid for it to acquire.
Replacement cost means the costs that are to be paid currently if the asset were to be replaced.
Ex: price that would have to be paid currently for acquiring same plant.
In 1974, the cost of a machine Rs.15,000, but now 85,000.
15,000 – Historical Cost, 85,000 – Replacement Cost
Controllable and Non-Controllable Costs :
These costs can be classified as controllable or non-controllable depends upon the level of
management. Some costs are not controlled by the shop level.
A controllable cost may be defined as one which is responsible subject to regulation by the
executive with whose responsibility that cost is being indentified.
Thus a cost which is uncontrollable at one level of responsibility may be regarded as controllable
at some other, usually higher level. Direct material, Direct Labour costs are usually controllable
and an allocated cost is not controllable.
Explicit Vs Implicit costs:
Explicit costs involve payment of cash. the rent for the landlord, wages for the labourer, interest
paid on the funds borrowed government taxes and so on. are the explicit costs.
Implicit costs are also called imputed costs. Implicit costs do not involve payment of cash as they
are not actually incurred.
Example: Intrest on own character, saving in terms of salary due to own supervision, rent of own
Accounting Cost Vs Economic Cost:
Accounting Cost refers to what are recorded as expenses in the books of accounting records. The
Accountent recognizes the cost only when it is incurred and recorded as this necessarily forms
the legal point of view.
The economic cost recognized by the economist and managers those are other implicit cost that
are never recorded in the books. But we must be considered in managerial decision making.
Example: An Economist evaluates the investment proposals based on their returns after
converting them to their present value.
Separable Cost Vs Joint Cost:
These costs are differentiated based on tracebility. The costs which can be traced or identified
directly with a particular unit, department, or a process of production are called Separable Cost
or Direct cost. Ex. Cost of raw materials used for a particular production process or product.
Joint products arise from the production process the costs spent till the common process or split
off point, are called common or Joint Cost.
Example: Electricity power for running mechines.
COST RECORDS AND SELECTION OF DATA:
The classifying of costs is a primary exercise in the process of decision-making. Costs are
to be viewed from different perspectives such as traceability, controllability, variability and so
on,so that these different cost concepts can be made use of in decision-making. It is to be noted
that different cost concepts are useful for different purposes. An understanding of the cost
concepts will enhance the quality of managerial decisions.
Cost records in the standard format cannot provide information as required for each
managerial decision. The accounting records, reports to the higher authorities such as Securities
Exchange Board Of India(SEBI) and financial institutions, annual reports to shareholders and so
forth, form the source of data.
The cost and output are related. The cost of production depends upon several factors such
as volume of production; relationship between cost and output; prices and productivity of the
inputs such as land, labour, capital and so forth, and the time scale.
The cost-output relationship significantly differs in the short-run and in the long-run. It is
because, in the short-run, the costs can be classified in to fixed costs and variable costs. The costoutput relationship in the short-run is governed by certain restrictions in terms of fixed costs.
Whereas in the long-run , the cost-output relationship studies the effect of varying the size of
plants upon its cost.
Cost-output relationship facilitates many managerial decisions such as
Formulating a rational policy on plant size and the standards of operation,
COSTS IN THE SHORT-RUN
Cost in the short-run are classified in to fixed costs and variable costs. The fixed costs may
be ascertained in terms of total fixed cost and average fixed cost oer unit. The variable cost can
be determined in terms of variable cost, total variable cost. The following table explains the
behavior of costs in the short-run.
b) e= (b)/(a)
Total cost cost Rs.
From the table, it is clear that:
Total fixed costs remain fixed irrespective of increase or decrease in production activity.
Average fixed cost per unit declines as the volume of production increases. The
relationship between the fixed cost per unit and volume of production is inverse
Fixed cost per unit =1/ Volume of production
The total variable cost increases proportionately with production
The total cost increases with the volume of production
The average total cost decreases upto a certain level of production. After this level, it
Marginal cost is the change in total cost resulting from a unit change in output. It also
decreases up to a certain level of production but later it rises steeply.
MC < AC
AC = MC
MC > AC
From the above diagram it is noticed that as the output goes on increasing, average fixed cost
curve(AFC) will continue to decrease. Hence AFC curve will slope downwards but it never
touch X axis. The average variable cost (AVC) is U shaped curve denoting that the AVC curve
tend to fall in the beginning when the output is increasing but after a particular level of output it
rises because of the application of law of variable proportions or law of diminishing returns.
Average total cost(ATC) is the sum of AVC and AFC. This ATC curve seems to be closure to
the AFC curve in the initial stages, after reaching the certain level of output it indicates the
minimum output after that it rises and seems to be closure to AVC curve.
Marginal cost curve is a U shaped curve. It falls in the beginning and rises sharply. The rising
marginal cost curve will pass through the minimum point of the AVC and the minimum point of
ATC at R and S respectively.
COST IN THE LONG-RUN
Long-run referes to the period of time over which all factors are variable. The firm has more time
at it disposal to make any change in the production depending on its requirements. It can expand
its production, enter into new markets, make necessary changes in the labour force, import
technology. It has no constrains in terms of resources. It has no fixed costs. All costs are
A long-run is also expressed as a series of short-runs. It is already discussed that every short-run
average cost curve is associated with a short-run. This further explains that the long-run is
associated with a series of short-run cost curves.
The long-run average cost curve(LAC) is flat U shaped curve enveloping a series of short-run
average cost curves(SACs). It is tangential to all the SACs. The points of tangency represent
minimum average cost in the long-run, not in the short-run.
The U-shape implies that the cost of production continuous to the low till the firm reaches the
optimum scale(Marginal Cost = Average Cost) beyond this level the cost of production
Long-run average cost curve is of great utility for the entrepreneur to make decisions relating to
expansion of the size of the firm. It helps to minimize the cost to the advantage of the firm.
However, it is to be noted that the U-shaped LAC curve assumes away the technological
Optimum Size of the Firm:
The term Optimum means the conditions that produce the best result where in the firm
maximizes the profits per unit at minimum average cost. Optimum size is defined by experts as
According to R. T. Bye, an Optimum firm is that organization of business enterprise which, in
given circumstances of technology and the market for its products can produces its goods at the
lowest average unit costs in the long-run.
From the above definition, a firm is said to be an optimum size when it is in a position to utilize
its resources, including technology, most efficiently. As a result of this the cost of production is
the minimal and the productivity is very high.
An understanding of optimum size of the firm will unable the entrepreneur or promoter to choose
the right size of the firm in the setting up of project. Generally in every industry, there is an
economic size of the firm.
A firm can achieve optimum size in the long-run only when its long-run average cost(LAC) is
the lowest. In the short-run, it can only ensure optimum utilization of given plant.
The optimum quantity of production is OQ at OC cost. The lowest point of LAC indicates the
lowest cost of production. A firm must expand till it reach optimum size as it goes on reducing
the average cost per unit. If the firm expands beyond optimum size it suffers from diseconomies
of scale and the average cost will go on increasing.
Cost – volume profit Analysis (or) B.E.P Analysis:
TC = TR
Volume Production (or) Profit.