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# Cost concepts

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### Cost concepts

1. 1. Various Type of Costs • There are different type of costs and can be classified by various ways • This lecture includes costs classifications mostly use by economists • Fixed & Variable Costs, Average Costs & Marginal Costs, Private & Social Costs • Opportunity Costs • Some other important cost concept you may come across: Sunk Cost and Sinking funds, Operation & Maintenance Cost (O&M Costs), Life-cycle Costs etc. 1-12 Fixed and Variable Costs • Fixed Costs: those costs that do not vary with the quantity of output produced.…any example ? Examples: rent to paid for factory building, interest on invested capital, maintenance, taxes etc • Variable Costs: are those costs that do vary with the quantity of output produced Examples: consumption of fuel for power generation ….it will vary as the production of a factor increases or decrease 1-13 1
2. 2. Total Costs • It maybe noted that Fixed Costs (FC) and Variable Costs(VC) may consist of more than one component and the sum of all respective components will make up TFC and TVC respectively • Total Costs (TC) is equal to sum of Total Fixed Costs (TFC) and Total variable costs (TVC): TC = TFC + TVC 1-14 Average Costs • Average Costs – Average costs can be determined by dividing the firm’s costs by the quantity of output it produces – The average cost is the cost of each typical unit of product • Average Costs can also be obtained by adding Average Fixed Costs (AFC) and Average Variable Costs (AVC) …i.e: ATC = AFC + AVC 1-15 2
3. 3. Average Costs Example: a firm produce 100 units of output at cost of \$1000, what is the average cost of the firm? AFC  AVC  Fixed cost FC  Quantity Q Variable cost VC  Quantity Q ATC  Total cost Quantity TC  Q = 1000/100 => \$10 1-16 Marginal Costs • Marginal Cost – Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production – Marginal cost helps answer the following question: • How much does it cost to produce an additional unit of output? MC  (change in total cost) TC  (change in quantity) Q 1-17 3
4. 4. Private / Social Cost • Private costs (benefits) of an action – accruing to the actor only • Social costs (benefits) – total costs of activity including those that accrue to people other than the actor • Example: driving a car – Private costs: fuel, maintenance – Social costs include pollution, road wear 1-18 Opportunity Costs I got a lottery of worth Rs 10 millions (1 core) Ranking the Choices 1 2 3 The Next best use is “buying house” that’s I forgone for paying my Credit card debts so that’s my Opportunity cost Opportunity Cost: The Next Best Decision you could make 1-19 4
5. 5. Opportunity Costs • Opportunity cost is the cost of second best use of the available/used resources in a certain action • The opportunity cost of you people sitting in this class is …the next best use of your this time … in work, recreational activities, sports or facebooking  • My opportunity cost of teaching you this Course is …… the time & earning opportunity I forgone to teach you 1-20 Sunk Cost • Sunk Cost: is the costs that are incurred in the past and can not be recovered by any future action • Theory states: ignore sunk costs, because they are paid in either case, and cannot be recovered • For example: If you lost the movie ticket worth Rs. 800 - you can't get it back - if you decide not to buy a second ticket and go home you won't get the first ticket you lost, back 1-21 5
6. 6. Sinking fund • A sinking fund is a fund established by an economic entity by setting aside revenue over a period of time to fund a future capital expense, or repayment of a long-term debt • Sinking funds can also be used to set aside money for purposes of replacing capital equipment as it becomes obsolete, or major maintenance or renewal of elements of a fixed asset, typically a building 1-22 Operation and Maintenance Cost (O&M Costs) • Operation and Maintenance Cost is the group of costs experienced continually over the useful life of the activity… any example ? • This includes costs like, labour costs for operating & maintenance personal, fuel and power costs, spare and repair part costs, costs for taxes etc. • These costs can be substantial and can exceed the initial costs 1-23 6
7. 7. Life-cycle Costs • Life-cycle - all the time from the initial conception of an idea to the death of a product (process) • Life-cycle costs - sum total of all the costs incurred during the life cycle • Life-cycle costing - designing a product with an understanding of all the costs associated with a product during it’s life-cycle 1-24 Product Life-cycle Begin Needs assessment and justification Time Conceptual or preliminary design phase Impact Analysis Requirements Overall Feasibility Conceptual Design Planning Proof of concept Prototype Development and testing Detailed design planning Detailed design phase Allocation of resources Detailed specification Component and supplier selection Production or construction phase Production or Construction Phase Product, goods and service built All supporting facilities built Operation al use planning End Operational Phase Decline and retirement phase Operational Use Use by ultimate customer Maintenance and support Process, materials and methods use Declined and retirement planning Decaling Use Phase out Retirement Responsible disposal 1-25 7
8. 8. Cumulative Life-cycle Costs Committed and Dollars Spent Total life-cycle cost % 100% Life-cycle costs committed 80% 60% Life-cycle costs spent 40% 20% 0% Definition and conceptual design Detailed design Production Operational use Decline/ Retirement Project Phase 1-26 8