MEANING - COST“ Cost is a sacrifice or foregoing that has occurred or has potential to occur in future, measured in monetary terms”• Cost results in current or future decrease in cash or other assets or a current or future increase in liability
DETERMINANTS OF COST• Cost is determined by various factors and each of these has significant implications for cost decisions.• An increase in any of these will affect cost pattern.• Important determinant – Price(uncontrollable –largely determined by external environment) – Marginal efficiency and productivity – Technology – Level of out put.
MATHEMATICAL EXPRESSION- COST C= F( Q , T , P)• Where – C= cost – Q= out put – T= technology – P= price• Cost are differentiated according to their purpose , type of product and time.
TYPES OF COSTS• There may be different types of costs incurred by a firm under different circumstances.• Cost of a firm may include money or may not be measurable in money terms.• Cost is a function of output in economic theory.• A managerial economist’s concept of cost does not necessarily coincide with that of accountants.
TYPES OF COST• Actual Costs / Acquisition / outlay : It means the actual expenditure incurred for acquiring or producing a good or service. These are generally recorded in the books of accounts. Eg. Wages paid, cost of materials purchased, interest paid, etc.• Opportunity Cost / Alternative Cost: Revenue forgone by not making the best alternative use or opportunities.
• Imputed Cost / Implicit cost: They are the costs which are not actually incurred but would have been incurred in the absence of employment of self-owned factors. These are unrecognized by the accounting systems. Eg. Rent of own building, Salary for Entrepreneur, etc.• Explicit cost / Paid out costs: Those expenses which are actually paid by the firm. Appears in the accounting books.• Sunk Costs / Non-avoidable / Non escapable: They are not altered by a change in quantity and cannot be recovered. All the past expenses are sunk costs Eg Depreciation, interest, machineries not in use.
• Incremental / Differential cost ( Avoidable, escapable or Differential): It is the additional cost due to a change in level or nature of business activity.• Out-of-Pocket costs: These are expenses which are current cash payments to the outsiders. (All Explicit costs)• Book Costs: These are business costs which do not involve any cash payments but for them a provision is made in the books of account. Eg. Depreciation, Implicit cost.
• Accounting cost / Past Cost: How much expenditure has already been incurred on a particular process or on production as such.• Economic cost / Future cost: Cost relate to future.• Direct costs / Traceable / Assignable: These costs have direct relationship with a unit of operation.• Indirect / Non-traceable / Non assignable: These costs cannot be easily & definitely traced to a plant or department.
• Historical Cost / Original cost: It states the cost of plant, equipment and materials at the price paid originally for them.• Replacement cost: It states the cost that the firm would have to incur if it wants to replace or acquire the same assets now.• Controllable costs: Costs which are capable of being controlled or regulated.• Non-Controllable cost: costs which cannot be subjected to administrative control and supervision. Eg. Depreciation, Obsolescence.
• Private costs: Micro level. Costs incurred by an individual or a firm for its business activity.• Social costs: Macro level. Total cost s to the society on account of production of a good.• Shutdown Costs: Those costs incurred when firm temporarily stops it operations.• Abandonment Costs: Costs incurred when the firm is retiring altogether.• Short run costs: a period in which the supply of at least one of the inputs cannot be changed by the firm. Inputs are fixed.
• Long run costs: Period in which all inputs can be carried as desired.• Fixed Cost: Part of total cost of the firm which does not vary with output.• Variable cost: Part of total cost that are directly dependent on the volume of output or service.• Total cost: It is money value of the total resources required for production of goods and services by the firm. TC = FC + VC
• Average cost: It is the cost per unit of output. – AC = TC / n – n = number of unit• Marginal cost: It is the change in total cost due to unit change in out put MCn (TCn TCn1 )
COSTS IN SHORT RUN• Classification of costs is on the basis of time – Short run cost – Long run cost• The short run is a time period where some factors of production remain fixed and only few are variable. – Fixed inputs – land ,machine and technology – Variable inputs – labor and raw material
Contd…• Therefore in short run we divide costs in two broad categories – Fixed costs • Costs on fixed inputs – Variable costs • Costs on variable inputs
TOTAL COSTS FUNCTIONS AND CURVES FOR SHORT RUN• As we discussed short run cost have two components• Fixed cost – This cost do not vary with output – Cost incurred in plant, machinery fitting , equipments, land etc. – Any change in volume of output does not depends upon fixed cost – The shape of the TFC(TOTAL FIXED COST) curve is straight line from origin parallel to quantity axis.
GRAPH - TFC X AXIS – QUANTITY Y AXIS – COST TFC
• Variable cost – These are costs that vary with output and are incurred in getting more and more inputs. – Variable costs are equal to zero if there is no out put – Cost of raw materials , wages are called variable cost. – TVC is an inverse S shaped upward sloping curve starting from origin.
GRAPH INFERENCE• The shape of curve determined by law of variable proportions.• According to this law as more and more units of the variable factor are added in production its productivity goes on increasing.• This lead to fall in per unit cost in the beginning. if the variable input is increased beyond certain level its marginal productivity starts diminishing.• So TVC increases at increasing rate.
GRAPH – TOTAL COST TC TVC TFC X AXIS – QUANTITYTOTAL COST = TFC + TVC Y AXIS – COST
SHORT RUN – AVERAGE AND MARGINAL COST • AVERAGE COST – Average cost is cost per unit of out put – We can derive AFC (average fixed cost) AVC( average variable cost) and AC (average cost) from total fixed , total variable and total costs respectively. – AFC is fixed cost per unit of output and this is equal to the ratio of TFC and units of output • AFC = TFC / NUMBER OF UNITS OF OUT PUT – AVC is variable cost per unit of out put and this is equal to the ratio of TVC and units of output • AVC = TVC / NUMBER OF UNITS OF OUT PUT – AC is total cost per unit of out put • AC = TC /NUMBER UNITS OF OUTPUT
• MARGINAL COST – MC is the change in total cost due to unit change in out put – Rate of change in total cost. MCn (TCn TCn1 )
AVERAGE AND MARGINAL COST CURVES- SHORT RUN MC AC AVC AFC X AXIS – QUANTITY Y AXIS – COST
AVC , AFC AND AC GRAPH - INFERENCE• The AVC and AC curve are both U shaped. – This explained by law of diminishing returns. – Cost decline when there are increasing returns(output)• AC being the sum of AFC and AVC at each level of output lies above both AFC and AVC curve.• Initially AC falls with increase in out put reaches minimum and then increases.
..contd• When both AFC and AVC fall AC also falls.• AVC soon reaches minimum and start rising .• While AFC continues to fall.• How ever the rise in AVC compensate falls in AFC and AVC pulls AC up after reaches a minimum.
MARGINAL COST GRAPH - INFERENCE• The magnitude of marginal cost is interlinked with changes in average cost.• When average cost decline MC lies below AC.• When average costs are constant the MC passes through the minimum points of average cost curves.• When average cost rise MC curve lies above them.• AC and AVC fall MC lies below them• AC and AVC rise MC lies above them.
RELATIONSHIP AMONG CURVES – MATHEMATICALN SUMMARIZATION• TC = TFC + TVC• AFC = TFC / Q• AVC = TVC/ Q• AC = TC /Q = (TFC + TVC)/Q = AFC + AVC• MC = TC q – TC q-1 = change in total cost (d TC)/ total out put (dQ)
COSTS IN LONG RUN• All cost are variable in the long run since factors of production – Size of plant – Machinery and technology are all variable.• The long run cost function is often referred to as the “planning cost function”• The long run average cost (LAC) curve is known as the “ planning curve”• All the cost are variable only the average cost curve is relevant to the firm’s decision making process in the long run.• Long run cost curve is the composite of many short run cost curves……*
LONG RUN AVERAGE COST (LAC)• When the plant size and other fixed inputs of the firm increase in the long run the short run cost curves shift to the right.• We consider in the long run the firm operates with three different plant sizes – Plant size I , II , III• It can switch over to a different plant size depending on cost consideration.
…CONTD• SAC 1 relates to average cost of the firm when the plant size I.• When the plant size increases to II the corresponding SAC 1 curve is SAC 2 and so on.• So – Plant size I – SAC I – Plant size II – SAC II – Plant size III – SAC III
X AAXIS – QUANTITY LAC CURVE Y AXIS –AC,MC MC1 MC2 MC3 SAC1 SAC2 SAC3 plant size I plant size II plant size IIIQ0 Q1 Q2
GRAPH- INFERENCE• As out put increases from Qo to Q1 in the short run the firm can continue to produce along SAC1, utilizing its installed capacity of plant size I.• Further ahead at an out put level of Q1 this capacity is over worked.• So it would be the cost effective for the firm to shift to higher plant size say plant size II. – Thus switching from SAC1 to SAC2• This shift would lower the average cost of the firm.• The same concept is followed for subsequent output.
…contd• The LAC curve has a scalloping pattern as its is drawn with three plant sizes only.• We assumed that the firm operates with only 3 alternative plant sizes. – But in reality ……………. Multiple such alternatives. – So in reality it may have multiple SAC also….• The LAC function is an envelope of the short run cost functions and LAC curves envelopes the SAC curve hence LAC curve is also known as “ envelope curve”
..contd• The LAC curve is also known as “planning curve”• According to the entire planning horizon in which the managerial economist can select the most appropriate plant size , given the existing (or expected) level of demand for the product.
X AAXIS – QUANTITYLAC - ENVELOPECURVE Y AXIS –AC,MC SMC1 SMC2 SAC1 SMC2 SAC3 SAC2 Q0 Q1 Q* Q3
LONG RUN MARGINAL COST• Long run marginal cost (LMC) curve joints the points on the short run marginal cost (SMC) curves.
X AAXIS – QUANTITYLMC - CURVE Y AXIS –AC,MC SMC1 SMC2 C SAC1 SMC2 SAC3 SAC2 A LMC B Q0 Q1 Q* Q3
GRAPH INFERENCE• At out put level of Qo. The relevant long run marginal cost is Aqo.• The LMC curve joins the points A,B,C• According to assuming sufficient demand the optimum plant size is II.• So the optimum level of out put is Oq*. – Where long run and short run marginal cost and average costs are equal.
LAC – DIFFERENT SHAPES X AAXIS – QUANTITY Y AXIS –AC
GRAPH - INFERENCE• Once we have the long run average cost of producing an output we can readily derive the long run total cost of output.• Since total cost is the quantity of output times average cost.
COST OF A MULTIPRODUCT FIRM• So far we have assumed that the firm produces a single good /service.• How ever in the real business world many firms produce more than one product.• A cost of multiproduct firm is differ from costs of single product.• In order to ascertain the costs of multiproduct form we need to first modify some of the cost concepts.
EXAMPLE• Take multiproduct firm producing 2 goods – Product 1 and product 2• For simplicity we assume that the firm uses the same capital requirements in producing the above 2 goods.• So TC of production would be the sum of fixed cost (TFC) and total variable cost (TVC)- C1 and C2 of producing both the product times the quantities of 2 goods be Q1 and Q2 – TC = TFC + C1 Q1 + C2 Q2
…. CONT– WEIGHTED AVERAGE COST OF MULTIPRODUCT FIRM– AC w(Q) = F + C1 (X1 Q) + C2 (X2 Q) ---------------------------------- QWhereX1 and X2 are proportions in which products 1 and 2 are producedQ is the total out put.
COSTS OF JOIN PRODUCTS• There are certain goods which are produced jointly – That is if one good is produced the other will automatically be produced. – Example = normally found in agriculture , minerals etc• Costing of such products is different from traditional costs method.• Two or more products undergo the same production process up to split off point
…contd• Split off point – The beyond which joint products acquire separate identities and one or more of the products may undergo additional processing there from. – Example • Cream and milk • Oil and gas
JOINT PRODUCTS – COST CONCEPTS• In this there would be common costs which cannot be identified with a single joint product.• The join products incur common costs until they reach split off point.• After the split off point the product incurred the separate costs.• The allocation of common costs are according to – Physical measure – Sales value
LINKAGE BETWEEN COST, REVENUE AND OUTPUT• TOTAL REVENUE (TR) – Total revenue is the total amount of money received by a firm from goods sold during certain period of time. – TR = Q X P • Q – QUANTITY P – PRICE• AVERAGE REVENUE (AR) – Average revenue is the revenue earned per unit of output sold. – It is equal to the ratio of TR and out put – AR = TR / Q = (Q x P) / Q – AR = P
…CONTD• MARGINAL REVENUE (MR) – Marginal revenue is the revenue a firm gains in producing one additional unit of a commodity – It is calculated by determining the difference between the total revenues earned before and after increase in production – MRq = TRq - TR q-1 = d TR / d Q
TR AND MR - RELATIONSHIP X AAXIS – QUANTITY Y AXIS –PRICE , REVENUE MR is slope of TR CURVE TR MR
GRAPH - INFERENCE• The graph shows the relationship between total revenue and marginal revenue.• TR will be zero when nothing is sold.• The shape of TR curve is inverted U starts from origin.• After it reaches maximum dipping to X axis.• Rise in total revenue curve is the change in total revenue with rise in level of output – So therefore we can say MR is the slope of TR curve
MR AND AR – RELATION SHIP• AR curve can have the following positions – Straight line – Convex to the origin X AAXIS – QUANTITY Y AXIS –MR – Concave to the origin PANEL A PANEL B PANEL C AR AR AR MR MR MR
GRAPH INFERENCE• PANEL A – When AR is a straight line MR will be lie midway to AR• PANEL B – When AR is convex to the origin MR will lie less than midway to AR• PANEL C – When AR is concave to the origin MR will lie more than midway to AR
PROFIT MAXIMIZATION• The profit function shows a range of outputs at which the firm makes positive profits• Two types of profits – Normal profit • It is amount of return to the firm which must be earned to keep in that business activity • It is the part of total cost – Supernormal profit • Any thing above normal profit is super normal profit • It is accounting profit occurs when TR > TC
..CONTD• A firm maximizes profit at the point where MR = MC• Rules of optimization – The second order condition of profit maximization requires the slope of MR = slope of MC
BREAK EVEN ANALYSIS“Break even point is the point where total cost just equals the total revenue it is the no profit and no loss point”• It is also known as cost volume profit analysis• It is a first step in planning decision
APPROACHES IN BREAK EVEN ANALYSIS• Graphical method• Algebraic method• Contribution margin• PV ratio• Margin of safety.
GRAPHICAL METHOD TR PROFIT TC E VC FC X AAXIS – QUANTITY Y AXIS – COST REVEUE
DRAWING -BREAK EVEN GRAPH• The break even chart assumes constant AVC for a given range of output.• After point E the firm achieve profit.• The point E is the break even point.• The gap between the total costs line and revenue line beyond the break even point represents the level of profit.• If the gap is such that TC line is above the TR line the area represent loss.• If the TR line is above TC line the area represent profit
ALGEBRAIC METHOD• Let us understand the break even analysis algebraically• Let P be the price of a goods• Q is the quantity produced• AVC be the average variable cost• AFC be the average fixed cost• Let Q* be the break even output, where total revenue equals total cost.
..contd• TOTAL REVENUE (TR) = P x Q• TOTAL COST (TC) = TFC + TVC = TFC + AVC x Q• P x Q = TFC + AVC x Q• (P – AVC) x Q = TFC Q= TFC/ (P- AVC)
CONTRIBUTION MARGIN• Contribution margin per unit sales is the difference between price and average variable cost – CONTRIBUTION MARGIN = P – AVC• It represents that portion of the price of the commodity produced by the firm that can cover the fixed costs and contribute to profits
PV RATIO• Profit volume (PV) ratio is the ratio of contribution margin and sales• It is defined as the ratio of marginal change in profit and marginal change in sales• PV RATIO = CONTRIBUTION / SALES• BEP = FC / PV RATIO – FC = FIXED COST
MARGIN OF SAFETY• Margin of safety = planned sales – break even sales
LIMITATIONS – BREAK EVEN ANALYSIS• It does not take into account possible changes in costs over the time period under consideration• It assumes that whatever is produced is sold• It does not keep any provision for a changes in selling price.• It does not allow for changes in market conditions• It is difficult to find out BEP in service sector.
ECONOMIES OF SCALE• “Economies” refer to lower costs hence economies of scale would mean lowering of costs of production by way of producing in bulk.• In simple terms economies of scale refers to the efficiencies associated with large scale of operations.• When production increases the average cost per unit decreases.• Economies of scale are extremely important in real world production processes.
TYPES OF ECONOMICS OF SCALE• INTERNAL ECONOMIES OF SCALE – Cost per unit depends upon the size of the firm• EXTERNAL ECONOMIES OF SCALE – Cost per unit depends upon the size of the industry not the firm.
INTERNAL ECONOMIES• The reason behind the internal economies – Specialization • Jobs can be broken down into components/process • Specialization in particular job – Greater efficiency of machine – Managerial economies • Better supervision, administration, planning & organization – Financial economies • Large firms going for large volume of production may able to raise capital from the market with much less difficulties than small firm. – Production in stages • Houses all the process in production
EXTERNAL ECONOMIES• The reason behind external economies• As an industry grows in size would create various economies for existing firms in the industry – Technological advancement. – Easier access to cheaper raw materials. – Financial institutions in proximity. – Pool of skilled labors.
DISECONOMIES OF SCALE• It is a reverse of economies of scale.• It is refers to decreases in productivity when there are equal increases of all inputs. Assuming that no inputs is fixed.• Diseconomies may rise if the size of operations become un widely by size. – Coordinating among different work groups and units may become complex – Management become less effective and thus indirectly improve costs