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# Cost concepts

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Cost Concepts

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### Cost concepts

1. 1. COST CONCEPTS
2. 2. Theory of costs  Costs of a firm is incurred to establish the production unit and to purchase different factors of production.  Cost of a firm (TC) is classified into two broad categories - Fixed cost (TFC) and Variable cost (TVC). i.e. TC = TFC + TVC  However, nothing is fixed in the long run.
3. 3. Concepts of Costs  Fixed Cost FC : Fixed costs, are those which are independent of output, that is, they do not change with changes in output.  Even if the firm closes down for some time in the short run remains in business, these costs have to be borne by it.  Fixed costs are also known as overhead costs and include charges such as contractual rent, insurance fee, maintenance costs, property taxes, interest on the capital invested, minimum administrative expenses such as manager's salary, watchman's wages etc.  Variable cost [VC]: Variable costs, on the other hand, are those costs which are incurred on the employment variable factors of production whose amount can be altered.  These costs include payments such as wages of labour employed, prices of the raw materials, fuel and power used, the expenses incurred on transporting.
4. 4. Concept of total cost , Average Cost and marginal cost  Total cost is the sum of its total variable costs and total fixed costs. Thus: TC = TFC + TVC where TC stands for total cost, TFC for total fixed cost and TVC for total variable cost.  Average fixed cost is the total fixed cost divided by the number of units of output produced.  Average Variable Cost (AVC): Average variable cost is the total variable cost divided by the number of units of output produced. Therefore,  Average total cost (ATC) is the sum of the average variable cost [AVC] and average fixed cost [AFC]  Marginal cost {MC] can be found for further units of output where ΔTC represents a change in total cost and ΔQ represents a unit change in output or total product.
5. 5. Relationships among AVC, ATC and MC  All three cost measures first fall, then remain constant and eventually rise as output increases  The rate of change in MC is greater than that in AVC and hence the minimum MC is at an output lower than the output at which AVC is minimum  The ATC falls for a longer range of output then the AVC and hence the minimum ATC is at a larger output than the minimum AVC  When MCAVC is rising  When MC is below ATC, ATC is falling  is below AVC, AVC is falling  When MC is above AVC, When MC is above ATC, ATC is rising
6. 6. COST FUNCTION  The relation between cost and output is called Cost function.  The cost function of the firm depends upon the production conditions and the prices of the factors used for production.  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 = C (Q).  Cost functions are derived functions. They are derived from the production functions, which identify the efficient methods of production available at any particular point of time.  The cost function can be derived from the input cost combinations of the firm, The input costs of the two inputs of production i.e. labor (L) and capital (K) are given to be constant as the wage rate (w) and rent (r), respectively.  Along any expansion path, the level of output increases as
7. 7. Types of cost  Explicit costs: are those expenses which are actually paid by the firm (paid-out costs). Both costs are equally important while making business decisions, but sometimes implicit costs are ignored as they are not as apparent as explicit costs  Implicit or Imputed costs: are theoretical costs in the sense that they can go unrecognized by the accounting system. 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
8. 8. • Accounting costs: These are the actual or outlay costs. These costs point out how much expenditure has already been incurred on a particular process or on production as such. • Economic costs: These costs relate to future. They are in the nature of the incremental costs. •Opportunity cost can be defined as the cost of any decision measured in terms of the next best alternative, which has been sacrificed. In order to maximize the value of the firm, a manger must view costs from this perspective.
9. 9. Short run Cost Functions •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 (SRA TC) and average variable costs (AVC) are slightly U-shaped. • 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 the representative of
10. 10. •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 tills point (M). •The short-run average. total cost function (SRATC) is minimum at the point Q1 which is the short-run capacity of the firm. Any variation of output from Q1 leads to higher short run average total cost. • However, if the output is more than its short run capacity, it is due to over-utilization of the firm's plant and machinery. •If the quantity produced goes beyond Q1 the short run average total cost of the firm rises as a result of high marginal cost
11. 11. The Long-run Cost Function •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.
12. 12. • If there is an unexpected rise in the demand and the firm wants to increase the output from Q, to Q2, 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 C2, A short run average cost function like SAC2 can be determined for the new set of inputs.