Cost Analysis

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In this presentation, we will discuss in details about cost of production and various concepts of cost like fixed cost, variable cost, average cost, marginal costs, etc.
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Cost Analysis

  1. 1. Cost AnalysisCost - definition. the cost of production may be defined as the aggregate of expenditure incurred by the producer in the process of production. cost is, therefore, the valuation placed on the use of resources.
  2. 2. Cost AnalysisCost - concepts.Fixed Cost and Variable Cost Fixed costs are those costs that remain fixed, irrespective of changes in the output. They are incurred even if there is no output. Are incurred on buildings , equipment, etc. Are also known as supplementary costs or overheads or indirect costs.
  3. 3. Cost AnalysisCost - concepts.Fixed Cost and Variable Cost Variable costs are those costs which vary with the output. They include cost of raw materials, electricity, gas, fuel etc. Are also known as Prime cost or Operating costs or direct costs.
  4. 4. Cost AnalysisCost - concepts.Fixed Cost and Variable Cost Fixed costs are those costs that remain fixed, irrespective of changes in the output. Variable costs are those costs which vary with the output. The distinction is valid in the short run. In the long run all factors are variable and thus all costs are variable.
  5. 5. Cost AnalysisCost - concepts.Total Cost, Average Cost and Marginal CostTotal cost TC is the aggregate (sum total) cost of producing all the units of output. Y TCTotal 60 TVCCost 50 40 30 20 TFC 10 X 1 2 3 4 Units of X 7 8 9 10 11 12
  6. 6. Cost AnalysisCost - concepts.Total Cost, Average Cost and Marginal Cost Total cost TC curve is parallel to the total variable cost TVC curve, as it is the sum of total fixed cost TFC & TVC. Y TCTotal 60 TVCCost 50 40 30 20 TFC 10 X 1 2 3 4 Units of X 7 8 9 10 11 12
  7. 7. Cost AnalysisCost - concepts.Total Cost, Average Cost and Marginal Cost The average cost AC is the cost per unit of output produced. TCAC = Q Where TC is total cost, AC is average cost and Q total quantity of output. Average cost is often referred to as Average Total Cost or Average Total Unit Cost.
  8. 8. Cost AnalysisCost - concepts.Total Cost, Average Cost and Marginal Cost The average fixed cost AFC is the fixed cost per unit of output produced. TFC i.e. AFC = Q ► If the output goes on increasing, the AFC will go on falling as the total fixed cost is thinly spread over the number of units of output. ► The average fixed cost curve slopes downwards from left to right as you can see next.
  9. 9. Cost AnalysisCost - concepts.Total Cost, Average Cost and Marginal Cost ► The average fixed cost curve slopes downwards from left to right as you can see below. 160 140 A verage Fixed C os t 120 100 80 60 40 20 0 AFC 1 2 3 4 5 6 Output
  10. 10. Cost AnalysisCost - concepts.Total Cost, Average Cost and Marginal Cost The average variable cost AVC is the variable cost per unit of output. TVCi.e. AVC = QTo begin with the avc is very high, but as more and more units of output are produced , the firm starts enjoying economies and avc goes on falling.After a certain size of output, increase in output brings in disadvantages , and avc begins to rise.
  11. 11. Cost AnalysisCost - concepts.Total Cost, Average Cost and Marginal Cost After a certain size of output, increase in output brings in disadvantages , and average variable cost begins to rise. AVC Curve 20 Average Variable Cost 15 10 5 0 1 2 3 4 5 6 Output
  12. 12. Cost AnalysisCost - concepts.Total Cost, Average Cost and Marginal Cost The average cost AC curve is the lateral summation of the average fixed AFC and variable cost AVC curves.i.e. AC = AFC + AVC.We saw that AFC curve slopes downwards & AVC first goesdownwards then bends upwards . AC curve which issummation of these two , therefore, is U shaped.
  13. 13. Cost AnalysisCost - concepts.Total Cost, Average Cost and Marginal CostWe saw that AFC curve slopes downwards & AVC first goesdownwards then bends upwards . AC curve which issummation of these two , therefore, is U shaped. Further, when the firm starts production AC is high. Once output increases, it reaps benefits of economies of scale and AC falls. But once optimum combination of factors of production is reached , diseconomies set in, and AC starts rising. Thus the AC curve becomes U shaped.
  14. 14. Cost AnalysisCost - concepts.Total Cost, Average Cost and Marginal Cost Marginal cost is the net addition to total cost for producing an additional unit of output.i.e. MCnth = TCn - TC n-1MC depends only on variable costs. ΔTC MC = ΔQ
  15. 15. Cost AnalysisCost - concepts.Total Cost, Average Cost and Marginal CostRelation between Average Cost and Marginal costWhen AC is falling, the MC lies below it.MC cuts the AC at the lowest point of AC curve.When AC starts to rise , the MC will be above the AC.
  16. 16. Cost AnalysisCost - concepts.Total Cost, Average Cost and Marginal CostLong Run Average Cost Curve. ► In the short run producer can increase his output only up to an optimum use of fixed assets. ►In the long run the scale of operation can be further increased with additions to fixed assets to the most feasible extent. ► There will be a new short run average cost each time the scale is revised. We can thus have a series of short run AC curves in the long run.
  17. 17. Cost AnalysisCost - concepts.Total Cost, Average Cost and Marginal CostLong Run Average Cost Curve. LRACC► There will be a new short run average cost each time the scale is revised. We can thus have a series of short run AC curves in the long run.►The tangent to all possible short run average cost curves gives us the long run AC curve. LRACC
  18. 18. Cost AnalysisCost - concepts.Total Cost, Average Cost and Marginal CostLong Run Average Cost Curve. LRACCThe tangent to all possible short run average cost curves gives us the long run AC curve. LRACC► Under the assumption of constant factor prices and perfect divisibility of factors , the minimum points of AC lie in the same plane. Thus LRACC may become horizontal.► That means the U shape of long run AC curve is flatter than the U shape of short run AC curves.
  19. 19. Cost AnalysisCost - concepts.Total Cost, Average Cost and Marginal CostL shaped Long Run Average Cost Curve. LRACC◘ With continuous technological improvements and innovations the average cost gets reduced with each & every new long run AC curve.
  20. 20. Cost AnalysisCost - concepts.Total Cost, Average Cost and Marginal CostL shaped Long Run Average Cost Curve. LRACC◘ With continuous technological improvements and innovations the average cost gets reduced with every new long run AC curve.◘ The AC also reduces as a result of process of ‘learning’. With experience the factors of production deliver more output at the same cost.
  21. 21. Cost AnalysisCost - concepts.Total Cost, Average Cost and Marginal CostL shaped Long Run Average Cost Curve. LRACC◘ With continuous technological improvements and innovations the average cost gets reduced with every new long run AC curve.◘ The AC is reducing also as a result of process of ‘learning’. With experience, the factors of production deliver more output at the same cost.◘ As a result over a period of time LRAC curve is more L shaped than U shaped.
  22. 22. Cost AnalysisCost - concepts.Learning and Cost There is an element of learning involved through experience. The learning curve (also known as experience curve) phenomenon has an effect on average costs, similar to that for any technological advance that provides an improvement in productive efficiency.
  23. 23. Cost AnalysisCost - concepts.Learning and Cost The fall in the average costs due to scale or technological factors and learning curve must be differentiated. Economies of scales are shown in terms of cost-output relation measured along the same LRWC curve. Learning cost relate cost differences to total cumulative output levels for a single product . These are measured in terms of shifts of average long run AC curves.
  24. 24. Cost AnalysisCost - concepts.Learning and Cost LRAC Curve 20 Average Cost 15 10 5 0 1 2 3 4 5 6 OutputLRACt Long Range AC curve for period T -----LRACt+1 Long Range AC curve for period T+1 ------As result of learning, long run AC has declined from LRACt toLRACt+1 for every level of output.
  25. 25. Cost AnalysisCost – other concepts.A : Money Cost and Real Cost :-♠ Money costs of production are the prices which have to be paid to factors of production. Expenses of production is money cost.♠ The sacrifices of factors made during the process of production are the real costs. As such, real costs cannot be measured.
  26. 26. Cost AnalysisCost – other concepts.B: Explicit Cost and Implicit Cost :-♠ Explicit cost refers to the making of actual payments in the process of production.♠ Implicit cost means even though work is performed there is no corresponding payment. If a driver brings materials to works , there is explicit cost in the form of his salary. If the manager brings it, there is no such cost as manager is not paid to drive a car.
  27. 27. Cost AnalysisCost – other concepts.C :Private and Social Cost :-♠ When a factory is set up, there is private cost to the owner in the form of buildings, plant etc.♠ There is also public cost caused by smoke, effluents, etc. ( for which there is no cost to the owner)
  28. 28. Cost AnalysisCost – other concepts.C :Private and Social Cost :-♠ When a factory is set up, it generates in its neighborhood certain effects. These are called externalities of the firm.♠ Externalities that take the form of Garden, School or a new bus stop are beneficial to the Society . These are positive externalities.♠ When they take the form of pollution, congestion etc., these are negative externalities.
  29. 29. Cost AnalysisCost – other concepts.D : Historical Cost and Replacement Cost :-♠ Historical cost is the original cost incurred by the firm while purchasing the input in the past.♠ Replacement cost is the current cost that will have to be incurred by the firm to purchase the input acquired in the past.♠ Financial accountants, tax authorities are concerned with historical cost; while management accountants are concerned with replacement ( or current ) costs.
  30. 30. Cost AnalysisCost – other concepts.E : Opportunity Cost (alternative or transfer cost) :-♠ the opportunity cost of anything produced can be defined as the next best alternative, that can be produced instead, by the same factors.♠ the cost of using something in a particular venture, is the benefit foregone (or opportunity lost) ,by not using it in its best alternative use.
  31. 31. Cost AnalysisCost of Multiple Products.ф When two or more products emerge from processing of a single raw material, they get identified as separate products at the end of common processing called ‘ split of point’.ф The costs that are incurred up to the split of point are common costs. These cannot be traced to the individual product.ф The problem of product costing arises in identifying parts of common costs with particular products.
  32. 32. Cost AnalysisCost of Multiple Products.ф The problem of product costing arises in identifying parts of common costs with particular products.Common Products : -Joint Products - when increase in output of one product causes increase in output of another product, then the products and their costs are termed Joint.Alternative Products - when increase in output of one product is accompanied by a reduction in output of other products, it is a case of alternative products.By-product – when one product is much less important that the other, it is regarded as by-product.
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