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. To know more about Welingkar School’s Distance Learning Program and courses offered, visit: http://www.welingkaronline.org/distance-learning/online-mba.html

1. Cost Analysis
Cost - 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. Cost Analysis
Cost - 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. Cost Analysis
Cost - 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. Cost Analysis
Cost - 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. Cost Analysis
Cost - concepts.
Total Cost, Average Cost and Marginal Cost
Total cost TC is the aggregate (sum total)
cost of producing all the units of output.
Y TC
Total 60 TVC
Cost 50
40
30
20 TFC
10
X
1 2 3 4 Units of X 7 8 9 10 11 12

6. Cost Analysis
Cost - 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 TC
Total 60 TVC
Cost 50
40
30
20 TFC
10
X
1 2 3 4 Units of X 7 8 9 10 11 12

7. Cost Analysis
Cost - concepts.
Total Cost, Average Cost and Marginal Cost
The average cost AC is the cost per unit of
output produced.
TC
AC =
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. Cost Analysis
Cost - 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. Cost Analysis
Cost - 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. Cost Analysis
Cost - concepts.
Total Cost, Average Cost and Marginal Cost
The average variable cost AVC is the variable
cost per unit of output.
TVC
i.e. AVC =
Q
To 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. Cost Analysis
Cost - 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. Cost Analysis
Cost - 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 goes
downwards then bends upwards . AC curve which is
summation of these two , therefore, is U shaped.

13. Cost Analysis
Cost - concepts.
Total Cost, Average Cost and Marginal Cost
We saw that AFC curve slopes downwards & AVC first goes
downwards then bends upwards . AC curve which is
summation 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. Cost Analysis
Cost - 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-1
MC depends only on variable costs.
ΔTC
MC =
ΔQ

15. Cost Analysis
Cost - concepts.
Total Cost, Average Cost and Marginal Cost
Relation between Average Cost and Marginal cost
When 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. Cost Analysis
Cost - concepts.
Total Cost, Average Cost and Marginal Cost
Long 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. Cost Analysis
Cost - concepts.
Total Cost, Average Cost and Marginal Cost
Long 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. Cost Analysis
Cost - concepts.
Total Cost, Average Cost and Marginal Cost
Long Run Average Cost Curve. LRACC
The 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. Cost Analysis
Cost - concepts.
Total Cost, Average Cost and Marginal Cost
L 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. Cost Analysis
Cost - concepts.
Total Cost, Average Cost and Marginal Cost
L 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. Cost Analysis
Cost - concepts.
Total Cost, Average Cost and Marginal Cost
L 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. Cost Analysis
Cost - 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. Cost Analysis
Cost - 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. Cost Analysis
Cost - concepts.
Learning and Cost
LRAC Curve
20
Average Cost
15
10
5
0
1 2 3 4 5 6
Output
LRACt 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 to
LRACt+1 for every level of output.

25. Cost Analysis
Cost – 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. Cost Analysis
Cost – 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. Cost Analysis
Cost – 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. Cost Analysis
Cost – 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. Cost Analysis
Cost – 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. Cost Analysis
Cost – 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. Cost Analysis
Cost 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. Cost Analysis
Cost 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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