COST ANALYSIS

Dr.Mrutyunjay Dash
COST OF PRODUCTION

• A firm’s cost of production includes Explicit

and Implicit Costs.

• Explicit costs are those cots which are

incurred by the firm when it makes
payment to different factors of production in
terms of wages, salaries, insurance premium
etc. Thus these costs are called actual costs
or business costs.
• Implicit costs: The firm does not make
any cash payment for these type of
costs. As such they do not appear in
the accounting system. Opportunity
cost is an example of implicit cost.
• Entrepreneur and his salary
Fixed cost and Sunk cost:
Fixed costs are those cost that are paid by a firm in
business, regardless of the level of output it produces.
Salaries of the executives
Ofiice space
Support staff
Sunk costs are costs that have been incurred and cannot be
recovered.
The cost of the factory and equipment is not a fixed cost,
because it cannot be recovered.
COST DETERMINANTS
• Level of output
• Prices of Input Factors
• Productivities of Factors of Production
• Size of Plant
• Output Stability
• Lot size
• Learning Effect
• Laws of Returns
• Technology
Costs in the Short Run

• Fixed Costs (FC) : cost that do not vary with

the level of output in the short run. It is the
cost of all fixed factors of production.

• Variable Costs (VC) : cost that do vary with

the level of output in the short run. It is the
cost of all variable factors of production.
Fixed and Variable Costs

• Total Costs
– Total Fixed Costs (TFC)
– Total Variable Costs (TVC)
– Total Costs (TC)
– TC = TFC + TVC
Fixed and Variable 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.
Fixed and Variable Costs

• Average Costs
– Average Fixed Costs (AFC)
– Average Variable Costs (AVC)
– Average Total Costs (ATC)
– ATC = AFC + AVC
Average Costs
F i x e d F cC o s t
A F =C =
Q u a n Qt i t y

V a r i o a sb t Vl e C c
A V = C =
Q u a n t Qi t y

T o t a l T c Co s t
A T =C =
Q u a n Qt i t y
Fixed and Variable 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?
Marginal Cost

( c h a n t go et a i)l n c∆ T o Cs t
M =C =
( c h a n q g u e a ni n t∆ Qi t y )
Costs in the Short Run
Q FC VC TC
0 30 0 30
4 30 10 40
14 30 20 50
27 30 30 60
43 30 40 70
58 30 50 80
72 30 60 90
81 30 70 100
86 30 80 110
COST FUNCTIONS

• Linear Cost Functions

• Quadratic Cost Functions
• Cubic Cost Functions
Economies of scope:
If a single firm producing multiple products can
together produce them cheaper compared to a situation
where each product is produced by a separate firm, then
economies of scope exist.
COST FUNCTIONS Continued………

• Linear Cost Functions:

TC(Y)=a+bX
• At zero output, total fixed cost, such as rent,
insurance payments, etc. equals total cost.
• Increases in total cost due to increases in output are
represented by total variable costs.
• The average or unit cost function can be obtained by
dividing the total cost function by output X.
………..Continued
• It continues to decline as X increases and
remains practically constant after it nearly
“flattens out”.
• Since average fixed cost in the above formula is
a/x, subtracting this from the equation leaves
average variable cost b.
• The marginal cost can be obtained by
elementary differential calculus. Thus MC=b
…………Continued

Quadratic Cost Functions:

• This type of function which has been widely used in
empirical studies is represented by the equation:
Y=a+bX+cX2
• When x=0,then Y =a, inotherwords , total cost equals fixed cost when output is zero.

• The average cost equation can be derived by dividing the total cost function by output X

• ATC= Y/X=a/X+b+cX

• Since average fixed cost in the above equation equals a/x,

subtracting this out gives average variable cost, b+cX
………Continued

• The equation for marginal cost can

be obtained by differentiating the
total cost function. Thus, MC=b+2cX
Figure 10-2: The Total,
Variable,
and Fixed Cost Curves
ECONOMIES OF SCALE

•Internal Economies
•External Economies
Internal economies are those which arise from the
expansion of the plant-size and are internalised.

•Economies in Production
•Economies in Marketing
•Economies in Transport and Storage
………….Continued
Technological Advantages: It enables the firm to have
economy in operating on large scale basis.
Ex.: Dairy Firm
Printing Press
Ditch digging : Expansion of scale normally
permits the introduction of automation devices
which ultimately reduce the unit cost of pdn.
Division Of Labour and Specialisation: Innovation and
Efficiency
Economies in Marketing:
Large-scale purchase of raw materials
Economies in advertisement costs
Large-scale distribution through wholesalers
……..Continued

Managerial Economies
Specialisation in Management:Pdn.,Sales
Mechanisation of managerial Functions
like use of advanced technique of
communication;
telephones,fax,computers,etc.
Result in Quick decision making.
……..Continued

• Economies in Transport and Storage:

Own transport system: Reduction of Transport
costs/ own railway tracks
Own godowns for Storage.
External Economies of Scale:
The economic advantages accrued to a firm
from outside during process of expansion.
Growth of ancillary industries/increasing returns
to scale/healthy competition/reduction of input
costs.
 Diseconomies of Scale

Managing any business entails controlling and coordinating a wide

variety of activities: production, transportation, finance, sales, and so
on. As the scale of plant expands beyond a certain point contact with the
daily routine of operation tends to be lost, and efficiency of operation
declines. Red tape and paperwork expand and finally the cost of the
managerial function increases, as does the unit cost of production
Figure 10-1: Output as a
Function
of One Variable Input
Optimum Plant:
An optimum plant is the one which operates at
the scale at which, in the existing conditions of
technique and organisational strength, has the
lowest average cost of production when all
those costs which must be covered in the long
run are included.
That plant which produces the optimum output
[least-cost output] at the minimum point of the
long-run average cost curve.
Cost Curves and Their Shapes

• The average total-cost curve is U-shaped.

• At very low levels of output average total cost is
high because fixed cost is spread over only a few
units.
• Average total cost declines as output increases.
• Average total cost starts rising because average
variable cost rises substantially.
Costs

Rs3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50 ATC

1.25 AVC
1.00
0.75
0.50
AFC
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Copyright © 2004 South-Western
Cost Curves and Their Shapes

• The bottom of the U-shaped ATC

curve occurs at the quantity that
minimizes average total cost. This
quantity is sometimes called the
efficient scale of the firm.
Cost Curves and Their Shapes

• Relationship Between Marginal Cost

and Average Total Cost
– The marginal-cost curve crosses the
average-total-cost curve at the efficient
scale.
• Efficient scale is the quantity that minimizes
average total cost.
Cost Curves and Their Shapes

• Relationship between Marginal Cost

and Average Total Cost
– Whenever marginal cost is less than
average total cost, average total cost is
falling.
– Whenever marginal cost is greater than
average total cost, average total cost is
rising.
Cost Curves and Their Shapes

• Marginal cost rises with the amount

of output produced.
– This reflects the property of diminishing
marginal product.
Graphing the Total, Variable,
and Fixed Cost Curves
• Notice the relationship between the shape of the
VC curve and the production function. Why is
this the case?

• On the increasing returns to labour portion of the

production function a given increase in output
requires successively smaller increments in the
variable input, labour. As a result variable costs
grows at a diminishing rate on this portion of
the production function. And vice versa.
Graphing the Total, Variable,
and Fixed Cost Curves
• The fixed cost curve is a horizontal
line, since fixed costs do not vary with
the level of output.

• The vertical distance between the TC

and VC curve is everywhere equal to
FC. Thus the TC and VC curves are
parallel.
Figure 10-3: The Production Function
Q = 3KL, with K = 4
Figure 10-4: The Total, Variable,
and Fixed Cost Curves for the Production Function
Q – 3KL
Graphing the Short Run
Average and Marginal Cost
Curves
• AFC declines steadily as output increases
since FC do not vary with output.

• AVC initially falls as output increases and

then later rises.

• ATC = AVC + AFC

Graphing the Short Run
Average and Marginal Cost
Curves
• The minimum point on the ATC curve
always lies to the right of the minimum
point on the AVC curve.

• The MC curve is the most important

curve, as it plays a vital role in the
firm’s decision of how much output to
produce.
Graphing the Short Run
Average and Marginal Cost
Curves
• The MC curve is initially downward
sloping, coinciding with the increasing
returns to labour portion of the
production function. It is upward
sloping when diminishing returns sets
in.
Graphing the Short Run Average and
Marginal Cost Curves
• When MC is less than either ATC or AVC
the average cost curves must be
decreasing with output; and when Mc is
greater than average cost, average cost
must be increasing.
• The MC curve must always intersect both
the ATC and AVC curves at their minimum
points.
Figure 10-9: The Relationship
Between MP, AP, MC, and AVC
COSTS IN THE SHORT RUN
AND IN THE LONG RUN
• For many firms, the division of total
costs between fixed and variable
costs depends on the time horizon
being considered.
– In the short run, some costs are fixed.
– In the long run, fixed costs become
variable costs.
COSTS IN THE SHORT RUN
AND IN THE LONG RUN
• Because many costs are fixed in the
short run but variable in the long run,
a firm’s long-run cost curves differ
from its short-run cost curves.
 Figure 7 Average Total Cost in the Short and
Long Run

Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory

Rs 12,000

ATC in long run

0 1,200 Quantity of
Cars per Day
Copyright © 2004 South-Western
 Figure 7 Average Total Cost in the Short and
Long Run

Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory ATC in long run

$12,000

10,000

Economies Constant
of returns to
scale scale Diseconomies
of
scale

0 1,000 1,200 Quantity of

Cars per Day
Copyright © 2004 South-Western
Summary

• The goal of firms is to maximize profit,

which equals total revenue minus total
cost.
• When analyzing a firm’s behavior, it is
important to include all the opportunity
costs of production.
• Some opportunity costs are explicit while
other opportunity costs are implicit.
Summary
• A firm’s costs reflect its production process.
• A typical firm’s production function gets flatter as the
quantity of input increases, displaying the property of
diminishing marginal product.
• A firm’s total costs are divided between fixed and
variable costs. Fixed costs do not change when the firm
alters the quantity of output produced; variable costs do
change as the firm alters quantity of output produced.
Summary

• Average total cost is total cost divided by

the quantity of output.
• Marginal cost is the amount by which total
cost would rise if output were increased by
one unit.
• The marginal cost always rises with the
quantity of output.
• Average cost first falls as output increases
and then rises.
Summary

• The average-total-cost curve is U-shaped.

• The marginal-cost curve always crosses the
average-total-cost curve at the minimum of ATC.
• A firm’s costs often depend on the time horizon
being considered.
• In particular, many costs are fixed in the short
run but variable in the long run.
Economies and Diseconomies of
Scale
• Economies of scale refer to the property
whereby long-run average total cost falls as the
quantity of output increases.
• Diseconomies of scale refer to the property
whereby long-run average total cost rises as
the quantity of output increases.
• Constant returns to scale refers to the property
whereby long-run average total cost stays the
same as the quantity of output increases
 Average Total Cost in the Short and Long
Run

Average
ATC in short ATC in short ATC in short
run with run with run with
small factory medium factory large factory

Rs 12,000

ATC in long run

0 1,200
Cars per Day