Académique Documents
Professionnel Documents
Culture Documents
What is cost?
In producing a commodity a firm has to employ an aggregate of various factors of production such as land, labour, capital and entrepreneurship. These factors are to be compensated by the firm for their contribution in producing the commodity. This compensation (factor price) is the cost.
Cost concepts
6. Production Costs
Total Cost (TC) Total Fixed Cost (TFC) Total Variable Cost (TVC) Average Fixed Cost (AFC) Average Variable Cost (AVC) Average Total Cost (ATC) and Marginal Cost (MC)
Real Cost
The real cost of production refers to the physical quantities of various factors used in producing a commodity. Real cost signifies the aggregate of real productive resources absorbed in the production of a commodity (or a service).
Opportunity Cost
The concept of opportunity cost is based on the scarcity and alternative applicability characteristics of productive resources. The real cost of production of something using a given resource if the benefit forgone (or opportunity lost) of some other thing by not using that resource in its best alternative use. An opportunity cost or alternative cost is the value of a resource in a foregone employment.
Sunk Costs
Sunk cost is a cost once incurred cannot be retrieved. It is associated with commitment of funds to specialized equipment or facilities which cannot be used for anything else in the present or future. E.g.brewery plant during prohibition.
Shutdown Costs
Shut down costs are costs which would be incurred when plan operation is suspended, but would have been saved if the operation was continuing. E.g. costs of sheltering plant and equipment. Construction or hiring of sheds for storing exposed property. Expenses on recruitment and training incurred on re-employment of workers.
Abandonment Costs
Abandonment arises when there is complete cessation of activities and there is a problem of disposal of assets.
E.g.discontinuance of using typewriters and shifting over usage to computers. Shifting to paperless operations.
Economic Cost
Explicit costs are direct contractual monetary payments incurred through market transactions. Explicit costs are usually costs shown in the accounting statements and include costs of raw materials, wages and salaries, power and fuel, rent, interest payments of capital invested, Insurance, Taxes and duties, Misc. expenses such as selling, transport, advertising & sales promotional expenses.
Fixed Costs
Fixed costs are those costs that are incurred as a result of the use of fixed factor inputs. They remain fixed at any level of output. While engaging in productive activity the producer always has to incur some expenditure which remains fixed whatever the level of production.
Fixed Costs
In the short run, fixed costs remain fixed because the firm does not change its size and the amount of fixed factors employed which include:
Payments of rent for building. Interest on capital. Insurance premium Depreciation and Maintenance allowances Adm. Expenses (Managerial & Staff salaries) Property and business taxes, licence fees etc.
Variable Costs
Variable costs are those costs that are incurred by the firm as a result of the use of variable factor inputs. They are dependant on the level of output. The cost which keeps on changing with the changes in the quantity of output produced is known as variable cost.
Variable costs
The short-run variable costs include
Prices of raw materials, Wages paid for labour Fuel and power Excise duties, sales tax, octroi, VAT. Freight (or transportation) charges..
Production Costs
Total Cost (TC) Total Fixed Cost (TFC) Total Variable Cost (TVC) Average Fixed Cost (AFC) Average Variable Cost (AVC) Average Total Cost (ATC) and Marginal Cost (MC)
Output (Units) 0 1 2 3 4 6
Total Total Total Cost Fixed Cost Variable Cost 240 0 240 240 120 360 240 160 400 240 180 420 240 212 452 240 280 520
Cost curves
ATC MC AVC
AFC
OUTPUT
Average Fixed Cost, Average Variable Cost and Average Total cost of the Firm Output (Units) 1
2
Average Average Variable Cost Total Cost TVC Q TC Q 120 1 = 120 360 1 = 360
160 2 = 80 400 2 = 200
3 4 5 6
180 3 = 60 420 3 = 140 212 4 = 53 452 4 = 113 280 5 = 56 520 5 = 104 420 6 = 70 660 6 = 110
5
6
520
660
280
420
68
140
TVC (3) 0 25 40 50
4
5 6 7
100
100 100 100
60
80 110 150
160
180 210 250
25
20 16.3 14.2
15
16 18.3 21.4
40
36 35 35.7
10(160-150)
22(180-160) 30(210-180) 40(250-210)
8 9
100 100
300 500
400 600
12.5 11.1
37.5 55.6
50 66.7
150(400-250) 200(600-400)
TVC (3) 0 25 40 50
4
5 6 7
100
100 100 100
60
80 110 150
160
180 210 250
25
20 16.3 14.2
15
16 18.3 21.4
40
36 35 35.7
10(160-150)
22(180-160) 30(210-180) 40(250-210)
8 9
100 100
300 500
400 600
12.5 11.1
37.5 55.6
50 66.7
150(400-250) 200(600-400)
Problem: Based on your knowledge of the various measures of short run cost, complete the following table.
Output (units) TFC TVC TC AFC (TFC/Q) AVC (TVC/Q) ATC (TC/Q) MC
(1)
0 1 2 3 4 5 6
(2)
---------------
(3)
----204 ----525 ---
(4)
1200
(5)
X
(6)
X
(7)
X 1265
(8)
X
494 86
286
7
8
-----
--768
97
---
---
97
Problem: Based on your knowledge of the various measures of short run cost, complete the following table.
Output (units) TFC TVC TC AFC (TFC/Q) AVC (TVC/Q) ATC (TC/Q) MC
(1)
0 1 2 3 4 5 6
(2)
1200 1200 1200 1200 1200 1200 1200
(3)
0 265 204 283 369 525 580
(4)
1200 1265 1404 1483 1569 1725 1780
(5)
X 1200 600 400 300 240 200
(6)
X 265 102 94 92 105 96
(7)
X 1265 702 494 392 345 286
(8)
X 265 139 79 86 156 65
7
8
1200
1200
679
768
1879
1968
171
150
97
96
239
246
99
89
1200
873
2073
133
97
230
105
TFC (2) 100 100 100 100 100 100 100 100 100 100
TC (4) 100 125 140 150 160 180 210 250 400 600
MC (8) -25 (125-100) 15(140-125) 10 (150-140) 10(160-150) 22(180-160) 30(210-180) 40(250-210) 150(400-250) 200(600-400)
1. When Average Cost is minimum, Marginal cost is equal to Average Cost. MC curve intersects at the minimum point of ATC curve. 2. When MC curve is below AC curve, marginal cost is less than average cost, and the latter falls. 3.When the MC curve is above AC curve, marginal cost is more than average cost, the latter rises.
MC AC
A B C O L M N N P
OUTPUT
ATC = TC/Q = TFC/Q + TVC/Q = TC=a + bQ MC = dTC = b dQ Illustration: TFC TC = 100 + 0.5Q (Q=10) TFC = 100 ; TVC = 0.5Q output At Q = 10, TVC = 0.5 x 10 = 5 and TC = 100 + 5 = 105 ATC = a/Q + b = 100/10 + 0.5 = 10.5 MC = b = 0.5
TC = a + bQ + cQ2
ATC = a/Q + b + cQ MC = b + 2cQ
TFC
output Here, the firm has Fixed Costs Rs.5000 and Variable costs for (labour, raw materials etc.) to produce Q units are 250Q + 3Q2 Firms initial cost of producing Q units is 250Q Additional units can be produced at increased cost due to shortage of raw materials and other inputs (their price being higher) ups their price by +3Q2 which is the last variable.
There can be another type of Quadratic Equation TC = a + bQ cQ2 Here cQ2 represents reduction in costs on account of increased productivity. The TC curve will rise at a decreasing rate.
TC = a + bQ -- cQ2
TFC
output
Problem: ABC Ltd.estimates its total cost Rs.Y of manufacturing X units of electronic gauges per month as Y = 8000 + 300X + 0.1X2 (i) Calculate the average cost of producing 200 gauges per month. (ii) If the company doubles this output, will it halve its average cost? (iii)If not, what will be its average cost be? (iv) How much is the average variable cost of producing 200 units per month? (v)What will be the average variable cost if no units are Produced? (vi) What will be the marginal cost function of the company?
TFC output
(i)Total cost of producing 200 gauges Y = 8000 + 300X + 0.1X2 = 8000 + 300(200) + 0.1(200)2 = 8000 + 60000 + 0.1(40000) = 8000 + 60000 + 4000 = 72000 Rs.72000 (ii) Doubling the output, X = 400 Y = 8000 + 300X + 0.1X2 = 8000 + 300(400) + 0.1(400)2 = 8000 + 120000 + 0.1(160000) = 8000 + 120000 + 16000 = 144000 Rs.1,44,000. (iii)Average cost of producing 200 units Y = 8000 + 300 + 0.1(200) X 200 = 40 + 300 + 20 = 360. Rs.360
(iv) Average cost of producing 400 units Y = 8000 + 300 + 0.1(400) X 400 = 20 + 300 + 40 = 360 Rs.360 The average cost has not been halved. The reduction in fixed cost has been offset by increase in AVC. (v)Average variable cost of producing 200 units per month is AVC = b + cX = 300 + 0.1(200) = 300 + 20 = Rs.320 If no units are produced, X really does not exist. So no question of AC. (vi)MC = 300 + 0.2X