Table of Contents
S.No Contents Slide No.
1 Introduction 3
2 Classification of cost 4
3 Other basis of Classification 5-9
4 Law of Variable Proportion and its impact on cost 10-14
5 Cost output relationship 11-13
6 Cost output relationship in short term 14-21
7 Cost output relationship in Long term 22-24
8 References 25
What is Cost Analysis ?
Cost analysis refer to the study of behaviour of cost
in relation to one or more production
size of output
scale of operations
prices of factors of production
And other relevant economic variables.
What are Explicit and Implicit ?
• Explicit Cost :
These cost are normally shown in the accounting
statement and such arises from transactions between
the firm & service of the input or carrying out the
• Implicit Cost: The cost associated with use of the
firm own resources like capital, skills, land etc and
therefore such cost is difficult to measure. It is called
Accounting costs relate to the costs which involve cash payments by
the entrepreneur of the firm. Thus, accounting cost are explicit costs
and include all the payments and charges made by the entrepreneur
to the suppliers of various productive factors.
Economic costs take into account these accounting costs; in addition,
they also take into account the amount of money the entrepreneur
could have earned if he had invested his money and sold his own
services and other factors in the next best alternative uses.
Direct costs are those which have direct relationship with a
component of operation like manufacturing a product, organizing
a process or an activity etc.
Indirect costs are those which are not easily and definitely
identifiable in relation to a plant, product, process or department.
Incremental cost refers to the additional cost incurred by a firm as
result of a business decision. For example, incremental costs will
have to be incurred by a firm when it makes a decision to change
its product line, replace worn out machinery, buy a new
production facility or acquire a new set of clients.
Sunk costs refer to those costs which are already incurred once and for all
and cannot be recovered
A fixed cost is a cost that does not change with an increase or decrease in
the amount of goods or services produced or sold. These are expenses that
have to be paid by a company, independent of any business activity.
Ex. Salary, Rent etc.
Variable costs are costs that are a function of output in the production
Ex. Wages of Casual labourers, cost of raw material etc
Law of Variable Proportion and its impact on
Law of Diminishing returns:-
An increase in some inputs relative to other fixed
inputs will in a given state of technology cause output
to increase, but after a point the extra output resulting
from the same additions of extra inputs will become
less and less.
• Total Product:-It is the sum total of output each unit of
the variable factor used in the process of production.
• Marginal Product: It is additional output caused by the
use of an additional unit of variable factor.
• Average Product: It is output per unit of variable factor
used in the process of production.
Cost output relationship
• Cost function is a function which is obtained from
production function and the market supply of
inputs. It therefore expresses relationship between
cost and output.
Cost-output relationship has 2 aspects:
Cost-output relationship in the short run,
Cost-output relationship in the long run
• The SR is a period which doesn’t permit alterations in the
fixed equipment (machinery , building etc) & in the size of
• The LR is a period in which there is sufficient time to alter
the equipment (machinery, building, land etc.) & the size
of the org. output can be increased without any limits
being placed by the fixed factors of production
Short Run may be studied in terms of
Average Fixed Cost
Average Variable Cost
Average Total cost
Total, average &
1. Total cost (TC) = TFC +
TVC, rise as output rises
2. Average cost (AC) =
3. Marginal cost (MC) =
change in TC as a result
of changing output by
Fixed cost & variable
1.Total fixed cost (TFC) =
cost of using fixed factors
= cost that does not
change when output is
2. Total variable cost (TVC)
= cost of using variable
factors = cost that
changes when output is
Average Fixed Cost and Output
The greater the output, the lower the fixed
cost per unit, i.e. the average fixed cost.
Total fixed costs remain the same & do not
change with a change in output.
Average Variable Cost and output
The avg. variable costs will first fall & then rise as more & more
units are produced in a given plant.
Variable factors tend to produce somewhat more efficiently near
a firm’s optimum output than at very low levels of output.
Greater output can be obtained but at much greater avg variable
E.g. if more & more workers are appointed, it may ultimately
lead to overcrowding & bad org. moreover, workers may have to
be paid higher wages for overtime work.
Average Total cost and output
Average total cost, also known as average costs, would
decline first & then rise upwards.
Average cost consists of average fixed cost plus
average variable cost.
Average fixed cost continues to fall with an increase in
output while avg. variable cost first declines & then
So , as Avg. variable cost declines the Avg. total
cost will also decline. But after a point the Avg.
variable cost will rise.
When the rise in AVC is more than the drop in Avg.
fixed cost that the Avg. total cost will show a rise.
long run period enables the producers to change all
the factor & he will be able to meet the demand by
adjusting supply. Change in Fixed factors like
building, machinery, managerial staff etc..
All factors become variable in the long run.
In the long run we have only 3 costs i.e. total cost,
Average cost & Marginal Cost
1. Total cost (TC) = TFC + TVC, rise as output rises
2. Average cost (AC) = TC/output
3. Marginal cost (MC) = change in TC as a result
of changing output by one unit
When all the short run situations are combined, it forms
the long run industry.
During the SR, Demand is less & the plant’s capacity is
limited. When demand rises, the capacity of the plant is
When SR avg. cost curves of all such situations are
depicted, we can derive a long run cost curve out of
We can make a LR cost curve by joining the tangency
points of all SR curves
We use long run costs to decide scale issues, for example
In the long run, we can build any size factory we wish,
based on anticipated demand, profits, and other
Once the plant is built, we move to the short run. Therefore,
it is important to forecast the anticipated demand. Too small
a factory and marginal costs will be high as the factory is
stretched to over produce.
Conversely too large a factory results in large fixed costs
(e.g.. air conditioning, or taxes) and low profitability.
'Input-Output Analysis' Input-output analysis ("I-
O") is a form of economic analysis based on the
interdependencies between economic sectors. This
method is most commonly used for estimating the
impacts of positive or negative economic shocks
and analyzing the ripple effects throughout an