2. Lecture Plan
Objectives
Introduction
Kinds of Costs
Costs in Short Run
Costs in Long Run
Costs of a Multi Product Firm
Costs of Joint Products
Linkage between Cost, Revenue and Output through Optimization
Break Even Analysis
Economies of Scale
Economies of Scope
Costs and Learning Curves
3. Objectives
To understand the meaning of cost in economic analysis
and its relevance in managerial decision making.
To explain different types of costs, with focus on the
difference
between
economic
and
accounting
philosophies.
To analyze the importance of matching costs with
relevant time frames and to understand the short and
long run costs.
To help develop an understanding of estimation of cost
functions.
To introduce the concepts of economies of scale,
economies of scope, break even analysis and learning
curve.
4. Introduction
Cost is defined in simple terms as a sacrifice or foregoing which
has already occurred or has potential to occur in future with an
objective to achieve a specific purpose measured in monetary
terms.
Cost results in current or future decrease in cash or other assets,
or a current or future increase in liability.
Determinants of cost:
Price of inputs
Productivity of inputs
Technology
Level of output
Mathematically we can express the cost function as:
C= f(Q, T, Pf)
where C=cost; Q=output; T=technology; Pf = price of inputs.
5. Kinds of Costs
Accounting Costs/ Explicit Costs/ Out of Pocket
Costs
Which can be identified, measured and accounted for;
e.g. cost of raw materials, wages and salary and
capital costs like cost of the factory building.
Which result in cash outflow or increase in liability
Real Costs
More or less social and psychological in nature and
non quantifiable in money terms; e.g. cost of
sacrificing leisure and time.
Not considered by accountants.
Opportunity Costs
Help in evaluation of the alternative uses of an input
other than its current use in production
6. Kinds of Costs
Implicit Costs
Do not involve cash outflow or reduction in assets, or increase in
liability; e.g. owner working as manager in own building
Important for opportunity cost measurement
Direct Costs
Which can be attributed to any particular activity, such as cost of
raw material, labour, etc.
Indirect Costs
Costs which may not be attributable to output, but are distributed
over all activities are indirect costs
Also known as overheads.
Replacement costs
Current price or cost of buying or replacing any input at present.
Social Costs
Costs to the society in general because of the firm’s activities.
E.g. pollution caused by industrial wastes and emissions.
7. Kinds of Costs
Historic Costs/ Sunk Cost
Incurred at the time of purchase of assets; no longer relevant for
decision making
Future Costs
Opposite of historic costs and are budgeted or planned costs.
Not included in the books of accounts.
Controllable Costs and Uncontrollable Costs
Controllable Costs are subject to regulation by the management
of a firm; e.g. fringe benefits to employees, costs of quality
control.
Uncontrollable Costs are beyond regulation of the management;
e.g. minimum wages are determined by government, price of raw
material by supplier.
Production Costs and Selling Costs
Production Costs are estimated as a function of the level of
output
Selling costs occur on making the output available to the
consumer.
8. Costs in Short Run
Costs
C
O
TFC
Quantity
Costs
TFC
O
Quantity
Fixed Costs
Do not vary with output; e.g.
plant, machinery, building.
Total Fixed Cost (TFC) curve
is a straight line, parallel to
the quantity axis, indicating
that output may increase to
any level without causing
any change in the fixed cost.
In the long run plant size
may increase hence FC
curve may be step like,
where each step showing
FC in a particular time
period.
9. Costs in Short Run
Costs
TC
TVC
TFC
O
Quantity
Costs
TC
TVC
TFC
O
Quantity
Variable Costs
Costs that vary with level of
output and are zero if no
production; e.g. cost of raw
materials, wages.
Normally TVC is like a straight
line starting from origin.
TVC may be an inverse S
shaped upward sloping curve,
due
laws
of
variable
proportions.
Total cost (TC)
Sum of TFC and TVC
Slope
of TC curve is
determined by that of the TVC.
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10. Average and Marginal Cost
Average Cost (AC) is total cost per unit of output.
Average Fixed Cost (AFC) is fixed cost per unit of
output (AFC= TFC/Q)
Average Variable Cost (AVC) is variable cost per unit of
output (AVC= TVC/Q)
Marginal cost (MC) is the change in total cost due to a
unit change in output.
AC is equal to the ratio of TC and units of output. (TC/Q)
AC=AFC+AVC
MCQ= TCQ- TCQ-1
Since the fixed component of cost cannot be altered,
MC is virtually the change in variable cost per unit
change in output.
Also known as rate of change in total cost.
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11. Average and Marginal Cost Functions
Contd…
AC/MC
MC
AC
AVC
AFC
O
Quantity
AC curve is U shaped
When both AFC and AVC fall,
AC also falls and later starts
increasing.
When average costs decline,
MC lies below AC.
When average costs are
constant (at their minimum),
MC equals AC.
MC passes through the
minimum point of AC
curves.
When average costs rise, MC
curve lies above them.
When both AC and AVC fall,
MC lies below them.
12. Costs in Long Run
All costs are variable in the long run since factors of
production, size of plant, machinery and technology can
be varied in the long run.
The long run cost function is often referred to as the
“planning cost function” and the long run average cost
(LAC) curve is known as the “planning curve”.
As all costs are variable, only the average cost curve is
relevant to the firm’s decision making process in the long
run.
The long run consists of many short runs, therefore the
long run cost curve is the composite of many short run
cost curves.
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13. Costs in Long Run
In the long run the firm may increase plant size to increase output.
As output is increased from q0 to q1 capacity at SAC1 is overworked.
Hence the firm to shifts to a higher plant size SAC1 to SAC2.
This shift would lower the average cost of the firm.
The same process would be repeated if the firm increases its output further
to q2.
It shows scalloping curve as the plant costs are not smoothened.
AC, MC
MC1
SAC1
O
q0
q1
MC2
SAC2
q2
MC3
SAC3
LAC
Quantity
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14. Long Run Average Cost
The LAC function can be shown as an envelope curve of the short run
cost functions.
LAC curve envelopes SAC1, SAC2, SAC3, showing the average cost of
production at different levels of output turned out by plants 1, 2 and 3.
Each of the SAC curves represents the cost conditions for a plant of a
particular capacity.
LMC
AC, MC
SMC1
SAC1
SMC3
SMC2
LAC
SAC2
O
q0
q1
SAC3
q*
q3
Quantity
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15. Long Run Marginal Cost
Long run marginal cost (LMC) curve joins the points on
the short run marginal cost (SMCs) curves that are
associated with short run average costs corresponding
to each level of output on the LAC curve.
The optimum plant size is II, assuming sufficient
demand.
Optimal level of output is Oq*, where long run and short
run marginal and average costs are all equal.
LMC must be less than LAC when the latter is
decreasing
It would be equal to LAC when the latter reaches its
minimum.
LMC is greater than LAC when the latter is increasing.
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16. Costs of a Multi Product Firm
Assuming that a multi product firm manufactures two goods, with the
same plant and machine.
Total cost (TC) of production would be the sum of TFC and the total of
variable costs (C1 and C2) of producing both the products, times the
quantities of the two goods (Q1 and Q2).
TC= TFC+C1Q1+ C2Q2
If the two products are produced in fixed proportions, then we can use
the concept of weighted average cost (ACw) defined as:
F + C1 ( X 1Q) + C2 ( X 2Q)
ACw (Q)=
Q
(where X1 and X2 are the proportions in which products 1 and 2 are
produced (or the weights used in calculating average costs) and Q is
the total output. )
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17. Costs of Joint Products
Two or more products undergo the same production process up to a
split off; i.e. if one good is produced the other will automatically be
produced; e.g. agriculture, minerals.
Common costs
Cannot be identified with a single joint product.
Separable costs
Can be identified with a particular joint product.
Incurred for the product separated beyond the split off point.
Methods of allocating common costs
Physical measure
Common costs are allocated in proportion to a physical measure
identified to describe the quantity of each product obtained at the
split off point.
Sales value at split off
Common costs can be allocated in proportion to the sales value
of the products after split off point.
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18. Linkage between Cost, Revenue and Output
Total Revenue (TR)
The total amount of money received by a firm from goods sold (or
services provided) during a certain time period.
TR=Q.P, where Q is the quantity sold and P is the price per unit.
Average Revenue (AR)
Revenue earned per unit of output sold.
AR=TR/Q =P
Marginal Revenue (MR)
Revenue a firm gains in producing one additional unit of a commodity.
Calculated by determining the difference between the total revenues
produced before and after a unit increase in production.
MRQ= TRQ- TRQ-1;
or
dTR
MR= dQ
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19. Relationship between TR and MR
Price,
Revenue
O
TR
Price,
Revenue
Quantity
O
Quantity
TR will be zero when nothing
is sold, and zero again when a
great deal is sold at a zero
price.
It has the shape of an inverted
U, starting from the origin, and
dipping across the quantity
axis
after
reaching
a
maximum.
Rise in the total revenue curve
is the change in total revenue
with rise in level of output.
MR is the slope of the TR
curve.
MR
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20. Relationship between AR and MR
AR curve can have the following positions:
MR/AR
AR is a straight line, MR will lie midway to AR (Panel a)
AR is convex to the origin, MR will lie less than midway to AR
(Panel b)
AR is concave to the origin, MR will lie more than midway to AR
(Panel c)
Panel a
MR
O
MR/AR
Panel b
AR
MR/AR
AR
MR
MR
Quantity
O
Quantity
Panel c
O
AR
Quantity
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21. Break Even Analysis
Examines the relation between total revenue, total costs and total
profits of a firm at different levels of output.
Used synonymously with Cost Volume Profit Analysis.
Breakeven point is the point where total cost just equals the total
revenue, in other words it is the no profit no loss point.
Approaches to break even analysis:
Algebraic Method
If P be the price of a good, Q the quantity produced’ the
breakeven output is where total revenue equals total cost (Q* ).
Total Revenue= P.Q
Total Cost= TFC+TVC = TFC+AVC.Q
P.Q*=TFC+AVC.Q*
(P-AVC)Q*=TFC
Q*=
TFC
P − AVC
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22. Break Even Analysis
Contribution Margin
Represents that portion of the price of the commodity produced by
the firm that can cover the fixed costs and contribute to profits.
Contribution Margin = P - AVC
Profit Volume (PV) Ratio
Also defined as the ratio of marginal change in profit and marginal
change in sales.
Contribution
PV Ratio=
Sales
FC
Using PV ratio also, Break even point =
PVratio
Margin of Safety
Margin of Safety = Planned sales – Breakeven sales
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23. Break Even Analysis
Cost,
Revenue
Graphical Method
TR
fit
ro
P
TC
E
VC
ss
Lo
O
FC
Q*
Quantity
Plot TR and TC on the Y
axis and output on the X
axis.
TC is a straight line because
AVC
is assumed to be
constant
Total revenue is proportional
to output and the TR curve is
a straight line through the
origin.
Shows the profit (or loss)
resulting from each level of
sales by the firm.
Valuable information on
projected effect of output on
costs.
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24. Economies of Scale
Economies of scale refers to the efficiencies
associated with larger scale operations
This level is reached once the size of the market is
large enough for firms to take advantage of all
economies of scale.
Two types of economies of scale:
Internal economies (which occur to the firm due to large size
of operations);
e.g.
Division of labour/ specialization, Financial
economies, better managerial functions.
External economies (which occur due to expansion of the
industry, and the firm also benefits).
Technological advancement, development of infrastructure
pool of skilled workers
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25. Economies of Scope
When the production capacity can be utilised for producing more than
one goods, average costs are less as compared to when they are
produced by different firms separately; e.g. Computers and printers;
heavy vehicles and light vehicles.
Practice of economies of scope to business strategy is heavily based
on the development of high technology.
Globalization has made such economies even more important to firms
in their production decisions.
Measured by the ratio of average costs to marginal costs, when the
firm produces joint or multiple products.
Assume three products at individual costs of C1, C2 and C3, while Ct
is the total cost when the three activities are carried out together, the
Scope Index (S):
S=
(C 1 + C 2 + C 3 − C t )
C1 + C 2 + C 3
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26. Cost and Learning Curves
In economics learning by doing refers to the process by which
producers learn from experience.
The concept of learning curve is used to represent the extent to which
average cost of production falls in response to increase in output.
The equation of learning curve can be expressed as:
C=AQb
(where C is the cost of input for the Qth unit of output produced and A is the
cost of the first unit of output obtained).
Since increase in cumulative output leads to a decrease in cost, “b”
has a negative value.
Logarithmic form of this equation is :
ln C= ln A + b.ln Q,
(where b is the slope of the learning curve).
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27. Summary
Any production process must incur costs. Direct or variable costs vary with the
level of output; fixed costs remain at the same level, irrespective of the rate of
production.
The costs of a firm include accounting, real and opportunity costs. Financial
management recognizes only accounting costs or nominal cost that can be
recorded in the books of accounts.
The short run is the period within which some obligations associated with
management, plant, and equipment are not alterable by changing the firm's
managerial capacity or scale of operations.
In the long run all aspects of the firm's operations can be adjusted; so all costs
are variable in the long run.
The long run average cost (LAC) curve is a planning horizon, which envelopes
the firm's short run AC curves associated with different plant sizes.
Determination of the average cost of a multi product firm can be done with the
method of weighted average cost, if the two products are produced in fixed
proportions.
Allocation of common costs to the joint products can be done by physical
measure of outputs or by sales value at the spilt off point.
Breakeven analysis deals with determining profit at various projected sales
volume levels, identifying the breakeven point, and making a managerial
decision regarding the relationship between likely sales and breakeven point.
28. Summary
Total Revenue is the total amount of money received by a firm from goods
sold (or services provided) during a certain time period. Average Revenue is
the revenue earned per unit of output sold.
Marginal Revenue is the revenue a firm gains in producing one additional unit
of a commodity. Profit is the difference between Total Revenue and Total
Cost; the profit function shows a range of outputs at which the firm makes
positive (or supernormal) profits.
Economies of scale refer to the efficiencies associated with larger scale
operations; it is a situation in which the long run average costs of producing a
good or service decrease with increase in level of output.
Economies of scope refer to a situation in which average costs of
manufacturing a product are lower when two complementary products are
produced by a single firm, than when they are produced separately.
Learning by doing refers to the process by which producers learn from
experience, while technological change is an increase in the range of
production techniques that provides new vistas to producing goods.
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