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Concept of COST
For a manager the production decisions are not
possible without their respective cost considerations.
Cost and revenues are two important factors with
which a producer has to determine the profit.
It is the difference between revenue and cost, which
determine firms overall profitability.
From the decision making point of view, the concept
of cost is more important than the revenue, because
the firm can influence cost easily than the revenue.
More specifically, to know the profitability and
viability of the production process, one has to know the
cost side.
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Moreover, for a managerial decision making, it is the
future cost which matters a lot rather than the current
costs.
The current cost is relevant only if the management is to
continue with its past or present policies in future and
the environment in which the firm operates remain
unchanged.
The future cost condition is necessary to meet the
changing environment and production process.
In the traditional economic theory, cost can be classified
into short-run and long run costs.
Short-run costs are the costs over a period during which
some factors of production (capital and management)
are fixed.
On the other hand, the long-run costs are the costs over
a period which allows to change all factors of production.
In the long run all factors become variable.
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Both in short-run and long-run, the total cost is a
multi-variable function, which is derived by many
factors.
Symbolically, in the long-run:
TC= f (X, T, P
f
)
In the short-run:
TC= f (X, T, P
f
, K)
Where TC: Total Costs
X: Output
T: Technology
Pf: Price of factors
K: Fixed factors
The cost function can be written as
TC=f(X), ceteris paribus, which means, all other
factors remaining constant, cost is a function of
output.
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In a traditional short-run theory, the total cost of a
firm is split into total fixed cost and total variable
cost, i.e.
TC=TFC+TVC
Where Total Fixed Cost (TFC) includes:
Salaries of administrative staff
Depreciation (wear and tear) of machinery
Expenses for land maintenance and depreciation if
any
Expenses for building depreciation and repairs
The Variable Cost (TVC) includes:
The raw materials
The cost of direct labour
The running expenses of fixed capital, such as
fuel, ordinary repairs and routine maintenance.
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The concept of total cost, total variable cost and total
fixed cost in the short-run can be better understood by
the following table:

No. of Units of
Output
Total Fixed Cost
(TFC)
Total Variable
Cost (TVC)
Total Cost (TC)
0 50 0 50
1 50 20 70
2 50 35 85
3 50 60 110
4 50 100 150
5 50 145 195
6 50 190 240
7 50 237 287
8 50 284 334
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Fixed costs are also known as over head costs,
which includes charges such as contractual rent,
insurance fees, maintenance costs, property tax,
administrative expenses etc.
Thus, fixed costs are those which are incurred in
hiring the fixed factors of production whose amount
can not be altered in the short-run.
On the other hand, variable costs are also called
prime or direct costs, which are incurred on the
employment of variable factors of production whose
amount can be altered in the short-run.
Thus the total variable cost changes with changes in
output in the short-run, i.e. they increase or
decrease when the total output rises or falls.
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The total fixed cost is graphically denoted by
a strait line parallel to the output axis, shown
as:

Output
Cost
TFC
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The total variable cost in the traditional
theory of the firm has to broadly an Inverse-
S-Shape, which reflects the law of variable
proportion, can be shown as follows:

TVC
Output
Cost
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The total variable cost curve starts from the
origin which shows that when output is zero,
the variable costs are also zero.
According to this law, at initial stages of
production, with a given plant, as more of the
variable factors are employed, its productivity
increases and the average variable cost falls.
This continues till the optimal combination of
the fixed and variable factors is reached.
Beyond this point an increased quantities of
the variable factors are combined with the
fixed factors, the productivity of variable
factors decline.
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The total cost (TC) curve has been obtained by
vertical summation of the total fixed cost (TFC)
and the total variable cost (TVC) curves can be
shown as follows:
TC
TVC
TFC
Output
Cost
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It is seen from the diagram that the vertical
distance between TVC and TC is constant
through out.
This is because the vertical distance between
TVC and TC curves represents that the amount
of total fixed cost, which remains unchanged as
output increases in short-run.
It should be noted that the vertical distance
between the total cost curve (TC) and the total
fixed cost (TFC) represent the amount of total
variable cost (TVC) which increase with the
increase in output.
Therefore, the shape of total cost curve is the
same vertical distance always separates these
two curves.
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Average Fixed Cost (AFC):
Average fixed cost is the total fixed cost divided by
the number of units of output produced. Therefore,
AFC=TFC/q
Where, q is the number of units of output
produced.
Since total fixed cost is a constant quantity, average
fixed cost will steadily fall as output increases.
Therefore, AFC slopes downward through out its
length.
As output increases, the TFC spread out over more
and more units and AFC becomes less and less.
When output becomes very large, average fixed
cost approaches zero but will never be zero. This
can be shown by the following diagram as:
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Cost
AFC
Output
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It is seen from the diagram that AFC curve
continuously falls through out.
Mathematically speaking, AFC curve
approaches both output and Cost axis
asymptotically, i.e. the AFC curve gets very
nearer to both the axis but never touches it.
Average Variable Cost (AVC):
Average variable cost is the total variable cost
divided by the number of units of product
produced. Therefore:
AVC=TVC/q
Where, q represents the number of output
produced.
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Hence, the AVC is variable cost per units of output.
The AVC will generally fall as the output increases from zero
to normal capacity of the output due to the occurrence of
increasing returns.
But beyond the normal capacity output, the AVC will rise
steeply because of operation of diminishing returns. This can
be shown by the following diagram as:

Cost
Output
AVC
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From the diagram, it is clear that the AVC
which first falls, reach the minimum and then
rises.
Average Total Cost (ATC):
The average total cost (ATC) or average cost
(AC) is the total cost divided by the number of
units of output produced. Therefore:
ATC or AC = Total Cost/Number of Output
Or
ATC or AC = TC/q
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Since, the total cost is the sum of total variable cost
and total fixed cost, the average total cost is also the
sum of average variable cost and average fixed
cost.
This can be proved as follows:
ATC = TC/q
Since,
TC= TFC+TVC
ATC = (TFC+TVC)/q
= TFC/q + TVC/q
= AVC+AFC
So, ATC = AFC+AVC
Average total cost is also known as unit cost, since it
is cost per unit of output produced.
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Marginal Cost (MC):
Marginal cost is an addition to the total cost caused
by producing one more units of output. In other
words, marginal cost is the addition to the total cost
of producing n units instead of n-1 units, where n is
any given number.
In symbol,
MCn = TCn TC n-1
Suppose the production of 5 units of product
involves the total cost of Rs. 206. If the increase in
the production of 6 units raises the total cost to Rs.
236, then the marginal cost of the sixth unit is 30 i.e.
(236-206) = 30.
Since marginal cost is change in the total cost as a
result of unit change in output, it can also be written
as:
MC = TC/q
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The concepts of AFC, AVC, ATC, TC and MC can be
better understood by the following table as:
1 2 3 4 5 6 7 8
Units of
Output
Total
Fixed
Cost
Total
Variable
Cost
Total
Cost
AFC
(2/1)
AVC
(3/1)
ATC
(4/1)
MC
(TC
n
-TC
n-
1
)
0 50 0 0 0 0 0 -
1 50 20 70 50 20 70 -
2 50 35 85 25 17.50 42.50 15
3 50 60 110 16.66 20 36.66 25
4 50 100 150 12.50 25 37.50 40
5 50 145 195 10 29 39 45
6 50 190 240 8.33 31.66 40 45
7 50 237 287 7.11 33.85 40.96 47
8 50 284 334 6.25 35.50 41.75 47
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The average cost curves can be shown in
one diagram as follows:

Cost
Output
MC
ATC
AVC
AFC
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The Relation between AC and MC:
When marginal cost is less than average cost the average
cost falls and when marginal cost is greater than average
cost, the average cost rises.
Example: Situation I:
For a producer: 1st Product: 50 rupees
2nd Product: 45 rupees
This implies that AC falls as MC is less than AC.
Situation II: 1st Product: 50 rupees
2nd Product: 55 rupees
This implies that AC rises as MC is greater than AC.
Situation III: 1st Product: 50 rupees
2nd Product: 50 rupees
This implies that AC is equal to MC or AC=MC.
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This can be better understood by the following diagram as:
From the diagram it is clear that as long as short run marginal cost curve
(MC) lies below the short-run average cost curve (AC), the AC is falling.
When marginal cost (MC) lies above the AC curve, the AC is rising.
At the point of intersection L, where MC is equal to AC, AC is neither
falling nor rising. At the point L where MC curve crosses the AC curve
to lie above the AC curve, is the minimum point of AC curve.
So, the MC cuts AC at its minimum point.
Cost
Output
L
MC
AC