COST AND PRODUCTION ANALYSIS

Cost Analysis

Costs are bad things endured or good things lost. Cost always means cost to do
something. You cannot have a cost without a cost objective. Most of the
confusion about costs reflects a failure to be clear about cost objectives. This
cost concept mainly used in two different fields’ viz. accounts and economics.
We will concentrate on economic side.

Definition

Actual sacrifice involved in performing an activity, or following a decision or

course of action. It may be expressed as the total of opportunity cost (cost of
employing resources in one activity than the other) and accounting costs (the
cash outlays).

An example of opportunity cost would be going to the movies.  The cost of going
to the movie is Rs. 150 or whatever ridiculous amount of money movie theater
charges.  The opportunity cost would be something else you could have done
with that time, such as studying.

Economists define cost in terms of opportunities that are sacrificed when a

choice is made. Hence, economic costs are simply benefits lost (and, in some
cases, benefits are merely costs avoided). Economic costs are subjective -- seen
from the perspective of a decision maker not a detached observer -- and
prospective. Moreover, economic cost is a stock concept -- economic costs are
incurred when decisions are made. Economic cost estimates are used for
making decisions about pricing, output levels, buying or making, alternative
marketing tactics/strategies, product introductions and withdrawals, etc.
Cost Concepts

Cost concept is very vast indeed. But here we will try to cover many cost
concepts related to economics. Some of them are as follows.

Direct Cost
A cost that can be assigned specifically to a given or particular service.

Indirect Cost
A cost necessary for the functioning of the organization as a whole, but which
cannot be directly assigned to one service.

Total Cost
The sum of all costs, direct and indirect, associated with the provision of a
given or particular service.

Fixed Cost
A cost that does not change with increases or decreases in the amount of
service provided (e.g., rent).

Variable Cost
A cost that increases or decreases with increases or decreases in the amount of
service provided (e.g., salary).

Sunk Cost
A cost that has already been incurred (e.g., the cost of a previously purchased
computer system).

Marginal Cost

Marginal costs indicate by how much the total costs changes because of
modification in the production level by one unit.
Avoidable Cost
The amount of expense that would not occur if a particular decision was
implemented (e.g., if a clerk is laid off and a community is self-insured for
unemployment compensation, the avoidable cost is total direct salary less
payments for unemployment benefits plus savings in employee benefits).

Opportunity Cost
The benefit that would have been received if an alternative course of action had
been pursued.

Unit Cost: The cost of production of one “unit” of a given product or service.

Average Cost: By dividing the total costs by the quantity produces, one gets the
average costs.

Average cost = Total Cost

Quantity produced
Short run and Long run

Short Run

In economics, the concept of the short-run refers to the decision-making time

frame of a firm in which at least one factor of production is fixed. Costs which
are fixed in the short-run have no impact on a firm’s decision. For example a
firm can raise output by increasing the amount of labour through overtime.

A generic firm can make three changes in the short-run:

 Increase production
 Decrease production

 Shut down

In the short-run, a profit maximizing firm will:

 Increase production if marginal cost is less than price;

 Decrease production if marginal cost is greater than price;

 Continue producing if average variable cost is less than price, even if

average total cost is greater than price;

 Shut down if average variable cost is greater than price. Thus, the
average variable cost is the largest loss a firm can incur in the short-run.

The average total cost curve is constructed to capture the relation between cost
per unit and the level of output, ceteris paribus. A productively efficient firm
organizes its factors of production in such a way that the average cost of
production is at lowest point and intersects Marginal Cost. In the short run,
when at least one factor of production is fixed, this occurs at the optimum
capacity where it has enjoyed all the possible benefits of specialization and no
further opportunities for decreasing costs exist. This is usually not U shaped; it
is a checkmark shaped curve. This is at the minimum point in the diagram on
the right.
Long Run

In economic models, the long-run time frame assumes no fixed factors of

production. Firms can enter or leave the marketplace, and the cost (and
availability) of land, labor, raw materials, and capital goods can be assumed to
vary. In contrast, in the short-run time frame, certain factors are assumed to be
file. This is related to the long run average cost (LRAC) curve, an important
factor in microeconomic models.

A generic firm can make these changes in the long-run:

 Enter an industry
 Increase its plant

 Decrease its plant

 Leave an industry
In the long run, a firm will use the level of capital (or other inputs that are fixed
in the short run) that can produce a given level of output at the lowest possible
average cost. Consequently, the LRAC curve is the envelope of the short run
average total cost (SR ATC) curves, where each SR ATC curve is defined by a
specific quantity of capital (or other fixed input). This can be explained in
following diagram.