# COST CONCEPT Fixed and Variable costFixed cost are those cost which are incurred even when

the output is zero, it does not vary with change in output such cost are interest on loan, rent, salaries to top management etc. Variable cost is cost which changes with change in output. It increases with increase in output and decrease with the decrease in output e. g. cost of raw material, labour, sales commission etc.

T C (Total cost) C O S T

TVC (Total variable cost)

B

TFC (Total fixed cost)

O

OUTPUT

Average fixed cost (AFC) is equal to fixed cost at each level of output divided by the number of units produced. TC is the total cost incurred in producing units which includes advertisement. it includes maintenance expenses. it includes cost of labour. Long run period is a period which is long enough to change all the factors of production. taxes etc. for a painting firm it may be 2 days but for a steel making firm it may last for 4 years. rent etc TVC is the total variable cost which changes directly with the change in output. It is not possible to tell how long a short run will last. Fixed cost can not be changed in this period but variable cost can be increased and decreased. when we have some fixed cost and some variable cost. Short run average total cost (SATC or SAC) is average cost of producing a given output LAC is derived from SAC. raw material. raw material. power etc. wages. TFC is total fixed cost. insurance. LAC is also called planning curve and envelope curve. all the factors are variable factors. Therefore firm should have knowledge about per unit cost or average cost. the cost which will not change with output even if the output is zero. This is the time when business decisions are made except on the level of technology. Chamberlin LAC is planning curve as firms plan to expand its scale of production only in long run. It is called envelop curve as it envelops all the SAC curves. A unit of output which a firm produces does not cost the same but these units are sold at the same price. Short run average variable cost (SAVC) is TVC at each level of output divided by number of units produced. Short run cost curves The short run cost curves are divided into Total Fixed cost (TFC) and Total Variable cost (TVC). Average Cost Curves (AC) In short run period not only total cost but even average costs are important. . TFC has to be incurred. According to Prof.Short run period Short run period is a time period. which means there are no fixed factors. When the output increases the TVC will also increase and vice versa.

SMC SATC SAVC C O S T B C AFC O OUTPUT .

the total product will increase.Importance of cost concept in Management decision making With the age of more competition. A car manufacturer will need labour and machinery (input) to manufacture car. Law of variable proportion is also called Law of Diminishing Returns.Many American companies outsource their jobs to Asian countries. . Law of variable proportion or Law of diminishing returns These terms are important to understand the law better. labour and capital. But after a certain point it will increase at a diminishing rate and finally total product starts decreasing. There are some inputs which are kept constant or fixed. which transforms in put into output. 3. Total Product (TP) – Total quality of output produced by a firm. Marginal Product (MP) – Change in TP caused as a result of additional unit of Variable factor employed to the combination of Fixed Factor. it is difficult for the firm to increase profit margins by increasing prices. It examines the production function when one factor varies keeping the quantities of other fixed factors constant. Assumption This law is subject to certain assumptions 1. When Variable Factors are increased in equal doses keeping the Fixed Factor constant. Now days there are software which integrate planning. Only one factor of production must be variable. Average Product (AP) – The total produced by a firm divided by the quantity of variable factors used to produce. synchronizing. Companies find some ways to cut their cost and remain in competition. The state of technology is given 2. Now a day’s one can see cost cutting is done by out sourcing their work to low wages Asian countries and mergers. Production function is technical relationship between input and output. The law states. Re-location to lower wage countries . That is how the output varies when Variable Factors are employed to the fixed factors. But here to express production function we consider a single production process which utilizes two inputs. The best way to increase profit margin is to cut down the cost. changing technology and increasing customer’s expectation. Production function expresses the relationship between quantity of output produced and quantity of input required. In the example illustrated below we have taken it as labour. Meaning of Production Function Production is an activity. as the wages are low which decreases their cost of production. tracking and scheduling of entire production process for the companies.In 1990s. ERP (Enterprise Resource Planning) started which enables a company to deliver right product to the customers on time and in efficient way. Reduction in Cost through IT . In real life any commodity is produced by various inputs and with different methods of production.

B TOTAL PRODUCT I TP TOTAL PRODUCT 1 2 3 LABOUR MARGINAL PRODUCT AND AVERAGE PRODUCT D E F AVERAGE PRODUCT AP O M LABOUR MP MARGINAL PRODUCT .

At this stage. Initially when these analyst have very few contracts to work on. the reason behind increasing returns is that the fixed factors(land) is intensively used an so the production increases rapidly when the variable factor (labour) are under-utilised. output is the number of data processed by analyst and input is. The law of increasing returns operates. Here we take an example of a BPO. In this stage MP is below AP. This stage is called the stage of increasing returns. they are at stage I. which keeps pouring in. TP is rising rapidly. workers are many in comparison to the land available and it becomes impossible to cultivate. Stage III-Negative Returns: In this stage TP starts declining and MP becomes negative as the variable factors are too much compared to the fixed factors. when variable factors are applied on the fixed factors.Stage I. But this law is universal which says that the proportion of factors of production is disturbed by increasing only variable factors in relation to the fixed factors this may be due to scarcity of one in relation to the other factor. but when more . in the figure given above. This stage is called the economic stage as every producer likes to be in this phase for two reasons. as here the land is too much compare to the labour. firstly this is the stage when the TP reaches its maximum point and secondly both the factors variable and fixed are completely utilized. Any producer who is investing in the factors of production will be satisfied only if all the factors of production are properly utilized. the TP increases at an increasing rate till point I in the above figure. These stage workers are increased from 5 to 6 to cultivate the given land and it is used intensively. which has grown rapidly. Where there are fixed number of process analyst and the number of data to be processed is variable factors. Most of the examples of Production function.Diminishing Returns Stage III-Negative Returns Stage I. seen involve manufacturing sectors and agriculture. Stage II – Diminishing returns: This is an important stage as the AP reaches its maximum point E. In this example. IMPORTANCE IN MANAGEMANT DECISION MAKING Law of Variable Proportion is an old economic principle which was firstmost redefined version of Marshall. the number of process analyst.Increasing returns: In this stage.Increasing Returns Stage II. where AP and MP reaches its maximum point at point E and D respectively.

The short run production shows what happens when one factor of production changes keeping the other factors constant. Law of Returns to Scale This is also called the long run production function.and more contracts start coming. Assumption All factors of production are variable Technological changes are absent M A R G I N A L R E T U R N S C II D I III R S SCALE OF PRODUCTION The law states . then finally when these contracts increase. It describes the relationship between output and scale of input. they are occupied and they reach the stage II. The Law of Returns to Scale will show the change in the output when all the factors of production are increased together. the manager thinks of adding up to more analyst and some factors like computer gets overloaded and the stage III starts.

The reason is that indivisibility of factors of production like machine. This stage the diseconomies of scale sets in Economies of Scale Economies of scale exist when larger output is associated with low per unit cost. labour etc cannot be available in smaller size. Stage I Increasing Returns to Scale: In this stage. Stage III Diminishing Returns to Scale A constant return to scale is a passing phase and ultimately returns to scale starts declining. which is called the increasing returns to scale. they can employ better machinery. which are available when output of whole industry expands. It has been classified into Internal Economies and External Economies. this in turn increases the efficiency and productivity and the firm starts enjoying the internal economies. all the factors of production are doubled so the output increases by more than double resulting in increase in returns to scale. independent to the action of other firms. Stage II. As the scale of production increases the scope for specialization. (Here economies are advantages which a firm or industry will enjoy when they increase the scale of production) Internal Economies.they are external to the firms.Economies are internal to a firm. Business may become unwieldy and may face some problems of supervision. finance.Constant Returns to Scale Increasing returns to scale cannot increase indefinitely. division of labour increases. In this stage internal economies and diseconomies get neutralized and the output increases in the same proportion. When the increases in output are in the same proportion as the increase in input. It is shared by number of firms or industry. efficient managers to work etc this helps in increasing returns to scale. this stage is called the constant returns to scale. In this stage returns increases in the same proportion as the increase in input and gets constant returns on a large range of output. Finally when increase in the output is in less to the proportion of increase in input. they are available only in a minimum size and they can be used to their utmost efficiency. when it expands in its size. Internal Economies of Scale Under Internal Economies of scale there are more categories . It is open only for the firm.When there is increase in all inputs in same proportion by the firm it results in increase in output at increasing rate than the increase in input. this stage is called the diminishing returns to scale . control and rigidity and thus its leads to diminishing returns. when the scale of production increases in any industry. which is shown by the horizontal line CD in the above figure. External Economies.

They can diversify their products and counter balance the loss in one product by gains from the other product. Risk Bearing Economies.a large firm can afford specialist to managers and supervisors for all the departments like sales manager for sales department.in order to produce a commodity in large scale the firms will install up to date machinery.a firm enjoys the advantage of buying and selling. Technical Economies. Economies of Welfare. EXTERNAL ECONOMIES In external economies of scale again we have two categories • Real • Pecuniary Real External Economies of Scale. Marketing Economies. 3. production manager dealing with the production department and so on.g. It happens even when the firm gets low interest rate on loans due to the goodwill. Thus they enjoy the economies of linked processes. crèche for the infants of women workers. This brings more efficiency and leads to functional efficiency.many firms provide welfare facilities to their workers and provide better working conditions in and out of factory by providing canteen. Managerial Economies. health and medical facilities to the families of the workers Pecuniary Internal Economies This is also called monetary internal economies. recreational club. 4. 2. concession in advertisement and transportation cost due to good reputation. in form of better quality input. as the requirement is in bulk because they are able to get favourable terms. A large firm can utilizes the waste material as by product by installing a plant for this purpose e.large firms are in better position to spread risk.g. sugar producing firm can have their own farms with their own transport bringing the sugarcane to the factory and their own distribution system to send it to the market.it represents how a firm is benefited in an industry through technological interdependence of firms.Real Internal Economies of Scale which arises from the expansion of the firm are 1.They can have advantage of linked processes e. They can even diversify their market by selling their product in many markets and counter the loss in market by gains in the other market.• • Real Pecuniary Real Internal Economies of Scale. These economies are due to large scale of production as they have strong bargaining power. This happens due to reduction in market price of its inputs. 5. molasses left over in manufacturing sugar can be used to produce spirit . transport concessions etc. when the inputs are given in lower price due to purchase in bulk. The external economies are .

it faces many problems like lack of coordination. in textile industry.g. DISECONOMIES OF SCALE Diseconomies arise when large output leads to higher per unit cost. Economies of information. Work is not done efficiently. 2. firms in that industry start with different types of processes and the whole industry is benefited. it cannot continue indefinitely.many industries turn out large waste materials which can be used as input in process of manufacturing like iron-scarps in steel industry. Managerial Diseconomies – there may be failure on the part of management to supervise. Technical Diseconomies.an industry is in better position to set up research laboratories as they are able to gather large resources. there may be repeated breakdown in machinery and equipments.There are both internal and external diseconomies of scale Internal Diseconomies When a firm expands beyond its optimum level. 3. Technical Economies. decision making becomes difficult and per unit cost increases. the expenses of disposing off waste and they can earn certain amount by selling their waste material.the firm may face some marketing problems due to insufficient supply of raw material due to scarcity or decrease in demand as the taste of the people changes. Marketing Diseconomies. some internal diseconomies are 1. some in printing. a time comes when economies are taken by diseconomies . The industry can have their own information centre which gives information regarding the export potentials.when any industry expands. control and run the business properly. There is always a limit to expand the scale of production. molasses in the sugar industry etc. They can purchase the raw material at reasonable rates. Pecuniary External Economies of Scale These economies arise when the firms in an industry enjoy reduction in the factor price. The work of the research may be some new invention and the information about it is given to all the firms through the journals. This helps the efficiency and productivity of the whole industry. 3.1. This may arise due to having a institute training labour in the skill which is needed for all the firms in that industry. It gives them the advantage of waste management. management. some firms start specializing in manufacturing thread. modern technology and information. electricity board can supply power at a concessional rates etc. E.when the firm expands beyond its optimum limits. transportation can be made according to the needs of the industry. which can be useful for the firms by publishing in the journals. Economies of By-Product. New firms can enter the industry and use these waste materials to produce by products. some in dying others in shirting etc 2. market organization may fail to forecast the changes . marketing etc.

transportation. raw materials and other factors of production . External Diseconomies of Scale External Diseconomies of scale arises when the prices of factors increase due to the increase in demand. Due to overgrowth there is shortage of labour.in the market condition and the firms are not prepared for the risk. An error of judgment by sales or production manager may affect the sales and production and lead to huge loss. it in turn increases the per unit cost. power.