MARGINAL COST,AVERAGE

COST,EXPLICIT AND IMPLICIT

COST
BY: MOHAMMED FAISAL BARI.
. ROLL NO.:28.
. COURSE:BBA LLB
 WHAT IS MARGINAL COST?
Marginal cost represents the incremental costs incurred when
producing additional units of a good or service. It is calculated by
taking the total change in the cost of producing more goods and
dividing that by the change in the number of goods produced.
The usual variable costs included in the calculation are labor and
materials, plus the estimated increases in fixed costs (if any), such
as administration, overhead, and selling expenses. The marginal
cost formula can be used in financial modeling to optimize the
generation of cash flow.
MARGINAL COST
 WHAT IS THE FORMULA FOR MARGINAL COST?

THE MARGINAL COST FORMULA IS:

MARGINAL COST = (CHANGE IN COSTS) / (CHANGE IN QUANTITY)

 1. WHAT IS “CHANGE IN COSTS”?

• AT EACH LEVEL OF PRODUCTION AND DURING EACH TIME PERIOD, COSTS OF

PRODUCTION MAY INCREASE OR DECREASE, ESPECIALLY WHEN THE NEED ARISES TO
PRODUCE MORE OR LESS VOLUME OF OUTPUT. IF MANUFACTURING ADDITIONAL
UNITS REQUIRES HIRING ONE OR TWO ADDITIONAL WORKERS AND INCREASES THE
PURCHASE COST OF RAW MATERIALS, THEN A CHANGE IN THE OVERALL PRODUCTION
COST WILL RESULT.
• TO DETERMINE THE CHANGE IN COSTS, SIMPLY DEDUCT THE PRODUCTION COSTS
INCURRED DURING THE FIRST OUTPUT RUN FROM THE PRODUCTION COSTS IN THE
NEXT BATCH WHEN OUTPUT HAS INCREASED.
 2. WHAT IS “CHANGE IN QUANTITY”?

• IT’S INEVITABLE THAT THE VOLUME OF OUTPUT WILL INCREASE OR DECREASE WITH
VARYING LEVELS OF PRODUCTION. THE QUANTITIES INVOLVED ARE USUALLY
SIGNIFICANT ENOUGH TO EVALUATE CHANGES IN COST. AN INCREASE OR DECREASE
IN THE VOLUME OF GOODS PRODUCED TRANSLATES TO COSTS OF GOODS
MANUFACTURED (COGM).
• TO DETERMINE THE CHANGES IN QUANTITY, THE NUMBER OF GOODS MADE IN THE
FIRST PRODUCTION RUN IS DEDUCTED FROM THE VOLUME OF OUTPUT MADE IN THE
FOLLOWING PRODUCTION RUN.
 AN EXAMPLE OF THE MARGINAL COST FORMULA

• JOHNSON TIRES, A PUBLIC COMPANY, CONSISTENTLY MANUFACTURES 10,000 UNITS OF

TRUCK TIRES EACH YEAR, INCURRING PRODUCTION COSTS OF $5 MILLION. HOWEVER, ONE
YEAR FINDS THE MARKET DEMAND FOR TIRES SIGNIFICANTLY HIGHER, REQUIRING THE
ADDITIONAL PRODUCTION OF UNITS, WHICH PROMPTS MANAGEMENT TO PURCHASE MORE
RAW MATERIALS AND SPARE PARTS, AS WELL AS TO HIRE MORE MANPOWER.
•
• THIS DEMAND RESULTS IN OVERALL PRODUCTION COSTS OF $7.5 MILLION TO PRODUCE
15,000 UNITS IN THAT YEAR. AS A FINANCIAL ANALYST, YOU DETERMINE THAT THE MARGINAL
COST FOR EACH ADDITIONAL UNIT PRODUCED IS $500 ($2,500,000 / 5,000)
 HOW IMPORTANT IS MARGINAL COST IN BUSINESS
OPERATIONS?
• WHEN PERFORMING FINANCIAL ANALYSIS, IT IS IMPORTANT FOR MANAGEMENT TO EVALUATE
THE PRICE OF EACH GOOD OR SERVICE BEING OFFERED TO CONSUMERS, AND MARGINAL
COST ANALYSIS IS ONE FACTOR TO CONSIDER.
• IF THE SELLING PRICE FOR A PRODUCT IS GREATER THAN THE MARGINAL COST, THEN
EARNINGS WILL STILL BE GREATER THAN THE ADDED COST – A VALID REASON TO CONTINUE
PRODUCTION. IF, HOWEVER, THE PRICE TAG IS LESS THAN THE MARGINAL COST, LOSSES WILL
BE INCURRED AND THEREFORE ADDITIONAL PRODUCTION SHOULD NOT BE PURSUED – OR
PERHAPS PRICES SHOULD BE INCREASED. THIS IS AN IMPORTANT PIECE OF ANALYSIS TO
CONSIDER FOR BUSINESS OPERATIONS.
 WHAT JOBS USE THE MARGINAL COST FORMULA?

• PROFESSIONALS WORKING IN A WIDE RANGE OF CORPORATE

FINANCE ROLES CALCULATE THE INCREMENTAL COST OF
PRODUCTION AS PART OF ROUTINE FINANCIAL ANALYSIS.
ACCOUNTANTS WORKING IN THE VALUATIONS GROUP MAY
PERFORM THIS EXERCISE CALCULATION FOR A CLIENT, WHILE
ANALYSTS IN INVESTMENT BANKING MAY INCLUDE IT AS PART OF
THE OUTPUT IN THEIR FINANCIAL MODEL.
 AVERAGE COST

• DEFINITION: THE AVERAGE COST IS THE PER UNIT COST OF PRODUCTION OBTAINED BY
DIVIDING THE TOTAL COST (TC) BY THE TOTAL OUTPUT (Q). BY PER UNIT COST OF
PRODUCTION, WE MEAN THAT ALL THE FIXED AND VARIABLE COST IS TAKEN INTO THE
CONSIDERATION FOR CALCULATING THE AVERAGE COST. THUS, IT IS ALSO CALLED AS PER
UNIT TOTAL COST.
 AVERAGE COST

SYMBOLICALLY, THE AVERAGE COST IS EXPRESSED AS:

AC = TC/Q
ALSO,
AC = AVERAGE VARIABLE COST (AVC) + AVERAGE FIXED COST (AFC)
WHERE,
AVERAGE VARIABLE COST = TOTAL VARIABLE COST (TVC) / TOTAL OUTPUT (Q)
AVERAGE FIXED COST = TOTAL FIXED COST (TFC) / TOTAL OUTPUT (Q
 AVERAGE COST

.THE AVERAGE COST IS GREATLY INFLUENCED BY THE TIME PERIOD OF

PRODUCTION, SUCH AS INCREASING OR EXPANDING THE
PRODUCTION IN THE SHORT RUN MIGHT BE QUITE EXPENSIVE OR
IMPOSSIBLE. THUS, THE ECONOMISTS STUDY BOTH THE SHORT-RUN
AVERAGE COSTS AND LONG-RUN AVERAGE COSTS TO DECIDE THE
PRODUCTION FOR A GIVEN PERIOD.
 AVERAGE COST

• THE SHORT-RUN AVERAGE COST IS THE COST THAT VARIES WITH THE PRODUCTION OF
GOODS, PROVIDED THE FIXED COSTS ARE ZERO, AND THE VARIABLE COSTS ARE CONSTANT.
WHILE THE LONG-RUN AVERAGE COST INCLUDES ALL THE COST INVOLVED IN THE VARIATION
OF THE QUANTITIES OF ALL THE INPUTS USED FOR THE PRODUCTION. THE LONG-RUN IS THE
TIME PERIOD WHEREIN THE QUANTITIES OF ALL THE INPUTS TO BE USED CAN VARY, EVEN
CAPITAL. THUS, THE AVERAGE COST IS AN IMPORTANT FACTOR IN DETERMINING THE SUPPLY
AND DEMAND WITHIN THE MARKET.
AVERAGE COST CURVES
 RELATIONSHIP OF AVERAGE COST WITH MARGINAL
COST
• WHEN AVERAGE COST IS DECLINING AS OUTPUT INCREASES, MARGINAL COST IS LESS THAN
AVERAGE COST. WHEN AVERAGE COST IS RISING, MARGINAL COST IS GREATER THAN
AVERAGE COST. WHEN AVERAGE COST IS NEITHER RISING NOR FALLING (AT A MINIMUM OR
MAXIMUM), MARGINAL COST EQUALS AVERAGE COST
 WHAT IS AN IMPLICIT COST?

• AN IMPLICIT COST IS ANY COST THAT HAS ALREADY OCCURRED BUT NOT NECESSARILY
SHOWN OR REPORTED AS A SEPARATE EXPENSE. IT REPRESENTS AN OPPORTUNITY COST THAT
ARISES WHEN A COMPANY USES INTERNAL RESOURCES TOWARD A PROJECT WITHOUT ANY
EXPLICIT COMPENSATION FOR THE UTILIZATION OF RESOURCES. THIS MEANS WHEN A
COMPANY ALLOCATES ITS RESOURCES, IT ALWAYS FORGOES THE ABILITY TO EARN MONEY
OFF THE USE OF THE RESOURCES ELSEWHERE, SO THERE’S NO EXCHANGE OF CASH. PUT
SIMPLY, AN IMPLICIT COST COMES FROM THE USE OF AN ASSET, RATHER THAN RENTING OR
BUYING IT.
 EXAMPLES OF IMPLICIT COSTS

• .EXAMPLES OF IMPLICIT COSTS INCLUDE THE LOSS OF INTEREST INCOME ON FUNDS AND THE
DEPRECIATION OF MACHINERY FOR A CAPITAL PROJECT. THEY MAY ALSO BE INTANGIBLE
COSTS THAT ARE NOT EASILY ACCOUNTED FOR, INCLUDING WHEN AN OWNER ALLOCATES
TIME TOWARD THE MAINTENANCE OF A COMPANY, RATHER THAN USING THOSE HOURS
ELSEWHERE. IN MOST CASES, IMPLICIT COSTS ARE NOT RECORDED FOR ACCOUNTING
PURPOSES
 WHAT IS EXPLICIT COST?

• EXPLICIT COSTS ARE NORMAL BUSINESS COSTS THAT APPEAR IN

THE GENERAL LEDGER AND DIRECTLY AFFECT A COMPANY’S
PROFITABILITY. EXPLICIT COSTS HAVE CLEARLY DEFINED DOLLAR
AMOUNTS, WHICH FLOW THROUGH TO THE INCOME STATEMENT.
EXAMPLES OF EXPLICIT COSTS INCLUDE WAGES, LEASE PAYMENTS,
UTILITIES, RAW MATERIALS, AND OTHER DIRECT COSTS .
 UNDERSTANDING EXPLICIT COSTS

• EXPLICIT COSTS—ALSO KNOWN AS ACCOUNTING COSTS—ARE EASY TO IDENTIFY AND LINK

TO A COMPANY’S BUSINESS ACTIVITIES TO WHICH THE EXPENSES ARE ATTRIBUTED. THEY ARE
RECORDED IN A COMPANY’S GENERAL LEDGER AND FLOW THROUGH TO THE EXPENSES
LISTED ON THE INCOME STATEMENT. THE NET INCOME (NI) OF A BUSINESS REFLECTS THE
RESIDUAL INCOME THAT REMAINS AFTER ALL EXPLICIT COSTS HAVE BEEN PAID. EXPLICIT COSTS
ARE THE ONLY ACCOUNTING COSTS THAT ARE NECESSARY TO CALCULATE A PROFIT, AS THEY
HAVE A CLEAR IMPACT ON A COMPANY’S BOTTOM LINE. THE EXPLICIT-COST METRIC IS
ESPECIALLY HELPFUL FOR COMPANIES’ LONG-TERM STRATEGIC PLANNING.
 EXPLICIT COSTS VS. IMPLICIT COSTS

• EXPLICIT COSTS, INVOLVE TANGIBLE ASSETS AND MONETARY TRANSACTIONS AND RESULT IN
REAL BUSINESS OPPORTUNITIES. EXPLICIT COSTS ARE EASY TO IDENTIFY, RECORD, AND AUDIT
BECAUSE OF THEIR PAPER TRAIL. EXPENSES RELATING TO ADVERTISING, SUPPLIES, UTILITIES,
INVENTORY, AND PURCHASED EQUIPMENT ARE EXAMPLES OF EXPLICIT COSTS. ALTHOUGH THE
DEPRECIATION OF AN ASSET IS NOT AN ACTIVITY THAT CAN BE TANGIBLY TRACED,
DEPRECIATION EXPENSE IS AN EXPLICIT COST BECAUSE IT RELATES TO THE COST OF THE
UNDERLYING ASSET OWNED BY THE COMPANY.
 EXPLICIT COSTS VS. IMPLICIT COSTS

• .IN CONTRAST, IMPLICIT OR IMPLIED COSTS ARE NOT CLEARLY DEFINED, IDENTIFIED, OR
REPORTED AS EXPENSES. THEY OFTEN DEAL WITH INTANGIBLES AND ARE DESCRIBED AS
OPPORTUNITY COSTS—THE VALUE OF THE BEST ALTERNATIVE NOT ACCEPTED. AN EXAMPLE OF
AN IMPLICIT COST IS TIME SPENT ON ONE ACTIVITY OF A BUSINESS THAT COULD BETTER BE
SPENT ON A DIFFERENT PURSUIT. MANAGEMENT WILL UTILIZE EXPLICIT COSTS WHEN
REVIEWING A BUSINESS’S OPERATIONS, INCLUDING PROFITS; BUT WILL CALCULATE IMPLICIT
COSTS ONLY FOR DECISIONMAKING OR CHOOSING BETWEEN MULTIPLE ALTERNATIVES.
 EXPLICIT COSTS VS. IMPLICIT COSTS

• COMPANIES USE BOTH EXPLICIT AND IMPLICIT COSTS WHEN

CALCULATING A COMPANY’S ECONOMIC PROFIT—DEFINED AS THE
TOTAL RETURN A COMPANY RECEIVES BASED ON ALL COSTS
INCURRED TO ATTAIN THAT REVENUE. SPECIFICALLY, ECONOMIC
PROFIT IS USED EXTENSIVELY TO DETERMINE WHETHER A BUSINESS
SHOULD ENTER OR EXIT A MARKET OR INDUSTRY