Firm level cost concepts 3.

2
COST CONCEPTS

Cost concept is one of central area of behavioral analysis of the firm. Cost considerations
enter into almost every business decision. The kind of cost concept to be used in a
particular situation depends upon the type of economic or business decision to be made.
Thus, it is important to understand what these various cost concepts are, and how they are
useful in different economic as well as business decision. Major economic cost concepts are
as below

01. Fixed Cost & Variable Cost,

02. Total Cost, Average Cost, Marginal Cost,
03. Acquisition Cost & Opportunity Cost
04. Short-run Cost & Long-run Cost,

Fixed Cost & Variable Cost:

Fixed Cost (FC):

Fixed Cost represent the total dollar expense that is paid out even when no output is
produced; Fixed cost is unaffected by any variation in the level of output.

Variable Cost (VC):

Variable Cost represents expenses that vary with the level of output –including raw
materials, wages and fuel --- and includes all cost that are not fixed.
“Total Cost = Fixed Cost + Variable Cost”

Total Cost, Average Cost, Marginal Cost

Total Cost (TC) represent the lowest total dollar expense needed to produce each level of
output (q).
TC rises as ‘q’ rises.
Average Cost (AC) is the total cost divided by the number of units produced. It is a
statistical understanding about the cost of per unit.
Marginal Cost (MC) The marginal cost of an additional unit of output is the cost of the
additional inputs needed to produce that output.  More formally, the marginal cost is the
derivative of total production costs with respect to the level of output.
Mathematically, the marginal cost (MC) function is expressed as the derivative of the total
cost (TC) function with respect to quantity (Q).

Marginal cost and average cost can differ greatly.  For example, suppose it costs tk.1000 to
produce 100 units and tk.1111 to produce 101 units.  The average cost per unit is tk.11,
but the marginal cost of the 101st unit is tk.111.

For better understanding of the above cost concepts the following mathematical and
graphhical examples can be taken to the task:.

Quantity Total Total Total Quantit Average Average Average Marginal

of Fixed Variable Cost y of Fixed Variable Total Cost
Output Cost Cost Output Cost Cost Cost
0 30 0 30
1 30 20 50 1 30 20 50 20
2 30 30 60 2 15 15 30 10
3 30 45 75 3 10 15 25 15
4 30 80 110 4 7.5 20 27.5 35
5 30 145 175 5 6 29 35 65
The above cost table can be represented graphically as follows:
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 Firm level cost concepts 3.2

MC
TC

ATC

Cost
AVC
FC

Quantity

ACCOUNTING COSTS & ECONOMIC COSTS:

Cost often means different things to different people. Accountant and Economist, for
example, tend to look at costs to suit their own particular interests or purposes.
Accountants’ classification of costs are usually set up for legal, financial control and auditing
purposes while economists’ classifications are design to provide decision making guidelines
for management to achieve the firm’s economic goals. The classification of costs into fixed
and variable casts, Out of pocket Cost & Book Cost, Separable Cost & Common Cost (Direct
Cost & indirect Cost), controllable and uncontrollable costs, urgent and postponable costs,
escapable and unavoidable costs, is the accountants’ classification of the cost. The
remaining distinctions into Total Cost, Average Cost, Marginal Cost, Actual Cost &
Opportunity Cost, Historical Cost & Replacement Cost, Past and future costs, Short-run Cost
& Long-run Cost are based on a view of the cost problem from an economic point of view.
Accountants did not originally develop their cost concepts for the same purposes the
economists have in mind. The main function of accounting has been that of reporting,
stewardship, and control. it reports or records what has happened, present information that
will protect the interest of the stock holders, creditors and tax collectors, and provides
standards against which performance can be judge. It has only an indirect relationship to
decision-making, which is the emphasis of economic costs. Indeed, when it comes to
analysis for decision-making, economists and accountants are in close agreement. The
simultaneous development of managerial economics and managerial accounting has
profited from a close interaction between the two subjects and the two draw upon each
other a great deal.
Traditional accounting data are not directly suitable for decision-making. For example, in
measuring the cost involved in the use of resources such as materials or equipment, the
accountant concern himself with the acquisition cost of these resources. But decision-
making is necessarily concerned with future cost and revenues; the past is not always an
accurate guide for the future. Furthermore, the traditional accounting procedure for valuing
assets on the balance sheet is at acquisition cost minus depreciation. These values may
differ from it true, i.e., current market value for three reasons:
current market price of the assets may be different from their past market price,

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 Firm level cost concepts 3.2
accounting depreciation may be differ from the true depreciation,
the time value of the money is not taken to the account.

The managerial economists’ approach to valuation is to take a look at the future revenues
and costs that will result from an asset and to discount that future cash flows to present. In
whether to sell an asset or not, it is necessary to compare the price offer for it with present
value of its net future returns rather than with acquisition cost net of depreciation.

Traditional accounting data ignore the imputed or implicit costs. Surely such cost are
relevant to decision making. For example, an investment project may prove to be worth
undertaking if the salary of owner entrepreneurs and the interest cost of equity capital are
ignored while the same may not be economically viable when such cost are added to
explicit costs. Accounting data on overhead costs do not always clearly indicate which of
these are fixed cost and which are variable ones. A clear distinction between fixed and
variable cost i s essential particularly for short-run decisions.

Because of all these limitations, accounting cost data is not directly useful for all managerial
decisions. They have to be supplemented by additional data and re-classified for specific
uses.

DETERMINANTS OF PRODUCTION COST:

The followings are determinants of cost:

1. Output level
2. Price of factor of Production
3. Productivity of Factor of production,
4. Technology.

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