The College of Maasin

“Nisi Dominus Frustra”

Tunga-tunga, Maasin City

AE3 – MANAGERIAL ECONOMICS

Prepared by: MAUNECA LOU MELAGROSO
melagrosomaunecalou@gmail.com 09651335057

READING MATERIAL 6

THE ECONOMIC ANALYSIS OF COST

In economics, the Cost Analysis refers to the measure of the cost – output relationship, i.e. the
economists are concerned with determining the cost incurred in hiring the inputs and how well these
can be re-arranged to increase the productivity (output) of the firm.

In other words, the cost analysis is concerned with determining money value of inputs (labor, raw
material), called as the overall cost of production which helps in deciding the optimum level of
production.
There are several cost concepts relevant to the business operations and decisions and for the
convenience of understanding these can be grouped under two overlapping categories:

1. Cost Concepts Used for Accounting Purposes: Generally, the accountants use these cost
concepts to study the financial position of the firm. They are concerned with arranging the
finances of the firm and therefore keep a track of the assets and liabilities of the firm. The
accounting costs are used for taxation purposes and calculating the profit and loss of the firm.
These are:
 Opportunity Cost- value of the opportunity lost. In economics we have to choose the
greatest benefit at the lowest cost.
 Business Cost- includes all the costs (fixed, variable, direct, indirect) incurred in carrying
out the operations of the business.
 Full cost- is the total cost incurred in production and is comprised of business cost,
opportunity cost, and normal profit.
 Explicit cost- also called as Actual Cost is the cost actually incurred by the firm for
making all the physical payments and the contractual obligations.
 Implicit cost- Imputed Cost is the implied cost that does not take a form of cash outlay,
and neither is recorded in the books of accounts. (example is opportunity cost)
 Out-of-Pocket Cost- involves the potential future cash payments or cash transfers both
recurring and non-recurring, paid during the current accounting period or during the
project. In other words, the out-of-pocket cost involves the direct monetary payment
for the work done during the project.
 Book Cost- refers to those expenses which do not involve actual cash payments, but
rather the provisions are made in the books of accounts to include them in the profit
and loss accounts and avail the tax advantages.
2. Analytical Cost Concepts Used for Economic Analysis of Business Activities: These cost concepts
are used by the economists to analyze the likely cost of production in the future. They are
concerned with how the cost of production can be managed or how the input and output can be
re-arranged such that the overall profitability of the firm gets improved. These costs are:
 Fixed Cost- The Fixed Cost is the cost that remains fixed for a certain volume of output.
In other words, the cost that does not change with the change in the output or sales
revenue, i.e. it remains fixed irrespective of the volume of output is called the fixed cost.
 Variable Cost- is the cost proportionally related to the level of output, i.e. it increases
with the increase in the production and contracts with the decrease in the total output.
 Total Cost- is the actual cost incurred in the production of a given level of output. In
other words, the total expenses (cost) incurred, both explicit and implicit, on the
resources to obtain a certain level of output is called the total cost.
 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.
 Marginal Cost- refers to the change in the total cost as a result of the production of one
more unit of the product. In other words, the marginal cost is the increase or decrease
in the total cost due to the production of one additional unit of the product.
 Short-run Cost- the cost which has short-term implications in the production process,
i.e. these are used over a short range of output. These are the cost incurred once and
cannot be used again and again, such as payment of wages, cost of raw materials, etc.
 Long-Run Cost- is the cost having the long-term implications in the production process,
i.e. these are spread over the long range of output. These costs are incurred on the fixed
factors, Viz. Plant, building, machinery, etc. but however, the running cost and the
depreciation on plant and machinery is a variable cost and hence is included in the
short-run costs.
 Incremental Cost- refers to the additional cost that a company incurs in undertaking
certain actions such as expanding the level of production or adding a new variety of
product to the product line, etc.
 Sunk Cost- s the cost already incurred by the firm and cannot be recovered or refunded.
The cost which was incurred in the past and is now permanently lost is called as a Sunk
Cost.
 Historical Cost- The assets and liabilities recorded in the balance sheet with its original
acquisition cost, the i.e. amount spent at the time of its acquisition are called as the
Historical Cost. In other words, the historical cost is an accounting method in which the
assets of the firm are recorded in the books of accounts at the same value at which it
was first purchased.
 Replacement Cost- is the cash outlay that firm has to pay in order to replace an old asset
at the current market price. Simply, the amount paid to replace the existing property
with the new one having the similar utility, without considering the depreciation
constitutes the replacement costs.

Having the concepts of costs will give the economic manager ideas and analogy for his
decision making that will optimize their production and increase the profit of the business.