Theory of Cost

MBA 2022 Managerial Economics

 Introduction
• Cost is defined in simple terms as a sacrifice or foregoing
which has already occurred or has potential to occur in future
with an objective to achieve a specific purpose measured in
monetary terms.
• Cost results in current or future decrease in cash or other
assets, or a current or future increase in liability.
Introduction
• Determinants of cost:
• Price of inputs
• Productivity of inputs
• Technology
• Level of output
• Mathematically we can express the cost function as:
C= f(Q, T, Pf)
where C=cost; Q=output; T=technology; Pf = price of
inputs.

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 Kinds of Costs
•Accounting Costs/ Explicit Costs/Out of
Pocket Costs
•Which can be identified, measured and
accounted for; e .g. cost of raw materials,
wages and salary and capital costs like cost
of the factory building.
•Which result in cash outflow or increase in
liability
Kinds of Costs……
•Implicit Costs
• Do not involve cash outflow or reduction in
assets, or increase in liability; e.g. owner
working as manager in own building
• Important for opportunity cost
measurement
Kinds of Costs…….
•Real Costs
•More or less social and psychological in
nature and non quantifiable in money
terms; e.g. cost of sacrificing leisure and
time.
•Not considered by accountants.

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 Kinds of Costs……

•Opportunity Costs
•Help in evaluation of the alternative uses of
an input other than its current use in
production.
•Revenue foregone by not making the best
alternative use.

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Kinds of Costs……
• Direct Costs
• Which can be attributed to any particular activity, such as
cost of raw material, labour, etc.
•Indirect Costs
• Costs which may not be attributable to output, but are
distributed over all activities are indirect costs
• Also known as overheads.

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 Kinds of Costs……
• Replacement costs

•Current price or cost of buying or replacing

any input at present.

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Kinds of Costs……

•Social Costs
•Costs to the society in general because of the
firm’s activities. E.g. pollution caused by
industrial wastes and emissions.

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Kinds of Costs……

• Historic Costs/ Sunk Cost

• Incurred at the time of purchase of assets; no longer
relevant for decision making
• Future Costs
• Opposite of historic costs and are budgeted or
planned costs.
• Not included in the books of accounts. x
Kinds of Costs……
• Controllable Costs and Uncontrollable Costs
• Controllable Costs are subject to regulation by the
management of a firm; e.g. fringe benefits to employees,
costs of quality control.
• Uncontrollable Costs are beyond regulation of the
management; e.g. minimum wages are determined by
government, price of raw material by supplier.

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Kinds of Costs……
• Production Costs and Selling Costs
• Production Costs are estimated as a function of the level
of output
• Selling costs occur on making the output available to the
consumer.

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Fixed Costs

• Land, Machinery, Rental lease or mortgage payments, salaries,

insurance payments, property taxes, interest expenses, depreciation,
and some utilities.

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Variable Costs

• Costs of goods sold (COGS), raw materials and inputs to production,

packaging, wages, and commissions, and certain utilities (for
example, electricity or gas that increases with production capacity).

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Costs in Short Run

• Total Cost (TC)

• Total Fixed Cost (TFC)
• Total Variable Cost (TVC)
• Average Cost (AC)
• Average Fixed Cost (AFC)
• Average Variable Cost (AVC)
• Marginal Cost

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 Costs in Short Run

Cos
ts • Fixed Costs
C TF
• Do not vary with output; e.g. plant,
machinery, building.
C
• Total Fixed Cost (TFC) curve is a
straight line, parallel to the quantity
O axis, indicating that output may
Quant increase to any level without causing
ity any change in the fixed cost.
• In the long run plant size may
increase hence FC curve may be step
TF like, where each step showing FC in a
Cost C particular time period.
s

O
Quanti
ty
Cos
TC
TVC
Costs in Short Run
ts
◼ Variable Costs
◼ Costs that vary with level of
output and are zero if no
production; e.g. cost of raw
TF materials, wages.
C
◼ Normally TVC is like a straight
O
Quantity line starting from origin.
◼ TVC may be an inverse S
Cost TC shaped upward sloping curve,
s TV due laws of variable
C proportions.
◼ Total cost (TC)
TF ◼ Sum of TFC and TVC

C ◼ Slope of TC curve is
O determined by that of the TVC.
Quantity

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Average and Marginal Cost

• Average Cost (AC) is total cost per unit of output.

• Average Fixed Cost (AFC) is fixed cost per unit of output.

• Average Variable Cost (AVC) is variable cost per unit of output.

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 Average and Marginal Cost…..

• Marginal cost (MC) is the change in total cost due to a unit change in
output.
• MCQ= TCQ- TCQ-1

• Since the fixed component of cost cannot be altered, MC is virtually the

change in variable cost per unit change in output.
• Also known as rate of change in total cost.

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Cost Output Relationship in the Short
Run

• Average Fixed Cost and Output

• Average Variable Cost and Output

• Average Total Cost and Output

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Cost Output Relationship in the Short
Run
MC

Cost
AC

AVC

AFC
O
Output

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 Relationship Between AC & MC

• When average costs decline, MC lies below AC.

• When average costs are constant (at their minimum),

MC equals AC.
• MC passes through the minimum point of AC curves.

• When average costs rise, MC curve lies above them.

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Relationship Between AVC, ATC & AFC
• If both AFC & AVC fall, ATC will fall.
• If AFC falls but AVC rises;
a) ATC will fall where the drop in AFC is more than the rise in AVC.
b) ATC will not fall where the drop in AFC is equal to the rise in AVC.
c) ATC will rise where the drop in AFC is less than the rise in AVC.

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Average and Marginal Cost Functions
Contd…

• AC curve is U shaped
MC • When both AFC and AVC fall, AC
also falls and later starts increasing.
AC/MC
AC • When average costs decline, MC
lies below AC.
AVC
• When average costs are constant
(at their minimum), MC equals AC.
• MC passes through the minimum
point of AC curves.
• When average costs rise, MC curve
AFC lies above them.
O • When both AC and AVC fall, MC lies
Quantity below them.
27
Cost Analysis
Business Economics
 Average and Marginal Cost Functions
Contd…

• AC curve is U shaped
MC • When both AFC and AVC fall, AC
also falls and later starts increasing.
AC/MC
AC • When average costs decline, MC
lies below AC.
AVC
• When average costs are constant
(at their minimum), MC equals AC.
• MC passes through the minimum
point of AC curves.
• When average costs rise, MC curve
AFC lies above them.
O • When both AC and AVC fall, MC lies
Quantity below them.
 Costs in Long Run in Long Run
• All costs are variable in the long run since factors of production, size of
plant, machinery and technology can be varied in the long run.
• The long run cost function is often referred to as the “planning cost
function” and the long run average cost (LAC) curve is known as the
“planning curve”.
• As all costs are variable, only the average cost curve is relevant to the
firm’s decision making process in the long run.
• The long run consists of many short runs, therefore the long run cost
curve is the composite of many short run cost curves.

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Costs in Long Run

◼ In the long run the firm may increase plant size to increase output.
◼ As output is increased from q0 to q1 capacity at SAC1 is overworked.
◼ Hence the firm to shifts to a higher plant size SAC1 to SAC2.
◼ This shift would lower the average cost of the firm.
◼ The same process would be repeated if the firm increases its output
further to q2.
AC, MC MC1 MC2 MC3 SAC3
SAC SAC2
LAC
1

O q1
q0 q2 Quantity 31
Long Run Average Cost

• The LAC function can be shown as an envelope curve of the short run cost
functions.
• LAC curve envelopes SAC1, SAC2, SAC3, showing the average cost of production
at different levels of output turned out by plants 1, 2 and 3.
• Each of the SAC curves represents the cost conditions for a plant of a
particular capacity.
LMC
SMC1 SMC3 SAC3
AC, MC SAC1
SMC2
LAC
SAC2

O q0 q* q3 32
q1 Quantity
Long Run Marginal Cost

• Long run marginal cost (LMC) curve joins the points on the short run
marginal cost (SMCs) curves that are associated with short run average
costs corresponding to each level of output on the LAC curve.

• The optimum plant size is II, assuming sufficient demand.

• Optimal level of output is Oq*, where long run and short run marginal
and average costs are all equal.

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Long Run Marginal Cost

• LMC must be less than LAC when the LAC is decreasing

• It would be equal to LAC when the LAC reaches its minimum.

• LMC is greater than LAC when the LAC is increasing.

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Cost Analysis
Business Economics
Costs of a Multi Product Firm

• Assuming that a multi product firm manufactures two goods, with the same
plant and machine.
• Total cost (TC) of production would be the sum of TFC and the total of variable
costs (C1 and C2) of producing both the products. Q1 and Q2 are the quantities
of these two goods.
TC= TFC+C1Q1+ C2Q2
• If the two products are produced in fixed proportions, then we can use the
concept of weighted average cost (ACw) defined as:
F + C1 ( X 1Q) + C2 ( X 2Q)
ACw (Q)= Q

(where X1 and X2 are the proportions in which products 1 and 2 are produced
(or the weights used in calculating average costs) and Q is the total output. )

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Costs of Joint Products

• Two or more products undergo the same production process up to a

split off; i.e. if one good is produced the other will automatically be
produced; e.g. agriculture, minerals.
• Common costs
• Cannot be identified with a single joint product.
• Separable costs
• Can be identified with a particular joint product.
• Incurred for the product separated beyond the split off
point.

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Linkage between Cost, Revenue
and Output
Total Revenue (TR)
• The total amount of money received by a firm from goods sold (or services
provided) during a certain time period.
TR=Q.P, where Q is the quantity sold and P is the price per unit.
Average Revenue (AR)
• Revenue earned per unit of output sold.
AR=TR/Q =P
Marginal Revenue (MR)
• Revenue a firm gains in producing one additional unit of a commodity.
• Calculated by determining the difference between the total revenues produced
before and after a unit increase in production.
MRQ= TRQ- TRQ-1; or
dTR
MR= dQ
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 Relationship between TR and MR

Price, • TR will be zero when nothing is

Reven
ue sold, and zero again when a great
deal is sold at a zero price.
• It has the shape of an inverted U,
starting from the origin, and
O dipping across the quantity axis
TR Quanti after reaching a maximum.
Price, ty
• Rise in the total revenue curve is
Reven
ue the change in total revenue with
rise in level of output.
• MR is the slope of the TR curve.
O
Quanti
MR ty
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Relationship between AR and MR

• AR curve can have the following positions:

• AR is a straight line, MR will lie midway to AR (Panel a)
• AR is convex to the origin, MR will lie less than midway to AR (Panel b)
• AR is concave to the origin, MR will lie more than midway to AR (Panel c)

MR MR MR
/A /A /A
R R R

A A
M R MR AR
M R
R
O R Quantit
O Quanti Quantit O

ty
Panel a y
Panel b Panelyc
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Cost & Revenue Analysis
Break Even Analysis
Business Economics
Break Even Analysis

• Examines the relation between total revenue, total

costs and total profits of a firm at different levels of
output.
• Used synonymously with Cost Volume Profit Analysis.
• Breakeven point is the point where total cost just
equals the total revenue, in other words it is the no
profit no loss point.

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Approaches to break even analysis:

•Algebraic Method
• If P be the price of a good, Q the quantity produced’ the
breakeven output is where total revenue equals total cost
(Q* ).
Total Revenue= P.Q
Total Cost= TFC+TVC = TFC+AVC.Q
P.Q*=TFC+AVC.Q*
(P-AVC)Q*=TFC
Q*= TFC
P − AVC

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 Break Even Analysis

• Graphical Method
Cost, TR • Plot TR and TC on the Y axis and
Reven output on the X axis.
ue • TC is a straight line because AVC is
T assumed to be constant
C • Total revenue is proportional to
E output and the TR curve is a straight
line through the origin.
V
• Shows the profit (or loss) resulting
C from each level of sales by the firm.
F
• Valuable information on projected
C effect of output on costs.

O Quanti
Q
* ty

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When is Break even analysis used?

• Starting a new business

• Creating a new product
• Changing the business model

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Breakeven analysis is useful for the following
reasons
• It helps to determine remaining/unused capacity of the company
once the breakeven is reached. This will help to show the maximum
profit on a particular product/service that can be generated.
• It helps to determine the impact on profit on changing to automation
from manual (a fixed cost replaces a variable cost).
• It helps to determine the change in profits if the price of a product is
altered.
• It helps to determine the amount of losses that could be sustained if
there is a sales downturn.

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Benefits of Break-even analysis

• Set revenue targets

• Make smarter decisions
• Fund your business
• Better Pricing
• Cover fixed costs

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Economies of Scale
• Economies of scale refers to the efficiencies associated with larger
scale operations
• This level is reached once the size of the market is large enough for
firms to take advantage of all economies of scale.
• Two types of economies of scale:
• Internal economies (which occur to the firm due to large size of operations);
• e.g. Division of labour/ specialization, Financial economies, better
managerial functions.
• External economies (which occur due to expansion of the industry, and the
firm also benefits).
• Technological advancement, development of infrastructure pool of
skilled workers

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Economies of Scope

• When the production capacity can be utilised for producing more than one
goods, average costs are less as compared to when they are produced by
different firms separately; e.g. Computers and printers; heavy vehicles and
light vehicles.
• Practice of economies of scope to business strategy is heavily based on the
development of high technology.
• Globalization has made such economies even more important to firms in their
production decisions.
• Measured by the ratio of average costs to marginal costs, when the firm
produces joint or multiple products.
• Assume three products at individual costs of C1, C2 and C3, while Ct is the
total cost when the three activities are carried out together, the Scope Index
(S):

(C 1 + C 2 + C 3 − C t )
S=
C1 + C 2 + C 3

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Summary

• Any production process must incur costs. Direct or variable costs vary with the level of
output; fixed costs remain at the same level, irrespective of the rate of production.
• The costs of a firm include accounting, real and opportunity costs. Financial
management recognizes only accounting costs or nominal cost that can be recorded in
the books of accounts.
• The short run is the period within which some obligations associated with
management, plant, and equipment are not alterable by changing the firm's
managerial capacity or scale of operations.
• In the long run all aspects of the firm's operations can be adjusted; so all costs are
variable in the long run.
• The long run average cost (LAC) curve is a planning horizon, which envelopes the firm's
short run AC curves associated with different plant sizes.
• Determination of the average cost of a multi product firm can be done with the method of
weighted average cost, if the two products are produced in fixed proportions.
• Allocation of common costs to the joint products can be done by physical measure of
outputs or by sales value at the spilt off point.
• Breakeven analysis deals with determining profit at various projected sales volume
levels, identifying the breakeven point, and making a managerial decision regarding the
relationship between likely sales and breakeven point.
Summary
• Total Revenue is the total amount of money received by a firm from goods sold (or
services provided) during a certain time period. Average Revenue is the revenue
earned per unit of output sold.
• Marginal Revenue is the revenue a firm gains in producing one additional unit of a
commodity. Profit is the difference between Total Revenue and Total Cost; the profit
function shows a range of outputs at which the firm makes positive (or supernormal)
profits.
• Economies of scale refer to the efficiencies associated with larger scale operations; it
is a situation in which the long run average costs of producing a good or service
decrease with increase in level of output.
• Economies of scope refer to a situation in which average costs of manufacturing a
product are lower when two complementary products are produced by a single firm,
than when they are produced separately.
• Learning by doing refers to the process by which producers learn from experience,
while technological change is an increase in the range of production techniques that
provides new vistas to producing goods.

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