Cost Analysis

Meaning
• In ME, cost is normally considered from the producer’s pt.of
view .
• In producing a commodity(or service), a firm has to employ an
aggregate of various factors of production such as land,
labour,capital and entrepreneurship.
• These factors are to be compensated by the firm for their efforts
or contribution made in producing the commodity.
• This compensation (usually in terms of factor price) is the cost.
• Thus, the cost of production of a commodity is the aggregate of
price paid for the factors of production used in producing that
commodity
 Contd.
• The term cost has various concepts. These are (i) Real cost
(ii) Opportunity cost; (iii) Money cost
• The term “real cost of production” refers to the physical
quantities of various factors used in producing a
commodity.
• Opportunity Cost or Alternative cost- The real cost of
production of something using a given resource in an
objective sense in the benefit forgone (or opportunity lost)
of some other thing by not using that resource in its best
alternative use.
 Money cost
• Cost of production measured in terms of money is called
the money cost.
• Money cost is the monetary expenditure on inputs of
various kinds –raw materials, labour, etc.,required for the
output.
• It is the money spent on purchasing the different units of
factors of production needed for producing a commodity.
• Money cost is the outlay cost, i.e., actual financial
expenditure of the firm.
 Explicit and Implicit Cost
• Explicit and Implicit costs.
• Explicit costs are direct contractual monetary payments
incurred through market transactions.
• Implicit costs are the opportunity costs of the use of factors
which a firm does not buy or hire but already owns.
• Implicit costs are- (i) Wages of labour rendered by the
entrepreneur himself
(ii) Interest on capital supplied by him
(iii) Rent of land and premises belonging to the entrepreneur
himself and used in his production.
 Types of Production Costs and their
measurement
• Fixed Cost (FC)- Fixed costs are those costs which remain
fixed ,irrespective of the output.Fixed costs are also called
Supplementary costs or Overhead or Direct costs.
• Variable Cost (VC)- Variable costs vary with the
output.Variable costs are also called Prime costs ,Direct
costs or Operating costs
• Total Cost (TC)- TC is the aggregate (sum total) cost of
producing all the units of output. TC=TFC+ TVC
• Average Cost (AC)- The Average Cost is the cost per unit
of output produced. AC=TC/Q
• Average Fixed Cost (AFC)- The Average Fixed Cost is the
fixed cost per unit of output. AFC= TFC/Q
• Average Variable Cost-It is the variable cost per unit of
output. AVC=TVC/Q
 Average Cost Curve in the Short-
Run
• The average cost is the sum total of AFC and AVC .
• The AC curve is the summation of the average fixed and
variable cost curves.
• AC= AFC + AVC
• The U-shape of Average Cost Curve is explained in two
ways:
i) The Geometrical explaination
ii) The Theoretical explaination
 Marginal Cost

• Marginal Cost is the net addition to total cost for

producing an additional unit of output.
• MC= TCn – TCn-1
• MC only depend upon variable cost
• MC are independent of fixed costs
• MC= ∆TC/ ∆Q
 Important formulas
• AFC= TFC/Q
• AVC = TVC/Q
• AC= AFC + AVC
Or = TC/Q
• MCnth = TCn – TCn-1
 Relation between AC and MC

I When AC is falling, the MC lies below it.

II Secondly MC cuts the AC at the lowest point of AC curve
III Thirdly, when AC curves begin to rise, the marginal cost
curve will be above the AC curve showing that MC rises
faster than the AC curve.
 Long-run Average Cost Curve
• In the long run all the factors are variable.
• All costs are variable costs.
• The concepts of average cost and marginal cost are the only
ones relevant for the long run.
• The firm plans its course of action in the long run
• While doing so it takes into account numerous aspects of the
short run.
• Therefore, long run compromises of all possible short run
situations
• The LAC envelops a number of short run average cost curves.
 Features of LAC
1. It is tangent to a number of short run average cost
curves. Hence it is called as a tangent curve.
2. It is also called as “Envelope Curve” as it envelops a
group of short-run average cost curves relevant to
different levels of output.
3. It is also termed as the long run planning device as it
indicates the least unit cost of producing each possible
level of output.
4. The cost levels represented by LAC indicate the
minimum cost combinations of inputs to be used by the
firm at each long-run level of output.
 Contd.
• The LAC curve is less U shaped or rather dish shaped.
It implies that in the beginning it gradually slopes downwards
and then after reaching a point it gradually begins to slope
downwards and then after reaching a point it gradually
begins to slope upwards.
 Learning and Cost
• According to James L.Pappas and Mark Hirshey “ The
learning curve (also known as experience curve)
phenomenon has an effect on average costs similar to that
for any technological advance that provides an
improvement in productive efficiency”
• Learning through experience in production enables the
firm to produce output more efficiently and economically
at each and every level of output.
 Other Concepts of costs
• Private and Social costs
• Historical Cost and Replacement Cost
• Opportunity Cost(Alternative or transfer cost)
• Cost of Multiple Products