Module –3

Theory of Cost
• In business and accounting, cost is the monetary value that
a company has spent in order to produce something.
• Cost may be defined as the amount of expenditure
incurred on or attributable to a given thing.
• Cost denotes the amount of money that a company
spends on the creation or production of goods or services.
• The cost function of a firm shows a relationship between
output produced and the associated cost of producing it.
Hence costs are nothing but input prices.
 Cost Concept
• It is necessary for business executives to make
use of the cost concept for the following purpose.
• Determination of profits
• Payment of Tax
• To fix bonus
• To calculate dividend
• To know how much of goods to produce and sell.
 Actual cost
• Actual cost is the actual expenditure incurred
for producing a commodity or service.
 Actual wages paid
 Cost of materials purchased
 Interest paid etc. These costs are generally
recorded in the accounts books.
 Opportunity cost
• Life is full of choices. In choosing one thing we
must give up something else.
• Opportunity cost is the benefit forgone by
rejecting one course of action to another.
 Incremental costs/ Differential costs
• As name implies, incremental cost is the additional cost due to change in
the level of the business activities or the nature of the business activities.

• For example, if the cost of alternative A is Rs.10,000 per year and the cost of
alternative B is Rs.8,000 per year. The difference of Rs.2,000 would be
differential cost. The differential cost can be a fixed cost or variable cost.

The changes in business activities are obtained as follows.

 Addition of new product line.
 Change in channel of distribution
 Installation of new machines.
 Replacing old machines by better new machines
 Expansion in other markets.
 Sunk Cost
• The cost incurred by a decision which cannot be recovered is called as a
sunk cost.
• Sunk cost once incurred cannot be retrieved.
• Sunk cost is just like fixed cost. It is not affected by the change in the
level or the nature of the business activities.
For example, a company purchased a machine several years ago. Due
to change in fashion in several years, the products produced by the
machine cannot be sold to customers. Therefore the machine is now
useless or obsolete. The price originally paid to purchase the machine
cannot be recovered by any action and is therefore a sunk cost.
 Acquisition cost
 Service and maintenance costs.
 Space occupying costs( Manpower, electric power and raw materials.)
 Marginal cost
• To know how much should be produced and sold, a firm should
know its marginal cost of producing goods and services.
Marginal cost is the extra or additional cost of producing 1
extra unit of output.

E.g If a firm is producing 500 pen drives (USB) devices)

Total cost of producing 500 pen drives = Rs 25,000/-
Total cost of producing 501 pen drives = Rs 25090/-
Difference = Rs 90/-
Then the margianl cost of production is Rs 90/- for 501 pen drive.
Usually in economics, Margianl means extra or incremental.
 Average cost (AC)or unit cost
• Average cost is total cost divided by the
number of units produced.

Average cost = Total cost = TC

Output Q
 Fixed cost and Variable cost
Fixed costs
• Fixed costs are sometimes called as overhead costs
or overhead. Fixed cost are the costs involved in
 Capital for building and equipment
 Rents of the building, office and Go down.
 Salaries of permanent employees.
 Depreciation cost
 Servicing and maintenance cost
 Government Taxes.
 Y

Fixed Cost
•
Cost

O Output X

• The fixed cost must be paid even if the firm does not produce the
output. They will not change if the output changes. Therefore the fixed
costs are the fixed amount of cost that should be paid irrespective of
the level of output.
 Variable cost
• Variable costs are the costs that vary with the level of output.
Variable costs vary in direct proportion to the volume of production.
Therefore if the output increases, then the variable cost increases. If
the output decreases, then the variable cost decreases.

• Salespeople are paid a commission only if they sell products or

services, so this is clearly a variable cost.

 Steels cost and fiber cost to produce cars

 Production oriented temporary workers salary for production lines.
 Electric power to operate factories and so on.
 The variable cost is zero, when output is zero.
 Y

o st
Cost e c
b l
ria
Va

O Output X

Total cost
We get total cost by adding Fixed cost and variable cost
TC = FC + VC
 Semi variable cost
• These costs are neither Fixed costs nor variable costs. These
costs fall in between fixed costs and variable costs.
• E.g . Salesman will earn monthly salary whether he attains the
target or not. Even though he sells nothing, he will get salary.
If he sells more than the target, then he will get commission
related to sales volume.

Y Cost
r ia ble
i Va
Sem
Variable component

Fixed Component

O X
 Shut Down Point
• Economic losses motivate organizations to shut
down.
• shutdown point is a point of operations where
a company experiences no benefit for
continuing operations or from shutting down
temporarily; it is the combination of output
and price where the company earns just
enough revenue to cover its total variable
costs.
(1) (2) (3) (4) (5) (6) (7) (8)
Qty Fixed Variable Total Marginal Average Average Average
Q Cost Cost (VC) Cost Cost Cost Fixed Cost Variable Cost
(FC) TC= (MC) AC= TC AFC= FC AVC= VC
FC+VC Q Q Q

0 55 0 55 - - - Undefined

1 55 30 85 30 85 = 85 55 = 55 30 = 30
1 1 1

2 55 55 110 25 110 = 55 55 = 27.5 55 = 27.5

2 2 2

3 55 75 130 20 130 = 43.3 55 = 18.3 75 = 25

3 3 3

4 55 105 160 30 160 = 40 55 = 13.7 105 = 26.2

4 4 4
 Cost Output Relationship
• The cost output relationship can be analyzed
in two ways.
• Cost output relationship in short run
• Cost output relationship in long run
 Short Run Costs
• Short run costs vary with output when fixed
assets ( plant, capital and equipment) remain
the same.
• short run costs should be considered for
decision making for the immediate future.
• They decide whether to produce more or not
the immediate future.
 The cost output relationship in
short Run
It is analyzed by the following terms.
 Average Fixed Cost (AFC)
 Average Variable Cost( AVC)
 Average Total Cost (AC)
 Average Fixed Cost
• Since total fixed cost is constant, dividing it by
an increasing output gives a steady falling
average fixed cost curve.
• AFC = FC
Q
 Average Variable Cost Curve
• AVC first falls and then rises as more and ore
units are produced. So more the outputs, then
more will be the AVC.
• AVC=VC
Q
 Average total Cost Curve
• Average cost is total cost divided by the number of
units produced.

Average cost = Total cost = TC

Output Q
Total cost
We get total cost by adding Fixed cost and variable
cost
TC = FC + VC
 Cost output relationship in long run

Long Run Costs

• At the time of setting up the new plant the long run cost
will be considered. In addition, during expansion of the
new plant, the long run costs will be considered.
• Long run costs are helpful for planning the best scale of
plant or best size of the firm.
• Therefore the long run costs are useful for both opening
new industries and expansion of the existing firms.
 Break Even analysis
• The break even analysis is used to analyze the relationship
between cost volume and profit. It is also called as CVP( Cost
volume and profit).
• Break even analysis indicates at what level of output, costs and
revenues are equal.
• The break even point is most important in break even analysis.
• Break even point is that point of sales volume where total
revenues and total expenses are equal.
• It is a point of zero profit i.e stage of no profit and no loss.
• Production level below the break even point will result into loss
while production above break even point will result in profits.
The expression for BEP is developed as follows.
Let F = Fixed Cost per unit
V = variable Cost perunit
S = Selling Price per unit and
Q = Quantity( Volume of output)

Total Cost (TC) = Fixed cost + Variable cost= (F+V x Q)

Sales revenue (SR) = Selling Price per unit * Quantity = S x Q

The point of intersection of total cost line and the sales revenue is the break even point i.e at
Break Even point,

Total cost (TC) = Sales Revenue(SR).

F+(VxQ) = (SxQ)
F= (SxQ)–(VxQ)
F= Q(S-V)

Therefore break even point in units, Q= F units

(S - V)
Note:
• Total sales revenue = No of units sold * Selling price
per unit.
• Total sales Revenue – ( Fixed cost + Variable Cost) =
Profit/Loss
• At BEP, profit will be 0,
• When the no of units sold is less than BEP, there will
be loss and
• When the no. of units sold is greater than BEP, there
will be profit.
• The fixed expenses of a firm is Rs 400 per year.
The variable Cost per unit Rs.0.35 and selling
price is Rs. 0.5 per unit. If the budgeted sales
volume is 4000 units. Construct break even
chart and obtain breakeven point.
2500

2000 2000(Q, SR)

18000(Q, TC)
1500

1000
500
400

0 500 1000 1500 2000 2500 2667 3000 3500 4000

 Stages in the Product Life Cycle

From the birth to death each product passes four

different stages.
1. Introduction
2. Growth.
3. Maturity
4. Saturation
5. Decline.
We can represent the product life cycle by using a
graph.
1.Introduction
• Introduction stage starts when the new product is first
distributed and made available to the consumers.
• In this stage, profits are negative or low because of the low
sales and heavy distribution and promotion expenses.
• More money is needed to attract the distributors as well as
consumers.
• During this stage, the price of the new product shall also be
high because of the high costs, etc.
• Thus introduction stage is a period of heavy promotion,
demand creation and market capturing.
• Competition is low
• Sales is low
• Profit is low.
2.Growth
• Growth is a period of rapid market acceptance and increasing
profits because promotion costs are spread over a large volume.
• The main problem in this stage is to produce the product in
sufficient quantities and market the output with minimum delay.
• Competitors also enter into this filed during this stage. Therefore
the promotional expenditure also tend to be high during this
stage.
• Sales level is high
• Competition is very high.
• Profit level is high.
• Mass customers switch on to the product.
3.Maturity
• During this stage, competition becomes more acute. Sales
continue to increase but as a decreasing rate.
• Therefore the producers spend more on advertising and other
sales promotion measures to capture the market.
• Only firms with extremely effective marketing programe shall
withstand in this stage.
• The existing products should be improved; prices can also be
cut with a view to attract more customers and be compete with
other competitors.
• Levels of sales - high
• Profit - high
• Competition – high
• Customers- Mass customers.
4. Saturation:
• This is a period of stability.
• The sales of the product reach the peak and there is no further
possibility to increase it.
• During this stage, other competitors shall also become popular and
invade the market.

5.Decline:
• During this stage, sales began to decline.
• The decline in sales may be due to technological advances, consumers
shifts in taste and low competition- domestic and foreign.
• As sales and profit decline, some firms may withdraw from the market
Those remaining may reduce the number of their products.
• Sales – low
• Profit-low
• Competition-low.
 Market
• The place where the goods and services are
bought and sold is called as market.
• If there are so many buyers and so many
sellers in the market, then competition
prevails in the market.
• There are various types of market. A type of
market also refers to the type of competition.
 Market Structure
• Market structure refers to the competitive
environment within which a firm operates.
• Number of buyers and sellers substitutability, the
ease of entry and exist and level of competition
determine market structure.
• Economists divide market structure based on
competition into two basic types viz.
 Perfect Competition
 Imperfect competition
 Perfect Competition
• In theory, Perfect competition implies no rivalry
among firms.
• Perfect competition can be defined as a market
structure characterized by complete absence of rivalry
among the individual firms
• i.e perfect competition is a market structure where
there is a perfect degree of competition and single
price prevails.
• Small businesses such as convenience stores are an
example.
 Features of perfect Competition
 Homogeneous Product
 Large number of buyers and sellers
 Full Knowledge of Market
 Free entry and exist
 Advantages

• Only one price for a product will be existing.

• Buyers cannot be cheated.
• All firms will be getting nominal profit.
 Imperfect competition

• When the advantages and main characteristics

of perfect competition are absent, it implies
that imperfect competition is prevailing in the
market.
• The restaurant business in an example.
Imperfect competition is further classified as:-
 Monopoly
 Monopolistic competition
 Oligopoly
 Monopoly

• It implies that a single producer will sell a

particular product without having any competition.
• There will not be any substitute for the product.
• There will not be any other producer producing
that product.
• The single seller or group sellers will have the
power to control over the price to maximise the
profit.
 Characteristics of monopoly
• Single producer
• Single product
• No close substitutes
• No free entry to other producers
• Controlling power to maximize the profit and
quantity of products.
 Monopolistic Competition
• A monopolistic competition is defined as that market
structure in which each seller produces a differentiated
product.
• The concept of product differentiation means that the
product marketed by one seller can be distinguished from
the products marketed by other sellers in some form or
other.
• Some of the important methods of product differentiation
include trademarks , brand names, size, packing or color
etc. of the item and technical specifications.
 Product differentiation

Some product may be available in different

forms. Different brand products will be serve
same purpose.
E.g. for differentiated products are as follows:-
Cool drinks Soap Tooth paste
Pepsi Mysore Sandal Colgate
Miranda Lux Close up
Coke Hamam Pepsodent
Sprite Rexona
Limca
 Oligopoly
• In oligopoly competition few sellers produce
differentiated products which serve same
purpose.
• Differentiation occurs in so many products like
refrigerators, AC, shirts, medicines etc.
• Let us assume A and B are oligopolists If A
reduces his price, then consumers of B will rush
towards to A.
• The banking industry is an example.
 Cartel and collusion

Cartel:-
• A cartel is an agreement of cooperation formed between
competitors in a specific industry.
• Cartels are made up of companies in the same industry that
traditionally compete against each other,
• but who have realized that it is mutually profitable for all
players in the marketplace to work in cooperation to control
market conditions.
• E.g Organisation of Petroleum Exporting Countries (OPEC)
controls the production, distribution and prices of oil around
the world.
Collusion:-
• Collusion is a secretive agreement between
two or more organizations, formed with the
aim of gaining illegal mutual benefits.
• E.g , a super market selling a box of matches at
the same price as another supermarket is not
illegal unless it could be proven that the
supermarket is had a secret agreement to fix
the prices of match boxes at the same level.