COST ANALYSIS

Dr. ARUNA KUMAR DASH

IBS HYDERABAD
 Why Cost Analysis?
• Successful managers must compare the level of cost to revenue
to determine company’s profitability
• Cut costs or else…
• Big Companies: GM and GE pressured their suppliers to cut
costs or loose business
• Hotel Industry: In Covid 19 scenario, the hotel industry is
trying to reduce their cost for survival.
• The Airline Industry took a close look at costs after Sep. 9/11 terrorist
attacks on USA. Went for cutbacks in Schedules and work force. For
Example, American airlines in 2002 cut out all food service on
domestic flights.
• Entertainment industry: In Covid 19 scenario, the Entertainment
industry is trying to reduce their cost for survival. Their earning has
come down drastically because of lockdown and social distancing.
Hence, for sustainability of this industry they need to cut cost.
 General Observation
You as the manager of the company must cut the cost per unit
of your company. Thus

(1)Can sell your product at the same price as of your

competitors and thus earn benefit of greater price-cost
differential

(2)Lower the price and thus capture a larger market share

Cost Management:
The Effect of
Globalization and
Heavy Competition
I have Done It !
Cut Costs or Else Put
the shutters Down
Cutting Cost must be done
carefully: Not to Compromise
with Consumer’s Satisfaction

Consumer

Companies
 Types of Cost
Fixed Cost:
•The cost of employing fixed factors.
•Fixed Cost does not vary with the level of output in the short run.
•Fixed cost remains the same no matter how much output the firm
produces.
•Fixed cost must be paid even if there is no output.
•cost incurred in hiring fixed factors whose amount can not be
altered in the short run.
•Fixed cost include contractual rent, insurance fee, Property
taxes, Watchman’s wages, Machinery expenditure, Expenditure
on a plant, expenditure on Chairs, tables, fans and AC, payment
on borrowed capital, salary of the top management(that are fixed
by contract and must be paid over the life of the contract) whether
the firm produce or not.
•The only way the firm can eliminate fixed cost by going out of
business or shutting down the factory.
 Variable cost

 The cost of employing variable Factors.

Variable Costs change with changes in output in the short run
Variable Cost: Cost that Varies with the level of output in the
long run.
Variable costs are made only when some amount of output is
produced

Variable cost include wages, salary, raw material payments, fuel,

power, depreciation, labour cost, excise taxes etc.
 It affects marginal cost
Opportunity Cost: The cost of next best alternative foregone
•It is known as opportunity lost
•Eg. The opportunity cost of going to college is the money you
would have earned if you worked instead
•The opportunity cost of loosing 2 years of salary while doing
your MFC degree

Social Costs: The Cost that the Society bears because of

Companies activities. Air pollution, Noise, Garbage etc are the
costs for Societies.
Sunk Costs: Expenditure that has been already made and
can’t be recovered.
Eg. Litigation issue of a Highrise apartment near the
catchment area and you have booked your flat there. You
cant recover that money. Your building has no alternative
uses.
Eg. After 10th exam you decided to join science stream.
But after 1 year you changed your mind to move to
commerce stream. Hence, the money you have spend for
one year is known as sunk cost and you cant get it back .
Eg. Research and development expenditure to develop
Covid 19 vaccine. The expenditure on this equipment is
sunk cost If you failed to develop that, your entire money
has gone.

It should have no effect on any present or future

decisions.
Explicit Costs:
•It is the cost of all incurred expenditure.
•purchase of raw materials it require inIt refers to the
actual expenditure of the firm to hire labour (paid wages),
the rental price of hiring capital equipment's, payments
made for the the production.
•Explicit (Accounting) Cost: This is contractual cash
payment which a company makes to other factor owners
for using their services. Rent + Wage + Interest

Implicit Costs:
The cost of self employed inputs which are not entered in
the book of accounting. For example using your own land,
own labour, own machinery in your production process.
Though you are not paying any money to them but they
have market value.
Accounting Costs:
Accounting costs are the explicit costs, that are seen as money out of
your bank account that you need to run your business.
 These are production costs, lease payments, marketing budgets and
payroll.
In other words, these are the real costs in manufacturing, marketing and
delivering your products.
Eg: The accounting cost of attending a college include tuition fee, hotel
room charges, books, food and other expenditure.
Economic Costs:
Economic cost is the combination of explicit cost and implicit cost.
The economic cost of a college is the accounting cost plus
opportunity cost.
Operating cost are costs associated with the day-to-day
operations of a business. These costs can be either fixed or
variable depending on the unique situation.

Semi variable cost: Electricity cost. If you are not using

electricity, you are paying the minimum charge. If you are
using more you have to pay more.
Cost function describes the relationship
between cost and output.

Output

=?
Measure of costs
Output changes  Cost changes
Change in cost can be expressed in three ways:
Total cost (TC)
Average cost (AC)
Marginal cost (MC)
 Total cost (Total Fixed Cost)
 is the whole amount of payments to all factors used
in producing a given amount of output (Q). Total cost is
the combination of total fixed cost and total variable
cost. That is TC=TFC+TVC.

 Total fixed cost (TFC): is the whole amount of

payments to fixed factors.

 Total variable cost (TVC): is the whole amount of

payments to variable factors.
Formula:
Assume two factors only: Capital (fixed factor) and
labour (variable factor)

Total Cost: TC = TFC +TVC

• total fixed cost: a constant independent of output

• total variable cost: dependent of output

Average cost/average total cost (ATC)
Formula:
Average Total Cost:
TC TFC  TVC
ATC    AFC  AVC
Q Q

TFC
average fixed cost: AFC 
Q
Marginal Cost

• marginal fixed cost (MFC): is the change in fixed cost

for producing an additional unit of output

• marginal variable cost (MVC): is the change in variable cost

for producing an additional unit of output.
 Short Run Vs. Long Run Cost
• Short Run: Some factors are variable and Some factors are Fixed.
Variable Factors: Labor, Raw Materials, Chemicals etc. Fixed
factor: Capital Equipment and Building and Top Management
personnel etc.
• In short run we have Fixed cost and Variable Cost

• Long Run: Quite Enough a time to vary all the Factors with the
Change in the output level. Hence, in the long run, all cost is
variable.
• In long run, Cost means the cost incurred in hiring the variable
factors because all factors are variable in long run
Relationship between short run production function and short
run cost

Total
 Relationship between short run production function and short
run cost

 When output(Q) is zero, the total variable cost is zero

 When increase in output, the variable cost increases at a
diminishing rate(that is because of increasing return to factor)
 Further increase in output after some point, the variable cost
increases at an increasing rate(that is because of decreasing
return to factor)
 Short run Total Cost

Output Total Fixed Total Variable Total Cost(TC)

Cost(TFC) Cost(TVC)
0 10 0 10
1 10 10 20
2 10 15 25
3 10 18 28
4 10 30 40
5 10 60 70
 Short run Total Cost
In Short run Total Cost (TC): TC = TFC + TVC

Cost
 Important Points

• Short run total cost (STC) is function of Output

• STC is obtained by adding up vertically total fixed cost
curve(TFC) and total variable cost(TVC)
• The Distance between TVC and TC is Constant throughout
because of constant TFC
• The Distance between TFC and TC is Increasing as the Output
Increases because of Variable TVC
 Average Fixed Curve (AFC)
TFC
AFC 
q
Where q represents output

TFC Output(Q) AFC

10 0 -
10 1 10
10 2 5
10 3 3.3
10 4 2.5
10 5 2
 Average Fixed Cost
AFC never touches either axis
AFC Takes the form of Rectangular Hyperbola
AFC continuously diminishes and it can’t be
negative. The shape is like this because total
cost is constant and output is increasing.
Hence, AFC is downward slopping.
AFC is infinity when Q=0
AFC can’t be zero and negative
 Average Variable Cost
TVC
AVC 
q
Where q represents output
AVC is variable cost per unit of output
AVC falls as output increases due to the occurrence of
increasing returns to factor. Production increases at an
increasing rate. Hence cost falls.
It reaches minimum
AVC Rises steeply because of the operation of
diminishing returns to factor. Output increases at a
diminishing rate (Hence, cost increases)
 Average Variable Cost
• The average variable cost curve is U-shaped. Average variable cost is
relatively high at small quantities of output, then as production increases, it
declines, reaches a minimum value, then rises.
 Average Variable Cost
• AVC and AP are inversely related

• AVC will decrease as AP Increases

• AVC will increase as AP decreases

• AVC will be minimum when AP is maximum

Average Total Cost(ATC)
As you know average total cost is the combination of average fixed cost and
average variable cost. Point A to B represents Average fixed cost(AFC) and
point B to C is represents Average variable Cost(AVC). Remember ATC and
AVC is U shape where as AFC is not.

ATC
C C

B
 Average Total Cost

TC TVC  TFC
AC    AVC  AFC
q q
Some Points:
In the beginning, AVC and AFC AC
Fall, so AC Falls A
V
AVC rises but AFC steeply C
falling outweighs the rise in AVC
which leads to fall in AC
AVC rises steeply offsetting the
fall in AFC which leads to rise in AFC
AC
Output
 Marginal Cost
• Marginal Cost is addition to total cost because of the
production of one additional unit of output

TC
MC 
q

Marginal Cost is the addition to the total variable costs

It is independent of the fixed costs
Marginal Cost is the Slope of the Total Cost Curve
 Computation of Marginal Cost

Output Total Cost Marginal Cost

0 100 _
1 125 25
2 145 20
3 160 15
4 180 20
5 206 26
6 236 30
7 273 37
 Marginal Cost
Important Points
• MC and MP of variable factor, say Labor, is
inversely related
• The Shape of the MC Curve is determined the
Law of Variable Proportions
• MP rises, MC falls
• MP reaches Maximum, MC becomes Minimum
• MP falls, MC Rises
Relationship Between Average Cost and
Marginal Cost

• Marginal Cost < Average Cost, Average cost Falls

• Marginal Cost > Average Cost, Average Cost Rises

• Marginal-Average Relationship is Mathematical Truism. Example in

the Next Slide
 Sachin Tendulkar: The
Greatest Batsman the
World has Ever
Produced.
Batting Average (Test):

 
57
Next Innings (Marginal
Score): 50 Less Than the
                     Average Score
                              
Average Score will Fall
Generalization :
If Marginal < Average
then Average will Fall
Batting Average
(Test): 57
Next Innings
(Marginal Score):
100 Greater Than
the Average Score
Average Score will
Rise
Generalization :
If Marginal >
Average then
Average will Rise
Batting Average
(Test): 57
Next Innings
(Marginal Score): 57
equal to Average
Score
Average Score will
be Same
Generalization :
If Marginal =
Average then
Average is Same
Relationship Between Average Cost and
Marginal Cost
 Relationship

• When output is zero AC and MC are undefined

• When MC falls, AC also falls (MC< AC)
• When MC=AC, AC is minimum
• When MC rises, AC also rises (MC >AC)
Long Run Cost Curves
• Long Run Average Cost Curve: curve relating average cost of
production to output when all inputs are variable.

Short Run average Cost Curve: curve relating average cost of

production to output when level of capital is fixed.

Long run marginal cost curve: curve showing the changes in long run
total cost as output increased by 1 unit
Long run Average Cost Vs. Short run Average
cost

LTC/
 Reason behind the shape of the LTC
LTC curve increases at a diminishing rate up to point A that is
because of increasing return to scale. Increasing return to scale
means when you are increasing the inputs, the output
increases more than proportionately. More clearly, the output
is more than double while doubling the inputs. Keeping the
input prices constant, as output is increasing more in
comparison to inputs, the per unit cost diminishes. Up to point
A, the company enjoys economies of scale. After point A,
LTC increases at an increasing rate. That is because of
decreasing return to scale. Decreasing return to scale means
output increases less than proportionately in comparison to
inputs. Keeping the input prices remaining same/constant, as
output grows less than proportionately compared to inputs, the
per unit cost increases.
 Long Run Average Cost (LAC)
• LAC is the long run total cost divided by the level of output.
• In long run, a company has different plant size having
corresponding short run average cost curves
• LAC depicts the least possible average cost for producing all
possible levels of output.
• LAC is thus the locus of the tangency points with short run
average cost curves
 Why LAC is U-shaped in General?
• Each segment of the long run average cost curve reflects a
particular returns to scale.
- Falling part of LAC implies increasing returns to scale
(Economies of scale)

• Rising part of LAC implies decreasing returns to scale

(Diseconomies of scale)

• Minimum part of LAC implies constant returns to scale

(Exhausted Economies of Scale)

• The LAC is U shaped in economic theory because of the

assumption that technology is unchanged.
Breaking LAC into Three Parts such as
Figure A,B and C

Figure A

A
Point A to B corresponds to
increasing return to scale.
Increasing return to scale means
B decreasing cost.
 Figure B

Figure C

Constant return to scale means cost per units are the same for any level of output.
Decreasing return to scale means increasing cost.
By joining the Figure A, B and C , we will get LAC. Three possible shapes of LAC (U
shape, L shape and constantly declining)
 L-Shaped Average Cost: Frequently Confronted

• In some industries fixed start-up costs generate falling

average cost or increasing returns to scale.
• This seems to be the case in the cement industry: see Figure
in Next slide
Average Cost of Cement Companies

In the beginning, it falls

rapidly
It remains flat throughout
after a point or slope gently
downwards at its right hand.
No rising portion
 Reasons of L-Shaped LAC: Resolving the Contradiction
between Theory and Empirical Evidence

(1) Technological Progress

• The LAC is U-shaped in economic theory because of the
assumption that Technology is unchanged
• In real world Technological Progress takes place over period
of time and thus LAC will shift downward overtime
• Technological progress is rapid enough to reduce unit costs
outweighing the rise in unit costs due to the management
problem
 (2) Learning by Doing (Learning Curve)
• With greater production, a company learns to produce a commodity
more efficiently and thus cost per unit declines

Cost will be
reduced as both
Per unit cost

management and
labor become
more familiar
with the
production
process

Cumulative output
 Learning curve continues
• Learning curve describes the relationship between a firm’s cumulative output
and the amount of inputs needed to produce each unit of output.
As management and labour gain experiences with production, the firms marginal
and average costs of producing a given level of output fall for following reasons.
Worker often taken longer to accomplish a given task the first few times they do
it. As they become more adept, their speed increases
Managers learn to schedule the production process more effectively, from the
flow of materials to the organization of the manufacturing itself
Engineers who are initially cautious in their production design may gain
enough experience to be able to allow for tolerances in design that save costs
without increasing defects.

As a consequences, a firm “learns” over time as cumulative output increases.

Managers can use this learning process to help plan production and forecast
future costs.
The learning curve is crucial for a firm that wants to predict the cost of producing
a new product.
Learning Curve Example
• Aircraft industry(Air bus), where studies have found learning rates that
are as high as 40 percent. It is found that producing 10 to 20 airplanes
require far more labour to produce than the hundredth or two hundredth
airplane. Also note how the learning curve flattens out after a certain
point, in this case nearly all learning is complete after 200 airplanes have
been built.

• Manager can use learning curve information to decide whether a

production operation is profitable and, if so, how to plan how large the
plant operation and the volume of cumulative output need be to generate
a positive cash flow.
 Long run Average and Marginal Cost
Like short run average cost curve, the long run average cost curve is U shaped, but
the source of the U shape is increasing and decreasing return to scale , rather than
increasing and diminishing return to a factor of production

when LAC is falling , LMC lies below the LAC and when LAC is rising, LMC
lies above LAC. when LAC is falling LMC is lower than LAC. Conversely,
When LAC is increasing, LMC is greater than LAC.
Two curves intersect each other at point A, where the long run average cost curve
achieves its minimum. In the special case in which LAC is constant, LAC and
LMC are equal.
 Optimum Plant, Optimum Output,
Optimum Company
• What is optimum plant?
The plant, the minimum point of whose short-run average cost curve coincides
with the minimum point of the long run average cost curve. It is the least-cost
Plant.
• What is optimum output?
The plant being efficiently utilized produces the output called as optimum
output
 LAC is Envelope of Short Run Average Cost
Curve
• LAC is not tangent to the minimum points of the short-run average
cost curves
• When the LAC is falling, LAC will be tangent to the falling
portions of the SACs
• When the LAC is rising , LAC will be tangent to the rising portions
of the SACs
• The LAC curve never lies above any of the short run average cost
curves.
• Larger output can be produced at the lowest cost with larger plants
and smaller output can be produced at the lowest cost with smaller
plants.
• LAC is envelope of short run average cost curve.
• With the presence of economics and diseconomies of scale, the
minimum point of the short run average cost curves do not line on
the long run average cost curves.
LAC is Envelope of Short Run Average
Cost Curve
 Return to factor Vs. Return to scale
Return to factor
1.It is in short run production
2.Here the proportion between fixed
and variable input changes
3.There are 3 types of return to
factor(IRF, DRF , NRF
4.In case of return to factor, there
are some fixed factor and some
variable factor
Return to Scale
1.It occurs in the long run production
2.Here the proportion remains
constant
3.There are three types of return to
scale(IRS, CRS and DRS)
4.In this case all inputs are variable
Return to Scale Vs. Economies of Scale: Lets
Start with an Example
You studied 1 hour and score 10 Marks in Math
You studied 2 hours and score 20 Marks in Math

Here your return from input is constant. It is constant return to scale

only. Return to scale is with respect to input only. Return to scale
means output in terms of physical quantity.

Now you studied 2 hours but you scored 40. It is like miracle. How it is
possible? This might be your parents are encouraging you to study,
they might have told you the reality of life, they might have given you
one new laptop with your favourite brand, new headphone, one single
room with new AC, all the food you like is given to you. Some of your
best friends are encouraging you on regularly basis. Because of all the
factor the miracle occurs. This is nothing but economies of scope.
Economies of scope means many other factors (Internal and external)
factors other than inputs. Internal factors are new AC, New Laptop,
headphone etc and external factors are here your friends
 return to scale and economies of scale

• Consider a dairy firm. Milk production is a function of cows, feed,

land, equipment's. A dairy firms with 50 cows are milked with labour
not equipment's. For example 50 cows are milked by hands. If all
inputs are doubled, a firm with 100 cows could double its milk
production. The same will be true for the firms with 200 cows, and so
forth. In this case there are constant returns to scale.

• Large dairy firms, however have the option of using milking machine.
If a large firm continues milking cows by hand, regardless of the size
of the firm, constant return would continue to apply. However, when
the firm moves from 50 to 100 cows , it switches its technology
towards the use of machine, and , in the process, it able to reduce its
average cost of milk production from Rs. 10 per litre to Rs 7 per litre.
In this case, there are economies of scale.
 Economies of Scale Vs. Economies
of Scope
What is Economies of Scale
In the long run, the industry/Firm may experience certain advantages in
terms of cost reduction and output expansion. These advantages while
producing a single product is known as economies of scale. Per-unit declines
in the cost of production as quantity of production increases. Economies of
Scale is a situation in which output can be doubled for less than a doubling of
cost. In other words, a doubling of output requires less than a doubling of cost.
These benefits can be internal and external. Economies of scale occurs in the
long run and hence all inputs are variable. Economics of scale refers to  the
benefits a firm gets due to large scale operation

Eg. Economies of scale is a rail road track, which carries 100 trains per day . The
total cost will be higher when it carries one train .
 Internal and External Economies of
Scale
(a)Internal Economies of Scale
Internal factors are controlled by a firm/ industry. The benefits/advantages
the firm is getting while producing a single product in the long run is called
internal economies of scale. The benefits on which the industry has control
are called internal economies. Advantages accrue to the company due
to the changes within the company. Cost per unit declines.

(b) External Economies of Scale

External factors are not controlled by the firm/industry. The benefits
appropriated to the industry due to the factors on which the industry has no
control on it. External economies of scale occur outside of a firm,
within an industry when an industry's scope of operations expand.
 Internal Economies of Scale

Production economics of scale- if the firm operates on a large scale, workers can
specialize in the activities at which they are more productive.
Research and Development expenditure: more efficient use of research &
development expenditure
Improvement in technology: better and specialized machines ( Gujrat
Ambuja case study example replacement of V belt to flat belt)
Tanning: to enhance knowledge and skills of the employee
Labor economies: Specialized Labors
Replacement of coal for crushed sugar cane ang ground not husk
Transportation economics of scale-Efficient transportation. More than 200
KM distance they preferred by train, water ways
Inventory economics of scale-Ware housing(inventory management)
Quality control-every half an hour. 48 times per day
Managerial economics of scale: By varying the combination of inputs utilized
to produce the firms output, manager can organize the production process
more effectively.
Internal Economies of Scale continued…..
Financial economies: Large firms receives loans easily
compared to smaller firms and receives bank loan at lower
interest rates than the smaller firms.
Marketing economies: spread high cost of advertising
more bargaining power: The firm may able to acquire some
production inputs at lower cost because it is buying them in
large quantities and can therefore negotiate better prices.
Advertisement cost- Due to frequent advertisement, cost per
unit decreases
PC Production

 R&D costs are much

lower per unit when
mass produced.
 Bulk purchasing
applies.
 Other reasons?
 4-function calculator
would cost about Rs
2500 if not for
economies of scale.
 External Economies of Scale

The benefits appropriated to the industry due to the factors on which

the industry has no control on it
Local skilled labor force available
Area with good transportation network
Area with good communications network
Government policy(reduction of tax rate) and increase in
subsidy
Decrease in crude oil and raw material price

Note: In case of economies of scale LAC continuously

declines till it reaches minimum.
 Diseconomies of Scale
Dis economies of scale: the disadvantages occurring to a firm while expanding its
output in the long run is called dis economies of scale. Hence, per unit cost
increases.
Or
Diseconomies of Scale is a situation in which a doubling of output requires more
than a doubling of cost. At some point, however, it is likely that the average cost of
production will begin to increase with output.

Internal Diseconomies of Scale

• Managing a larger firm may become more complex and inefficient as the number
of task increases.
• The advantages of buying in bulk may have disappeared once certain quantities
are reached. At some point, available supplies of key inputs may be limited,
pushing their cost up.
Internal Diseconomies of Scale continued

• Communication begins to break down

• Management is out of touch with production process
• Decisions are bogged down by too much red tape
• Poor labor relationships may develop
• Mismanagement
• Inventory mis management
• Employee employer relation
• Less incentive
• No proper recognition to talent and skills
 External Diseconomies of Scale

Local labor force becomes scarce. Higher wages are needed to attract
workers.

Rents rise as area grows.

Transportation congestion occurs as area grows.

In more general setting, the U shape average cost curve characterizes the
firm facing economies of scale for relatively low output levels and
diseconomies of scale for higher levels of output.

When cost increases proportionately with output, there is neither

economies nor diseconomies of scale. When there is economies of scale
marginal cost is less than average cost (both are declining). When there is
diseconomies of scale marginal cost is greater than average cost.
 Economies of Scope
Economies of scope: is a situation in which joint output of a single firm is
greater than output that could be achieved by two different firms when
each produces a single product.
The advantages occurring to the firm or industry while producing the
more than one output(multiple output) in the long run is known as
economies of scope.
Economies of scope refers to lowering of cost that a firm often
experiences when it produces two or more products together rather
than producing them separately.
For example Gujrat Ambuja case example (a) dry cement (b) Semi dry
cement (c) Weight cement.
Another example: Tata Group which produces car, SUV, Bus, trucks. The
techniques employed in producing in both commodities are sufficiently
similar.

Why Farmers does not produce a single variety of rice production?

Whether Economies of scale or economies of scope will occur first?
Thank You