Economics For Managers

Course No - 401

Rup Ratan Pine

01552438118
ahirmrittika@yahoo.com
Cost Analysis
 Concepts of Cost of Production

Production cost refers to the cost incurred by a business when manufacturing a good or
providing a service.

Production costs include a variety of expenses including, but not limited to , 

(a) Purchase of raw machinery,
(b) Installation of plant and machinery,
(c) Wages of labor,
(d) Rent of Building,
(e) Interest on capital,
(f) Wear and tear of the machinery and building,
(g) Advertisement expenses,
(h) Insurance charges,
(i) Payment of taxes,
(j) In the cost of production,
(k) the imputed value of the factor of production owned by the firm itself,
(l) The normal profit of the entrepreneur, etc.
 
 Concepts of Cost of Production

Production Cost:
  It includes material costs, rent cost, wage cost, interest cost and normal profit of
the entrepreneur.

Selling Cost:
It includes transportation, marketing and selling costs.

Sundry Cost:
  It includes other costs such as insurance charges, payment of taxes and rate, etc.,
etc.

Unit Cost:
A unit cost is the total expenditure incurred by a company to produce, store and
sell one unit of a particular product or service.
 Concepts of Cost of Production
Explicit Cost:
Explicit cost is also called money cost or accounting cost. Explicit cost
represents all such expenditure which are incurred by an entrepreneur to pay for
the hired services of factors of production and in buying goods and services
directly.

Implicit Cost:
The implicit costs are the imputed value of the entrepreneur's own resources and
services. Expenses that an entrepreneur does not have to pay out of his own
pocket but are costs to the firm because they represent an opportunity cost.

Real Cost:
Real costs are the pains and inconveniences experienced by labor to produce a
commodity. These costs are not taken in the costing of a commodity by the firm.
Real cost has been defined differently by different economists.
 Concepts of Cost of Production

Sunk cost:
Sunk costs are those that cannot be recovered if a firm goes out of
business. Examples: spending on advertising and marketing, specialist
machines that have no scrap value, and stocks which cannot be sold off.

Direct Cost:
Direct costs can be defined as costs which can be accurately traced to a
cost object with little effort. Cost object may be a product, a
department, a project, etc. Examples: Cost of gravel, sand, cement and
wages incurred on production of concrete.

Indirect Cost:
Costs which cannot be accurately attributed to specific cost objects are
called indirect costs. Examples: Cost of depreciation, insurance, power,
salaries of supervisors incurred in a concrete plant.
 Concepts of Cost of Production
Opportunity Cost:
The concept of opportunity cost has a very important place in economic analysis.
The value of a resource in its next best use. It is the amount of income or yield that
could have been earned by investing in the next best alternative.

Historical cost:
A historical cost is a measure of value used in accounting in which the price of an
asset on the balance sheet is based on its nominal or original cost when acquired
by the company.

Replacement Cost:
The amount needed to replace an asset such as inventory, equipment, buildings,
etc.
 Concepts of Cost of Production
Social cost:
Social cost is the total cost to society. It includes both private costs plus any
external costs.
• Example: Smoking
• If anyone smokes, the private cost is Tk.100 for a packet of 20 cigarettes. But,
there are also external costs to society - Air pollution and risks of passive
smoking, Litter from discarded cigarette butts, health costs, etc.

Private Cost:
A producer's or supplier's cost of providing goods or services. It includes internal
costs incurred for inputs, labor, rent, and depreciation but excludes external costs
incurred as environmental damage (unless the producer or supplier is liable to pay
for them).
 Concepts of Cost of Production
The Short-run Cost is 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.

In a short-run, at least one factor of production is fixed while the other remains
variable. Therefore, in the short-run, the level of output can be increased only by
increasing the variable factors such as labor, raw materials while the other factors
such as capital, plant size, remain unchanged. The short-run cost includes both the
fixed cost (that do not change with the change in the level of output) and variable cost
(that varies with the variations in the level of output). Some factors remain fixed due
to the time constraints imposed on a company.
 Fixed Cost
Total Fixed Costs (TFC):
• Refer to the costs that remain fixed in the short period. These costs do not change
with the change in the level of output. For example, rents, interest, and salaries.
TFC remains constant with respect to change in the level of output. Therefore, the
slope of TFC curve is a horizontal straight line.
 Variable Cost
Total Variable Costs (TVC):
Refer to costs that change with the change in the level of production. For example,
costs incurred on purchasing raw material, hiring labor, and using electricity.
 Total Cost & Total Cost Curves
Total Cost (TC):
Involves the sum of TFC and TVC, Total Cost = TFC + TVC; TC
changes with the changes in the level of output as there is a
change in TVC.
 Average Fixed Cost
Average Fixed Costs (AFC):
• Refers to the per unit fixed costs of production. In other words, AFC implies fixed
cost of production divided by the quantity of output produced. It is calculated as
AFC = TFC/Q. TFC is constant as production increases, thus AFC falls.
 Average Variable Costs
Average Variable Costs (AVC):
Refer to the per unit variable cost of production. It implies organization’s variable
costs divided by the quantity of output produced. It is calculated as: AVC = TVC/
Q, Initially, AVC decreases as output increases. After a certain point of time, AVC
increases with respect to increase in output.
 Average Cost
Average Cost (AC)/Average Total Cost (ATC) :
Refer to the total costs of production per unit of output. AC is calculated as: AC =
TC/ Q. AC is also equal to the sum total of AFC and AVC. AC curve is also U-shaped
curve as average cost initially decreases when output increases and then increases
when output increases.
 Marginal Cost

Marginal Cost:
Refer to the addition to the total cost for producing an additional unit of the
product. Marginal cost is calculated as: MC = TCn - TCn-1
n= Number of units produced
It is also calculated as: MC = ∆TC/∆Q
MC curve is also a U-shaped curve as marginal cost initially decreases as output
increases and afterwards, rises as output increases. This is because TC increases at
decreasing rate and then increases at increasing rate.
 The significance of Marginal Cost

 The marginal cost curve is significant in the theory of the firm for two reasons:

i) It is the leading cost curve, because changes in total and average costs are
derived from changes in marginal cost.
ii) The lowest price a firm is prepared to supply at is the price that just covers
marginal cost.

 It is important to note that marginal cost is derived solely from variable cost, and
not fixed cost. The marginal cost curve falls briefly at first, then rises. Marginal
costs are derived from variable costs and are subject to the principle of
variable proportions.
Average Cost Curves
 Relationship between AC and MC

 Average cost and marginal cost are connected because they are derived from the
same basic numerical cost data.  The general rules governing the relationship are:

i) Marginal cost will always cut average cost from below.

ii) When marginal cost is below average cost, average cost will be falling, and
when marginal cost is above average cost, average cost will be rising.

iii) A firm is most productively efficient at the lowest average cost, which is
also where average cost (AC)=marginal cost (MC).
AC and MC Curve
Short-Run Cost Schedule
 Cost Curves in Short Run
 The short-run marginal cost (MC) curve will at first decline and then will go up
at some point, and will intersect the average total cost and average variable cost
curves at their minimum points.

 The average variable cost (AVC) curve will go down (but will not be as steep as
the marginal cost), and then go up. This will not go up as fast as the marginal
cost curve.

 The average fixed cost (AFC) curve will decline as additional units are
produced and continue to decline

 The average cost (AC) curve initially will decline as fixed costs are spread over
a larger number of units, but will go up as marginal costs increase due to the law
of diminishing returns.
 Long Run Cost

 In the long run, all the factors of production used by an organization vary.
The existing size of the plant or building can be increased in case of long
run.

 There are no fixed inputs or costs in the long run. Long run is a period in
which all the costs change as all the factors of production are variable.

 There is no distinction between the Long run Total Costs (LTC) and long run
variable cost as there are no fixed costs. It should be noted that the ability of
an organization of changing inputs enables it to produce at lower cost in the
long run.
 Long Run Total Cost

 Long run Total Cost (LTC) refers to the minimum cost at which given level
of output can be produced.

 The long run total cost of production is the least possible cost of producing
any given level of output when all inputs are variable.

 LTC represents the least cost of different quantities of output. LTC is

always less than or equal to short run total cost, but it is never more than
short run cost.
Long Run Total Cost
 Long Run Average Cost

Long run Average Cost (LAC) is equal to long run total costs divided by the level of
output.

The derivation of long run average costs is done from the short run average cost
curves. The long run average costs curve is also called planning curve or envelope
curve as it helps in making organizational plans for expanding production and
achieving minimum cost.
In the long run, all costs of a firm are variable. The factors of production can be
used in varying proportions to deal with an increased output. The firm having time-
period long enough can build larger scale or type of plant to produce the anticipated
output. The shape of the long run average cost curve is also U-shaped but is flatter
that the short run curve as is illustrated in the following diagram.

In the diagram given below, there are five alternative scales of plant SAC1
SAC2, SAC3, SAC4 and, SAC5. In the long run, the firm will operate the scale of
plant which is most profitable to it.
 
Long Run Average Cost
 Long Run Average Cost

• If the anticipated rate of output is 200 units per unit of time, the firm will choose the smallest
plant It will build the scale of plant given by SAC 1 and operate it at point A. This is because
of the fact that at the output of 200 units, the cost per unit is lowest with the plant size 1
which is the smallest of all the four plants. In case, the volume of sales expands to 400, units,
the size of the plant will be increased and the desired output will be attained by the scale of
plant represented by SAC2 at point B, If the anticipated output rate is 600 units, the firm will
build the size of plant given by SAC3 and operate it at point C. The optimum output of the
firm is obtained at point C on the medium size plant SAC 3.
• If the anticipated output rate is 1000 per unit of time the firm would build the scale of plant
given by SAC5 and operate it at point E. If we draw a tangent to each of the short run cost
curves, we get the long average cost (LAC) curve. The LAC is U-shaped but is flatter than tile
short run cost curves. Mathematically expressed, the long-run average cost curve is the
envelope of the SAC curves.
 
• In this figure, the long-run average cost curve of the firm is lowest at point C. CM is the
minimum cost at which optimum output OM can be, obtained.
 Long Run Marginal Cost

Long run Marginal Cost (LMC) is defined as added cost of producing an additional
unit of a commodity when all inputs are variable. This cost is derived from short run
marginal cost. On the graph, the LMC is derived from the points of tangency
between LAC and SAC.

If perpendiculars are drawn from point A, B, and C, respectively; then they would
intersect SMC curves at P, Q, and R respectively. By joining P, Q, and R, the LMC
curve would be drawn. It should be noted that LMC equals to SMC, when LMC is
tangent to the LAC.

In Figure, OB is the output at which:

• SAC2 = SMC2 = LAC = LMC
• We can also draw the relation between LMC and LAC as follows:
• When LMC < LAC, LAC falls
• When LMC = LAC, LAC is constant
• When LMC > LAC, LAC rises
Long Run Marginal Cost Curve
 Economies of Scale

 Economies of scale is the cost advantage that arises with increased output of a
product.

 Economies of scale arise because of the inverse relationship between the quantity
produced and per-unit fixed costs; i.e. the greater the quantity of a good produced,
the lower the per-unit fixed cost because these costs are spread out over a larger
number of goods.

 Economies of scale may also reduce variable costs per unit because of
operational efficiencies and synergies.

 Economies of scale can be classified into two main types: Internal – arising from
within the company; and External – arising from extraneous factors such as industry
size.
ECONOMIES OF SCALE: When output increases, long-
run average costs decline.

LRAC shows
Cost economies of
scale here. LRAC

Q
 Diseconomies of Scale
 Diseconomies of scale is an economic concept referring to a situation in which
economies of scale no longer functions for a firm.

 With this principle, rather than experiencing continued decreasing costs and
increasing output, a firm sees an increase in marginal costs when output is
increased.

 Diseconomies of scale can occur for various of reasons, but the root cause
usually comes from the difficulty of managing an increasingly large
workforce.
 DISECONOMIES OF SCALE: When output increases,
long-run average costs increase.

Cost LRAC shows

diseconomies of
scale here. LRAC