Cost of Production

Economic Cost vs Accounting Cost

• Accounting costs are actual costs, also known

as explicit costs, are costs that involve money
being spent such as rent, utility bills, interest
payments.
• The economic cost of a decision depends on both
the cost of the alternative chosen and the benefit
that the best alternative would have provided if
chosen. Economic cost differs from accounting cost
because it includes opportunity cost.
 What you should remember!
• Explicit Costs = easily identified and accounted
for cash outflows
• Implicit Costs = opportunity cost of forgoing
an alternative, hard to measure
• Accounting Profit = TR – Explicit costs
• Economic Profit = TR – Explicit - Implicit costs
= TR - Opportunity Cost
 Example Of Economic Profit And Accounting Profit
• Suppose a farmer spends 3 days working 8 hours a day farming his land
to produce corn that he can sell for $100. and let’s suppose the cost to
produce the corn is $40.
• Accounting Profit= Total Revenue – Explicit Cost
• Accounting Profit= 100 – 40 = $60
• (The accountant tells the farmer that he made $60 and the farmer is happy!!!)
• (Here comes the economics who tells the farmer that he forgot to include his opportunity cost!!!)
• Suppose the farmer could work at the local McDonald at $5 per hour, so
for every hour he spent farming he sacrifices $5 an hour working
elsewhere.
• Implicit cost = 3 days * 8 hr * $5 = $120
• Economic Profit= Total Revenue – Explicit cost – Implicit cost
• Economic Profit= 100 – 40 – 120 = $-60
• From an economic stand point, the farmer is better off working at the
local McDonald!!!
 Opportunity Cost
• Opportunity cost is the cost associated with opportunities
that are forgone by not putting the firm's resources to
their best alternative use.
• Example: consider a firm that owns a building and
therefore pays no rent for office space. Does this mean
that the cost of office space is zero?
• While the firm's accountant might say yes, an economist
would note that the firm could have earned rent on the
office space by leasing it to another company. This
forgone rent is the opportunity cost of utilizing the office
space and should be included as part of the economic
cost of doing business.
 Sunk Costs

• Money already spent and permanently lost. Sunk

costs are costs that are already incurred and cannot
be recovered regardless of future events.

• Example of a Sunk cost is insurance on machines of a factory,

this insurance cost paid for those machines cannot be
recovered.
• Cost of R&D of a pharmaceutical company.
• Cost of marketing.
 Quick Check 
Suppose you are trying to decide whether to drive or
take the train to Portland to attend a concert. You
have ample cash to do either, but you don’t want to
waste money needlessly. Is the cost of the train
ticket relevant in this decision? In other words,
should the cost of the train ticket affect the decision
of whether you drive or take the train to Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.
 Quick Check 
Suppose you are trying to decide whether to drive or
take the train to Portland to attend a concert. You
have ample cash to do either, but you don’t want to
waste money needlessly. Is the cost of the train
ticket relevant in this decision? In other words,
should the cost of the train ticket affect the decision
of whether you drive or take the train to Portland?
A. Yes, the cost of the train ticket is relevant.
B. No, the cost of the train ticket is not relevant.
Classifications of Manufacturing Costs

Direct Direct Manufacturing

Materials Labor Overhead

The Product
 Direct Materials
Raw materials that become an integral
part of the product and that can be
conveniently traced directly to it.

Example: The flour in the dough.

 Direct Labor

Those labor costs that can be easily traced to

individual units of product.

Example: Wages paid to bakers.

 Manufacturing Overhead
Manufacturing costs that cannot be easily
traced directly to specific units produced.

Examples: Indirect materials and indirect labor

Materials used to support Wages paid to employees

the production process. who are not directly
Examples: lubricants and involved in production
cleaning supplies to work. Examples: clean-up
maintain the bakery workers, janitors, and
equipment. security guards.
 Classification of
Nonmanufacturing Costs

Selling Administrative
Costs Costs

Costs necessary to All executive,

secure the order and organizational, and
deliver the product. clerical costs.
 Product Costs Versus Period Costs
Product costs include
direct materials, direct
labor, and manufacturing
overhead.
Period costs include all
selling costs and
administrative costs.

Inventory Cost of Good Sold Expense

Sale

Balance Income Income

Sheet Statement Statement
 Quick Check 
Which of the following costs would be
considered a period rather than a product
cost in a manufacturing company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.
 Quick Check 
Which of the following costs would be
considered a period rather than a product
cost in a manufacturing company?
A. Manufacturing equipment depreciation.
B. Property taxes on corporate headquarters.
C. Direct materials costs.
D. Electrical costs to light the production
facility.
E. Sales commissions.
 Cost in the Short Run
• Short run is a period of time over which at least one factor must
remain fixed. For most of the firms, the fixed resource or factors
which cannot be increased to meet the rising demand of the
good is capital i.e., plant and machinery.
• Short run, then, is a period of time over which output can be
changed by adjusting the quantities of resources such as labor,
raw material, fuel but the size or scale of the firm remains fixed.
• Therefore, the total cost of production equals the fixed cost (the
cost of the fixed inputs) plus the variable cost (the cost of the
variable inputs), or

TC  FC  VC
 Variable Cost
A cost that varies, in total, in direct proportion to changes in
the level of activity. In some cases your total texting bill is
based on how many texts you send.
Total Texting Bill

Number of Texts Sent

 Variable Cost Per Unit
However, variable cost per unit is constant. In some cases the
cost per text sent is constant at constant cost per text.

Cost Per Text Sent

Number of Texts Sent

 Fixed Cost
A cost that remains constant, in total, regardless of
changes in the level of the activity. However, if
expressed on a per unit basis, the average fixed cost
per unit varies inversely with changes in activity.
Monthly Cell Phone
Contract Fee

Number of Minutes Used

Within Monthly Plan
 Fixed Cost Per Unit
However, if expressed on a per unit basis, the average fixed cost
per unit varies inversely with changes in activity.

Monthly Cell Phone Contract

Fee

Number of Minutes Used

Within Monthly Plan
 Cost Curves for a Firm
Price 400
($ per
year)

300
Fixed costs are
the same at all
200 levels of output.

100
FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Output (units per year)
 Cost Curves for a Firm
VC
Price 400
($ per
year)

300
Variable cost
increases with
production and
200
the rate varies with
increasing &
decreasing returns.
100
FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Output (units per year)
 Cost Curves for a Firm
TC

Price 400 VC
($ per
year)

300
Total cost
is the vertical
sum of FC
200
and VC.

100
FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Output (units per year)
 Cost Curves for a Firm
TC

Price 400 VC
($ per
year)

300

200
A

100
FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Output (units per year)
 Marginal Cost
• Marginal Cost (MC) sometimes called incremental cost-is the
increase in cost that results from producing one extra unit of
output. Because fixed cost does not change as the firm's level of
output changes, marginal cost is equal to the increase in variable
cost or the increase in total cost that results from an extra unit of
output.
• We can write marginal cost as:
• MC = TC/q
or MC = VC/q (for short term cost)
 Average Total Cost
• Average Total Cost (ATC) or unit cost is equal to Total Cost
(TC) divided by the number of goods produced (the
output quantity, Q).
• It is also equal to the sum of Average Variable Costs (AVC)
(Total Variable Costs (TVC) divided by Q) plus Average
Fixed Costs (AFC) (Total Fixed Costs (TFC) divided by Q).

• ATC = TC / Q or ATC = AFC + AVC

• AVC = TVC / Q or AFC = TFC / Q

• TC = TFC + TVC
 Cost Curves for a Firm Marginal cost
decreases
initially then
Price 100 MC
increases.
($ per
unit)

75 Average total
cost decreases
Average variable initially
cost decreases then increases.
initially 50 ATC
then increases. AVC

25 Average fixed
cost fall
AFC continuously

0 1 2 3 4 5 6 7 8 9 10 11
Output (units per year)
 Problem 1
Output Fixed cost Variable Total cost Marginal Average Average Average
cost cost Fixed cost Variable cost Total Cost
0 50 0
1 50 50
2 50 78
3 50 98
4 50 112
5 50 130
6 50 150
7 50 175
8 50 204
9 50 242
10 50 300
11 50 385
 A Firm’s Short-Run Costs ($)
Rate of Fixed Variable Total Marginal Average Average Average
Output Cost Cost Cost Cost Fixed Variable Total
(FC) (VC) (TC) (MC) Cost Cost Cost
(AFC) (AVC) (ATC)

0 50 0 50 --- --- --- ---

1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
 Problem 2
• ABC company has a Fixed Cost of $16 and a
Variable cost as follows:
Quantity Average Variable Cost
1 1
2 2
3 3
4 4
5 5
6 6

Calculate the TVC, AFC, TC, MC, and ATC?

 Solution to Problem 2
Quantity AVC TFC TVC TC MC ATC AFC

1 1 16 1 17 1 17 16

2 2 16 4 20 3 10 8

3 3 16 9 25 5 8.3 5.3

4 4 16 16 32 7 8 4

5 5 16 25 41 9 8.2 3.2

6 6 16 36 52 11 8.7 2.7
 Long-run Cost of Production

• In the long run there is no fixed resource. All the factors of

production are variable. The length of the long run differs
from industry to industry depending upon the nature of
production.
 Problem 3
• Calculate the TFC, TVC, AFC, AVC, and MC for the short run TC.
• Calculate the long-run average total cost?

Quantity TC1 TC2

0 0 350
1 300 400
2 400 435
3 465 465
4 495 505
5 540 560
6 600 635
7 700 735
 Solution to Problem 3
Quantity TC1 TC2 TFC1 TVC1 AFC1 AVC1 MC1 LRATC

0 0 350 350 0 - - - -

1 300 400 350 50 350 50 50 300

2 400 435 350 85 175 42.5 35 200

3 465 465 350 115 117 38 30 155

4 495 505 350 155 87.5 38.75 40 123.75

5 540 560 350 210 70 42 55 108

6 600 635 350 285 58 47.5 75 100

7 700 735 350 385 50 55 100 100

 Multiple Choice Questions
• 1) A young boy decided to sell lemonade. He made $45.00 in revenue. He spent $12.00
on supplies and he could have made $27.00 mowing lawns. What is his accounting
profit?
a. $18
b. $33
c. $45
d. $39

2) Using the same numbers as above does the little boy have:
a. Economic loss
b. Zero economic profit
c. Economic profit

3) A man owns a small building in down town Indianapolis that he runs a coffee shop
out of. At the end of the year he realizes costs of $20,000, revenues of $80,000. His
accounting profit is $60,000. What is an implicit cost for this man?
a. Money earned from renting the building.
b. The costs of $20,000.
c. Cost of wages paid to employees.
d. Cost of maintenance on the building.
 Answers
1. The answer is b. Accounting profit only considers
revenue and explicit costs. In this case it would be
$45-$12=$33.
2. The answer is c. The little boy has economic profit.
Taking into consideration all costs including
opportunity costs the answer looks like this: $45-$12-
$27=$6 of economic profit.
3. The answer is a. Implicit costs are the cost of giving
up the next best alternative. Instead of running a
coffee shop the man could have rented the building.