Theory of Cost –Cost Concepts

Dr. Rakesh Kumar Sharma

SBSBS, Thapar University –Patiala
Actual Costs and Opportunity Costs
• Actual costs are those costs, which a firm
incurs while producing or acquiring a good or
service like raw materials, labor, rent, etc.
• Opportunity cost is defined as the value of a
resource in its next best use.
 Explicit and Implicit Costs
• Explicit costs are those costs that involve an
actual payment to other parties.
• Implicit costs represent the value of foregone
opportunities but do not involve an actual
cash payment. an implicit cost is the
opportunity cost of using resources that are
owned or controlled by the owners of the
firm.
Accounting Costs and Economic Costs

• The accounting costs are useful for managing

taxation needs as well as to calculate profit or
loss of the firm.
• Economic costs that are used for decision-
making. So it is that cost which is associated
with Future
 Direct Costs and Indirect Costs
• Direct Costs can be directly attributed to
production of a given product. The use of raw
material, labour input, and machine time
involved in the production of each unit can
usually be determined.
• Indirect Cost are Those expenses that cannot
easily and accurately be separated and
attributed to individual units of production,
except on arbitrary basis.
Total Cost, Average Cost and Marginal
Cost
• Total cost (TC) of a firm is the sum-total of all
the explicit and implicit expenditures incurred
for producing a given level of output.
• Average cost (AC) is the cost per unit of
output. That is, average cost equals the total
cost divided by the number of units produced
(N). If TC = Rs. 500 and N = 50 then AC = Rs.
10.
• Marginal cost (MC) is the extra cost of
producing one additional unit.
 Fixed and Variable Costs
• Fixed costs are that part of the total cost of
the firm which does not change with output,
Example ,Rent , Depreciation, Taxes, Interest
payment Etc.
• Variable Costs, on the other hand, change
with changes in output. Examples of variable
costs are wages and expenses on raw
material.
 Separable Costs and Common Costs
• The costs that can be easily attributed to a
product, a division, or a process are called
separable costs.
• On the other hand, common costs are those,
which cannot be traced to any one unit of
operation.
• e.g., In a university the salary of a Vice-Chancellor
is not separable department-wise but the salary
of teachers can be separable department-wise.
 Short-Run and Long-Run Costs
• Short-run costs are the costs that can vary with
the degree of utilization of plant and other fixed
factors. In other words, these costs relate to the
variation in output, given plant capacity. Short-
run costs are, therefore, of two types: fixed costs
and variable costs.
• Long-run costs, in contrast, are costs that can
vary with the size of plant and with other facilities
normally regarded as fixed in the short-run. In
fact, in the long-run there are no fixed inputs and
therefore no fixed costs, i.e. all costs are variable.
 Controllable Cost & Uncontrollable
Cost
• Controllable costs are those which are
capable of being controlled or regulated by
executive vigilance and, therefore, can be
used for assessing executive efficiency.
• Non-controllable costs are those, which
cannot be subjected to administrative control
and supervision.
 Out-of-pocket costs and Book costs
• Out of pocket costs are those costs that
improve current cash payments to outsiders.
For example, wages and salaries paid to the
employees are out-of pocket costs.
• Book costs are those business costs, which do
not involve any cash payments but for them a
provision is made in the books of account to
include them in profit and loss accounts and
take tax advantages.
 Past and Future costs
• Past costs are actual costs incurred in the past
and they are always contained in the income
statements. These costs can only be observed
and evaluated in retrospect.
• Future costs are those costs that are likely to be
incurred in future periods. Since the future is
uncertain, these costs have to be estimated and
cannot be expected to be absolutely correct
figures. Past costs serve as the basis for
projecting future costs.
 Historical and Replacement costs
• The historical cost of an asset is the actual
cost incurred at the time, the asset was
originally acquired.
• Replacement cost is the cost, which will have
to be incurred if that asset is purchased now.
*The difference between the historical and
replacement costs results from price changes
over time.
 Private Costs and Social Costs
• Private costs are those that accrue directly to
the individuals or firms engaged in relevant
activity.
• Social costs, on the other hand, are passed on
to persons not involved in the activity in any
direct way (i.e., they are passed on to society
at large). It is the cost which is borne by the
society
 Relevant Costs and Irrelevant Costs
• The relevant costs for decision-making
purposes are those costs, which are incurred
as a result of the decision unde consideration.
The relevant costs are also referred to as the
incremental costs.
• Irrelevant Costs that have been incurred
already and costs that will be incurred in the
future, regardless of the present decision
Sunk Costs and Incremental Costs
• Sunk costs are expenditures that have been
made in the past or must be paid in the future as
part of contractual agreement or previous
decision
• Incremental Cost refers to total additional cost of
implementing a managerial decision. Change in
product line, change in output level, adding or
replacing a machine, changing distribution
channels etc. are examples of incremental costs..
 COSTS IN THE SHORT RUN
• Let us consider a production process using two
inputs K and L only. Here the level of capital
input in the form of machines and tools cannot
be changed in the short run while amount of
labour- can be. The cost incurred on all fixed
inputs by the firm is total fixed cost
FC=rKO
R=rent, KO =Capital
Fixed Cost Curve
 Variable Cost
• Variable Cost(VC), on the other hand, is the
cost incurred on variable inputs. Often,
labour use of increases with increase in the
level of output. Accordingly, the cost of hiring
labour also increases. Hence, we see that
variable cost depends upon the level
• VC *Q1=WL1
 Shape Of Variable Cost Curve
• The shape of the VC curve reflects exactly the
opposite behavior of TP curve.
(a) When TP curve increases at an increasing rate VC
curve increases at a decreasing rate and vice versa.
• Thus, variable cost increases at a slower pace in the
beginning. In the second stage, after the point of
inflexion, the TP curve shows diminishing returns.
During this stage the variable cost will increase at a
faster pace.
Variable Cost Curve
Output & Cost
 Total Cost
• Total cost isthe sum of fixed cost and variable
cost. Therefore, we can write:
TC(Q1)=FC+VC(Q1)
• Total cost consists of two components FC and
VC. Out of these FC is constant. But VC
depends on level of output. Hence, TC also
depends on level of output. For a higher level
of output TC is higher.
Total Cost Curve
 Total Cost
• There is an equal gap between TC and VC
curves as can be seen from the figure. The
difference is equal to the level of fixed cost,
which is constant for all levels of output.
 Average Fixed Cost
• Average fixed cost (AFC) is defined as fixed
cost divided by level of output.
Symbolically,
AFC(Q1)=FC/Q1
As you know FC is constant for any level of
output. Hence AFC declines as Q increases.
Average Fixed Cost Curve
 Average Variable Cost (AVC)
It is the variable cost divided by units of
output, viz.,
AVC(Q1)=VC/Q1
Average Variable Cost Curve
 Average Total Cost
• Average total cost (ATC) is the sum of AFC
and AVC at the level of output under
consideration.
ATC(Q1)= AFC(Q1)+AVC(Q1)
As AFC and AVC both depend upon the level of
output, ATC also changes according~too utput
level.
Average Total Cost Curve
 Marginal Cost
• Marginal Cost (MC) is the increase in total cost
due to production of an additional unit 0f
output.
MC(Q1)=Change in Total Cost/Change in
output
Marginal Cost Curve
RELATIONSHIP BETWEEN AVERAGE COST
AND MARGINAL COST CURVES
• By now you are familiar with the shapes of
cost curves. Let us look into the relationships
between them.
 Cost Function
• Cost function expresses the relationship
between cost and its determinants.
C = f (S, O, P, T, E…..)
 Determinants of Cost Function
• Where, C = cost (it can be unit cost or total
cost)
• S = plant size
• O = output level
• P = prices of inputs used in production
• T = nature of technology
• E = managerial efficiency
 ESTIMATION OF COST FUNCTION
• Accounting Method
• This method is used by the cost accountants. In this
method, the cost-output relationship is estimated by
classifying the total cost into fixed, variable and semi-
variable costs.
• These components are then estimated separately. The
average variable cost, the semi-variable cost which is
fixed over a certain range of output, and fixed costs
are determined on the basis of inspection and
experience.
 Engineering Method
• The engineering method of cost estimation is based
directly on the physical relationship of inputs to
output, and uses the price of inputs to determine
costs. The shape of any cost function is dependent
on:
• (a) the production function and
• (b) the price of inputs.
 Econometric Method
• This method is also some times called
statistical method and is widely used for
estimating cost functions. Under this method,
the historical data on cost and output are
used to estimate the cost-output relationship.
The basic technique of regression is used for
this purpose.
Functional Forms of Cost Function
• The following are the three common functional
forms of cost function in terms of total cost function
(TC).
a) Linear cost function: TC = a1 + b1Q
b) Quadratic cost function: TC = a2 + b2Q + c2Q2
c) Cubic cost function: TC = a3 + b3Q + c3Q2 +d3Q3
• Where, a1, a2, a3, b1, b2, b3, c2, c3, d3 are
constants.
Linear Cost Function
 Linear Cost Function
• These cost functions have the following
properties: TC is a linear function, where AC
declines initially and then becomes quite flat
approaching the value of MC as output
increases and MC is constant at b1.
Linear Cost Function
Quadratic Cost Function
 Quadratic Cost Function
• These cost functions have the following
properties: TC increases at an increasing rate;
MC is a linearly increasing function of output;
and AC is a U shaped curve.
Quadratic Cost Function
Quadratic Cost Function
Cubic Cost Function
 Cubic Cost Function
• These cost functions have the following
properties:
• TC first increases at a decreasing rate up to
output rate
• Then increases at an increasing rate; and both
AC and MC cost functions are U shaped
functions.
 Cubic Cost Function
• The linear total cost function would give a
constant marginal cost and a monotonically
falling average cost curve. The quadratic
function could yield a U-shaped average cost
curve but it would imply a monotonically
rising marginal cost curve.
 Cubic Cost Function
• The cubic cost function is consistent both with
a U-shaped average cost curve and a U-
shaped marginal cost curve. Thus, to check
the validity of the theoretical cost-output
relationship, one should hypothesize a cubic
cost function.
Cubic Cost Function
Cubic Cost Function
 Long Run Cost
1. In the long run all factors of production are
assumed to be variable.
2. Since there are no fixed inputs, there are no
fixed costs. All costs are variable.
3. As in the case of the firm’s short-run cost
functions, long-run cost functions are intimately
related to the long-run production function.
4. In particular, the firm’s long-run cost functions
are related to the concept of returns to scale,
Long Run Production Curve
Long Run Total Cost Curve
 ECONOMIES OF SCALE
1. Economies of scale are intimately related to
the concept of increasing returns to scale.
2. The per-unit costs of production decline as
the scale of a firm’s operations increase the
firm is said to experience economies of scale.
3. An increase in the firm’s scale of operations
results in a decline in long-run average total
cost (LRATC).
Increasing Return to Scale or
Decreasing Cost
 Diseconomies of Scale
1. Diseconomies of scale are intimately related to the
concept of decreasing returns to scale.
2. Constant factor prices, the firm’s total cost of
production rises proportionately with an increase
in total factor usage, but the per-unit cost of
production increases because output increases less
than proportionately.
3. An increase in the firm’s scale of operations results
in an increase in the firm’s long-run average total
cost. Finally, in the case of constant returns to
scale, per-unit
Decreasing Return to Scale or
Increasing cost
 constant returns to scale,
• Per-unit cost of production remains constant
as production increases or decreases
proportionately with an increase or decrease
in factor usage.
• An increase or decrease in the firm’s size will
have no effect on the firm’s long-run average
total cost.
Constant Return to Scale or
Constant Cost
 Long Run Total Cost Curve
1. In order to draw the long-run total cost curve, let us
begin with a short-run situation. Suppose that a firm
having only one-plant has its short-run total cost
curve as given-by STCl.
2. If the firm decides to add two more plants to its size
over time, one after the other then in accordance
two more short-run total cost curves are added to
STCl in the manner shown by STC2 and STC3
3. The LTC can now be drawn through the minimum
points of STCl, STC2 and STC3 as shown by the LTC
curve corresponding to each STC.
Long Run Total Cost Curve
 Long-Run Average Cost
1. Combining the short-run average cost curves
(SACs) derives the long-run average cost curve
(LAC).
2. There is one SAC associated with each STC.
3. Just like STC1 STC2, and STC3 curves in panel there
are three corresponding SAC curves as given by
SAC1 SAC2 arid SAC3
4. Thus, the firm has a series of SAC curves, each
having a bottom point showing the minimum SAC.
Long Run Cost Curve
LRATC curve as the “envelope” of
the SRATC Curve
• Combining the short-run average cost curves
(SACs) derives the long-run average cost curve
(LAC).