CONCEPT OF COST

By- Gunjan Porwal

What is Cost??

Amount of expenditure
Actual

or Estimated

To be incurred For obtaining any particular commodity or advantage or facilities

Different context of Cost

In economics the meaning of word cost is taken in various context
Monetary

cost Real cost or Social cost Opportunity Cost Business view of Cost

I Monetary Cost

Money spent by the producer for use of various factors of production of any commodity is known as monetary cost or economic cost
Example:

wages, raw material, electricity, transportation and advertisement

Types of Monetary Cost

Types of Monetary Cost

Explicit

Cost: Producer has to pay for use of various factors of production

Example:

Raw Material, Interest on loan amount, Rent on land and Building, Expenditure on advertisements, insurance premium, expenses on management and marketing

Implicit

Cost: Price for those factors of production which are owned by the producers themselves
Producer

does not pay any price directly Example: Own land, building, capital, services and himself working as managers

II Real Cost or Social Cost

Efforts and sacrifices made by various sections of the society for production of a commodity is the real cost of production

III Opportunity Cost

Opportunity cost of an activity is equal to the value of next best possible alternative forgone Example: Limited coal can be used either in producing electricity or running engine

IV Business view of Costs

Incremental and Sunk Cost:

Incremental cost: Cost arising to a firm due to changes in the level and nature of business activities. Example replacement of old machine Sunk Cost: Cost on which level of business activities has no effects. Example: Depreciation due to time, rent of building

Business view of Costs contd..

Past and Future Cost:

Past Cost: Expenses which are actual and have been paid Future Cost: Forecast cost are costs which are borne by the firm for any future period
Direct Cost are those costs, which are undoubtedly related to any production process. Example: Salary of the regional manager in case of cost on basis of region Indirect Cost are those costs which are not directly not related to any particular department, process or the commodity, but these are paid together. Example expenditure on collective advertisement, organizational expenditure and expenditure on

Direct and Indirect Cost:

Business view of Costs contd..

Common Production Cost:

Some

industries, produce two or more commoditities Produced by same production process and same raw material Commodities are distinguished after collective production process is over The point at which distinction is done is known as Split off Point Cost borne upto split off point is Common Production Cost

Business view of Costs contd..

Out-of-Pocket and Book Cost

Out-of-Pocket:

Cash or out-of-pocket costs mean such cost which cash payment is required to be done, presently. Example: Expenditure for purchasing raw material, payment of wages Book Cost: Costs which are not paid by the firm, presently. Example: Depreciation

Business view of Costs contd..

Controllable and Uncontrollable cost:

Cost

which remain in the control of management and organization are controllable Costs Uncontrollable cost: Beyond the control of the management and the organization example: Fixed cost

Historical and Replacement cost:

Original

cost of any asset is the historical cost Purchase price of another similar assets in place of the existing asset is the replacement cost

Business view of Costs contd..

Urgent and Postponable Cost:

Cost

essential to keep the production, marketing continued

Example:

Raw material, Labor Fuel

Postponable Cost can be potponed for some time and they do not materially affect the production
Example:

Repair of a Building, Paint whitewash,

Business view of Costs contd..

Sunk, Shutdown and Abandonment Cost:

Sunk

Cost: Expenditure incurred in the past which is not required in the present and the future Shutdown Cost: Expenditure which the owner has to bear, even on closing production activities for sometime are known as shutdown cost
Example:

Expenditure on keeping machineries intact, Stocking of produced material

Production Function to Cost Function

Cost-Output Relationship studied with reference to two terms:

Cost-Output

Relationship in Short period Cost-Output Relationship in Long period

Cost-Output Relationship in Short period

In short period producer is not able to make adjustments, in accordance with change in market Limited changes are possible, as in respect of resources, raw material, fuel and temporary workers Two types of Cost are studied:
Total

Cost Average or Unit Cost

Total Cost

Total cost is divided in two parts:

Fixed

Costs: Do not change with change in level of output also known as overhead costs Variable Costs: Cost vary directly with the change in the level of output

Graph

Cost Chart
Quantity of Production
0 1

Total Fixed Costs

40 40

Total Variable Costs

0 60

Total Costs
40 100

2
3 4 5 6

40
40 40 40 40

80
90 110 150 200

120
130 150 190 240

Importance of Fixed and Variable Costs

Fixed and Variable, both the type of costs are required for production of any commodity Change in Production leads to change in only variable costs In short run if producer is able to cover only variable cost then he will continue the production but if price goes below variable costs the producer will have to close the production Difference of fixed and variable costs exists only in short period but in long period all costs are variable

Average or Unit Cost

Per unit cost of any commodity is known as average or unit cost Calculated by dividing the total costs by number of produced units Three parts:
Average

Variable Cost Average Fixed Cost Average Total Cost

Total Fixed Cost, Total Variable Costs Total Costs

Quantity of Production TFC TVC TC

0 1 2 3

40 40 40 40

0 60 80 90

40 100 120 130

4
5 6

40
40 40

110
150 200

150
190 240

Formulae

AFC=TFC/Output ; AFC= AC-AVC AVC=TVC/Output ;AVC= AC-AFC AC=TC/Output; AC=AFC+AVC Marginal Cost =TC/ Q
MC=TCn-TCn-1

Average Fixed Cost, Average Variable Costs, Average Costs, Marginal Cost
Quantity of Producti on 0 1 2 3 TFC TVC TC AFC AVC AC MC

131 n 87

40 40 40 40

0 60 80 90

40 100 120 130

40 20 13.3

60 40 30

100 60 43.3

60 20 10

4
5 6

40
40 40

110
150 200

150
190 240

10
8 6.7

27.5
30 33.3

37.5
38 40

20
40 50

AC, AVC and AFC

AC and AVC are U shaped curve because in initial stages AVC goes on decreasing till the firm does not reach to the point of least cost AFC is downward sloping from left to right
Because FC remains constant AFC decreases with the increase in number

AC or ATC is attained by adding AFC and AVC Law of Returns operate here:
Increasing Return Constant Return Diminishing Return

Marginal Cost

Increase in total cost due to production of an additional unit is known as marginal cost In short run marginal cost is equal to variable cost MC curve reaches to its lowest point even at low quantity of production as compared to AVC and ATC MC curve cuts AVC and ATC curves at their lowest points

Relationship of Average Cost and Marginal Cost (Graph)

AC and MC both calculated on the basis of total cost of production At initial stage, AC curve falls, then MC curve falls up to a limit, but after a stage, MC curve goes on rising, though AC curve goes on falling MC curve cuts AC at its lowest When AC curve increases, then MC curve is above AC curve and increases faster than AC curve

Relationship between AFC,AVC,AC and MC (Graphs)

AFC keeps on decreasing, but never touches the axis Difference between AVC and AC is equal to the difference between OX axis and AFC curve AVC falls with increase in level of production ; after a lowest point, it increases consistently AVC and AC curve have the tendency to come nearer to each other AC curve is equal to AFC and AVC MC curve reaches to its lowest point earlier than AVC and AC curve MC curve passes below AVC curve AC curve, cutting their lowest points

Importance of Short-term Cost Analysis in Business Decision Making

Regarding Production
Continuing

or Closing the production of any

commodity

Price Determination Scale of Production Use of Machinery Unused Capacity

Increasing

Production or renting it out

Cost-Production Relationship in Long Period

Producer can make all required changes in each factor of production All factors variable Two cost determining the price
Long

Term Average Cost Long Term Marginal Cost

Long Term Average Cost

9.1

Long term total cost / Total units of Production It is framed by touching various short term average cost of production Envelop of all short-term average curves LAC indicates minimum cost of production and optimum size of the firm LAC curve touches the SAC curves and not cuts them LAC curve is also U shaped like SAC curve but more flat as compared to SAC LAC curve does not touch all SAC curves at their lowest points

Till LAC curve falls it touches falling part of SAC LAC touches SAC at its lowest point at its own lowest point LAC rises upwards,it touches rising part of SAC

Long Term Marginal Cost

Long term all fixed cost become variable Total cost is equal to total variable Long term marginal Cost and Long term average cost have same relationship which is in short term marginal cost and short term average cost

Determinants of Cost

Production Techniques

High cost in beginning low production per unit cost

Operation of Law of Returns Size of Production

Higher the output, lower is the per unit cost of production

Utilization of Capacity of Plant: Fixed cost Price of factors of Production Continuity of production Level of Managerial Skills Taxation Policy of Government State of Trade: Boom or inflation

BREAK EVEN ANALYSIS

By- Gunjan Porwal

What is Break Even Point??

It is the point at which firms total revenue is equal to total cost Money cost (Fixed + Variable cost) equals to market price TR=TC Position below this point indicates losses whereas above it shows excess profits Total cost includes normal profit thus breakeven does not imply zero profit

What is Break Even Point??

In short run, a firm may operate below the break even point if the price goes down to the level which covers its variable cost In long run, firm must be at break even or above breakeven

Graph

Method of Break Even Analysis

Contribution Method:
Sales-Variable

Cost Fixed cost+ Profit

Profit-Volume Ratio Method:

P/V

Ratio = {Contribution/Sales} * 100 Break Even Point (in Rs) = FC/ (P/V ratio) C=S * P/V Ratio P/V Ratio= (Change in Profits/Change in Sales)*100

Method of Break Even Analysis

Break Even Point Method:

BEP

(in Rs.)=Fixed Cost/(P/V ratio) BEP (in units)=Fixed Cost/Contribution per unit

Breakeven Analysis
Assumptions: (1) Price is constant (p); (2) We have fixed costs; (3) We have constant variable cost.
Buy Cost (BC) = pQ Cost Making is better

Make Cost (MC) = FC + vQ

Buying is better Variable cost: vQ

Fixed Cost: FC

Quantity (Q) Q

Question

Shyam pvt. Ltd. manufactures soap. The fixed cost is Rs 40000,variable cost is Rs 3 per unit and selling Price is Rs 8 per unit. Suppliers can him the soap at Rs 7.5 Whether it should buy or make the soap at the following quantities?
5000

units 8000 units 10000 units

Producers Equilibrium
162-163

A producer is said to reach equilibrium at the level of output which gives him maximum profit and he has no incentive to increase or decrease output Two approaches:
TR

and TC approach: TR-TC is maximum (graph) MR and MC approach: MR=MC and MC should be rising (graph)