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Economics
Module No. 06
Theory of Cost
By Muhammad Shahid Iqbal
Should I go to work today? Should I go to college after high school? Should the government spend money on a new weapon system? These are decisions that are made everyday; however, what is the cost of our decisions? What is the cost of going to work, or the decision not to go to work? What is the cost of University, or not to go to University? Finally what is the cost of buying that weapon system, or the cost of not buying that weapon? In economics it is called opportunity cost. Opportunity cost is the cost we pay when we give up something to get something else. There can be many alternatives that we give up to get something else, but the opportunity cost of a decision is the most desirable alternative we give up to get what we want. Opportunity cost of an input is the return that it could earn in its best alternative use.
Economists measure a firms economic profit as total revenue minus total cost, including both explicit and implicit costs. Accountants measure the accounting profit as the firms total revenue minus only the firms explicit costs. When total revenue exceeds both explicit and implicit costs, the firm earns economic profit. Economic profit is smaller than accounting profit
C(Q) = VC + FC VC(Q)
C(Q) = FC + VC
Fixed costs are those costs that do not vary with the quantity of output produced Variable costs are those costs that do vary with the quantity of output produced
FC
a) b) c) d) e) f) g)
Fixed costs or overhead cost can be classified into factory overhead, administration overhead, selling overhead and distribution overhead. Variable costs can be further classified into direct material, direct labor and direct expenses. The selling price is derived as shown below Direct material cost + Dir. labor cost + Direct expenses = Prime cost Prime cost + Factory overhead = factory cost Factory cost + office and administrative overhead = cost of production Cost of production + opening finished stock Closing finished stock = cost of goods sold cost of goods sold + selling and distribution overhead = cost of sales cost of sales + profit Sales Sales/quantity sold selling price per unit
Marginal Cost: The marginal cost of a product is the cost of producing an additional unit of that output. More formally, the marginal cost is the derivative of total production costs with respect to the level of output. Marginal Revenue (MR) is the extra revenue that an additional unit of product will bring. It is the additional income from selling one more unit of a good; sometimes equal to price. It can also be described as the change in total revenue divided by the change in the number of units sold. i.e. Q = 40,000 2000P Marginal cost and average cost can differ greatly. For example, suppose it costs $1000 to produce 100 units and $1020 to produce 101 units. The average cost per unit is $10, but the marginal cost of the 101st unit is $20
Break-even point (BEP) is the point at which cost or expenses and revenue are equal: there is no net loss or gain. The main objective of break-even analysis is to find the cut-off production volume from where a firm will make profit. X = TFC/P-V X = TFC/Unit Contribution Contribution = Sales TVC Margin of Safety = Sales Break Even sales
Profit Volume Ratio (P/V Ratio), The ratio of contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee of sales and since the fixed cost remains constant in short term period, P/V ratio will also measure the rate of change of profit due to change in volume of sales. The P/V ratio may be expressed as follows: Profit = Contribution Fixed cost P/V ratio = Sales Variable costs = Contribution Sales Sales BEP = Profit P/V ratio
Some Definitions
Average Total Cost$ ATC = AVC + AFC ATC = C(Q)/Q Average Variable Cost AVC = VC(Q)/Q Average Fixed Cost AFC = FC/Q Marginal Cost MC = DC/DQ
MC ATC
AVC
AFC
AVC
Economies of scale arise when the cost per unit falls as output increases. Economies of scale are the main advantage of increasing the scale of production Bulk-buying economies Technical economies Financial economies Marketing economies Managerial economies lower unit costs as a result of the whole industry growing in size. Training and education becomes more focused on the industry Other industries grow to support this industry