COST ANALYSIS

• It refers to the study of behavior of cost in

relation to the production
 Definition of Cost Concept:
• The term ‘cost’ is most widely used as the
‘money cost’ of production which relates to
the money expenditure of a firm on:
• (i) Wages and salaries paid to the labour.
• (ii) Payment incurred on machinery and
equipment.
• (iii) Payment for materials, power, light, fuel,
transportation etc.
• (iv) Payments for rent and insurance.
• (v) Payments to Government by way of taxes.
Cost Concepts
 Cost Concepts
Accounting Cost
• Also known as EXPLICIT
COST.
• It refers to all the payments
made by the entrepreneur
to the supplier.
• For eg; wages to worker
Payment to supplier for raw
material, interest on loan,
Rent of the building etc.
Economic Cost
• It includes explicit and implicit
cost
• It include all the payments
made to the suppliers and
imputed payments.
• It refers to monetary rewards
for all the factors owned by
the entrepreneur himself.
• Eg; the normal returns on the
money capital invested by the
entrepreneur himself in his
own business.
 Cost Concept
OUTLAY COST
• It involves the actual
expenditure of funds on say
wages, rent, interest etc.
• Outlay costs are recorded in
the books of accounts.
OPPORTUNITY COST
• It is concerned with the cost
of opportunity foregone.
• Opportunity cost are not
recorded in the books of
accounts.
 Cost Concepts
DIRECT COST INDIRECT COST
• Also named ‘Traceable • Also named ‘Non Traceable
costs’ costs’
• Costs that are readily • Costs that are neither
identified and are traceable readily identified and are
to a particular product, nor traceable to a particular
operation or plant. good, service or operation.
• Eg; Manufacturing cost • Eg; Electric power
 Cost Concepts
Fixed Cost
• Costs which do not change
with the level of output.
• These cost vary with the
size of plant and not vary
with the output.
• Fixed costs cannot be
avoided until the operations
are completely closed
down.
• Eg; Rent, depreciation of
P&M, property taxes etc.
Variable Cost
• Costs which vary with the
level of output.
• Variable costs are function
of output in production
period.
• These costs vary directly
and sometimes
proportionately with output
• Eg; raw material cost, wages
etc.
 Cost Function
• It refers to the mathematical relationship
between the cost of a product and its
determinants.
C = f (Qx)
where, C= Cost
f = function
Qx = Quantity produced
Time Period
 Time Period
Short Run costs Long Run costs
• It is the time period in • It is the time period in
which output can be which output can be
changed by changing the changed by changing the
amount of variable factors amount of all factors .
only. • Building, P&M, Raw
• Raw material, labor, fuel, material, Labor etc
power etc • No fixed factor in long run.
• Quantity of Fixed factor
remains unchanged
 Short Run Costs
Short Run total costs Short run unit costs

Marginal Costs
• Total cost = cost of all the resources necessary
to produce particular level of output.
• TC always rises with the output
• TFC/ Supplementary cost = costs of fixed
inputs.
• TVC/ Prime cost = costs which incurred on the
use of variable factors of production.
 Average Fixed Cost
• It is a Fixed Cost per unit of output.
AFC = TFC/Q
AFC will slope downwards but never touches
either of the axis.
AFC cannot be Zero.
 Average variable Cost
• It is variable cost per unit of output.
• AVC = TVC/ Q
• AVC first falls, then reaches the minimum
and then rises.
• It is U shaped.
 Average Total Cost
• It is the sum total of AFC and AVC
–ATC = AFC + AVC
–Shape of ATC is also U shaped.
Relationship in Short Run Average Cost
Curves
• Initially both AFC and AVC falls
• Therefore , ATC falls
• ATC reaches its minimum point.
• As output increases AVC rises but AFC
continues to fall
• Therefore ATC rises.
• Due to the behavior of AFC and AVC, ATC is
U- shaped.
 Marginal Cost Curve
• It is the addition made to
the total cost by the
production of additional
unit output.
• MC = Δ TC / Δ Q
• where , Δ TC = change in total
cost
Δ Q = change in output
MC is not affected by the
Fixed costs. It changes
due to changes in variable
cost. It initially falls,
reaches to minimum and
then rises. It is U shaped.
 Why MC is U shaped?

• Due to the operation of Law of Variable

Proportion.
• Initially due to the increasing returns, MC falls
• Due to diminishing returns, MC rises.
 Relationship between AC and MC
• When AC decreases,
MC < AC
• When AC is minimum,
MC = AC
• When AC increases, MC
> AC
• MC cuts AC at its
minimum point.
• Economists usually assume that plant size is infinitely
divisible (variable). In the case of finely divisible plant
size, the LRAC curve might look like this:
Each small U-shaped
$/Q curve is a SAC curve.
LRAC

The LRAC
curve.

Average costs for a Q

typical firm.
Why LRAC is U shaped?
 Why LRAC is U shaped?
• Economies of scale: Labor specialization,
Management specialization, Efficient use of By
Products, Efficient use of capital etc.
• Average cost per unit falls. (Increasing Returns)
• Constant Returns.
• Diseconomies of Scale : Worker’s Alienation (large
supervision required), Communication problem,
Coordination and Control etc.
• Average cost per unit increases. (Diminishing returns)