COST MEANS SACRIFICE

IT’S A QUANTITATIVE + QUALITATIVE PHENOMENON

 Accounting/money cost
Financial management, including accounting, auditing & costing recognises
only money costs or nominal costs that can be recorded in the book of
accounts. E.g. cost of raw materials, wages& salary, interest on loans, capital costs
like cost of the factory building and equipment and overheads like electricity,
telephone etc. Also termed as explicit cost (OUT OF POCKET COST).
Real Cost
It covers all the aspects of sacrifice involved in acquiring a product. They are
more or less social and psychological in nature and non-quantifiable in money terms.
Historic and Future Costs
They are incurred at the time of purchase of assets. They are also regarded as
sunk costs as they cannot be retrieved from the business without loss. It is an
economic term for a sum paid in the past, which should no longer be relevant, hence
these costs are irrelevant in decision making with the perspective of time.
Future costs are budgeted or planned cost.
Replacement Costs
They are current price or cost of buying or replacing any input at present.
Social Cost
It consists of private costs of the firm and social costs paid by the society. Eg.
Pollution caused by an industry.
 IMPLICIT COST

 Implicit cost do not involve actual payment or

cash outflows or reduction in assets.
 An opportunity cost that is incurred without
an expenditure of money is an implicit cost.
Eg:
-If the owner of firm is also the manager no salary
is paid to him for the job of a manager
-Rent forgone on use of own property
-interest forgone on use of own capital
EXPLICIT COST

 Cost that involves an actual expenditure of

money is an explicit cost.
 These are cost which are actually incurred by the
firm in payment of labour,raw
material,machinery, travelling,transport etc.
 It refers to the actual expenditure of the firm to
hire or purchase inputs for production.
 BASIS FOR COMPARISON EXPLICIT COST IMPLICIT COST

Meaning The costs which involve outflow of cash due The costs in which there is no cash outlay, is
to the use of factors of production is known known as Implicit Cost.
as Explicit Cost.

Alternatively known as Out-of-pocket Costs Imputed Costs

Occurrence Actual Implied

Recording and Reporting Yes No

Estimation of Cost Objective Subjective

Which profit can be calculated with the help Accounting Profit and Economic Profit Economic Profit
of cost?

Example Salaries, rent, advertisement, wages, etc. Interest on owner's capital, Salary to owner,
rent of owner's building, etc. which do not
occur in reality.
COST FUNCTION

 A cost function shows the functional relationship

between output and cost of production.
 It gives the least cost combinations of inputs
corresponding to different levels of output.
C = f (Q,T,Pi,Pf)
where, C=cost, Q=output, T= Technology
Pi = Price of inputs and Pf= productivity of factors.
Costs: Explicit vs.
Implicit
Determine whether each of the following is an
explicit cost or an implicit cost:
a) Payments for labor purchased in the labor
market
b)A firm’s use of a warehouse that it owns and
could rent to another firm
c) Rent paid for the use of a warehouse not
owned by the firm
d)The wages that owners could earn if they did
not work for themselves
Economic Profit vs. Accounting Profit

 Accounting profit
= total revenue minus total explicit costs
 Economic profit
= total revenue minus total costs (including explicit and
implicit costs)
 Accounting profit ignores implicit costs,
so it’s higher than economic profit.
Normal profit(zero economic profit)
The accounting profit just sufficient to ensure that all
resources used by the firm earn their opportunity cost
Any accounting profit in excess of a normal profit is
economic profit
 Economist’s Accountant’s
View View

Economic
Profit Accounting
Profit

Implicit
Revenue Costs
Revenue
Economic
Costs
Explicit Explicit
Costs Costs
CLASS TASK -

 A young chef is considering opening his own

restaurant. To do so, he would have to quit his
current job, which pays Rs200000 a year, and
take over a store building that he owns and
currently rents to his brother for Rs60000 a
year. His expenses at the restaurant would be
Rs500000 per year for food and 20000 per
year for gas and electricity. What are his
explicit costs and implicit cost.
Class task-

Total Revenue = Rs100,000

Assistant’s salary = Rs 20,000
Material & equipment= Rs 15,000
Forgone salary = Rs30,000
Forgone interest= Rs 1,000
Foregone building rental = Rs10,000
Madhavi owns a small business that she operates
in a small building she owns. Given the
information , find out Madhavi's accounting
profit and Madhavi's economic profit .
Average & Marginal Cost
Curves
 AFC is always declining at a decreasing rate.
 ATC and AVC decline at first, reach a minimum, then
increase at higher levels of output.
 The difference between ATC and AVC is equal to AFC.

22
Calculus corner:
For minimum AC:
First order condition (FOC)
Second Order Condition
d AC/dQ = O (SOC)
Or, d (TC/Q)/dQ = O d2AC/dQ2 > O
Or, QdTC/dQ - TC = O Slope of MC > Slope of AC
MC cuts AC from below.
Q2
Or, QMC-TC =O
Q2
Or, QMC-TC=O
Or, MC=TC/Q
Or, MC=AC
From the given data find out, TVC
AVC AFC AC MC (given that TFC=60)
Units- 0 1 2 3 4 5 6
TC(Rs.)- 60 90 100 105 115 135 180
Q.2 From the data regarding a firm’s production
department, calculate i) AC ii) AVC iii)AFC
No. of units produced 200
No. of workers employed 50
Monthly wage of each worker 300
Rent 300
Cost of raw material 2000
Fuel consumption 400
Cost Elasticities & Economies of
Scale
It is very often easy to calculate scale economies by
considering cost elasticities.
Ec = Percentage change in TC/ Percentage change in
output
= TC/ TC  Q/Q
= TC/Q x Q/TC
Cost elasticity is related to
economies of scale as follows:
If
i) Percentage change in TC< Percentage change in Q,
Ec<1 : Economies of scale (decreasing AC)
ii) Percentage change in TC = Percentage change in Q,
Ec=1 : No economies of scale(constant AC)
iii) Percentage change in TC> Percentage change in Q,
Ec>1 : Diseconomies of scale (increasing AC)
An inverse relation exists between Ec and
economies of scale, while a direct relation exists
between Ec and diseconomies of scale.
Output Elasticities & Economies
of Scale
It is very often easy to calculate scale economies by
considering output elasticity also.
Ec = Percentage change in output/ Percentage change
in input
= Q/ Q  I/I
= Q/I x I/Q
Output elasticity is related to
economies of scale as follows:
If
i)Percentage change in TQ> Percentage change in Input (I),
Eq>1 : Increasing returns to scale,as ouput increases at a faster
rate than input usage.
ii) Percentage change in TQ = Percentage change in I,
Eq=1 : No effect of scale
iii)Percentage change in TQ<Percentage change in I,
Eq<1 : Decreasing returns to scale, as output increases slowly
than the usage of inputs
A direct relation exists between Eq and returns to scale.
Costs in long run-

• All costs are variable in the long run since the factor
endowments are variable.
• It implies radical changes in the cost structure of a
firm.
• The long run cost function is referred to as the
planning cost function.
• LAC curve is known as the planning curve.
• Since the long run consists of many short runs, the
cost curve is a composite of many short run cost
curves.
It arises with lower AC of manufacturing a product when two complementary
products are produced by a single firm.
Measuring Economies of Scope
For a firm producing say three products / activities,
If we assume that the individual costs of these
activities are- C1 ,C2 , C3 & Ct is the total cost of all
activities taken together
the Scope Index (S) can be measured as-
S= (C1 + C2 + C3 – C t )
C1 + C2 + C3
If S is positive , it is better to carry these three activities in the same plant
If S is negative, it is better to execute them separately.
ECONOMIES OF SCALE

refer to changes in output of a single product

type.
Economies of scope
refer to changes in a no. of products of different
types.
Learning by Doing
The concept of learning curve is used to represent the extent to
which AC of production falls in response to increase in output.
The eqn. of learning curve can be expressed as-
C = AQ b
Where, C= Cost of the input for the Qth unit of output produced.

A= Cost of the first unit of output obtained

Now, following the logic that increase in cumulative output leads
to decrease in cost, “b” has a negative value.
Taking log form-
log C = log A + b. log Q
In this log form, b is the slope of the learning curve.