Concept of COST

For a manager the production decisions are not possible without their respective cost considerations. Cost and revenues are two important factors with which a producer has to determine the profit. It is the difference between revenue and cost, which determine firms overall profitability. From the decision making point of view, the concept of cost is more important than the revenue, because the firm can influence cost easily than the revenue. More specifically, to know the profitability and viability of the production process, one has to know the cost side.
1

 Moreover, for a managerial decision making, it is the future cost which matters a lot rather than the current costs. The current cost is relevant only if the management is to continue with its past or present policies in future and the environment in which the firm operates remain unchanged. The future cost condition is necessary to meet the changing environment and production process. In the traditional economic theory, cost can be classified into short-run and long run costs. Short-run costs are the costs over a period during which some factors of production (capital and management) are fixed. On the other hand, the long-run costs are the costs over a period which allows to change all factors of production . 2 In the long run all factors become variable.

 Both in short-run and long-run, the total cost is a multi-variable function, which is derived by many factors. Symbolically, in the long-run: TC= f (X, T, Pf ) In the short-run: TC= f (X, T, Pf , K) Where TC: Total Costs X: Output T: Technology Pf: Price of factors K: Fixed factors The cost function can be written as TC=f(X), ceteris paribus, which means, all other factors remaining constant, cost is a function of output. 3

 In a traditional short-run theory, the total cost of a firm is split into total fixed cost and total variable cost, i.e. TC=TFC+TVC Where Total Fixed Cost (TFC) includes: Salaries of administrative staff Depreciation (wear and tear) of machinery Expenses for land maintenance and depreciation if any Expenses for building depreciation and repairs The Variable Cost (TVC) includes: The raw materials The cost of direct labour The running expenses of fixed capital, such as fuel, ordinary repairs and routine maintenance.
4

 The concept of total cost, total variable cost and total fixed cost in the short-run can be better understood by the following table:
No. of Units of Output 0
1 2 3 4 5 6 7 8

Total Fixed Cost (TFC) 50

Total Variable Cost (TVC) 0

Total Cost (TC)

50
70 85 110 150 195 240 287 334
5

 Fixed costs are also known as over head costs, which includes charges such as contractual rent, insurance fees, maintenance costs, property tax, administrative expenses etc. Thus, fixed costs are those which are incurred in hiring the fixed factors of production whose amount can not be altered in the short-run. On the other hand, variable costs are also called prime or direct costs, which are incurred on the employment of variable factors of production whose amount can be altered in the short-run. Thus the total variable cost changes with changes in output in the short-run, i.e. they increase or decrease when the total output rises or falls. 6

The total fixed cost is graphically denoted by a strait line parallel to the output axis, shown as:

Cost

TFC

Output
7

The total variable cost in the traditional theory of the firm has to broadly an InverseS-Shape, which reflects the law of variable proportion, can be shown as follows:
TVC Cost

Output

 The total variable cost curve starts from the origin which shows that when output is zero, the variable costs are also zero. According to this law, at initial stages of production, with a given plant, as more of the variable factors are employed, its productivity increases and the average variable cost falls. This continues till the optimal combination of the fixed and variable factors is reached. Beyond this point an increased quantities of the variable factors are combined with the fixed factors, the productivity of variable factors decline.
9

The total cost (TC) curve has been obtained by vertical summation of the total fixed cost (TFC) and the total variable cost (TVC) curves can be shown as follows:
TC Cost TVC

TFC

Output

10

It is seen from the diagram that the vertical distance between TVC and TC is constant through out. This is because the vertical distance between TVC and TC curves represents that the amount of total fixed cost, which remains unchanged as output increases in short-run. It should be noted that the vertical distance between the total cost curve (TC) and the total fixed cost (TFC) represent the amount of total variable cost (TVC) which increase with the increase in output. Therefore, the shape of total cost curve is the same vertical distance always separates these two curves.
11

Average Fixed Cost (AFC): Average fixed cost is the total fixed cost divided by the number of units of output produced. Therefore, AFC=TFC/q Where, q is the number of units of output produced. Since total fixed cost is a constant quantity, average fixed cost will steadily fall as output increases. Therefore, AFC slopes downward through out its length. As output increases, the TFC spread out over more and more units and AFC becomes less and less. When output becomes very large, average fixed cost approaches zero but will never be zero. This 12 can be shown by the following diagram as:

Cost

AFC

Output

13

 It is seen from the diagram that AFC curve continuously falls through out. Mathematically speaking, AFC curve approaches both output and Cost axis asymptotically, i.e. the AFC curve gets very nearer to both the axis but never touches it. Average Variable Cost (AVC): Average variable cost is the total variable cost divided by the number of units of product produced. Therefore: AVC=TVC/q Where, q represents the number of output produced. 14

 Hence, the AVC is variable cost per units of output. The AVC will generally fall as the output increases from zero to normal capacity of the output due to the occurrence of increasing returns. But beyond the normal capacity output, the AVC will rise steeply because of operation of diminishing returns. This can be shown by the following diagram as:
Cost
AVC

Output

15

 From the diagram, it is clear that the AVC which first falls, reach the minimum and then rises. Average Total Cost (ATC): The average total cost (ATC) or average cost (AC) is the total cost divided by the number of units of output produced. Therefore: ATC or AC = Total Cost/Number of Output Or ATC or AC = TC/q
16

 Since, the total cost is the sum of total variable cost and total fixed cost, the average total cost is also the sum of average variable cost and average fixed cost. This can be proved as follows: ATC = TC/q Since, TC= TFC+TVC ATC = (TFC+TVC)/q = TFC/q + TVC/q = AVC+AFC So, ATC = AFC+AVC Average total cost is also known as unit cost, since it is cost per unit of output produced. 17

Marginal Cost (MC): Marginal cost is an addition to the total cost caused by producing one more units of output. In other words, marginal cost is the addition to the total cost of producing n units instead of n-1 units, where n is any given number. In symbol, MCn = TCn TC n-1 Suppose the production of 5 units of product involves the total cost of Rs. 206. If the increase in the production of 6 units raises the total cost to Rs. 236, then the marginal cost of the sixth unit is 30 i.e. (236-206) = 30. Since marginal cost is change in the total cost as a result of unit change in output, it can also be written as: 18 MC = TC/q

The concepts of AFC, AVC, ATC, TC and MC can be better understood by the following table as:
1 Units of Output 0 1 2 2 Total Fixed Cost 50 50 50 3 Total Variable Cost 0 20 35 4 Total Cost 50 70 85 5 AFC (2/1) 0 50 25 6 AVC (3/1) 0 20 17.50 7 ATC (4/1) 0 70 42.50 8 MC (TCn-TCn1) 70 15

3 4
5 6 7 8

50 50
50 50 50 50

60 100
145 190 237 284

110 150
195 240 287 334

16.66 12.50
10 8.33 7.11 6.25

20 25
29 31.66 33.85 35.50

36.66 37.50
39 40 40.96 41.75

25 40
45 45 47 47
19

The average cost curves can be shown in one diagram as follows:

ATC

AVC

AFC

Output

20

The Relation between AC and MC:

Example: Situation I: For a producer: 1st Product: 50 rupees 2nd Product: 45 rupees This implies that AC falls as MC is less than AC. Situation II: 1st Product: 50 rupees 2nd Product: 55 rupees This implies that AC rises as MC is greater than AC. Situation III: 1st Product: 50 rupees 2nd Product: 50 rupees This implies that AC is equal to MC or AC=MC. 21

This can be better understood by the following diagram as:

AC
L

Output

From the diagram it is clear that as long as short run marginal cost curve (MC) lies below the short-run average cost curve (AC), the AC is falling. When marginal cost (MC) lies above the AC curve, the AC is rising. At the point of intersection L, where MC is equal to AC, AC is neither falling nor rising. At the point L where MC curve crosses the AC curve to lie above the AC curve, is the minimum point of AC curve. So, the MC cuts AC at its minimum point. 22