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COST ANALYSIS

• The payments made to the factors of production are known as cost of production. In other words, cost of production of a commodity means the payments made to the factors of production of the commodity. Cost of production mainly depends on quantity of output.

It can, therefore, be said that cost of production is a function of output. i.e.

C=F(O)

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Cost Classification

Costs are classified as :

(1) Money Cost

(2) Opportunity Cost

(3) Real Cost

(4) Private, external and Social Cost.

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TYPES OF COST

• Money Cost – Ordinarily the term cost of production refers to the money expenses incurred in the production of a commodity. The amount spent in terms of money to produce a commodity, is called its money cost.

• The following expenses are included in monetary cost :

• (1) Cost of Raw Materials

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(2) Interest(3) Rent(4) Wages(5) Expenses on power or electricity(5) Expenses on publicity or selling costs(7) Packing Charges(8) Transport Cost(9) Insurance Charges(10) Normal Profits

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• Explicit Costs – All those expenses that a firm incurs to make payment to others are called explicit costs. According to Leftwitch, “Explicit costs are those cash payments which firms make to outsiders for their services and goods.” These include wages paid to the labourers, rent paid for premises, cost of raw materials, interest on loans, depreciation charges, premium paid towards insurance against fire, theft etc.

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• Implicit Costs : “Implicit costs are costs of self owned and self-Employed resources.”

These include the rewards for the entrepreneurs self owned land, building, labour and capital.

Total Cost=Explicit Cost+Implicit Cost

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• Opportunity Cost – The concept of opportunity cost is the most important modern concept in economic theory. According to this concept, in an economy supply of economic resources is limited relative to their demand. As such when resources are used for producing a given commodity, then some amount of other commodities, in whose production these resources could have been helpful, has to be sacrificed.

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• Every action we take involves an opportunity cost. For instance, every variable factor must be paid what it receives in its next best alternative, that is the opportunity cost, otherwise the factor input cannot be retained in its current employment.

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Real Cost – Real cost is computed in terms of the pain and the discomfort involved for labour when it is engaged in production and also the abstinence and sacrifice involved in saving and capital accumulation.

The concept of real cost, however, does not carry any significance in the cost of production because it is subjective concept and lacks precision.

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• Private, External and Social Cost- A cost that is not borne by the firm, but is incurred by others in society is called an external cost.

Social Cost= Private Cost+External Cost

or

External Cost= Social Cost-Private Cost

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Types of Costs

Fixed Costs :- In the short period the expenses incurred on fixed factors are called the fixed costs. These costs do not change with changes in the quantity of output. Production or no; production; whatever may be the level of output, fixed costs remain constant. According to Benham, “the fixed costs are those costs that do not vary with the size of its output. “Even if the production is zero, fixed costs remain the same. Fixed costs include the following expences.

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• Variable Costs: Variable Costs are those costs which are incurred on the use of variable factors of production.

according to Dooley “Variable costs are those costs which vary as the level of output varies.”

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• Total Costs –Total costs of a firm for various levels of output are the sum of total fixed costs and total variable costs. Symbolically.

TC=TFC+TVC

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Significance of difference between the Fixed and Variable Costs.

• 1. Decision to Shut Down the Firm: A producer tries to cover both fixed and variable costs while selling his output. But in the short run due to some reasons price may fall so much that the producer is unable to cover all his costs.

• 2. Control over Costs: In the short-run, the firm has no control over fixed costs.

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• 3. Break-even Point: The study of cost-volume-profit relationship is frequently referred to as the break-even analysis.

• The break-even point is the point of intersection of TC and TR curves.

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Average Cost and Marginal Cost Curves

• 1. Average Cost: Per unit cost of a good is called its average cost. “Average Cost is total cost divided by output.”

AC= TC Q

AC= AFC+AVC

AFC= TFC TQ

AVC= TVC TQ

Relation between AC, AFC and AVC

Output AFC (Rs.)

AVC (Rs.)

AC=AFC+AVC (Rs.)

1 10 10 20

2 5.0 9 14.0

3 3.3 8 11.3

4 2.5 7 9.5

5 2.0 6.4 8.4

6 1.7 6.3 8

7 1.4 6.6 8

8 1.2 7.8 9

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• When output increases average cost falls. After a minimum point, it begins to rise. Reason being that when output increases, initially law of increasing returns or diminishing costs applies.

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Why AC curve is a U-shaped curve?

• 1. Behaviour of Average Fixed Cost and Average Variable Cost:

• 2. Law of Variable Proportions: The “U” shape of the short run average cost curve can also be explained in terms of the law of variable proportions. The average costs of the firm continue to fall as output increases, because it operates under increasing returns, due to various internal economies. 19

• When the variable factors are increased further, the firm is able to work that machines to their optimum capacity. It produces optimum output and its average cost of production will be minimum. If the firm tries to raise output beyond this point by increasing the quantities of variable factors, this would lead to diseconomies of production and diminishing returns.

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• Hence, due to the working of the law of variable proportions in the short-run average cost curve is U-shaped.

MC= TC Q

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Relationship between Average Cost and Marginal Cost

• 1. Both AC and MC are derived from TC

• 2. When AC falls, MC is also falling:

• 3. When AC rises, MC is also rising:

• 4. MC begins to rise at a lesser level of output than AC:

• 5. MC cuts AC at its Minimum point

• 1. Long-run Average Cost (LAC)

• 2. Long-run Marginal Cost (LMC)

• 1. Long-Run Average Cost Curve or Envelope Curve-Long-run average cost refers to minimum possible per unit cost of producing different quantities of output of a good in the long period.

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• The Shape of Average Cost in the Long-run- In the long-run the average cost curve is said to be “U”-shaped to show that it declines, first and rises later. Where it is the lowest, it is optimum output point.

• 2. Long-Run Marginal Cost Curve- Change in the total cost, in the long-run due to the production of one more unit, is called long-run marginal cost. Long-run marginal cost curve (LAC) that any given short-run marginal cost bears to short-run average cost. LMC curve cuts LAC at its lowest point.

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