COST ANALYSIS

C O N C E P T O F C O S T O F P R O D U C T I O N

1. The Cost Of Production Theory Of Value is the theory that the price of anobject or condition is determined by the sum of the cost of the resources thatwent into making it.

2. The cost can compose any of the factors of production (including labor,capital, or land) and taxation.

3. Production costs are those which must be received by resource owners in orderto assume that they will continue to supply

T Y P E S O F E C O N O M I C C O S T S

1. Accounting Cost. Actual expenses plus depreciation.2. Economic Cost. Cost to a firm of using resources in production. Also called

opportunity cost, the most valuable forgone alternative

1 . E X P L I C I T C O S T

1. Also called Money Cost or Accounting Cost2. A cost that is represented by lost opportunity in actual cash payments.3. It is the cost of factors of production and/or services that entrepreneur has to

buy directly.4. It includes Wages, Salary, Expenses Of Factors Of Production, Fuel,

Advertisement, Transportation Taxes and Depreciation Charges.

2 . I M P L I C I T C O S T

1. A cost that is represented by lost opportunity in the use of a company's ownresources, excluding cash

2. For example, the time and effort that an owner puts into the maintenance ofthe company rather than working on expansion

3. The implicit cost begins and ends with foregoing the benefits and satisfaction4. Opportunity Cost Without Payment Or Transaction: an opportunity cost for

which no payment is made nor any asset value reduced

E x p l i c i t C o s t V s . I m p l i c i t C o s t

1. Explicit cost can be counted in terms of money whereas implicit cost can notbe traded and therefore can not be counted in terms of money.

2. Explicit cost is a direct tangible cost whereas implicit cost is indirectintangible cost.

4 . N O M I N A L C O S T

1. Nominal Cost is the money cost of production. It is also called Expenses OfProduction

2. Producer must make sure that he covers expenses of factors of production inproducing the good in long term.

5 . R E A L C O S T

1. Also called Opportunity Cost2. The cost of an opportunity forgone (and the loss of the benefits that could be

received from that opportunity); the most valuable forgone alternative.3. The value of the next best alternative foregone as the result of making a

decision. Opportunity cost analysis is an important part of a company'sdecision-making processes but is not treated as an actual cost in any financialstatement.

4. Money Cost and Real Cost do not coincide

P R O F I T

A C C O U N T I N G P R O F I T

1. Accounting profit is the difference between price and the costs of bringing tomarket whatever it is that is accounted as an enterprise (whether by harvest,extraction, manufacture, or purchase) in terms of the component costs ofdelivered goods and/or services and any operating or other expenses.

2. The difference between a business's revenue and it's accounting expenses.3. A business is said to be making an accounting profit if its revenues exceed the

accounting cost of the firm.

E C O N O M I C P R O F I T

1. Economic Profit is the difference between a company's Total Revenue and itsOpportunity Costs.

2. It is the increase in wealth that an investor has from making an investment,taking into consideration all costs associated with that investment includingthe opportunity cost of capital.

3. The value that remains after all costs, including the opportunity costs of theoperator’s labor and capital, have been subtracted from gross income. Sameas the return to management.

4. An economic profit arises when revenue exceeds the opportunity cost ofinputs, noting that these costs include the cost of equity capital that is met by"normal profits."

N o r m a l P r o f i t

1. Normal profit is a component of the firm's opportunity costs.2. The time that the owner spends running the firm could be spent on running

another firm.3. The return the entrepreneur can expect to earn or the profit that the business

owners considers necessary to make running the business worth his/her while

4. Normal profits arise in circumstances of perfect competition when economicequilibrium is reached. At equilibrium, average cost equals marginal cost atthe profit-maximizing position. Since normal profit is economically a cost,there is no economic profit at equilibrium

S u p e r n o r m a l P r o f i t

1. Positive economic profit is sometimes referred to as Supernormal Profit or asEconomic Rent

2. In a single-goods case, a Positive Economic Profit happens when the firm'saverage cost is less than the price of the product or service at the profit-maximizing output. The economic profit is equal to the quantity of outputmultiplied by the difference between the average cost and the price.

S o c i a l P r o f i t

1. The social profit from a firm's activities is the normal profit plus or minus anyexternalities that occur in its activity.

2. A firm may report relatively large monetary profits, but by creating negativeexternalities their social profit could be relatively small.

P r o f i t a b i l i t y

1. Profitability is a term of economical efficiency. Mathematically it is a relativeindex – a fraction with profit as numerator and generating profit flows orassets as denominator.

S H O R T - R U N A N D L O N G - R U N C O S T S

1. The long run and the short run do not refer to a specific period of time such as3 months or 5 years.

2. The difference between the short run and the long run is the flexibilitydecision makers have.

3. The Short Run is a period of time in which the quantity of at least one input isfixed and the quantities of the other inputs can be varied

4. In other words, in Short Run, a firm cannot build another plant or abandonone

5. The Long Run is a period of time in which the quantities of all inputs can bevaried

6. There is no fixed time that can be marked on the calendar to separate theshort run from the long run

S H O R T R U N C O S T S

1 . T o t a l V a r i a b l e C o s t s ( T V C )

1. Some costs vary more or less proportionately with the output, known as Primeor Variable Costs

2. Variable Costs are expenses that change in proportion to the activity of abusiness

3. In other words, variable cost is the sum of marginal costs. It can also beconsidered normal costs

4. When period is short (Short Run), distinction between fixed and variable costcan be made, but in a longer period (Long Run) all fixed costs are changedinto variable costs

2 . F i x e d C o s t s ( T F C )

1. Some costs are fixed and do not vary with variation in output, these are knownas Supplementary, Overhead or Fixed Costs

2. In economics, Fixed Costs are business expenses that are not dependent onthe activities of the business

3. Supplementary or fixed costs must be paid even though production has beenstopped temporarily.

4. They include Land Rent, Salaries, Interest On Capital etc

3 . T o t a l C o s t s ( T C )

1. Total Cost (TC) describes the total economic cost of production and is madeup of variable costs, which vary according to the quantity of a good producedand include inputs such as labor and raw materials, plus fixed costs, which areindependent of the quantity of a good produced and include inputs (capital)that cannot be varied in the short term, such as buildings and machinery

2. Sum of TFC and TVC

A V E R A G E C O S T

A v e r a g e F i x e d C o s t ( A F C )

1. It is fixed cost per unit of output2. Mathematically [Q = Quantity Of Output]

3. Average fixed cost is a per-unit measure of fixed costs. As the total number ofgoods produced increases, the average fixed cost decreases because the sameamount of fixed costs are being spread over a larger number of units.

A v e r a g e V a r i a b l e C o s t ( A V C )

1. It is variable expenses per unit of output2. Average variable cost (AVC) is an economics term to describe a firms variable

costs (labor, electricity, etc.) divided by the quantity (Q) of total units ofoutput.

3. Mathematically

4. AVC decreases with increase in output, but after a point it starts to increase.It is because firm was not producing efficiently

A v e r a g e T o t a l C o s t ( A T C )O r A v e r a g e C o s t ( A C )

1. Average total cost is the sum of all the production costs divided by the numberof units produced.

2. Average Cost is equal to total cost divided by the number of goods produced(the output quantity, Q).

3. It is also equal to the sum of average variable costs (total variable costsdivided by Q) plus average fixed costs (total fixed costs divided by Q).

4. Mathematically:

Or AC = AFC + AVC

M A R G I N A L C O S T ( M C )

1. Marginal Cost is the increase or decrease in costs as a result of one more orone less unit of output

2. Note that the marginal cost may change with volume, and so at each level ofproduction, the marginal cost is the cost of the next unit produced

L O N G R U N C O S T S

L O N G R U N A V E R A G E C O S T ( L R A C )

1. The long-run average cost curve depicts the per unit cost of producing a goodor service in the long run when all inputs are variable.

2. The curve is created as an envelope of an infinite number of short-run averagetotal cost curves. The LRAC curve is U-shaped, reflecting economies of scalewhen negatively-sloped and diseconomies of scale when positively sloped.

3. LRAC are normally U shaped but will be relatively flatter then short run curves

L O N G R U N M A R G I N A L C O S T ( L R M C )

1. In the beginning, LRMC falls sharply2. After reaching minimum it starts to rise sharply3. It has U shaped curve

R E L A T I O N S H I P S B E T W E E N C O S T S

M A R G I N A L A N D A V E R A G E C O S T S

1. When declining, marginal cost is always below average cost2. At the point when MC crosses AVC/ATC, AVC/ATC stops declining3. When increasing, marginal cost is always above average cost

4.

M A R G I N A L A N D T O T A L C O S T S

1. When total cost is increasing at increasing rate marginal cost is increasing2. When total cost is increasing at decreasing rate marginal cost in decreasing3. When total cost has reached maximum marginal cost is 0