Cost analysis

1. Cost Analysis
Cost is the expense incurred in producing a commodity.
It is the most important force governing the supply of a product.
It is determined by the price of factor inputs used in the production of a
product
If the price of the factor inputs are high the cost of production also will
be high.
Business executives use the cost figures in the determination of profit.
The managerial economists use cost analysis to solve managerial
problems.

2. Cost Concepts
A. Real cost and Money Cost
Real Cost – Includes the trouble, commotion and sacrifices
involved in producing a product.
It is purely subjective and beyond accurate measurement.
Money Cost- It refers to the total money expenditure incurred by a
firm on various items which it uses for production. Eg. Wages,
Prices for raw material, fuel,power,transport, advertising, etc.

3. They are included in the cost of production
Money cost is divided into two
i) 1. Explicit Cost- It includes those costs which are made by
the firm to those factors of production not belonging to it. Eg.
Wages and Salaries
ii) 2. Implicit cost – It refers to those costs which do not take
the form of cash outlay or appear in the accounting system. It
means those factors which are possessed and supplied by the
employer himself.
Implicit cost are hidden and do not appear in the accounting
record of a firm.

4. i) 3. Actual cost and opportunity cost
Actual cost – are those that involve financial expenditure
incurred for acquiring inputs for producing a commodity.
They are recorded in the books of accounts of the firm. It is
the actual cost or outlay cost.
Opportunity cost –It is the cost of producing any commodity
which is the next best alternative good i.e. sacrificed. It is also
called alternative cost.
In business decision making opportunity cost concept is very
important
It helps in determining the remuneration to services.

5. Importance of the concepts of Opportunity cost
When the company with its limited resources wants
to make a choice between another layer of
advertising in the established markets or some
basic changes in the product line, it has to examine
the opportunity cost of these proposals.

6. Past and Future costs
Past costs are costs incurred in the past and are
mentioned in the financial accounts.
Future costs are those cost which are to be incurred
in the near future and are useful for forecast and
managerial decisions.

7. Short run and Long run costs
Short run costs are those associated with variation in
the utilization of fixed plant and other facilities.
Long run costs encompassed changes in the size and
kind of plant.

8. Fixed cost and Variable cost
Fixed costs are those cost which remain fixed
whatever be the level of output.
Variable costs are those cost which changes in the
level of output.

9. Incremental cost and Sunk Cost
Incremental costs are added costs of a change in the
level of a production or the nature of activity .
Sunk costs are those costs which can not be altered in
any way. Eg. The cost for constructing a building.

10. Traceable and Common cost (Direct and Indirect
cost)
Traceable or Direct cost is that cost which can be easily
identified and traced.
Common or Indirect costs are those cost which can not
be easily identified and traced to any plant or
machinery. For Eg. Salary of a divisional manager is a
direct cost and salary of General Manager is an Indirect
cost.

11. Replacement and Historical Cost
Historical Cost is the actual cost incurred at the
time of the purchase of machinery Replacement
cost which will have to be incurred if an new
machinery is purchased in the place of the old
one.

12. Cost Output Relationship
Short run
It defined as the period in which the firm can vary its output
by varying the amount of variable factors only .
Long run is defined as a period in which quantity is of all
factors can be increased.
In the Long run there are no fixed cost but all cost are
variable.

13. Total Cost Curve
The cost of production can be analysed from another point.
Some cost are more or less fixed while others are variable.
Variable cost are also known as prime cost, while the latter is
called supplementary cost.
The total cost is obtained by adding total fixed cost and total
variable cost.

15. Average total cost and Marginal Cost
Average total cost is total cost divided by the number of units of
the product.
It will generally for has output rises from zero to normal capacity output due
to increasing returns. But beyond the normal capacity output the average cost
will rise steeply because of the operation of diminishing returns.

16. Average Fixed Cost and Average Variable cost
Average Fixed cost is the total fixed cost divided by the number
of units of output produced.
Average variable cost is the total variable cost divided by the
number of units of output produced.

17. Marginal Cost
It is the addition to the total cost by producing one unit of the
output or marginal cost is the addition to the total cost of
producing N units instead of n-1 units (or one less) where n is any
given number.
MCn =TCn –TCn-1
Marginal cost varies inversely with marginal product of the
variable factor.
Marginal cost taken along with marginal revenue concept, helps
the management in rational decision taking.

19. Relationship between AC and MC
 Initially both AC and MC slopes downwards
 After a certain level of output MC starts rising while AC continues to fall.
 MC intersects AC only at its minimum quantity.
Before intersection AC was greater than MC but after intersection MC is greater than AC.

20. Long run Average cost curve
In the long run the firm can vary all its inputs unlike short run in
which some inputs are fixed and others are variable. A long run
cost curve depicts the functional relationship between out put and
the long run cost of production.
Long run is defined as a period of time during which the firm can
vary all its inputs the long run average cost is the long run total
cost divided by the level of output. It depicts the least possible the
average cost of producing all possible level of output.

21. To derive the long run average cost curve we may take three short
run average cost curves. They are also called Plant Curves.
The term plant refers to input size of the plant which is fixed and it
can not be increased or decreased.
The three short run average cost curves show three different scales
of production or three different plant sizes.

22. In the long run it will examine with which size of plants or on
which short average cost curves it should operate to produce a
given level of output with minimum cost.
Up to OB amount of output the firm will operate on SAC1 though
he could also produce with SAC2
If the level of output is OA it will cost AL per unit and if it is
produced with SAC2 it will cost AH which is more than AL.
Similarly if the firm wants to produce an output larger than OB but
less than OD then it will not be economical to produce on SAC1.
Here the firm will have to use SAC2 .

23. Similarly the firm will use SAC3 for output larger than
OD.
It shows that in the long run the firm has a choice in the
employment of plant and it will employ that plant which
yields minimum possible unit cost for producing a given
output.

24. Long run average cost curve
It is also called planning curve. Because it helps a firm to plan to produce any
output by choosing a plant on the long run average cost curve enveloping a
family of plant curves (short run cost curves).

25. Features of long run average cost curve
a. LAC curve is an envelope curve because it envelops all the
short run average cost curves.
b. It is also called as tangent curve because it is drawn by
joining the loci of various planned curves relating to different
operational short run periods also called planning curve of the firm
because it indicates the least unit cost of producing each possible
level of output.
c. It is called flatter U shaped because it slops downwards and
then after reaching a certain point it gradually begins to slop
upwards.
d. LAC curve represents minimum cost combinations for each
level of output in the long run.

26. Long run Marginal Cost Curve (LMC)
It is derived from the short run marginal cost curves to derive LMC the
tangency points between SACs and LAC should be consider.
In the diagram when the firm produces OM1 level of output LMC is equal to M1 D.

27. If the out put increases to OM2 LMC decreases to BM2 it starts
rising if the output is produced beyond OM2. Similarly CM3
measures LMC at output OM3. The LMC curve is also a flat U
shape. The shape of LMC curve is also a flatter U shape indicating
that as output expands in the long run with increasing scale of
production.