2. Topics to be covered
– Accounting Costs and Economic Costs
– Short Run Cost Analysis: Fixed, Variable and Total Cost Curves
– Average and Marginal Costs
– Long Run Cost Analysis: Economies and Diseconomies of Scale
– Long Run Average and Marginal Cost Curves
3. Cost Concept
– It refers to the expenditure incurred by a producer on the factor as well as non-factor inputs for a
given amount of output of a commodity.
– Cost Function: A cost function shows the functional relationship between output and cost of
production. It is given as
– C = F(Q)
– Where, C – cost, F = function, Q = output
– Implicit Cost These are the costs of self-owned and self-employed or self-supplied resources,
e.g. rent of own land, interest on own capital, etc.
– Explicit Cost These are those actual cash payments, which firms make to outsiders for their
goods and services, e.g. wages, payment for raw material , rent, interest, etc.
4. Accounting Cost VS Economic Cost
– 1. Accounting costs
– Accounting costs are those for which the entrepreneur pays direct cash for procuring resources for production.
These include costs of the price paid for raw materials and machines, wages paid to workers, electricity
charges, the cost incurred in hiring or purchasing a building or plot, etc. Accounting costs are treated as
expenses. Chartered accountants record them in financial statements.
– Accounting costs are the explicit costs, also known hard costs that are seen as money out of your bank account
that you need to run your business. These are production costs, lease payments, marketing budgets and
payroll. In other words, these are the real costs in manufacturing, marketing and delivering your products.
– Explicit costs have a monetary value and are easily identified on a bookkeeper's ledger. Accounting costs are
generally real-time costs that are deducted from revenues in any given accounting period.
– Accounting costs are used as a very traditional means to determine a company's financial health. As a business
owner, you want to know what money is coming in and what funding gets applied to which expense. This is why
accounting costs are very popular when determining the financial health of the company. Accounting costs are
used in reporting taxes.
5. Economic Costs
– 2. Economic costs
– There are certain costs that accounting costs disregard. These include money which the entrepreneur forgoes
but would have earned had he invested his time, efforts and investments in other ventures. For example, the
entrepreneur would have earned an income had he sold his services to others instead of working on his own
business.
– Economic costs include the same explicit costs that accounting costs use in calculations, but economic costs
also include implicit costs. Implicit costs are those values that are not listed on the ledger, and they are
assumed by the business to utilize resources. The idea with implicit costs is that the business could make more
by using an asset in a different, more traditional fashion. A paper company with a tree grove could yield more
money from the resource, if it sold lumber rather than if it harvested the trees for paper production.
– Economic costs are still very valuable to a business, because they determine long-term strategies. Economic
costs provide a high-level overview of what the company is really valued at and what it could be valued at, if it
changed the way it uses its resources and assets. This information could effect strategies to enter or exit
markets or to hold existing market patterns. Knowing that a company has a resource of value is also important
for financing, because it gives lenders and investors the confidence that the company has assets of real value
that can be leveraged for capital.
6.
7. – Economic cost takes into account costs attributed to the alternative chosen and costs specific to the forgone
opportunity. Before making economic decisions, there are a series of components of economic costs that a firm
will take into consideration. These components include:
• Total cost (TC): total cost equals total fixed cost plus total variable costs (TC = TFC + TVC).
• Variable cost (VC): the cost paid to the variable input. Inputs include labor, capital, materials, power, land, and
buildings. Variable input is traditionally assumed to be labor.
• Total variable cost (TVC): same as variable costs.
• Fixed cost (FC): the costs of the fixed assets (those that do not vary with production).
• Total fixed cost (TFC): same as fixed cost.
• Average cost (AC): total costs divided by output (AC = TFC/q + TVC/q).
• Average fixed cost (AFC): the fixed costs divided by output (AFC = TFC/q). The average fixed cost function
continuously declines as production increases.
• Average variable cost (AVC): variable costs divided by output (AVC = TVC/q). The average variable cost curve is
normally U-shaped. It lies below the average cost curve, starting to the right of the y axis.
• Marginal cost (MC): the change in the total cost when the quantity produced changes by one unit.
• Cost curves: a graph of the costs of production as a function of total quantity produced. In a free market
economy, firms use cost curves to find the optimal point of production (to minimize cost). Maximizing firms use
the curves to decide output quantities to achieve production goals.
8. Fixed Cost vs Variable Cost
– Fixed Cost Meaning
– Fixed cost is referred to as that cost which does not register a change with an increase or decrease in the
quantity of goods produced by a firm. Fixed costs are those costs that a company should bear irrespective of
the levels of production.
– Fixed costs are less controllable in nature than the variable costs as they are not dependent on the production
factors such as volume.
– The different examples of fixed costs can be rent, salaries, property taxes.
– Variable Cost Meaning
– Variable cost is referred to as that type of cost that will show variations as per the changes in the levels of
production. Depending on the volume of production in a company, the variable cost increases or decreases.
– The various examples of variable costs are cost of raw materials that are used for production, sales
commissions, labour cost etc.
9. MEANS OF DIFFERENTIATIONS VARIABLE COST
FIXED COST
Definition Costs that vary/change
depending on the
company’s production
volume
Costs that do not
change in relation to
production volume
When Production
Increases
Total variable costs
increase
Total fixed cost stays
the same
When Production
Decreases
Total variable costs
decrease
Total fixed cost stays
the same
Examples Direct Materials (i.e.
kilograms of wood,
tons of cement)
Rent
Direct Labor (i.e. labor
hours)
Advertising
Insurance
Depreciation
10. Fixed Cost Variable Cost
Definition
Fixed cost is referred to as that cost which does
not register a change with an increase or decrease
in the quantity of goods produced by a firm
Variable cost is referred to as that type of cost
that will show variations as per the changes in the
levels of production.
Nature of Cost
It is time dependent and changes after a certain
time period
It is volume dependent and changes based on
volume produced
How are they incurred?
Fixed costs are incurred irrespective of any units
are produced or not
Variable costs are incurred as and when any units
are produced
Does it change with the number of units?
Fixed cost decreases with increase in number of
units produced
Variable cost remains same irrespective of
number of units produced
Impact on Profit
Higher production results in reduced costs which
increases profits
There is no impact on profit with the level of
production
Examples
Rent, Salaries, Property taxes Labour cost, cost of raw materials, sales
commissions
12. Average Cost Vs Marginal Cost
• Marginal cost: The increase in cost that accompanies a unit increase in output; the partial derivative
of the cost function with respect to output. Additional cost associated with producing one more unit of
output. In economics, marginal cost is the change in the total cost when the quantity produced
changes by one unit. It is the cost of producing one more unit of a good. Marginal cost includes all of
the costs that vary with the level of production. For example, if a company needs to build a new
factory in order to produce more goods, the cost of building the factory is a marginal cost. The amount
of marginal cost varies according to the volume of the good being produced. Economic factors that
impact the marginal cost include information asymmetries, positive and negative externalities,
transaction costs, and price discrimination. Marginal cost is not related to fixed costs.
• Average cost: In economics, average cost or unit cost is equal to total cost divided by the number of
goods produced. The average cost is the total cost divided by the number of goods produced. It is
also equal to the sum of average variable costs and average fixed costs. Average cost can be
influenced by the time period for production (increasing production may be expensive or impossible in
the short run). Average costs are the driving factor of supply and demand within a market. Economists
analyze both short run and long run average cost. Short run average costs vary in relation to the
quantity of goods being produced. Long run average cost includes the variation of quantities used for
all inputs necessary for production.
13. Relation between Average Cost and Marginal Cost:
Relation between average cost and marginal cost is explained through Table 8 and Fig. 9.
14. Marginal cost is estimated as the difference between total
costs of two successive units of output. Thus,
MCn = TCn – TCn-1
(ii) When MC is diminishing, TC increases at a
diminishing rate.
(iii) When MC is rising, TC increases at an increasing rate.
(iv) When MC reaches its lowest point (point Q in Fig. 11),
TC stops increasing at a decreasing rate (point Q* in Fig.
11).
Briefly, MC is the rate of TC.
15. SHORT RUN COSTS
– What Is Short Run Cost?
– According to the short run, there are both fixed and variable costs. According to long run,
there are no fixed costs. Methodical long run cost prices are sustained when the blend
of end results that an enterprise manufactures outcomes in the desired amount of
the commodities at the lowest and inexpensive possible price. Variable costs differ
with the end results (output).
– Definition
– Short Run Cost is the cost price which has short-term inferences in the manufacturing
procedures, i.e., these are utilised over a short degree of end results. These are the cost
sustained once and cannot be used again, such as payment of wages, cost price of raw
materials, etc.,
16. – In a short-run, at least 1 aspect of production is fixed while the other
stays variable. Hence, in short-run, the degree of end results can be
raised only by increasing the variable aspects such as raw materials,
labour, while other factors such as plant size, capital, remains constant.
The short-run cost comprises both the fixed cost (that do not differ with
the change in the degree of end results) and variable cost (that differs
with the changes in the level of degree of end results). Some factors
remain constant or fixed due to the time restrictions forced on an
establishment.
18. LONG RUN COSTS
– What Is Long Run Costs?
– According to the long run, all inputs are variable. There is no fixed cost. The total cost and the total variable cost
hence, coincide and concur in the long run. Long run average cost (LRAC) is derived as cost price per unit of end
result (Output), i.e
– LRAC = TC / q
– The long run is a spell of time in which all factors of manufacturing and costs are variable. In the long run,
enterprises are capable of modifying all cost prices, whereas, in the short run, enterprises are only capable of
impacting cost prices through modifications made to production degrees.
– There is no difference between the LTC (Long run Total Costs) and long run variable cost as there are no fixed
costs. It must be noted that the capability of an establishment of changing inputs sanctions it to manufacture at
less price in the long run.
19. Short Run and Long Run Costs
– Long Run Costs
– Long run costs are accumulated when firms change production levels over time in response to
expected economic profits or losses. In the long run there are no fixed factors of production. The
land, labor, capital goods, and entrepreneurship all vary to reach the the long run cost of producing
a good or service. The long run is a planning and implementation stage for producers. They analyze
the current and projected state of the market in order to make production decisions. Efficient long
run costs are sustained when the combination of outputs that a firm produces results in the desired
quantity of the goods at the lowest possible cost. Examples of long run decisions that impact a firm’s
costs include changing the quantity of production, decreasing or expanding a company, and
entering or leaving a market.
– Short Run Costs
– Short run costs are accumulated in real time throughout the production process. Fixed costs have
no impact of short run costs, only variable costs and revenues affect the short run production.
Variable costs change with the output. Examples of variable costs include employee wages and
costs of raw materials. The short run costs increase or decrease based on variable cost as well as
the rate of production. If a firm manages its short run costs well over time, it will be more likely to
succeed in reaching the desired long run costs and goals.
20. – Differences
– The main difference between long run and short run costs is that there are
no fixed factors in the long run; there are both fixed and variable factors in
the short run. In the long run the general price level, contractual wages, and
expectations adjust fully to the state of the economy. In the short run these
variables do not always adjust due to the condensed time period. In order to
be successful a firm must set realistic long run cost expectations. How the
short run costs are handled determines whether the firm will meet its future
production and financial goals.
–
27. Economies and Diseconomies of
scale
– Economies of scale are when the cost per unit of production (Average
cost) decreases because the output (sales) increases.
– Diseconomies of scale are when the cost per unit of production (Average
cost) increases because the output (sales) increases.
– Growth brings both advantages and disadvantages to a business. These interact,
and depending on the nature of the business and the way it is managed, decide
the optimum or most efficient size for the business.
– This is the area of economies and diseconomies of scale.
28. – Economies of scale are defined as the cost advantages that an organization can achieve by
expanding its production in the long run.
– In other words, these are the advantages of large scale production of the organization. The cost
advantages are achieved in the form of lower average costs per unit.
– It is a long term concept. Economies of scale are achieved when there is an increase in the
sales of an organization. As a result, the savings of the organization increases, which further
enables the organization to obtain raw materials in bulk. This helps the organization to enjoy
discounts. These benefits are called as economies of scale.
– Diseconomies of scale occur when the long run average costs of the organization increases. It
may happen when an organization grows excessively large. In other words, the diseconomies
of scale cause larger organizations to produce goods and services at increased costs.
30. Reasons for economies of scale
The most common reason for Economies of scale is that some production costs
are fixed (as production increseases these costs stay constant). Therefore since
costs per unit (Average Costs) are calculated by dividing the cost by the number
of units of output
AC=Costs/quantity
Then any average involving Fixed Costs (Numerator) must decrease as quantity
produced (Denominator) increases (make sure you follow this ok)
AFC=FC/Quantity
Fixed Cost economies of scale:
1. Managerial - managers are on a fixed salary
2. Marketing - advertising, endorsements promotional events do not directly
depend on quantity produced
3. Techinical - machinery, buildings etc are paid for as a fixed amount
31. Reasons for diseconomies of scale
1. Communication - becomes more complex
2. Coordination - between departments
3. X- Inefficiency - management costs increase (non-productive costs)
4. Principle agent problem - delegating to employees who are not as
committed as the owner
