Cost-Output Relationship

A proper understanding of the nature and behavior of costs is a must for regulation and control of cost of
production. The cost of production depends on money forces and an understanding of the functional relationship
of cost to various forces will help us to take various decisions. Output is an important factor, which influences
the cost.

The cost-output relationship plays an important role in determining the optimum level of production.
Knowledge of the cost-output relation helps the manager in cost control, profit prediction, pricing, promotion
etc. The relation between cost and its determinants is technically described as the cost function.
C= f (S, O, P, T ….)

Where;

 C= Cost (Unit or total cost)

 S= Size of plant/scale of production
 O= Output level
 P= Prices of inputs
 T= Technology
Considering the period the cost function can be classified as (1) short-run cost function and (2) long-run cost
function. In economics theory, the short-run is defined as that period during which the physical capacity of the
firm is fixed and the output can be increased only by using the existing capacity allows to bring changes in output
by physical capacity of the firm.

1. Cost-Output Relationship in the Short-

Run
The cost concepts made use of in the cost behavior are Total cost, Average cost, and Marginal cost.
Total cost is the actual money spent to produce a particular quantity of output. Total Cost is the summation of
Fixed Costs and Variable Costs.

TC=TFC+TVC
Up to a certain level of production Total Fixed Cost i.e., the cost of plant, building, equipment etc, remains fixed.
But the Total Variable Cost i.e., the cost of labor, raw materials etc., vary with the variation in output. Average
cost is the total cost per unit. It can be found out as follows.

AC=TC/Q

The total of Average Fixed Cost (TFC/Q) keep coming down as the production is increased and Average Variable
Cost (TVC/Q) will remain constant at any level of output.

Marginal Cost is the addition to the total cost due to the production of an additional unit of product. It can be
arrived at by dividing the change in total cost by the change in total output.

In the short-run there will not be any change in Total Fixed C0st. Hence change in total cost implies change in
Total Variable Cost only.

Units of Total Total Total Average Average Average

Output fixed variable cost variable fixed cost cost
Q cost cost TVC (TFC + cost (TVC (TFC / Q) (TC/Q)
TFC TVC) / Q) AVC AFC AC
TC

0 – – 60 – – –

1 60 20 80 20 60 80

2 60 36 96 18 30 48

3 60 48 108 16 20 36

4 60 64 124 16 15 31

5 60 90 150 18 12 30
 6 60 132 192 22 10 32

The above table represents the cost-output relationship. The table is prepared on the basis of the law of
diminishing marginal returns. The fixed cost Rs. 60 May include rent of factory building, interest on capital,
salaries of permanently employed staff, insurance etc. The table shows that fixed cost is same at all levels of
output but the average fixed cost, i.e., the fixed cost per unit, falls continuously as the output increases. The
expenditure on the variable factors (TVC) is at different rate. If more and more units are produced with a given
physical capacity the AVC will fall initially, as per the table declining up to 3rd unit, and being constant up to
4th unit and then rising. It implies that variable factors produce more efficiently near a firm’s optimum capacity
than at any other levels of output and later rises. But the rise in AC is felt only after the start rising. In the table
‘AVC’ starts rising from the 5th unit onwards whereas the ‘AC’ starts rising from the 6th unit only so long as
‘AVC’ declines ‘AC’ also will decline. ‘AFC’ continues to fall with an increase in Output. When the rise in
‘AVC’ is more than the decline in ‘AFC’, the total cost again begin to rise. Thus there will be a stage where the
‘AVC’, the total cost again begin to rise thus there will be a stage where the ‘AVC’ may have started rising, yet
the ‘AC’ is still declining because the rise in ‘AVC’ is less than the droop in ‘AFC’.
Thus the table shows an increasing returns or diminishing cost in the first stage and diminishing returns or
diminishing cost in the second stage and followed by diminishing returns or increasing cost in the third stage.
The short-run cost-output relationship can be shown graphically as follows.
In the above graph the “AFC’ curve continues to fall as output rises an account of its spread over more and more
units Output. But AVC curve (i.e. variable cost per unit) first falls and than rises due to the operation of the law
of variable proportions. The behavior of “ATC’ curve depends upon the behavior of ‘AVC’ curve and ‘AFC’
curve. In the initial stage of production both ‘AVC’ and ‘AFC’ decline and hence ‘ATC’ also decline. But after
a certain point ‘AVC’ starts rising. If the rise in variable cost is less than the decline in fixed cost, ATC will still
continue to decline otherwise AC begins to rise. Thus the lower end of ‘ATC’ curve thus turns up and gives it a
U-shape. That is why ‘ATC’ curve are U-shaped. The lowest point in ‘ATC’ curve indicates the least-cost
combination of inputs. Where the total average cost is the minimum and where the “MC’ curve intersects ‘AC’
curve, It is not be the maximum output level rather it is the point where per unit cost of production will be at its
lowest.

The relationship between ‘AVC’, ‘AFC’ and ‘ATC’ can be summarized up as follows:

1. If both AFC and ‘AVC’ fall, ‘ATC’ will also fall.

2. When ‘AFC’ falls and ‘AVC’ rises
 ‘ATC’ will fall where the drop in ‘AFC’ is more than the raise in ‘AVC’.
 ‘ATC’ remains constant is the drop in ‘AFC’ = rise in ‘AVC’
 ‘ATC’ will rise where the drop in ‘AFC’ is less than the rise in ‘AVC’
2. Cost-output Relationship in the Long-
Run
Long run is a period, during which all inputs are variable including the one, which are fixes in the short-run. In
the long run a firm can change its output according to its demand. Over a long period, the size of the plant can
be changed, unwanted buildings can be sold staff can be increased or reduced. The long run enables the firms to
expand and scale of their operation by bringing or purchasing larger quantities of all the inputs. Thus in the long
run all factors become variable.

The long-run cost-output relations therefore imply the relationship between the total cost and the total output. In
the long-run cost-output relationship is influenced by the law of returns to scale.

In the long run a firm has a number of alternatives in regards to the scale of operations. For each scale of
production or plant size, the firm has an appropriate short-run average cost curves. The short-run average cost
(SAC) curve applies to only one plant whereas the long-run average cost (LAC) curve takes in to consideration
many plants.

The long-run cost-output relationship is shown graphically with the help of “LCA’ curve.

To draw on ‘LAC’ curve we have to start with a number of ‘SAC’ curves. In the above figure it is assumed that
technologically there are only three sizes of plants – small, medium and large, ‘SAC’, for the small size, ‘SAC2’
for the medium size plant and ‘SAC3’ for the large size plant. If the firm wants to produce ‘OP’ units of output,
it will choose the smallest plant. For an output beyond ‘OQ’ the firm wills optimum for medium size plant. It
does not mean that the OQ production is not possible with small plant. Rather it implies that cost of production
will be more with small plant compared to the medium plant.

For an output ‘OR’ the firm will choose the largest plant as the cost of production will be more with medium
plant. Thus the firm has a series of ‘SAC’ curves. The ‘LCA’ curve drawn will be tangential to the entire family
of ‘SAC’ curves i.e. the ‘LAC’ curve touches each ‘SAC’ curve at one point, and thus it is known as envelope
curve. It is also known as planning curve as it serves as guide to the entrepreneur in his planning to expand the
production in future. With the help of ‘LAC’ the firm determines the size of plant which yields the lowest average
cost of producing a given volume of output it anticipates.

Description of Cost-Output Relationship : Managerial Economics

Cost-output relationship plays an important role in determining the optimum level of production.
Knowledge of thecost-output relation helps the manager in cost control, profit prediction, pricing,
promotion etc. The relation between cost and its determinants is technically described as the cost
function.
Proper understanding of the nature and behavior of costs is a must for regulation and control of cost
of production. The cost of production depends on money forces and an understanding of the functional
relationship of cost to various forces will help us to take various decisions. Output is an important
factor, which influences the cost.

Cost-Output Relationship in Short-Run - Cost concepts made use of in the cost behavior are
Total cost, Average cost, and Marginal cost. Total cost is the actual money spent to produce a
particular quantity of output. Total Cost is the summation of Fixed Costs and Variable Costs.
TC=TFC+TVC
Upto a certain level of production Total Fixed Cost i.e., the cost of plant, building, equipment etc,
remains fixed. But the Total Variable Cost i.e., the cost of labor, raw materials etc., vary with the
variation in output. Average cost is the total cost per unit. It can be found out as follows.
AC=TC/Q
Total of Average Fixed Cost (TFC/Q) keep coming down as the production is increased and
Average Variable Cost (TVC/Q) will remain constant at any level of output.

Cost-output Relationship in Long-Run – This is a period, during which all inputs are variable
including the one, which are fixes in the short-run. In the long run a firm can change its output
according to its demand. Over a long period, the size of the plant can be changed, unwanted
buildings can be sold staff can be increased or reduced. The long run enables the firms to expand
and scale of their operation by bringing or purchasing larger quantities of all the inputs. Thus in
the long run all factors become variable.

Long-run cost-output relations therefore imply the relationship between the total cost and the total
output. In the long-run cost-output relationship is influenced by the law of returns to scale. In the
long run a firm has a number of alternatives in regards to the scale of operations. For each scale
of production or plant size, the firm has an appropriate short-run average cost curves. The short-
run average cost (SAC) curve applies to only one plant whereas the long-run average cost (LAC)
curve takes in to consideration many plants.

COST OUTPUT RELATIONSHIP IN THE SHORT RUN

COST OUTPUT RELATIONSHIP IN THE SHORT RUN

In the short-run a change in output is possible only by making changes in the

variable inputs like raw materials, labour etc. Inputs like land and buildings, plant and
machinery etc. are fixed in the short-run. It means that short-run is a period not sufficient
enough to expand the quantity of fixed inputs. Thus Total Cost (TC) in the short-run is
composed of two elements – Total Fixed Cost (TFC) and Total Variable Cost (TVC).

TFC remains the same throughout the period and is not influenced by the level of
activity. The firm will continue to incur these costs even if the firm is temporarily shut down.
Even though TFC remains the same fixed cost per unit varies with changes in the level of
output.

On the other hand TVC increases with increase in the level of activity, and decreases
with decrease in the level of activity. If the firm is shut down, there are no variable costs.
Even though TVC is variable, variable cost per unit is constant.

So in the short-run an increase in TC implies an increase in TVC only. Thus:

TC = TFC + TVC

TFC = TC – TVC

TVC = TC – TFC

TC = TFC when the output is zero.

The graph below shows Short-run cost output relationship.

In the graph X-axis measures output and Y-axis measures cost. TFC is a straight line
parallel to X-axis, because TFC does not change with increase in output.

TVC curve is upward rising from the origin because TVC is zero when there is no
production and increases as production increases. The shape of TVC curve depends upon
the productivity of the variable factors. The TVC curve above assumes the Law of Variable
Proportions, which operates in the short-run.

TC curve is also upward rising not from the origin but from the TFC line. This is
because even if there is no production the TC is equal to TFC.

It should be noted that the vertical distance between the TVC curve and TC curve is
constant throughout because the distance represents the amount of fixed cost which
remains constant. Hence TC curve has the same pattern of behaviour as TVC curve.

Short-run Average Cost and Marginal Cost

The concept of cost becomes more meaningful when they are expressed in terms of
per unit cost. Cost per unit can be computed with reference to fixed cost, variable cost, total
cost and marginal cost. The following diagram reveals the relationship that exists among
these concepts:
Average Fixed Cost (AFC): Average fixed cost is obtained by dividing the TFC by the
number of units produced. Thus:

AFC = TFC/Q where, ‘Q’ refers quantity of production.

Since TFC is constant for any level of activity, fixed cost per unit goes on diminishing
as output goes on increasing. The AFC curve is downward sloping towards the right
throughout its length, with a steep fall at the beginning.

Average Variable Cost (AVC): Average Variable Cost is obtained by dividing the TVC by the
number of units produced. Therefore:

AVC = TVC / Q

Due to the operation of the Law of Variable Proportions AVC curve slopes downwards
till it reaches a certain level of output and then begins to rise upwards.

Average Total Cost (ATC): Average Total Cost or simply Average Cost is obtained by dividing
the TC by the number of units produced. Thus:
 ATC = TC / Q

The ATC curve is very much influenced by the AFC and AVC curves. In the beginning
both AFC curve and AVC curve decline and therefore ATC curve also declines. The AFC curve
continues the trend throughout, though at a diminishing rate. AVC curve continues the
trend till it reaches a certain level and thereafter it starts rising slowly. Since this rise initially
is at a rate lower than the rate of decline in the AFC curve, the ATC curve continues to
decline for some more time and reaches the lowest point, which obviously is further than
the lowest point of the AVC curve. Thereafter the ATC curve starts rising because the rate
of rise in the AVC curve is greater than the rate of decline in the AFC curve.

Marginal Cost (MC): Marginal Cost is the increase in TC as a result of an increase in output
by one unit. In other words it is the cost of producing an additional unit of output.

MC is based on the Law of Variable Proportions. A downward trend in MC curve shows

decreasing marginal cost (i.e. increasing marginal productivity) of the variable input.
Similarly an upward trend in MC curve shows increasing marginal cost (i.e. decreasing
marginal productivity). MC curve intersects both AVC and ATC curves at their lowest points.

The relationship between AVC, AFC, ATC and MC can be summed up as follows.

1. If both AFC and AVC fall ATC will also fall because ATC = AFC + AVC

2. When AFC falls and AVC rises (a) ATC will fall where the drop in AFC is more than the rise
in AVC (b) ATC remains constant if the drop in AFC = the rise in AVC, and (c) ATC will rise
where the drop in AFC is less than the rise in AVC.

3. ATC will fall when MC is less than ATC and ATC will rise when MC is more than ATC. The
lowest ATC is equal to MC.

The following Table illustrates cost output relationship in the short-run, with
reference to different concepts of cost.
Least Cost Input Combination
In the short run least cost input combination lies at the output level where marginal
cost is equal to average total cost (MC = ATC). At this output level the ATC will be the least.
It is also called the short-run stage of optimum output.

1
Cost Output Relation and Learning Curve
Cost Output Relation and Learning Curve
Content

Types of costs

Cost Function

Cost output Relation

Cost output Relation

Economies of scale

Diseconomies of scale

Learning curve

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Cost Output Relation and Learning Curve
Learning Curve

The Learning Curve was first described by psychologist Hermann Ebbinghaus in1885 and
elaborated by psychologist Arthur Bills in 1934.

It is a concept that describes how new knowledge or skills can be quickly acquiredinitially, but
subsequent learning becomes much slower. At first, a minimalinvestment of resources yields
significant results, but the payback from continuingeffort is small.

A learning curve is a graphical presentation of a changing rate of learning (in theaverage person)
for the given level of activity or tool. Typically, the increase inretention of information is
sharpest after the initial attempts, and then gradually evensout, meaning that less and less new
information is retained after each repetition.

The learning Curve also represent at a glance the initial difficulty of learningsomething and, to
an extent, how much there is to learn, but offers little after initialfamiliarity. For Example the
Windows program notepad is extremely simple to learn, but offers very little after it which
means as u learn how to work on notepad there arevery less features that you can use or limited
functions that can be performed. On theother hand is a UNIX terminal editor vi, which is
difficult to learn, but offers a widearray of features to master after the user has figured out how to
work it which impliesthat once you are familiar with the operations of UNIX there are wide
range of functions that you can perform but the most difficult task is to learn the basicoperations
of UNIX terminal editor. It is possible for something to be easily learned, but difficult to master
or hard to learn with little beyond this.
The Learning Curve is one of the methods of estimating cost, especially direct labor cost. The
theory assumes that at the early stage of production staff will use moreaverage hour to finish a
process and as they gain experience the average time per piece of unit produced or customer
service will reduce. The reduction in the averagetime taken is on a constant rate as production
mounts. A Learning curve of 70%, 80%or 90% means that as production mounts or doubles, the
average time per unit falls by30%, 20% or 10% respectively.

The concept of learning Curve basically states that there is less and less learning asmore
repetitive steps are taken and The Boston Consulting Group has conducted someempirical study
and below are the conclusions from that study:

The time required to perform a task decreases as the task is repeated.

The amount of improvement decreases as more units are produced

The rate of improvement has sufficient consistency to allow its use as a predictiontool.

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Cost Output Relation and Learning Curve

Consistency in improvement has been found to exist in the form of a constant percentage
reduction in time required over successively doubled units of quantity produced. The constant
percentage by which the costs of doubled quantities decreaseis called the rate of learning. The
slope of learning curve is 100 minus the rate of learning. For Example, if the hours between
doubled quantities are reduced by 20%(rate of learning), it would be described as a curve with an
80% slope. The shape of curve would be:

For Optimal learning to take place, make sure there is interest and motivation inthings being
learned. Otherwise learning and performance will be compromised.Learning curve can be
applied to every aspect of business and life
–
from software, tolearning about your consumer needs.
Learning Curve in long term introduces new information to increase efficiency andworkers or
managers can become better adapted to their jobs, more experienced, moreefficient by which
long term average cost decreases.

Here ‘Efficiency’ means greater amo

unt of output generated per labor unit over thesame amount of input of labor hours in the process
of production. This happens onaccount of following factors:

The labor units or the workers who are engaged in the production or manufacturing process
become familiar with the process of production with the passage of time.Thus, they require less
time or labor hours to generate same amount of output whichthey were earlier producing by
using more labor hours.

Managers who are involved in the management and scheduling of the production process also get
familiar with the process and are thus in better position to use theresources at their disposal in
better manner as well as scheduling the production process more efficiently thus leading to more
output for the same amount of input.

Following Diagram is representation of the Learning Curve Effect:

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Cost Output Relation and Learning Curve

In the above diagram on the X axis, we have taken the number of lots or batches of Good
produced and on the Y axis we are considering the labor hours required per lotof Good produced.
It is clear from the diagram that the labor hours required to produce each lot is higher when the
firm is producing the first or initial few lots or batches of good. The labor hours required per lot
of production to produce the secondlot or later lots on the other hand is lower. As per the above
depicted diagram thelabor hours required to produce the first lot is close to four hours. While the
labor hours required for producing the second lot is close to two hours. The labor
hour requirement per lot further goes down by the time company is producing the third andthe
fourth lot of the Good or Product.