COST THEORY AND ESTIMATION

In managerial economics another area which is of great importance is cost of

production. The cost which the firm incurs is the process of production of its goods and services
is an important variable for decision making. Total cost together with total revenue determines
the profit level of a business. In order to maximize profits a firm endeavor to increase its
revenue and lower its costs.
Cost Concepts
Cost play a very important role in managerial decisions especially when a selection
between alternative courses of action is required. It helps in specifying various alternative in
terms of their quantitative values.
Cost Determinants
The costs of production of goods and services depends on various inputs factors used by
the organization and it differs from firm to firm. The major cost determinants are:
1. Level of output. The cost of production varies according to the quantum of output. If
the size of production is large, then the cost of production will also be more.

2. Price of input factors. A rise in the cost of input factors will increase the total cost of
production.

3. Productivities of factors of production. When the productivity of the input factors is

high then the cost of production will fall.

4. Size of plant. The cost of production will be low in a large plant due to mass production
with mechanization.

5. Output stability. The overall cost of production is low when the output is stable over a
period.

6. Lot size. Larger the size of production per batch then the cost of production will come
down because the organization enjoy economies of scale.

7. Laws of returns. The cost of production will increase if the law of diminishing returns
applies in the firm.

8. Levels of capacity utilization. Higher the capacity utilization, lower the cost of
production.

9. Time period. In the long run cost of production will be stable.

10. Technology. When the organization follows advanced technology in their process then
the cost of production will be low.

11. Experience. Over a period of time the experience of production process will help the
firm to reduce cost of production.
 12. Process range of products. Higher the range of products produced, lower the cost of
production.

13. Supply chain and logistics. Better the logistics and supply chain, lower the cost of
production.

14. Government incentives. If the government provides incentives on input factors, then
the cost of production will be lower.

Types of Costs
There is various classification of coast based on the nature the purpose of calculation.
But in economics and for accounting purpose the following are the important cost concepts.
Actual cost/ Outlay cost/Absolute cost/Accounting cost: The cost or expenditure which a firm
incurs for producing or ACQUIRING A GOOD OR SERVICES ( e.i. Raw material cost)
Opportunity cost: the revenue which could have been earned by employing the good or service
in some other alternative uses. ( e.i. a land owned by the firm does not pay rent. Thus, a rent is
an income forgone by not letting it out.
. The opportunity cost associated with choosing a particular decision in measured by
the benefits foregone in the next best alternative.

Sunk cost: Are retrospective (past) costs that have already been incurred and cannot be
recovered.
Historical cost: The price paid for a plant originally at the time of purchase.
Replacement cost: The price that would have to be paid currently for acquiring the same plant.
Incremental cost; Is the addition to costs resulting from a change level of business activity.
Change in cost caused by a given managerial decision.
. Incremental costs are associated with a choice and therefore only ever include
forward-looking
Cost (sunk costs not included)

Explicit cost: Cost actually paid by the firm. If the factors of production are hired or rented,
then it is an explicit cost.
. The actual expenditures of the firm
. Accounting cost

Implicit cost: If the factors of production are owned by a firm then is cost is implicit cost.
. Value of the inputs owned and used by the firm
. Economic costs
. cost that does not require the firm to give up money but rather opportunity

Book cost: Costs which do not involve any cash payments, but a provision is made in the books
of accounts to include in the profit and loss account to take tax advantages.
Social Cost: Total costs incurred by the society on account of production of a good or service.
Transaction cost: The cost associated with the exchange of goods and services.
Controllable cost: Costs which can be controllable by the executives are called as controllable
cost.
Shut down cost: Cost incurred if the firm temporarily stops its operation. These can be saved
by continuing business.
Economic costs are related to future. They play a vital role in business decisions as the
costs considered in decision making are usually future costs. They are similar in nature to that
of incremental, imputed explicit and opportunity cost.

Determinants of Short-Run Cost

Fixed cost: some inputs are used over a period for producing more than one batch of
goods. The costs incurred in these are called fixed cost. For example: amount spend on
purchase of equipment, machinery, land and building.
Variable cost: when output has increased the firm spends more on these items. For example,
the money spends on labor wages, raw material and electricity usage. Variables costs vary
according to the output. In the long run all costs become variable.
Total Cost: the maker value of all resources used to produce a good or service.
Total Fixed cost: Cost of production remains constant whatever the level of output.

Average cost: Total cost divided by the level of output.

Average variable cost: Variable cost divided by the level of output.
Average Fix cost: Total fixed cost divided by the level of output.
Marginal cost: Cost of producing an extra unit of output.
. Marginal costs refer to the cost to produce one more unit of product or service

Marginal Cost = ∆ total cost

∆ total quantity

Short Run Cost Output Relationship

Fixed cost curve is a horizontal line which is parallel to the “X” axis. The cost is constant
with respect to output in the short run. Fixed cost does not change with output. It must be paid
even if “0” units of output are produced. For example: if you have purchased a building for the
business you have invested capital on building even if there is no production.

Total fixed cost: (TFC) consists of various costs incurred on the building, machinery, land,
etc. For example, if you have spent P2M and bought machinery and building which is used to
produce more than one batch of commodity, then the same cost of P 2M is fixed cost for all
batches. The total variable costs vary according to the output. Whenever the output increases
the firm must buy more raw materials, use more electricity, labor, and other resources therefore
the total variable cost (TVC) curve is upward sloping. The total cost consists of fixed (TFC)
and variables cost (TVC). The TFC of P 2M included with the variable cost throughout the
production schedule so the total cost (TC) is above the TVC line.

Graph- Total Cost Curve

Graph- Average Cost Curve

Graph- Short-Run per Units

The above set of graphs indicates clearly that the average variable cost curve looks like a
boat. Average fixed cost curves decline as output increases and it’s a hyperbola to the origin.
The Marginal cost curve slopes like a tick mark which declines up to an extent then it starts
increasing along with the output. Let us see and understand the nature of each curve with an
example. The table and graphs shown below indicates the total costs curves and average cost
curves at various output level.
Table – Cost Schedule
Output TC TFC TVC AFC ATC AVC MC
0 1200 300
1 1800 300
2 2000 300
3 2100 300
4 2250 300
5 2600 300
6 3300 300

Graph- Average Cost Curves

Graph- Total Cost Curves

For the above table and set of graphs we can understand that capital is the fixed factor of
production and the total fixed cost will be the same P300. The total variable cost will increase
as more and more goods are produced. So, the total variable cost (TVC) of producing 1 unit
is P1500 for 2 units 1700 and so on.
Total cost = TFC=TVC for 1 unit TC = 300= 1500= 1800.
The marginal cost of producing an extra unit is calculated based on the difference in total
cost.

MC2=TC2-TC2-1 = 2000 – 1800 = 200

MC for 5th unit= TC5th unit minus TC of 4th unit.
In our example 2,600 -2225 =350
AVC also is calculated in the same manner TVC/output = 2600/5 = 460
AFC= TFC/output =300/5 = 60

Relationship Between Marginal Cost and Average Cost Curve:

The marginal cost and average cost curves are U shapes because of law of diminishing
returns. The marginal cost curve cuts the average cost curve and average variable cost curves
at their lowest point. Marginal cost curves cut the average variable cost from below. The AC
curve is above the MC curve when AC is falling. The AC curve is below the MC when the
AC is increasing. The intersecting point indicates that AC=MC and that is the minimum
average cost with an optimum output. (No more output can be produced at this average cost
without increasing the fixed cost of production)
Graph – Relationship Between Average Cost and Marginal Cost

Optimum Output and Minimum Cost

The MC and AC curves are mirror image of the MP and AP curves. It is presented in the
graph below.
All organizations aim for maximum output with minimum cost. To achieve this goals,
they like to derive the point where optimum output can be produced with the given amount of
input factors and with a minimum average cost. In the graph the MP=AP at maximum
average production. On the other hand, MC=AC at minimum average variables cost.
Therefore, this is the optimum output to be produced to achieve their managerial goals.

Graph- Optimum Cost and Output

 The above set of cost curves explain the cost output relationship in the short period but in
the long run there is no fixed cost because all costs vary over a period. Therefore, in the long
run the firm will have only average cost curve that is called as long run average cost curve
(LAC). Let us see how the average cost curve is derived in the long run. This LAC also
slopes loke the short period average cost curve (U shaped) provided the law of diminishing
returns prevails. In the case returns to scale are increasing or constant then the LAC curve
will have a different slope. It will be a horizontal line. Which is parallel to the “X” axis.

Cost Output Relationship in the Long Run

In the long run costs fall as output increase due to economies of scale, consequently the
average cost (AC) of production falls. Some firms experience diseconomies of scale if the
average cost begins to increase. This fall and rise derive as U shapes or boat shapes average
cost curve in the long run which is denoted as Long average cost (LAC). The minimum point
of the curve is said to be the optimum output in the long run. It is explained graphically in the
chary given below.

In the long run all factors are variables, and the average cost may fall or increase to A, B
respectively but all these costs are above the long run cost average cost. LAC is the lower
envelope of all the short run average cost curves because it contains them all. At point “E”
the SAC1 and SMC1 intersects each other, in case organization increases output from OM to
OM1 they have to spend OCI amount. In case the organization purchases one more machine
(increase in fixed cost) then they will get a new set of cost curves SAC2 and SMC2. But the
new average cost curve reduces the cost of production from OCI to OC2. That means they
can save the difference of C1C2 which is nothing but AB. Therefore, in the long run due to
business expansion a firm can reduce their cos life they will meet many t of production.
During their business combinations of optimum production and minimum cost in different
short periods. In the long run due to law of diminishing returns the long run average cost
curve LAC also slopes like boat shape.

Economies Scale
Economies of scale exist when long run average costs decline and output is increased.
Diseconomies of scale exist when long run average cost rises as output is increases. It is
graphically presented in the following graph. The economies of scale occur because of (i)
technical economies: the change in production process due to technology adoption. (ii)
Managerial economies, (iii) purchasing economies, (iv) marketing economies and (v)
financial economies.
Economies of scale means a fall in average cost of production due to growth in the
size of the industry within which a firm operates.

Diseconomies of Scale
Arises due to managerial problems. If the size of the business become too large, then
it becomes difficult for management to control the organization activities therefore
diseconomies of scale arise.

When we talk about the scale of production of a firm, we often hear about the fact that the
large-scale production, usually, helps in reducing the cost of production. Economies of scale
refer to the reduced costs per unit arising due to an increase in total output. Diseconomies of
scale, on the other hand, occur when the output increases to such a great extent that the cost
per unit starts increasing.
Factors Causing Economies of Scale:
There are various factor influencing the economies of scale of an organization. They
are generally classified in to two categories as Internal factors and External factors.

Internal Factors:
1. Labor economies: if the labor force of a firm is specialized in a specific skill, then the
organization can achieve economies of scale due to higher labor productivity.

2. Technical economies: with the use of advanced technology, they can produce large
quantities with quality which reduces their cost of production.

3. Managerial economies: the managerial skills of an organization will be advantageous

to achieve economies of scale in various business activities.

4. Marketing economies: use of various marketing strategies will help in achieving

economies of scale.

5. Vertical integration: if there is vertical integration then there will be efficient use of
raw material due to internal factor flow.

6. Financial economies: the firm’s financial soundness and past record of financial
transactions will help them to get financial facilities easily.

7. Economies of risk spreading having variety of products and diversification will help
them to spread their risk and reduce losses.

8. Economies of scale in purchase: when the organization purchases raw material, bulk
reduces the transportation cost and maintains uniform quality.

External Factors:
1. Better repair and maintenance facilities: When the machinery and equipment’s are
repaired and maintained, the production process never gets affected.

2. Research and Development: research facilities will provide opportunities to introduce

New products and process methods.

3. Training and Development: continuous training and development of skills in the

managerial, production level will achieve economies of scale.

4. Economies of Location: the plant location plays a major role in cutting down the cost
of materials, transport and other expenses.

5. Economies of Information Technology: advanced information technology provides

timely accurate information for better decision making and for better services.

6. Economies of by-products: Organizations can increase the economies of scale by

minimizing waste and can be environment responsible by using the by-products of the
organization.
Economies of scope: producing variety to get cost advantage. In retail business it is
commonly used. Product diversification within the same scale of plant will help them to
achieve success.

Factors Causing Diseconomies of Scale:

1. Labor union: continuous labor problem and dissatisfaction can lead to diseconomies
scale.

2. Poor teamwork: Poor performance of the team leads to diseconomies of scale.

3. Lack of coordination: lack of coordination among the work force has a major role to
play in causing diseconomies of scale.

4. Difficulty in fund raising: difficulties in fund raising reduce the scale of operation.

5. Difficulty in decision making: the managerial inability, delay in decision making also
a factor that determines the economies of scale.

6. Scarcity of Resources: raw material availability determines the purchase and price.
Therefore, there is a possibility of facing diseconomies in firms.

7. Increased risk: growing risk factors can cause diseconomies of scale in an

organization. It is essential to reduce the same.

Return to Scale
Return to scale, the quantities change in output of a firm or industry resulting from a
proportionate increase in all inputs. Such economic scale may occur because of greater
efficiency is obtained as the firm moves from small- to large scale operation.

Constant Returns to Scale:

In the long run if the returns to scale are constant then the average cost of production will be
the same. For example: ABC magazine, started 100 years ago and it was sold in the market
for 25 pieces but now it is still sold at a nominal cost of P15. The price increased because raw
material cost and printing and labor costs have also increased but in the long run the price of
the commodity has not increased much.
The constant returns to scale curve is graphically presented below which indicates that the
LRAC is not a boat shape curve.
Break Even Analysis
Break even analysis helps to identify the level of output and sales volume at which the
firm “break even” It means the revenues are sufficient to cover all costs of production.
Various managerial decisions of firms are taken by the managers based on the break- even
point.
It is a study of cost, revenues and sales of a firm and finding out the volume of sales
where the firm’s costs and revenues will be equal. There is no profit and no loss. The total
revenue is equal to the total cost of production. The amount of money which the firm receives
by the sale of its output in the market is known as revenue.

The above graph shows the break- even point of an organization. The total revenue
curve (TR) and total cost curve (TC) is given. When the produce 50 units the total cost and
total revenue are equal that is P 150,000 which is at the intersecting point of the curves.
Breakeven point always denotes the quantity produced or sold to equalize the revenue and
cost.
 When the firm produces less than 50 units the revenue earned is less than the cost of
production (TR<TC) therefore in the initial period the firm incurs loss which is shown in the
graph. Through selling more than the difference increases and provides profit to the
organization (TR>TC).
It can be calculated with the help of the following formula.

Break even quantity = _____TFC_______

Selling Price – AVC

To decide a quantity to achieve a targeted profit = TFC + targeted profit

Selling price - AVC

Safety margin = Sales - BEP x 100

Sales

Managerial Uses of Break-Even Analysis:

1. Product planning: it helps the firm in planning its new product development.
Decisions regarding removal or addition of new products in their product line.

2. Activity planning: the firm decided the expansion of production capacity.

3. Profit planning: this helps the firm to plan about their profit well in advance and at the
same it helps to identify the quantity to be sold to achieve the targeted profit.

4. Target Capacity: the targeted sales quantity helps to decide the purchase, inventory
and management.

5. Price and cost decision: Decision regarding how much the price of the commodity
should be reduced or increased to cover their cost of production.

6. Safety margin: it helps to understand the extent to which the firm can withstand their
fall in sales.

7. Price decision: the selling price can be fixed based on its expected revenue or profit.

8. Promotional decision: the firm can decide the kind of promotion required and how
much amount could be spent.

9. Distribution decision: Break even analysis helps to improve the distribution system
and for business expansion.
10. Dividend decision: firm can decide the dividend to be fixed for their shareholders.

11. Make or buy decision: break even analysis helps to decide on whether to make or buy
the product. It means outsourcing or in-house production.

We could conclude that the break-even analysis is a useful tool for decision making and
various levels of a business firm in the short and long run. Therefore, it is an essential tool to
be used by the managers.

Operating Leverage (OL)

Operating Leverage refers to the ratio of the firms total fixed costs to total variables cost.
DOL means the degree of operating leverage.

Empirical Estimation of Cost (see attached power point)

Architecture of Ideal Firm

⮚ Core competencies

⮚ Outsourcing of Non-Core Tasks

⮚ Learning Organization

⮚ Efficiency and Flexibility

⮚ Location near markets

⮚ Agility of responding to market forces.