Chapter 8 Cost Concepts
Chapter 8 Cost Concepts
Chapter 8 Cost Concepts
Cost Concepts
Lecture Plan
Objectives
Introduction
Kinds of Costs
Costs in Short Run
Costs in Long Run
Costs of a Multi Product Firm
Costs of Joint Products
Linkage between Cost, Revenue and Output through Optimization
Break Even Analysis
Economies of Scale
Economies of Scope
Costs and Learning Curves
Objectives
To understand the meaning of cost in economic analysis
and its relevance in managerial decision making.
To explain different types of costs, with focus on the
difference between economic and accounting
philosophies.
To analyze the importance of matching costs with
relevant time frames and to understand the short and
long run costs.
To help develop an understanding of estimation of cost
functions.
To introduce the concepts of economies of scale,
economies of scope, break even analysis and learning
curve.
Introduction
Cost is defined in simple terms as a sacrifice or foregoing which
has already occurred or has potential to occur in future with an
objective to achieve a specific purpose measured in monetary
terms.
Cost results in current or future decrease in cash or other assets,
or a current or future increase in liability.
Determinants of cost:
Price of inputs
Productivity of inputs
Technology
Level of output
Mathematically we can express the cost function as:
C= f(Q, T, Pf)
where C=cost; Q=output; T=technology; Pf = price of inputs.
Kinds of Costs
Implicit Costs
Do not involve cash outflow or reduction in assets, or increase in
liability; e.g. owner working as manager in own building
Important for opportunity cost measurement
Direct Costs
Which can be attributed to any particular activity, such as cost of
raw material, labour, etc.
Indirect Costs
Costs which may not be attributable to output, but are distributed
over all activities are indirect costs
Also known as overheads.
Replacement costs
Current price or cost of buying or replacing any input at present.
Social Costs
Costs to the society in general because of the firm’s activities. E.g.
pollution caused by industrial wastes and emissions.
Kinds of Costs
Historic Costs/ Sunk Cost
Incurred at the time of purchase of assets; no longer relevant for
decision making
Future Costs
Opposite of historic costs and are budgeted or planned costs.
Not included in the books of accounts.
Controllable Costs and Uncontrollable Costs
Controllable Costs are subject to regulation by the management
of a firm; e.g. fringe benefits to employees, costs of quality
control.
Uncontrollable Costs are beyond regulation of the management;
e.g. minimum wages are determined by government, price of raw
material by supplier.
Production Costs and Selling Costs
Production Costs are estimated as a function of the level of output
Selling costs occur on making the output available to the
consumer.
Costs in Short Run
Co Fixed Costs
sts
Do not vary with output; e.g.
C TF plant, machinery, building.
C Total Fixed Cost (TFC) curve
is a straight line, parallel to
the quantity axis, indicating
O that output may increase to
Qua
ntity any level without causing
any change in the fixed cost.
In the long run plant size
TF may increase hence FC
Cos C curve may be step like,
ts where each step showing
FC in a particular time
period.
O
Quan
tity
Costs in Short Run
TC
Co TV
sts C Variable Costs
Costs that vary with level of
output and are zero if no
production; e.g. cost of raw
materials, wages.
TF
C Normally TVC is like a straight
line starting from origin.
O
Quant TVC may be an inverse S
ity shaped upward sloping curve,
Cos TC
TV due laws of variable
ts
C proportions.
Total cost (TC)
Sum of TFC and TVC
TF Slope of TC curve is
C
determined by that of the TVC.
O
Quan 9
tity
Average and Marginal Cost
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Average and Marginal Cost Functions
Contd…
AC curve is U shaped
MC When both AFC and AVC fall,
AC also falls and later starts
AC/MC increasing.
AC
When average costs decline,
AVC MC lies below AC.
When average costs are
constant (at their minimum),
MC equals AC.
MC passes through the
AFC minimum point of AC
O curves.
Quantity When average costs rise, MC
curve lies above them.
When both AC and AVC fall,
MC lies below them.
Costs in Long Run
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Costs in Long Run
In the long run the firm may increase plant size to increase output.
As output is increased from q0 to q1 capacity at SAC1 is overworked.
Hence the firm to shifts to a higher plant size SAC1 to SAC2.
This shift would lower the average cost of the firm.
The same process would be repeated if the firm increases its output further
to q2.
It shows scalloping curve as the plant costs are not smoothened.
O q1
q0 q2 Quantity
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Long Run Average Cost
The LAC function can be shown as an envelope curve of the short run
cost functions.
LAC curve envelopes SAC1, SAC2, SAC3, showing the average cost of
production at different levels of output turned out by plants 1, 2 and 3.
Each of the SAC curves represents the cost conditions for a plant of a
particular capacity.
LMC
SMC1 SMC3 SAC3
AC, MC SAC1
SMC2
LAC
SAC2
O q0 q* q3
q1 Quantity
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Long Run Marginal Cost
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Costs of a Multi Product Firm
Assuming that a multi product firm manufactures two goods, with the
same plant and machine.
Total cost (TC) of production would be the sum of TFC and the total of
variable costs (C1 and C2) of producing both the products, times the
quantities of the two goods (Q1 and Q2).
TC= TFC+C1Q1+ C2Q2
If the two products are produced in fixed proportions, then we can use
the concept of weighted average cost (ACw) defined as:
F + C1 ( X 1Q) + C2 ( X 2Q)
ACw (Q)= Q
AR=TR/Q =P
Marginal Revenue (MR)
Revenue a firm gains in producing one additional unit of a commodity.
Calculated by determining the difference between the total revenues
produced before and after a unit increase in production.
MRQ= TRQ- TRQ-1; or
dTR
MR= dQ
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Relationship between TR and MR
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Relationship between AR and MR
MR MR MR
/A /A /A
R R R
A A
M R M AR
M R
R R
O O R
Quan O Quan
Quan
tity
Panel a tity Paneltity
c
Panel b 20
Break Even Analysis
Examines the relation between total revenue, total costs and total
profits of a firm at different levels of output.
Used synonymously with Cost Volume Profit Analysis.
Breakeven point is the point where total cost just equals the total
revenue, in other words it is the no profit no loss point.
Approaches to break even analysis:
Algebraic Method
If P be the price of a good, Q the quantity produced’ the
breakeven output is where total revenue equals total cost (Q* ).
Total Revenue= P.Q
Total Cost= TFC+TVC = TFC+AVC.Q
P.Q*=TFC+AVC.Q*
(P-AVC)Q*=TFC
TFC
Q*= P − AVC
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Break Even Analysis
Contribution Margin
Represents that portion of the price of the commodity produced by
the firm that can cover the fixed costs and contribute to profits.
Contribution Margin = P - AVC
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Break Even Analysis
Graphical Method
Plot TR and TC on the Y
T axis and output on the X
Cost, axis.
Reve R
nue TC is a straight line because
it T AVC is assumed to be
r of
P C constant
E Total revenue is proportional
V
to output and the TR curve is
a straight line through the
C origin.
o ss F
L Shows the profit (or loss)
C
resulting from each level of
sales by the firm.
O Valuable information on
Q Quan
projected effect of output on
* tity costs.
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Economies of Scale
Economies of scale refers to the efficiencies
associated with larger scale operations
This level is reached once the size of the market is
large enough for firms to take advantage of all
economies of scale.
Two types of economies of scale:
Internal economies (which occur to the firm due to large size
of operations);
e.g. Division of labour/ specialization, Financial
economies, better managerial functions.
External economies (which occur due to expansion of the
industry, and the firm also benefits).
Technological advancement, development of infrastructure
pool of skilled workers
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Economies of Scope
When the production capacity can be utilised for producing more than
one goods, average costs are less as compared to when they are
produced by different firms separately; e.g. Computers and printers;
heavy vehicles and light vehicles.
Practice of economies of scope to business strategy is heavily based
on the development of high technology.
Globalization has made such economies even more important to firms
in their production decisions.
Measured by the ratio of average costs to marginal costs, when the
firm produces joint or multiple products.
Assume three products at individual costs of C1, C2 and C3, while Ct
is the total cost when the three activities are carried out together, the
Scope Index (S):
(C 1 + C 2 + C 3 − C t )
S=
C1 + C 2 + C 3
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Cost and Learning Curves
In economics learning by doing refers to the process by which
producers learn from experience.
The concept of learning curve is used to represent the extent to which
average cost of production falls in response to increase in output.
The equation of learning curve can be expressed as:
C=AQb
(where C is the cost of input for the Qth unit of output produced and A is the
cost of the first unit of output obtained).
Since increase in cumulative output leads to a decrease in cost, “b”
has a negative value.
Logarithmic form of this equation is :
ln C= ln A + b.ln Q,
(where b is the slope of the learning curve).
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Summary
Any production process must incur costs. Direct or variable costs vary with the
level of output; fixed costs remain at the same level, irrespective of the rate of
production.
The costs of a firm include accounting, real and opportunity costs. Financial
management recognizes only accounting costs or nominal cost that can be
recorded in the books of accounts.
The short run is the period within which some obligations associated with
management, plant, and equipment are not alterable by changing the firm's
managerial capacity or scale of operations.
In the long run all aspects of the firm's operations can be adjusted; so all costs
are variable in the long run.
The long run average cost (LAC) curve is a planning horizon, which envelopes
the firm's short run AC curves associated with different plant sizes.
Determination of the average cost of a multi product firm can be done with the
method of weighted average cost, if the two products are produced in fixed
proportions.
Allocation of common costs to the joint products can be done by physical
measure of outputs or by sales value at the spilt off point.
Breakeven analysis deals with determining profit at various projected sales
volume levels, identifying the breakeven point, and making a managerial
decision regarding the relationship between likely sales and breakeven point.
Summary
Total Revenue is the total amount of money received by a firm from goods
sold (or services provided) during a certain time period. Average Revenue is
the revenue earned per unit of output sold.
Marginal Revenue is the revenue a firm gains in producing one additional unit
of a commodity. Profit is the difference between Total Revenue and Total
Cost; the profit function shows a range of outputs at which the firm makes
positive (or supernormal) profits.
Economies of scale refer to the efficiencies associated with larger scale
operations; it is a situation in which the long run average costs of producing a
good or service decrease with increase in level of output.
Economies of scope refer to a situation in which average costs of
manufacturing a product are lower when two complementary products are
produced by a single firm, than when they are produced separately.
Learning by doing refers to the process by which producers learn from
experience, while technological change is an increase in the range of
production techniques that provides new vistas to producing goods.
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