By Muhammad Shahid Iqbal Engineering Economics Module No. 06 Theory of Cost By Muhammad Shahid Iqbal

The Concepts of cost Should I go to work today? Should I go to college after high school? Should the government spend money on a new weapon system? These are decisions that are made everyday; however, what is the cost of our decisions? What is the cost of going to work, or the decision not to go to work? What is the cost of University, or not to go to University? Finally what is the cost of buying that weapon system, or the cost of not buying that weapon? In economics it is called opportunity cost.

The Concepts of cost Opportunity cost is the cost we pay when we give up something to get something else. There can be many alternatives that we give up to get something else, but the opportunity cost of a decision is the most desirable alternative we give up to get what we want. Opportunity cost of an input is the return that it could earn in its best alternative use.

The Concepts of cost Accounting Costs and Economic Costs A firm’s cost of production includes all the opportunity costs of making its output of goods and services. Explicit and Implicit Costs A firm’s cost of production include explicit costs and implicit costs. Explicit costs: All cash payments which the firm makes to other factor owners for purchasing or hiring the various factors.

The Concepts of cost Implicit costs: The normal return on money-capital invested by the entrepreneur and wages or salary of his services and money rewards for other factors which the entrepreneur himself owns and employs them in his own firm. Economic Cost = Accounting costs + Implicit costs

Economic Profit v/s Accounting Profit Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs. Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs. When total revenue exceeds both explicit and implicit costs, the firm earns economic profit. Economic profit is smaller than accounting profit

Total and Variable Costs The total expenditure put up by an entrepreneur to produce a certain amount of a good is called TC: C(Q) = FC + VC Fixed costs are those costs that do not vary with the quantity of output produced Variable costs are those costs that do vary with the quantity of output produced $ Q C(Q) = VC + FC VC(Q) FC

The elements of cost Fixed costs or overhead cost can be classified into factory overhead, administration overhead, selling overhead and distribution overhead. Variable costs can be further classified into direct material, direct labor and direct expenses. Market price; it is the price that a good or service is offered at, or will fetch, in the marketplace; The selling price is derived as shown below Direct material cost + Dir. labor cost + Direct expenses = Prime cost Prime cost + Factory overhead = factory cost Factory cost + office and administrative overhead = cost of production Cost of production + opening finished stock – Closing finished stock = cost of goods sold cost of goods sold + selling and distribution overhead = cost of sales cost of sales + profit Sales Sales/quantity sold selling price per unit

The elements of cost Sunk Cost: A cost that is forever lost after it has been paid. ACME Coal paid $5000 to lease a rail car. Under the terms of the lease $1000 of this payment is refundable if the rail car is returned within two days of signing the lease. Average cost: average cost or unit cost is equal to total cost divided by the number of goods produced (the output quantity, Q). It is also equal to the sum of average variable costs (total variable costs divided by Q) plus average fixed costs (total fixed costs divided by Q).

The elements of cost Marginal Cost: The marginal cost of a product is the cost of producing an additional unit of that output. More formally, the marginal cost is the derivative of total production costs with respect to the level of output. Marginal Revenue (MR) is the extra revenue that an additional unit of product will bring. It is the additional income from selling one more unit of a good; sometimes equal to price. It can also be described as the change in total revenue divided by the change in the number of units sold. i.e. Q = 40,000 − 2000P Marginal cost and average cost can differ greatly.  For example, suppose it costs $1000 to produce 100 units and $1020 to produce 101 units.  The average cost per unit is $10, but the marginal cost of the 101st unit is $20

Break Even Analysis Break-even point (BEP) is the point at which cost or expenses and revenue are equal: there is no net loss or gain. The main objective of break-even analysis is to find the cut-off production volume from where a firm will make profit. X = TFC/P-V X = TFC/Unit Contribution Contribution = Sales – TVC Margin of Safety = Sales – Break Even sales Margin of safety represents the strength of the business. It enables a business to know what is the exact amount he/ she has gained or lost and whether they are over or below the break even point. margin of safety = (current output - breakeven output)

Break Even Analysis Profit Volume Ratio (P/V Ratio), The ratio of contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee of sales and since the fixed cost remains constant in short term period, P/V ratio will also measure the rate of change of profit due to change in volume of sales. The P/V ratio may be expressed as follows: Profit = Contribution – Fixed cost P/V ratio = Sales – Variable costs = Contribution Sales Sales BEP = F.C P/V ratio

Some Definitions $ Average Total Cost ATC = AVC + AFC ATC = C(Q)/Q Average Variable Cost AVC = VC(Q)/Q Average Fixed Cost AFC = FC/Q Marginal Cost MC = DC/DQ ATC MC AVC AFC

Derivation of Average costs Q FC VC TC AFC AVC ATC MC 0 2000 0 76 400 248 800 492 1200 784 1600 1100 2000 1416 2400 1708 2800 1952 3200 2124 3600 2200 4000

Relationship b/w Average & Marginal Cost whenever MC is below AC curve, the average curve is falling. The low MC Drags down the Average. when MC is above AC curve, it pull the average up; the AC curve rises. When MC equal AC, it has a neutral effect. AC curve is flat. It has reached its lowest point. Thus MC curve cuts through the lowest point on the ATC curve. MC also cuts AVC through its lowest point. AVC

LR Cost Functions: Economies of Scale Economies of scale arise when the cost per unit falls as output increases. Economies of scale are the main advantage of increasing the scale of production Bulk-buying economies Technical economies Financial economies Marketing economies Managerial economies lower unit costs as a result of the whole industry growing in size. Training and education becomes more focused on the industry Other industries grow to support this industry