1. COST ANALYSIS

2. What is cost?
In producing a commodity a firm has to employ an aggregate of various factors of production such as land, labour, capital and entrepreneurship.
These factors are to be compensated by the firm for their contribution in producing the commodity.
This compensation (factor price) is the cost.

3. Various concepts of Cost
1. Real Cost
2. Opportunity or Alternative Cost
3. Money Cost – Explicit & Implicit Costs
4. Accounting & Economic Costs
5. Fixed and Variable Costs

4. Cost concepts 6. Production Costs – Total Cost (TC)
Total Fixed Cost (TFC)
Total Variable Cost (TVC)
Average Fixed Cost (AFC)
Average Variable Cost (AVC)
Average Total Cost (ATC) and
Marginal Cost (MC)

5. Real Cost
The ‘real cost of production’ refers to the physical quantities of various factors used in producing a commodity.
Real cost signifies the aggregate of real productive resources absorbed in the production of a commodity (or a service).

6. Opportunity Cost
The concept of opportunity cost is based on the scarcity and alternative applicability characteristics of productive resources.
The real cost of production of something using a given resource if the benefit forgone (or opportunity lost) of some other thing by not using that resource in its best alternative use.
An opportunity cost or alternative cost is the value of a resource in a foregone employment.

7. Economists’ Money Costs
Economists wish to include imputed value of all the inputs provided by the producer himself in addition to outright money transactions between the firm and other parties from whom inputs are purchased for carrying out production.
Thus money costs in economic terms or
Economic cost = explicit or Accounting costs implicit costs.

8. Sunk Costs
Sunk cost is a cost once incurred cannot be retrieved. It is associated with commitment of funds to specialized equipment or facilities which cannot be used for anything else in the present or future. E.g.brewery plant during prohibition.

9. Shutdown Costs
Shut down costs are costs which would be incurred when plan operation is suspended, but would have been saved if the operation was continuing.
E.g. costs of sheltering plant and equipment.
Construction or hiring of sheds for storing exposed property.
Expenses on recruitment and training incurred on re-employment of workers.

10. Abandonment Costs
Abandonment arises when there is complete cessation of activities and there is a problem of disposal of assets.
E.g.discontinuance of using typewriters and shifting over usage to computers.
Shifting to paperless operations.

11. Replacement and Historical Costs
Historical cost means the cost of a plant at a price originally paid for it. Replacement cost means the price that would have to be paid currently for acquiring the same plant.

12. Economic Cost
Explicit costs are direct contractual monetary payments incurred through market transactions.
Explicit costs are usually costs shown in the accounting statements and include costs of raw materials, wages and salaries, power and fuel, rent, interest payments of capital invested, Insurance, Taxes and duties, Misc. expenses such as selling, transport, advertising & sales promotional expenses.

13. Economic Cost (contd.)
Implicit costs are the opportunity costs of the use of factors which a firm does not buy or hire but already owns.
Implicit costs include
Wages of labour rendered by the entrepreneur himself.
Interest on capital supplied by him.
Rent of land and premises owned by the entrepreneur and used for production.
Normal returns or profits of entrepreneur as compensation for his management and organizational services.

14. Fixed Costs
Fixed costs are those costs that are incurred as a result of the use of fixed factor inputs. They remain fixed at any level of output.
While engaging in productive activity the producer always has to incur some expenditure which remains fixed whatever the level of production.

15. Fixed Costs
In the short run, fixed costs remain fixed because the firm does not change its size and the amount of fixed factors employed which include:
Payments of rent for building.
Interest on capital.
Insurance premium
Depreciation and Maintenance allowances
Adm. Expenses (Managerial & Staff salaries)
Property and business taxes, licence fees etc.

16. Variable Costs
Variable costs are those costs that are incurred by the firm as a result of the use of variable factor inputs. They are dependant on the level of output.
The cost which keeps on changing with the changes in the quantity of output produced is known as variable cost.

17. Variable costs The short-run variable costs include
Prices of raw materials,
Wages paid for labour
Fuel and power
Excise duties, sales tax, octroi, VAT.
Freight (or transportation) charges..

18. Production Costs Total Cost (TC) Total Fixed Cost (TFC)
Total Variable Cost (TVC)
Average Fixed Cost (AFC)
Average Variable Cost (AVC)
Average Total Cost (ATC) and
Marginal Cost (MC)

19. Theory of Cost in the Short run
Total Cost TC = TFC + TVC
Average Fixed Cost AFC = TFC  Q
Average Variable Cost AVC = TVC  Q
Average Total Cost ATC = TC  Q
= TFC/Q + TVC/Q
Marginal Cost
MC = TC OR DTVC
Q DQ

20. Short-run Production costs
Figures in rupees
Output
(Units)
Total
Fixed Cost
Variable Cost
Total Cost
240 1
120
360 2
160
400 3
180
420 4
212
452 6
280
520

21. Cost curves
ATC MC
AVC
COST
AFC
OUTPUT

22. Average Fixed Cost, Average Variable Cost and Average Total cost of the Firm
Output
(Units)
Average
Fixed Cost
TFC  Q
Variable Cost
TVC Q
Total Cost
TC Q 1
= 240
1 = 120
= 360 2
= 120
= 80
= 200 3
= 80
= 60
= 140 4
= 60
= 53
= 113 5
= 48
= 56
= 104 6
= 40
= 70
= 110

23. Calculation of Marginal Cost
Output
(units)
Total Cost
(Rupees)
Total Variable Cost(Rupees)
Marginal Cost
240 -- 1
360
120 2
400
160 40 3
420
180 20 4
452
212 32 5
520
280 68 6
660
140

24. Output
(units)
TFC
TVC TC
AFC
(TFC/Q)
AVC
(TVC/Q)
ATC
(TC/Q) MC
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
100 -- 1 25
125
25 ( ) 2 40
140 50 20 70
15( ) 3
150
33.3
16.6
10 ( ) 4 60
160 15
10( ) 5 80
180 16 36
22( ) 6
110
210
16.3
18.3 35
30( ) 7
250
14.2
21.4
35.7
40( ) 8
300
400
12.5
37.5
150( ) 9
500
600
11.1
55.6
66.7
200( )

25. Output
(units)
TFC
TVC TC
AFC
(TFC/Q)
AVC
(TVC/Q)
ATC
(TC/Q) MC
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
100 -- 1 25
125
25 ( ) 2 40
140 50 20 70
15( ) 3
150
33.3
16.6
10 ( ) 4 60
160 15
10( ) 5 80
180 16 36
22( ) 6
110
210
16.3
18.3 35
30( ) 7
250
14.2
21.4
35.7
40( ) 8
300
400
12.5
37.5
150( ) 9
500
600
11.1
55.6
66.7
200( )

26. Problem: Based on your knowledge of the various measures of
short run cost, complete the following table.
Output
(units)
TFC
TVC TC
AFC
(TFC/Q)
AVC
(TVC/Q)
ATC
(TC/Q) MC
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
---
1200 X 1
1265 2
204 3
494 4 86 5
525 6
286 7 97 8
768 9

27. Problem: Based on your knowledge of the various measures of
short run cost, complete the following table.
Output
(units)
TFC
TVC TC
AFC
(TFC/Q)
AVC
(TVC/Q)
ATC
(TC/Q) MC
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
1200 X 1
265
1265 2
204
1404
600
102
702
139 3
283
1483
400 94
494 79 4
369
1569
300 92
392 86 5
525
1725
240
105
345
156 6
580
1780
200 96
286 65 7
679
1879
171 97
239 99 8
768
1968
150
246 89 9
873
2073
133
230

28. Output
(units)
TFC
TVC TC
AFC
(TFC/Q)
AVC
(TVC/Q)
ATC
(TC/Q) MC
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
100 -- 1 25
125
25 ( ) 2 40
140 50 20 70
15( ) 3
150
33.3
16.6
10 ( ) 4 60
160 15
10( ) 5 80
180 16 36
22( ) 6
110
210
16.3
18.3 35
30( ) 7
250
14.2
21.4
35.7
40( ) 8
300
400
12.5
37.5
150( ) 9
500
600
11.1
55.6
66.7
200( )

29. Relationship between Marginal Cost and Average Cost
1. When Average Cost is minimum, Marginal cost is equal to Average Cost.
MC curve intersects at the minimum point of ATC curve.
2. When MC curve is below AC curve, marginal cost is less than average cost, and the latter falls.
3.When the MC curve is above AC curve, marginal cost is more than average cost, the latter rises.

30. MARGINAL COST AND AVERAGE COST LINESMC AC
COST M A P B N N C O L Q
OUTPUT

31. Esimation of Cost Functions
Relationship between cost and output is expressed by cost function.
TC = f(Q)
TC = Total Cost Q = Quantity of output

32. Three variants of Short-run Cost function 1.Linear Cost function
1. Linear function: TC = a bQ
(TFC TVC) (TFC) (AVCxQ)
TVC
ATC = TC/Q = TFC/Q + TVC/Q = a/Q b
MC = dTC = b dQ
Illustration:
TC = Q (Q=10)
TFC = 100 ; TVC = 0.5Q
At Q = 10, TVC = 0.5 x 10 = 5 and TC = = 105
ATC = a/Q + b = 100/ = 10.5
MC = b = 0.5
TC=a + bQ
cost
TFC
output

33. Explanation of Linear Cost function
The firm has fixed costs which must be met irrespective of the quantity of output produced. This is represented by a in the equation TC=a+bQ
The firm must pay proportional amount for rawmaterials, labour and other inputs, which is the TVC represented by bQ in the equation.
The equation for Total Cost = Total Fixed Cost + Total Variable Cost
Will thus be given as TC = a + bQ.
At Zero output TC = a + bxo = a =TFC
Average Total Cost = TC  Output Q = a/Q + b
Average Fixed Cost = a/Q and Average variable cost = b
Since in the shortrun, TFC is the same irrespective of output, all increases (differentials) in cost due to increase (differentials) in output will be the Marginal Cost MC = b

34. Quadratic Cost Function
TC=a + bQ + cQ2
TC = a + bQ + cQ2
ATC = a/Q + b + cQ
MC = b + 2cQ
cost
TFC
output
Here, the firm has Fixed Costs Rs.5000 and
Variable costs for (labour, raw materials etc.) to produce Q units are 250Q + 3Q2
Firm’s initial cost of producing Q units is 250Q
Additional units can be produced at increased cost due to shortage of raw materials and other inputs (their price being higher) ups their price by +3Q2 which is the last variable.

35. Implications of the Quadratic equation: a + bQ + cQ2
1. If Q = 0, TC = a = TFC
2. Number of bends in the Graph is 1,
Number of bends = 1 less than highest exponent.(Q2) .
ATC = TC/Q = a/Q + b + cQ
AFC = a/Q, therefore, AVC = b + cQ
MC = b + 2cQ (by differentiation)
When Q = 0 MC = AVC = b

36. There can be another type of Quadratic Equation TC = a + bQ – cQ2
Here – cQ2 represents reduction in costs on account of increased productivity. The TC curve will rise at a decreasing rate.
TC = a + bQ -- cQ2
cost
TFC
output

37. Problem:
ABC Ltd.estimates its total cost Rs.Y of manufacturing X units of
electronic gauges per month as Y = X + 0.1X2
Calculate the average cost of producing 200 gauges per month.
If the company doubles this output, will it halve its average cost?
(iii)If not, what will be its average cost be?
(iv) How much is the average variable cost of producing 200 units
per month?
(v)What will be the average variable cost if no units are
Produced?
(vi) What will be the marginal cost function of the company?

38. Cubic Cost Functions TC=a + bQ = cQ2 +dQ3 cost TFC output
Cubic type of function will be
TC = a + bQ + cQ2 + dQ3
Here the highest exponent is 3. Hence one less than 3 bends will be thre in the cost curve.
This function combines both increasing and decreasing productivity or returns.
TC=a + bQ = cQ2 +dQ3
Increasing
Productivity
Decreasing
Productivity
cost
TFC
output

39. (i)Total cost of producing 200 gauges
Y = X + 0.1X2
= (200) + 0.1(200)2
= (40000) =
= Rs.72000
(ii) Doubling the output, X = 400
= (400) + 0.1(400)2
= (160000) =
= Rs.1,44,000.
(iii)Average cost of producing 200 units
Y = (200) X =
= Rs.360
(iv) Average cost of producing 400 units
Y = (400) X =
= Rs.360
The average cost has not been halved. The reduction in fixed cost has been offset by increase in AVC.
(v)Average variable cost of producing 200 units per mointh is
AVC = b + cX
= (200)
= = Rs.320
If no units are produced, X really does not exist. So no question of AC.
(vi)MC = X