COST ANALYSISCOST ANALYSIS

Meaning of cost

Types

- Economic Costs Outlay costOutlay cost – Actual financial expenditure. – Actual financial expenditure. Opportunity cost, Pecuniary cost, Social (opportunity) cost Opportunity cost, Pecuniary cost, Social (opportunity) cost Explicit costExplicit cost– Direct contractual monetary payments – Direct contractual monetary payments

incurred through market transactions.incurred through market transactions. Implicit costImplicit cost – Opportunity cost of owners’ own assets. – Opportunity cost of owners’ own assets. Production cost & Selling costsProduction cost & Selling costs Real cost & money costReal cost & money cost Incremental costIncremental cost – Total additional expenditure associated – Total additional expenditure associated

with the expansion of output.with the expansion of output. Short run costs & long run costsShort run costs & long run costs

- Accounting Costs Capital costs, Overhead costs (indirect), Direct costs, Period Capital costs, Overhead costs (indirect), Direct costs, Period

costs costs Out-of-pocket cost & Book costsOut-of-pocket cost & Book costs Replacement cost & Original / Historical costReplacement cost & Original / Historical cost

Avoidable & Unavoidable costAvoidable & Unavoidable cost Direct & Indirect cost ( Traceable / Assignable Cost and Non-Direct & Indirect cost ( Traceable / Assignable Cost and Non-

Traceable / non-assignable cost)Traceable / non-assignable cost) Present Vs Future costsPresent Vs Future costs - Engineering Costs Planning costsPlanning costs Execution costsExecution costs Operation costsOperation costs

Short run costs Fixed cost / Supplementary cost – Costs that are incurred on Costs that are incurred on

fixed factor input. They remain fixed at any level of out put.fixed factor input. They remain fixed at any level of out put. Variable cost / Prime cost – Cost incurred on the variable factor Cost incurred on the variable factor

inputs. They vary directly with the levelinputs. They vary directly with the level of output.of output. Behavioural Costs Total cost Total Fixed cost – TFC remains constant at all levels of output, TFC remains constant at all levels of output,

thus independent of output.thus independent of output. Total variable cost – TVC varies with the output, thus directly TVC varies with the output, thus directly

dependent on output. dependent on output. * TVC initially increases at a decreasing rate, but after a point it TVC initially increases at a decreasing rate, but after a point it

increases at an increasing rate. ( Law of variable proportion)increases at an increasing rate. ( Law of variable proportion)

Total cost – TC varies in the same proportion as the TVC

Per unit cost - Average cost Average Fixed cost – Per unit fixed cost * As the output increases the TFC gets spread over a larger

output and hence AFC goes on progressively declining.AFC curve is rectangular hyperbola. It approaches both the axes asymptotically I.e., it gets very close to both the axes but never touches them.

* The product of AFC with the output for any given level of output at that level always remains same.

Average variable cost – Per unit variable cost * AVC declines initially, reaches its minimum and then

begins to rise sharply. AVC is slightly U shaped.

Average total cost – Per unit total cost *If the output of the firm is increased, ATC decreases

initially up to a point, then remains constant for a while & thereafter starts rising. AC assumes U shape. ( declining phase, constant phase and rising phase)

Marginal cost – MC is the rate of change in the total cost when the output is increased by one unit. (The cost of producing the last unit)

- In short run MC is independent of FC & is directly related to the VC. Mc

curve also assumes U shape.

Relationship between marginal cost and average cost

- When AC is falling, MC is also falling and AC>MC i.e., When both MC and AC are falling, MC curve lies below the AC curve

- At certain stage MC starts rising but AC continues to fall, AC is still above the MC.

- When AC is minimum, MC=AC i.e., MC intersects AC at its lowest point.

- When both Ac & MC are rising, MC>AC i.e., AC curve lies below MC.

Area underlying the unit costs

- The point on each average cost curve measures the average cost, but the area underlying them denotes total cost as under.

- Area underlying AFC curve measures the total fixed cost. - Area underlying AVC curve measures the total variable cost. - Area underlying MC curve measures the total variable cost. - Area underlying ATC curve measures the total cost.

Long run costs In the long run, all costs are variable cost. There is no In the long run, all costs are variable cost. There is no

dichotomy of total cost into fixed and variable costs.dichotomy of total cost into fixed and variable costs. Long run average cost curve: It is an envelope of various : It is an envelope of various

SACs. SACs.

-- Features-- Features

- It is a tangent curve- It is a tangent curve

- It is an envelope curve- It is an envelope curve

- It is a planning curve- It is a planning curve

- It is a minimum cost combination curve- It is a minimum cost combination curve

- It assumes flatter U shape - It assumes flatter U shape Long run marginal cost curve : It is derived from the slope : It is derived from the slope

of total cost curve at various points relating to the given of total cost curve at various points relating to the given output each time. This curve also assumes flatter U shape.output each time. This curve also assumes flatter U shape.

Relationship between LAC and LMC

Same as in the case of SAC and SMCSame as in the case of SAC and SMC