INTRODUCTION

Cost is normally considered from the producer’s or

firm’s point of view. A firm has to employ an

aggregate of various factors of production such as

land, labour, capital and entrepreneurship.

The cost of production of a commodity is the

aggregate of price paid for the factors of production

used in producing that commodity. Cost of

production, therefore, denotes the value of the

factors of production employed.

Total revenue is the amount of a firm receives for

the sale of its output. Total cost is the market value

of the inputs a firm uses in production.

Profit = total revenue minus total cost.

The Cost of Production

“Real cost of production” refers to the physical

quantities of various factors used in producing a

commodity. Real cost, thus, signifies the aggregate

of real productive resources absorbed in the

production of a commodity (or a service).

The real cost of production signifies toils, troubles,

sacrifice on account of loss of consumption for

savings, social effects of pollution caused by factory

smoke, automobiles, etc.

Real Cost –

The real cost of production of a commodity refers to

the exertion of labour. Sacrifice involved in the

abstinence from present consumption by the savers

to supply capital and social effects of pollution

congestion, etc.

It’s an abstract idea. Its exact measurement is not

possible.

Opportunity Cost – The cost of something is what

you give up to get it.

The concept of opportunity cost is based on the

scarcity and versatility characteristics of productive

resources. It is the most fundamental concept in

Economics.

It is the cost measured in terms of forgone benefits

from the next best alternative use of a given

resource.

The concept of opportunity cost is based on the

scarcity and versatility (alternative applicabilities)

characteristics of productive resources. It is the most

fundamental concept in economics.

Wants are multiple. When we choose the resource in

one use to have one commodity for satisfying a

particular want, it is obvious that its other use as some

other commodity that can be produced by it cannot be

available simultaneously.

This means,the second alternative use of the resources

(or another commodity) is to be sacrificed to have the

resource employed in one particular way,

i.e. to get a particular commodity; because the same

resource cannot be employed in two ways at the

same time. The sacrifice or loss of alternative use of

a given resource is termed as “opportunity cost”.

Importance of the Concept of Opportunity Cost

1. Determination of Relative Prices of Goods:

The concept of opportunity cost is useful in

explaining the determination of relative prices of

different goods. For instance, if the same group of

factors can produce either one car or six scooters,

then the price of one car will tend to be at least six

times more than that of one scooter.

2. Determination of Normal Remuneration to a

Factor: The opportunity cost sets the value of a

productive factor for its best alternative use. It

implies that if a productive factor is to be retained

in its next best alternative use, it must be

compensated for or paid at least what it can earn

from its next best alternative use.

3.Decision-Making and Efficient Resource

Allocation:

The concept of opportunity cost is essential in rational

decision-making by the producer.

It follows that a resource will always tend to move or

will be used in an occupation where it has a high

opportunity cost. Thus, the concept of opportunity

cost serves as a useful economic tool in analyzing

optimum resource allocation and rational decision-

making.

Importance –

(1) Determination of Relative prices of goods.

(2) Determination of normal remuneration to

a factor.

(3) Decision making & efficient resource allocation.

Money Cost – Cost of production measured in terms

of money is called money cost. It is the monetary

expenditure on inputs of various kinds – raw

material, labour, etc.

Money Cost

“Money cost” is the monetary expenditure on inputs

of various kinds – raw materials, labour etc., required

for the output, i.e., the money spent on purchasing

the different units of factors of production needed for

producing a commodity. Money cost is, therefore, the

payment made for the factors in terms of money.

Explicit & Implicit Costs

Explicit cost are direct contractual monetary

payments incurred through market transaction.

Explicit costs refer to the actual money outlay of

the firm to buy or hire the productive resources.

It includes –

(1) Costs of raw material

(2) Wages & Salaries

(3) Power Charges

(4) Rent of business or factory premises

(5) Interest payment of capital invested

(6) Insurance premium

(7) Taxes like property tax, duties, license fees

(8) Miscellaneous – Marketing & advertising expenses.

Implicit Costs

Implicit money costs are imputed payments which

are not directly or actually paid out by the firm. It

arises when the firm or entrepreneur supplies

certain factors owned by himself.

Implicit costs are as follows -

1) Wages of labour rendered by the entrepreneur

himself.Contd..2……..

2) Interest on capital supplied by him.

3) Rent of land and premises belonging to the

entrepreneur himself.

4) Normal returns of entrepreneur, a compensation

needed for his management and organisational

activity.

The distinction between explicit and implicit money

cost is important in analysing the concept of profit.

Fixed Cost –

Amount spent by the firm on fixed inputs in the short

run known as supplementary costs or overhead costs

it usually include –

1) Payments of rent for building

2) Interest paid on capital

3) Insurance premium

4) Depreciation and maintenance allowances

5) Administrative expenses – salaries

6) Property & business taxes, license fees, etc.

FIXED COST

Recurrent(Rent, interest,

insurance premium)

Allocable(Depreciation

Charges)

Variable Cost – (Prime Costs)

These costs are incurred by the firm as a result of the

use of variable factor inputs. They are dependent

upon the level of output.

It includes –

o Prices of raw materials

o Wages of Labour

o Fuel & Power charges

o Excise duties, sales tax

o Transport expenditure

The distinction between prime costs (variable costs)

and supplementary costs (fixed costs) is, however, not

always significant. In fact,the difference between fixed

and variable costs is meaningful and relevant only in

the short period. In the long run, all costs are variable

because all factors of production become adjustable in

the long run. In the short period, only those costs are

variable which are incurred on the factors which are

adjustable in the short period.

In the short run,however,the distinction between

prime and supplementary costs is very significant

because it influences the average cost behavior of the

product of the firm. Thus, it has a significant bearing

on the theory of firm. In specific terms, the

significance of making this distinction between fixed

and variable costs is that in the short period a firm

must cover at least its variable or prime costs if it is to

continue in production.

Even if a firm is closed down, it will have to incur

fixed or supplementary costs. The firm will suffer

no great loss in continuing production, if it can

cover at least its variable costs under the

prevailing price.

Types of Production Costs & their measurement

Total Cost – Aggregate of expenditures incurred by

the firm in producing a given level of output.

TC = TFC + TVC

TFC – It is the total cost of fixed factors of production

employed by the firm in the short run.

In economic analysis, the following types of costs are considered in studying cost data of firm:

1. Total Cost (TC),

2. Total Fixed Cost (TFC),

3. Total Variable Cost (TVC),

4. Average Fixed Cost (AFC),

5. Average Variable Cost (AVC),

6. Average Total Cost (ATC), and

7. Marginal Cost (MC).

Total Fixed Cost (TFC)

Suppose a small furniture-shop proprietor starts his

business by hiring a shop at a monthly rent of

Rs.1,000, borrowing loan of Rs.10,000 from a bank at

an interest rate of 12%, and buys capital equipment

worth Rs.900. Then his monthly total fixed cost is

estimated to be:

Rs.1,000 + Rs.900 + Rs.100 = Rs.2,000.

(Rent) (Equipment Cost) (Monthly Interest

on the loan)

Definition: Total fixed cost is the total cost of

unchargeable,or fixed, factors of production

employed by the firm in the short run.

Again, TVC = f (Q) which means, total variable cost is

an increasing function of output.

Suppose,in our illustration of the furniture-shop

proprietor, if he was to start with the production of

chairs, he employs a carpenter on a piece-wage of

Rs.100 per chair. He buys wood worth Rs.2,000,

rexine-sheets worth Rs.3,000, spends Rs.500 for other

requirements to produce 5 chairs.

Then his total variable cost is measured as:

Rs.2,000(wood price)+Rs.3,000(rexine cost)+ Rs.500

(allied cost)+Rs.500 (labour charges)= Rs.6,000.

Definition: Total variable cost is the total costs of

variable factors employed by the firm at each level

of output.

TVC - TVC = F (Q)

It is the total cost of variable factors employed by the

firm at each level of output.

AFC – Total fixed cost divided by total units of output

(Q stands for the numbers of units of the product)

AVC-Total variable cost divided by total units of output

ATC – Total cost divided by total units of output

Marginal Cost (MC) -

It is the addition made to the total cost by producing

one more unit of output.

Long run costs :

Long run period is long enough to enable a firm to

vary all its factor inputs. In the long run a firm can

move from one plant capacity to another. Firm can

increase or decrease plant capacity according to

nature of demand.

Calculate Costs

TP (Q)

(1)

TFC

(2)

TVC

(3)

TC

(4)

AFC= TFC Q

(5)

AFC= TVC Q

(6)

AFC = TC Q

(7)

MC

(8)

0 100 0 100 - - - -

1 100 25 125 100 25 125 25 (125-100)

2 100 40 140 50 20 70 15 (140-125)

3 100 50 150 33.3 16.6 50 10 (150-140)

4 100 60 160 25 15 40 10 (160-150)

5 100 80 180 20 16 36 20 (180-160)

6 100 110 210 16.3 18.3 35 30 (210-180)

7 100 150 250 14.2 21.4 35.7 40 (250-210)

8 100 300 400 12.5 37.5 50 150 (400-250)

9 100 500 600 11.1 55.6 66.7 200 (600-400)

10 100 900 1000 10 90 100 400 (1000-600)

MCAC

A

B

C

M

N

L Q

COST

AC & MC RELATIONSHIP

In the long run there is no dichotomy of total cost

into fixed and variable costs as in the short run.

Long run involves various short run adjustments

visualized over a period of time.

Long run average cost curve is the envelope of the

various short run AC curves.

LACY

O Q1

COST

OUTPUT

SAC3

SAC2SAC1

Q2 Q3

• LAC is the Locus of all these points of tangency.

• LAC is enveloping to a number of plant sizes and the related sizes.

• It is regarded as the long run planning device. A rational entrepreneur would select the optimum scale of plant.

• It is flatter U shaped means in the beginning it slopes down gradually after a certain point it begins to slope upward.

X

Cost Leadership

Introduced By Michel Porter towards Competitive Advantage

Lowest cost of peration in the business by the firm

Business Strategy of doing the business at the owest possible cost in a market

AVIATION INDUSTRY MALAYSIA-Air Asia-Lowest COST –Largest profit

How to achieve cost leadership?

Cost Control measures

Avoiding wastage ‘better supervision on the workers

Access to cheaper source of capital and required finance

Focus on quantitative targets for the business expansion

ensuring that the cost is maintained at the minimum level

Contd..Wall Mart has earned cost leadership

reputation in retail trade

Modern business follows two generic evel stretegies

Product differentiation Cost leadership

Sources of cost leadershipEconomics of scaleReaching to a level of minimum efficient

scale much earlier than the competing firms in the market

Learning curve effect.Inter nationalization.Technological acquisition and improvement. Access to low cost inputs.Knowledge management.

Competitive threats by a firm Threat of new entry

Threat of rivalry

Threat of substitutes

Threat of suppliers

Threat of buyers