unit 2 c 2
DESCRIPTION
TRANSCRIPT
COST
(COST MEANS SACRIFICE)
MEANING - COST
“ Cost is a sacrifice or foregoing that has occurred or has potential to occur in future, 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
• Cost is determined by various factors and each of these has significant implications for cost decisions.
• An increase in any of these will affect cost pattern.
• Important determinant – Price(uncontrollable –largely determined by external
environment) – Marginal efficiency and productivity – Technology – Level of out put.
MATHEMATICAL EXPRESSION- COST
C= F( Q , T , P)
• Where
– C= cost
– Q= out put
– T= technology
– P= price
• Cost are differentiated according to their purpose , type of product and time.
TYPES OF COSTS
• There may be different types of costs incurred by a firm under different circumstances.
• Cost of a firm may include money or may not be measurable in money terms.
• Cost is a function of output in economic theory.
• A managerial economist’s concept of cost does not necessarily coincide with that of accountants.
TYPES OF COST
• Actual Costs / Acquisition / outlay : It means the actual expenditure incurred for acquiring or producing a good or service. These are generally recorded in the books of accounts. Eg. Wages paid, cost of materials purchased, interest paid, etc.
• Opportunity Cost / Alternative Cost: Revenue forgone by not making the best alternative use or opportunities.
• Imputed Cost / Implicit cost: They are the costs which are not actually incurred but would have been incurred in the absence of employment of self-owned factors. These are unrecognized by the accounting systems. Eg. Rent of own building, Salary for Entrepreneur, etc.
• Explicit cost / Paid out costs: Those expenses which are actually paid by the firm. Appears in the accounting books.
• Sunk Costs / Non-avoidable / Non escapable: They are not altered by a change in quantity and cannot be recovered. All the past expenses are sunk costs Eg Depreciation, interest, machineries not in use.
• Incremental / Differential cost ( Avoidable, escapable or Differential): It is the additional cost due to a change in level or nature of business activity.
• Out-of-Pocket costs: These are expenses which are current cash payments to the outsiders. (All Explicit costs)
• Book Costs: These are business costs which do not involve any cash payments but for them a provision is made in the books of account. Eg. Depreciation, Implicit cost.
• Accounting cost / Past Cost: How much expenditure has already been incurred on a particular process or on production as such.
• Economic cost / Future cost: Cost relate to future.
• Direct costs / Traceable / Assignable: These costs have direct relationship with a unit of operation.
• Indirect / Non-traceable / Non assignable: These costs cannot be easily & definitely traced to a plant or department.
• Historical Cost / Original cost: It states the
cost of plant, equipment and materials at the price paid originally for them.
• Replacement cost: It states the cost that the firm would have to incur if it wants to replace or acquire the same assets now.
• Controllable costs: Costs which are capable of being controlled or regulated.
• Non-Controllable cost: costs which cannot be subjected to administrative control and supervision. Eg. Depreciation, Obsolescence.
• Private costs: Micro level. Costs incurred by an individual or a firm for its business activity.
• Social costs: Macro level. Total cost s to the society on account of production of a good.
• Shutdown Costs: Those costs incurred when firm temporarily stops it operations.
• Abandonment Costs: Costs incurred when the firm is retiring altogether.
• Short run costs: a period in which the supply of at least one of the inputs cannot be changed by the firm. Inputs are fixed.
• Long run costs: Period in which all inputs can be carried as desired.
• Fixed Cost: Part of total cost of the firm which does not vary with output.
• Variable cost: Part of total cost that are directly dependent on the volume of output or service.
• Total cost: It is money value of the total resources required for production of goods and services by the firm. TC = FC + VC
• Average cost: It is the cost per unit of output.
– AC = TC / n
– n = number of unit
• Marginal cost: It is the change in total cost due to unit change in out put
)( 1 nnn TCTCMC
COSTS IN SHORT RUN
• Classification of costs is on the basis of time
– Short run cost
– Long run cost
• The short run is a time period where some factors of production remain fixed and only few are variable.
– Fixed inputs – land ,machine and technology
– Variable inputs – labor and raw material
Contd…
• Therefore in short run we divide costs in two broad categories
– Fixed costs
• Costs on fixed inputs
– Variable costs
• Costs on variable inputs
TOTAL COSTS FUNCTIONS AND CURVES FOR SHORT RUN
• As we discussed short run cost have two components
• Fixed cost – This cost do not vary with output
– Cost incurred in plant, machinery fitting , equipments, land etc.
– Any change in volume of output does not depends upon fixed cost
– The shape of the TFC(TOTAL FIXED COST) curve is straight line from origin parallel to quantity axis.
GRAPH - TFC
TFC
X AXIS – QUANTITY Y AXIS – COST
• Variable cost
– These are costs that vary with output and are incurred in getting more and more inputs.
– Variable costs are equal to zero if there is no out put
– Cost of raw materials , wages are called variable cost.
– TVC is an inverse S shaped upward sloping curve starting from origin.
GRAPH - TVC
X AXIS – QUANTITY Y AXIS – COST
GRAPH INFERENCE
• The shape of curve determined by law of variable proportions.
• According to this law as more and more units of the variable factor are added in production its productivity goes on increasing.
• This lead to fall in per unit cost in the beginning. if the variable input is increased beyond certain level its marginal productivity starts diminishing.
• So TVC increases at increasing rate.
GRAPH – TOTAL COST
TC
TVC
TFC
X AXIS – QUANTITY Y AXIS – COST
TOTAL COST = TFC + TVC
SHORT RUN – AVERAGE AND MARGINAL COST
• AVERAGE COST
– Average cost is cost per unit of out put
– We can derive AFC (average fixed cost) AVC( average variable cost) and AC (average cost) from total fixed , total variable and total costs respectively.
– AFC is fixed cost per unit of output and this is equal to the ratio of TFC and units of output
• AFC = TFC / NUMBER OF UNITS OF OUT PUT
– AVC is variable cost per unit of out put and this is equal to the ratio of TVC and units of output
• AVC = TVC / NUMBER OF UNITS OF OUT PUT
– AC is total cost per unit of out put
• AC = TC /NUMBER UNITS OF OUTPUT
• MARGINAL COST
– MC is the change in total cost due to unit change in out put
– Rate of change in total cost.
)( 1 nnn TCTCMC
MC
AC
AVC
AFC
X AXIS – QUANTITY Y AXIS – COST
AVERAGE AND MARGINAL COST CURVES- SHORT RUN
• The AVC and AC curve are both U shaped. – This explained by law of diminishing returns.
– Cost decline when there are increasing returns(output)
• AC being the sum of AFC and AVC at each level of output lies above both AFC and AVC curve.
• Initially AC falls with increase in out put reaches minimum and then increases.
AVC , AFC AND AC GRAPH - INFERENCE
..contd
• When both AFC and AVC fall AC also falls.
• AVC soon reaches minimum and start rising .
• While AFC continues to fall.
• How ever the rise in AVC compensate falls in AFC and AVC pulls AC up after reaches a minimum.
MARGINAL COST GRAPH - INFERENCE
• The magnitude of marginal cost is interlinked with changes in average cost.
• When average cost decline MC lies below AC.
• When average costs are constant the MC passes through the minimum points of average cost curves.
• When average cost rise MC curve lies above them.
• AC and AVC fall MC lies below them
• AC and AVC rise MC lies above them.
RELATIONSHIP AMONG CURVES – MATHEMATICALN SUMMARIZATION
• TC = TFC + TVC
• AFC = TFC / Q
• AVC = TVC/ Q
• AC = TC /Q
= (TFC + TVC)/Q
= AFC + AVC
• MC = TC q – TC q-1
= change in total cost (d TC)/ total out put (dQ)
COSTS IN LONG RUN • All cost are variable in the long run since factors
of production – Size of plant
– Machinery and technology are all variable.
• The long run cost function is often referred to as the “planning cost function”
• The long run average cost (LAC) curve is known as the “ planning curve”
• All the cost are variable only the average cost curve is relevant to the firm’s decision making process in the long run.
• Long run cost curve is the composite of many short run cost curves……*
LONG RUN AVERAGE COST (LAC)
• When the plant size and other fixed inputs of the firm increase in the long run the short run cost curves shift to the right.
• We consider in the long run the firm operates with three different plant sizes
– Plant size I , II , III
• It can switch over to a different plant size depending on cost consideration.
…CONTD
• SAC 1 relates to average cost of the firm when the plant size I.
• When the plant size increases to II the corresponding SAC 1 curve is SAC 2 and so on.
• So – Plant size I – SAC I
– Plant size II – SAC II
– Plant size III – SAC III
LAC CURVE
MC1 MC2 MC3
SAC1 SAC2 SAC3
plant size I plant size II plant size III
Q0 Q1 Q2
X AAXIS – QUANTITY Y AXIS –AC,MC
GRAPH- INFERENCE
• As out put increases from Qo to Q1 in the short run the firm can continue to produce along SAC1, utilizing its installed capacity of plant size I.
• Further ahead at an out put level of Q1 this capacity is over worked.
• So it would be the cost effective for the firm to shift to higher plant size say plant size II. – Thus switching from SAC1 to SAC2
• This shift would lower the average cost of the firm.
• The same concept is followed for subsequent output.
…contd • The LAC curve has a scalloping pattern as its
is drawn with three plant sizes only.
• We assumed that the firm operates with only 3 alternative plant sizes.
– But in reality ……………. Multiple such alternatives.
– So in reality it may have multiple SAC also….
• The LAC function is an envelope of the short run cost functions and LAC curves envelopes the SAC curve hence LAC curve is also known as “ envelope curve”
..contd
• The LAC curve is also known as “planning curve”
• According to the entire planning horizon in which the managerial economist can select the most appropriate plant size , given the existing (or expected) level of demand for the product.
LAC - ENVELOPECURVE
SMC1 SMC2
SAC1 SMC2 SAC3
SAC2
Q0 Q1 Q* Q3
X AAXIS – QUANTITY Y AXIS –AC,MC
LONG RUN MARGINAL COST
• Long run marginal cost (LMC) curve joints the points on the short run marginal cost (SMC) curves.
LMC - CURVE
SMC1 SMC2
C
SAC1 SMC2 SAC3
SAC2
A LMC
B
Q0 Q1 Q* Q3
X AAXIS – QUANTITY Y AXIS –AC,MC
GRAPH INFERENCE
• At out put level of Qo. The relevant long run marginal cost is Aqo.
• The LMC curve joins the points A,B,C
• According to assuming sufficient demand the optimum plant size is II.
• So the optimum level of out put is Oq*.
– Where long run and short run marginal cost and average costs are equal.
LAC – DIFFERENT SHAPES
X AAXIS – QUANTITY Y AXIS –AC
LONG RUN TOTAL COST - CURVE
COST LRTC
QUANTITY
GRAPH - INFERENCE
• Once we have the long run average cost of producing an output we can readily derive the long run total cost of output.
• Since total cost is the quantity of output times average cost.
COST OF A MULTIPRODUCT FIRM
• So far we have assumed that the firm produces a single good /service.
• How ever in the real business world many firms produce more than one product.
• A cost of multiproduct firm is differ from costs of single product.
• In order to ascertain the costs of multiproduct form we need to first modify some of the cost concepts.
EXAMPLE
• Take multiproduct firm producing 2 goods – Product 1 and product 2
• For simplicity we assume that the firm uses the same capital requirements in producing the above 2 goods.
• So TC of production would be the sum of fixed cost (TFC) and total variable cost (TVC)- C1 and C2 of producing both the product times the quantities of 2 goods be Q1 and Q2 – TC = TFC + C1 Q1 + C2 Q2
…. CONT
– WEIGHTED AVERAGE COST OF MULTIPRODUCT FIRM
– AC w(Q) = F + C1 (X1 Q) + C2 (X2 Q)
----------------------------------
Q
Where
X1 and X2 are proportions in which products 1 and 2 are produced
Q is the total out put.
COSTS OF JOIN PRODUCTS
• There are certain goods which are produced jointly – That is if one good is produced the other will
automatically be produced.
– Example = normally found in agriculture , minerals etc
• Costing of such products is different from traditional costs method.
• Two or more products undergo the same production process up to split off point
…contd
• Split off point
– The beyond which joint products acquire separate identities and one or more of the products may undergo additional processing there from.
– Example
• Cream and milk
• Oil and gas
JOINT PRODUCTS – COST CONCEPTS
• In this there would be common costs which cannot be identified with a single joint product.
• The join products incur common costs until they reach split off point.
• After the split off point the product incurred the separate costs.
• The allocation of common costs are according to
– Physical measure
– Sales value
LINKAGE BETWEEN COST, REVENUE AND OUTPUT
• TOTAL REVENUE (TR) – Total revenue is the total amount of money received
by a firm from goods sold during certain period of time.
– TR = Q X P • Q – QUANTITY P – PRICE
• AVERAGE REVENUE (AR) – Average revenue is the revenue earned per unit of
output sold. – It is equal to the ratio of TR and out put – AR = TR / Q = (Q x P) / Q – AR = P
…CONTD
• MARGINAL REVENUE (MR)
– Marginal revenue is the revenue a firm gains in producing one additional unit of a commodity
– It is calculated by determining the difference between the total revenues earned before and after increase in production
– MRq = TRq - TR q-1
= d TR / d Q
TR AND MR - RELATIONSHIP
MR is slope of TR CURVE
TR
MR
X AAXIS – QUANTITY Y AXIS –PRICE ,
REVENUE
GRAPH - INFERENCE
• The graph shows the relationship between total revenue and marginal revenue.
• TR will be zero when nothing is sold.
• The shape of TR curve is inverted U starts from origin.
• After it reaches maximum dipping to X axis.
• Rise in total revenue curve is the change in total revenue with rise in level of output – So therefore we can say MR is the slope of TR curve
MR AND AR – RELATION SHIP
• AR curve can have the following positions
– Straight line
– Convex to the origin
– Concave to the origin
PANEL A PANEL B PANEL C
AR AR AR
MR MR MR
X AAXIS – QUANTITY Y AXIS –MR
GRAPH INFERENCE • PANEL A
– When AR is a straight line MR will be lie midway to AR
• PANEL B
– When AR is convex to the origin MR will lie less than midway to AR
• PANEL C
– When AR is concave to the origin MR will lie more than midway to AR
PROFIT MAXIMIZATION
• The profit function shows a range of outputs at which the firm makes positive profits
• Two types of profits – Normal profit
• It is amount of return to the firm which must be earned to keep in that business activity
• It is the part of total cost
– Supernormal profit • Any thing above normal profit is super normal profit
• It is accounting profit occurs when TR > TC
..CONTD
• A firm maximizes profit at the point where MR = MC
• Rules of optimization
– The second order condition of profit maximization requires the slope of MR = slope of MC
BREAK EVEN ANALYSIS
“Break even point is the point where total cost just equals the total revenue it is the no profit and no loss point”
• It is also known as cost volume profit analysis
• It is a first step in planning decision
APPROACHES IN BREAK EVEN ANALYSIS
• Graphical method
• Algebraic method
• Contribution margin
• PV ratio
• Margin of safety.
GRAPHICAL METHOD
TR
PROFIT
TC
E
VC
FC
X AAXIS – QUANTITY Y AXIS – COST
REVEUE
DRAWING -BREAK EVEN GRAPH
• The break even chart assumes constant AVC for a given range of output.
• After point E the firm achieve profit.
• The point E is the break even point.
• The gap between the total costs line and revenue line beyond the break even point represents the level of profit.
• If the gap is such that TC line is above the TR line the area represent loss.
• If the TR line is above TC line the area represent profit
ALGEBRAIC METHOD
• Let us understand the break even analysis algebraically
• Let P be the price of a goods
• Q is the quantity produced
• AVC be the average variable cost
• AFC be the average fixed cost
• Let Q* be the break even output, where total revenue equals total cost.
..contd
• TOTAL REVENUE (TR) = P x Q
• TOTAL COST (TC) = TFC + TVC
= TFC + AVC x Q
• P x Q = TFC + AVC x Q
• (P – AVC) x Q = TFC
Q= TFC/ (P- AVC)
CONTRIBUTION MARGIN
• Contribution margin per unit sales is the difference between price and average variable cost
– CONTRIBUTION MARGIN = P – AVC
• It represents that portion of the price of the commodity produced by the firm that can cover the fixed costs and contribute to profits
PV RATIO
• Profit volume (PV) ratio is the ratio of contribution margin and sales
• It is defined as the ratio of marginal change in profit and marginal change in sales
• PV RATIO = CONTRIBUTION / SALES
• BEP = FC / PV RATIO – FC = FIXED COST
MARGIN OF SAFETY
• Margin of safety
= planned sales – break even sales
LIMITATIONS – BREAK EVEN ANALYSIS
• It does not take into account possible changes in costs over the time period under consideration
• It assumes that whatever is produced is sold
• It does not keep any provision for a changes in selling price.
• It does not allow for changes in market conditions
• It is difficult to find out BEP in service sector.
ECONOMIES OF SCALE
• “Economies” refer to lower costs hence economies of scale would mean lowering of costs of production by way of producing in bulk.
• In simple terms economies of scale refers to the efficiencies associated with large scale of operations.
• When production increases the average cost per unit decreases.
• Economies of scale are extremely important in real world production processes.
TYPES OF ECONOMICS OF SCALE
• INTERNAL ECONOMIES OF SCALE
– Cost per unit depends upon the size of the firm
• EXTERNAL ECONOMIES OF SCALE
– Cost per unit depends upon the size of the industry not the firm.
INTERNAL ECONOMIES • The reason behind the internal economies
– Specialization
• Jobs can be broken down into components/process
• Specialization in particular job
– Greater efficiency of machine
– Managerial economies
• Better supervision, administration, planning & organization
– Financial economies
• Large firms going for large volume of production may able to raise capital from the market with much less difficulties than small firm.
– Production in stages
• Houses all the process in production
EXTERNAL ECONOMIES
• The reason behind external economies
• As an industry grows in size would create various economies for existing firms in the industry
– Technological advancement.
– Easier access to cheaper raw materials.
– Financial institutions in proximity.
– Pool of skilled labors.
DISECONOMIES OF SCALE
• It is a reverse of economies of scale.
• It is refers to decreases in productivity when there are equal increases of all inputs. Assuming that no inputs is fixed.
• Diseconomies may rise if the size of operations become un widely by size. – Coordinating among different work groups and units
may become complex
– Management become less effective and thus indirectly improve costs