Cost analysis

• In managerial economics, cost is
generally considered from the producer’s
or firm’s point of view. The firm or
producer employs various factors of
production such as; land, labour, capital
and entrepreneurship. These factors are
compensated in terms of their factor
prices. This compensations are the costs .
The cost of production is thus the sum
total of the prices paid for the factors of
production.

Types of costs
• Real cost: Real cost of production refers to the physical
quantities of various factors used in producing a commodity.
• Opportunity Cost: It is the foregone benfits from the next
best alternative use of a given resource.
• Explicit cost: actually incurred expenses
• Implicit cost: It is the opportunity cost of the use of factors
which a firm does not buy or hire. Ex: Self managed
business.
• Accounting cost: It is the explicit cost
• Economic cost: It includes both explicit and implicit costs.
• Replacement cost:Cost of duplicating/replacing the
productive capability of the existing technology

 Fixed Costs: The cost remain fixed at any level of out put: ex:
rent of building, interest on capital , etc.
 Variable costs: These costs are incurred by the firm using the
variable factors of production (cost of raw materials, wages of
labour, fuel and power charges, transport exp etc.)
 Incremental cost
It is the change in the costs involve with multiple unit of
output. It differs from the marginal cost that involves a single
unit of output.
It is the change in cost tied to a managerial decision.
 Sunk Cost
It is the Irreversible expenses incurred previously.
Sunk costs are irrelevant to managerial decisions.

• Total (TC), average (AC)and
marginal cost(MC)
• TC= TVC+TFC
• AC=TC/Q
• MC=ΔTC/ Δ1Q ………Δ1denotes
change in output by one unit
only

•TC is the vertical sum
of FC and VC
•VC starts from origin;
increases slowly at first;
with diminishing returns,
VC increases rapidly
•FC = $200 at all levels
of output

MC first declines: increasing marginal
returns; then increases: diminishing marginal
returns

Time element in costs
Short run and long run cost
In the short run some factors of
production remain fixed and only few are
variable.
In the long run all costs are variable.
There are radical changes in the cost
structure of the firm. The long run cost
function is therefore known as planning
cost function and the long run cost curve
is known as planning curve.

 Average Cost in the short run
• √ Average total cost: ATC = TC/Q
 √ Average variable cost :AVC = VC/Q
 √ When MC < average cost (AC)
 The average cost falls
 √ When MC > average cost(AC)
 The average cost rises
√ When MC=AC, AC is at minimum

•ATC and AVC first decline, and
reach the lowest points, then rise.
•When MC is above AVC (ATC), AVC(ATC) is Increasing
•When MC is below AVC (ATC), AVC (ATC) is falling
•When MC = AVC (ATC), AVC (ATC) is at its minimum.

Costs in the Long Run
 All resources can be varied
 Long run is always in the Planning horizon
 Firms plan in the long run
 Firms produce in short run
 long-run average cost curve is U-shaped

Short-Run Average Total Cost Curves Form the Long-Run
Average Cost Curve, or Planning Curve
SS’, MM’, LL’ are three short run ATC curves respectively
Cost per unit
0
M M’
q qa q’ q Output per period b
S
S’
L
L’
Long run ATC curve: SabL’
a b

Many Short-Run ATC Curves Form a Firm’s
LRAC Curve, or Planning Curve
ATC1
ATC2
$ 11
0 q q’
ATC10
ATC9
LAC
Output per period
ATC1….ATC10 are many
possible short run
cost curves
Cost per unit
10 ATC3
ATC4
ATC5
ATC7
ATC6
ATC8
Long-run average cost or
Planning curve/envelop
curve as it envelops many
short run av.cost curves
b
a
Each short-run curve is
tangent to the long run
average cost curve at
its lowest point
Each point of tangency represents the least cost way of producing that level of
output.

Short run and long run average costs and
Marginal costs
LMC
a
SMC
LAC
At a : Optimal level
of output where
SAC=SMC=LMC=LAC
At point ‘a’ the long
run average costs are
minimised which is
known as minimum
efficient scale or
least cost of
production.
Q
C
SAC1
SAC2
SAC3
t
r

The long run cost curve also operates in
Economies and diseconomies of scale
Economies of scale
–LRAC falls as output expands
Diseconomies of scale
–LRAC increases as output expands
Constant long-run average cost

A Firm’s Long-Run Average
Cost Curve
Cost per unit
0 A
Output per period
B
Economies
of scale
Long-run
average cost
Diseconomies
of scale
Constant
average cost

• Cost and output relationship:
• Cost function:TC=f(Q) or TC=a+bQ
Where a= TFC, b=Change in TVC due to change
in quantity
Given the following equation:
P=$940-$0.02Q
TC=$250,000+$40Q+$0.01Q2
Find:MR,MC, optimal level of output,price and
Profit(Π).

TR
TC
TVC
Profit
Loss
B
Q
B is the breakeven
point, where TR=TC
output
Cost
and
reve
nue
Break-even Analysis
FC

Economies of scale: It means lowering the
cost of production by producing the output in
bulk. In other words it refers to the efficiency in
the production process. The cost of production
decreases with increase in the level of output.
For example, it might cost Rs 100 for one unit
of output, Rs180 for 2 units and Rs220 for three
units.
Economies of Scope: It arises with lower
average costs of manufacturing a product when
complementary products are produced by a
single firm rather than they are produced
separately. Ex: Tata , Hindustan lever

• Scope Index= S= (C1+C2+C3-Ct)/
C1+C2+c3
• C1,C2,C3 : cost of the three products and Ct is
the total cost.
• If S positive it is better to produce together
and if S is negative it is better to execute them
separately.

• Learning Curve: Economists and Business
analyst have discovered another factor that
causes decrease in average cost over a large
scale of production. In this case the producers
learn from experiences through learning by
doing.
The average cost may decline with cumulative
production, because of managerial and other
learning effects. The concept of learning curve
is used to represent the extent to which
average cost of production falls in response to
increase in output.

LEARNING CURVE
LRACt
LRACt+1
Qt Qt+1
C
B
A
Cumulative output
AC in
Rs
•It is widely used
in many
manufacturing
and service
industries like
ship building,
aero plane,
petroleum
products power
plants etc.
•It is also used in
forecasting the
manpower and
material needs of
the company
Learning Rate=(1-AC2/AC1)x100
AC falls as ourput increases

The learning curve can be expressed as:
C=aQb
or LnC=Lna +b LnQ
where ‘C’ is the average cost at output ‘Q’; ‘a’ is
the cost for the first unit of output and ‘b’ is the
rate of decrease in AC with cumulative increase
in output. The value of b is expected to be
negative because of the decrease in cost with
cumulative increase in output. The greater is
the value of b, the faster is the decrease in AC.
The cost reduction is the learning on the part of
the managers as well as for the organisations.

Cost analysis

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