Unit 2 c 2
- 2. 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
- 3. 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.
- 4. 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.
- 5. 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.
- 6. 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.
- 7. • 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.
- 8. • 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.
- 9. • 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.
- 10. • 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.
- 11. • 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.
- 12. • 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
- 13. • 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 MCn (TCn TCn1 )
- 14. 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
- 15. Contd… • Therefore in short run we divide costs in two broad categories – Fixed costs • Costs on fixed inputs – Variable costs • Costs on variable inputs
- 16. 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.
- 17. GRAPH - TFC X AXIS – QUANTITY Y AXIS – COST TFC
- 18. • 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.
- 19. GRAPH - TVC X AXIS – QUANTITY Y AXIS – COST
- 20. 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.
- 21. GRAPH – TOTAL COST TC TVC TFC X AXIS – QUANTITY TOTAL COST = TFC + TVC Y AXIS – COST
- 22. 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
- 23. • MARGINAL COST – MC is the change in total cost due to unit change in out put – Rate of change in total cost. MCn (TCn TCn1 )
- 24. AVERAGE AND MARGINAL COST CURVES- SHORT RUN MC AC AVC AFC X AXIS – QUANTITY Y AXIS – COST
- 25. AVC , AFC AND AC GRAPH - INFERENCE • 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.
- 26. ..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.
- 27. 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.
- 28. 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)
- 29. 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……*
- 30. 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.
- 31. …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
- 32. X AAXIS – QUANTITY LAC CURVE Y AXIS –AC,MC MC1 MC2 MC3 SAC1 SAC2 SAC3 plant size I plant size II plant size III Q0 Q1 Q2
- 33. 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.
- 34. …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”
- 35. ..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.
- 36. X AAXIS – QUANTITY LAC - ENVELOPECURVE Y AXIS –AC,MC SMC1 SMC2 SAC1 SMC2 SAC3 SAC2 Q0 Q1 Q* Q3
- 37. LONG RUN MARGINAL COST • Long run marginal cost (LMC) curve joints the points on the short run marginal cost (SMC) curves.
- 38. X AAXIS – QUANTITY LMC - CURVE Y AXIS –AC,MC SMC1 SMC2 C SAC1 SMC2 SAC3 SAC2 A LMC B Q0 Q1 Q* Q3
- 39. 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.
- 40. LAC – DIFFERENT SHAPES X AAXIS – QUANTITY Y AXIS –AC
- 41. LONG RUN TOTAL COST - CURVE COST LRTC QUANTITY
- 42. 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.
- 43. 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.
- 44. 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
- 45. …. 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.
- 46. 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
- 47. …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
- 48. 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
- 49. 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
- 50. …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
- 51. TR AND MR - RELATIONSHIP X AAXIS – QUANTITY Y AXIS –PRICE , REVENUE MR is slope of TR CURVE TR MR
- 52. 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
- 53. MR AND AR – RELATION SHIP • AR curve can have the following positions – Straight line – Convex to the origin X AAXIS – QUANTITY Y AXIS –MR – Concave to the origin PANEL A PANEL B PANEL C AR AR AR MR MR MR
- 54. 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
- 55. 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
- 56. ..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
- 57. 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
- 58. APPROACHES IN BREAK EVEN ANALYSIS • Graphical method • Algebraic method • Contribution margin • PV ratio • Margin of safety.
- 59. GRAPHICAL METHOD TR PROFIT TC E VC FC X AAXIS – QUANTITY Y AXIS – COST REVEUE
- 60. 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
- 61. 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.
- 62. ..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)
- 63. 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
- 64. 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
- 65. MARGIN OF SAFETY • Margin of safety = planned sales – break even sales
- 66. 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.
- 67. 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.
- 68. 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.
- 69. 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
- 70. 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.
- 71. 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