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 CostIt 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 costsShort run and long run costIn 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

Cos

t pe

r un

it

0 q qa q’ Output per periodqb

S

S’

M M’

L

L’

SS’, MM’, LL’ are three short run ATC curves respectively

Long run ATC curve: SabL’

a b

Many Short-Run ATC Curves Form a Firm’s LRAC Curve, or Planning Curve

ATC1

ATC2

0 q q’Output per period

ATC1….ATC10 are many possible short run cost curves

Co

st p

er u

nit

$ 11

10 ATC3

ATC4

ATC5

ATC6

ATC7

ATC8

ATC9

ATC10

Long-run average cost or Planning curve/envelop curve as it envelops many short run av.cost curves

b

aEach 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.

LAC

a

LMC

SMC

LAC

At a : Optimal level of output whereSAC=SMC=LMC=LACAt 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

Short run and long run average costs and Marginal costs

tr

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

Cos

t pe

r un

it

0 AOutput 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+bQWhere a= TFC, b=Change in TVC due to change

in quantityGiven the following equation:P=$940-$0.02QTC=$250,000+$40Q+$0.01Q2

Find:MR,MC, optimal level of output,price and Profit(∏).

TR

TC

TVC

Profit

LossB

Q

B is the breakeven point, where TR=TC

output

Cost and revenue

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+1

LRACt

Qt Qt+1

C

BA

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 companyLearning Rate=(1-AC2/AC1)x100

AC falls as ourput increases

The learning curve can be expressed as: C=aQb

or LnC=Lna +b LnQwhere ‘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.