Understanding of Cost Theory& its connection to Cost Accounting

Gunel Poladova

Date 02\10\07

Cost Object

A cost object-is any activity for which a separate measurement of costs is desired . Cost of a product, cost of rendering a service to a bank customer or hospital patient, or indeed anything for which one wants to measure the cost of recourses used.

Impicit&Explicit costs

Implicit cost-Input costs that do not require an outlay of money by the firm

(Horace is skilled by computer could earn $100 per hour working as programmer, for every hour he works at his pizza factory he gives up $100 income and this forgone income is also part of his costs )

Explicit cost-Input cost that require an outlay of money by the firm

Economists& Accountants analyse of the cost Economists are interested in studying how

the firm make production and pricing decisions

Theses decisions are based on both explicit and implicit costs

Accountants have the job of keeping track of money that flows into and out of firms.They count explicit cost and often ignore implicit cost

Economists& Accountants analyse of the cost When Horace gives up the opportunity to

earn money as computer programmer his accountant will not count this as a cost of his pizza business .Because no money flows out the business to pay for this cost, it never shows in financial statements

Economists& Accountants analyse of the cost An Economist however will count the foregone

Income as a cost because it will affect the decisions that Horace makes in his pizza business

If his wage as computer programmer rises from $ 100 to $ 500 per hour he might decide that running his pizza business is too costly and choose to shut down the factory to become a full-time programmer

The cost of Capital as an Opportunity Cost Horace used $300 000 of his savings to buy

his pizza factory from his previous owner. If Horace had instead left this money deposited in a saving accounts that pays an interest rate pf 5 per cent he would have earned $ 15 000 a year in interest income. To own his business he has given up $ 15 000 a year in interest income. This foregone $ 15 000 one of the implicit costs of his business

The cost of Capital as an Opportunity CostThe Economist views the $ 15 000 in interest

Income that Horace gives up every year as cost of their business even though it is implicit cost

Accountant will not show this & 15 000 as cost because no money flows out of the business to pay for it

The cost of Capital as an Opportunity Cost Horace did not have the entire & 300 000 to

buy the factory but instead he used $ 100 000 from his own savings and borrowed $ 200 000 from a bank at an interest rate of 5 per cent. Horaces accountant will count the $ 10 000 that they paid on bank loan every year as a cost

According to economist view the opportunity cost of owning business is still $ 15 000

The cost of Capital as an Opportunity Cost The opportunity cost equals the interest on

the bank loan (an explicit cost $ 10 000) plus the forgone interest on savings (an implicit cost of $ 5000)

Economic&Accounting profit

Economic profit as the firms total revenue minus all the opportunity costs (exp&impl) of producing the goods and services sold Accounting profit as the firms total revenue minus only the firms explicit costs

For a business to be profitable from an economists standpoint , total revenue must cover all the opportunity costs,both expl&impl

Economic&Accounting profit

Economic profit-total revenue minus total cost, including both explicit&implicit cost

Accounting profit – total revenue minus total explicit cost

An Economist Views An Accountant Views

Economic&Accounting profit

Economic Profit

Implicit costs

Explicit costs

Accounting profit

Explicit costs

RevenueRevenue

Total opportunity Cost

Farmer MacDonald gives bagpipe lessons for $ 20 an hour. One days he spends 10 hours planting $ 100 worth of seeds on his farm. What opportunity cost has he incurred?

What cost would his account measure? If these seeds will yield $ 200 worth of crops

does old Mac Donald earn an accounting profit? Does he earn an economic profit?

Quick Quiz

Production Function

Number Output Marginal Cost Cost Total Cost of

of workers quantity product of of inputs

pizzas of labour factory workers (cost factory&work)

0 0 30 0 30

1 50 50 30 10 40

2 90 40 30 20 50

3 120 30 30 30 60

4 14o 10 30 40 70

5 150 30 50 80

Production Function

Number of workers hired

Production function

Number of workers

Quantity of output

The Production Function

Relationship between the quantity of input (workers) and quantity of output Production Function

The marginal product of any input in the production process is the increase in in the quantity of output obtained from one additional unit of that input

The Diminishing Marginal Product the property whereby the marginal product of an input declines as the quantity of the input increase

Production Function

The number of workers increase , the Marginal product declines.

At first only a few workers hired and they have easy access to kitchen equipment.As the number of workers increases additional workers have to share equipment and work in more crowded conditions.

More and more workers are hired each additional worker contributes less to the production of the pizza

Total Cost Curve

Total Cost Curve

010

2030

4050

6070

8090

0 50 100 150 200

Total Cost Curve

Quantity of output

Total Cost

Production Function& Total Cost Curve The Total Cost Curve gets steeper as the amount

produced rises, whereas the production function gets flatter as production rises.

This changes in slope occur for the same reason High production means that kitchen is crowded, each

additional worker adds less to production Kitchen is crowded producing an additional pizza

requires a lot of additional labor is thus very costly Therefore, when the quantity produced is large, the

total cost curve is relatively steep

If farmer Jones plants no seeds on his farm, he gets no harvest. If he plants 1 bag of seeds he gets 3 tones of wheat. If he plants 2 bags he gets 6 tones. A bag of seeds cost $ 100 and seeds are his only cost. Use this data to graph the farmers production function and Total Cost Curve.

Quick Quiz

Average and Marginal Cost

How much does it cost to make the typical unit?

How much does it cost to increase production

of 1 more unit?

Cost Terms

Fixed& Variable Cost Direct& Indirect Costs Period& Product Costs Cost behavior in relation to volume of ativity Relevant and irrelevant costs Avoidable and unavoidable cots Sunk Costs Opportunity Costs Incremental and marginal costs

Fixed& Variable Cost

Fixed Cost do not vary with quantity of output produced. They are incurred even if the firm produces nothing t all.

RentSalary workersVariable Cost change as the firm alters the quantity of

output producedSugarPaper cupsA firms total Cost-is the sum fixed and variable costs