13 Theory of Cost-I

Dr. Savita

1. Learning Outcome

After completing this module the students will be able to understand:

The various types of cost concepts

Difference between those cost elements that are relevant for managerial decision- making and those elements which are not useful for this purpose.

Appreciate the significance of opportunity costs in business decision- making. Nature of cost curves in short period.

Relation among various cost curves

Why short-run cost curves ‘U’ shaped

2. Introduction

In managerial economics, cost is bethought from the producer’s or firm’s point of view. In producing a commodity or service, a firm has to employ various factors of production such as land, labour, capital and entrepreneurship. These factors are to be rewarded by the firm for their contribution in producing that commodity. This reward is the cost, usually it terms as factor price. Thus, the cost of production of a commodity is the aggregate of price paid for the factors of production used in producing that commodity. The term cost has different meaning. Accountant view of cost is different from that of economics the accountant tend to focus on the explicit and historical cost. On the other hand, economists emphasize that for the efficient decision making by the firm it is opportunity cost rather than explicit and historical cost that must be considered.

3. Types of Cost

The term cost has various concepts. These are: (a) Money cost. (b) Opportunity cost. (c) Real cost.

(a) Money Cost: When a producer pays in term of money or cash in order to produce a commodity is called money cost. The payment made in cash or money to the owner of factors of production, raw material or any other resource used in production is called money cost. This cost may be in form of payment in money for the purchase of Raw material, payment of Interest for the use of Capital, payment of Rent for the use of Land or Building, Electricity bill, Publicity, Packing charges, Transport and Insurance premium etc.

Money cost has two constituents: (a) Explicit cost (b) Implicit cost

(1) Explicit cost— Explicit cost refers to all expenses made by a firm to purchase good directly. It include, payments for raw material, wages, rent, interest, depreciation charges, transportation, power, high fuel, advertising, taxes and so on. In nut shell we can say that, explicit costs are those payments which firms make to outsiders for contributing their services and goods.

(2) Implicit cost— Implicit costs may be defined as the earning of those employed resources which belongs to the owner itself. In fact these costs refer to the implied or unnoticed costs. Implicit cost includes the Rent for entrepreneur’s own building or land ,Interest on his own capital, Wages for his own labour etc. in short we can say that, implicit cost are the costs of self owned, self employed resources.

Total cost= Explicit cost+ Implicit cost

(b) Opportunity cost: The concept of opportunity costs was first developed by Austrian School of Economics. But afterward, it was propounded by American economist named Devenport. It is also known as Transfer cost or Alternative cost. In simple words, it is the comparison between the policy that was chosen and the policy that was rejected. So cost of production of any unit of commodity for the value of factors of production used in producing other unit is called opportunity cost. As the resources of the society are scarce and have alternative uses. When these resources are put to use for the production of particular type of commodity, then they are not available to produce other goods at that point of time. The productions of some of the other goods have been sacrificed. For example, you have 100 rupee. You can buy pen or register with this amount. The price of both is the same. If u buy pen, you have to sacrifice register and if you buy register, you have to sacrifice pen. So the opportunity cost of pen is register and opportunity cost of register is pen. So the opportunity cost is the next best alternative that you have to sacrifice. It is the cost of next best alternative gone.

(c) Real cost: Another concept of cost is the Real costs. It is a philosophical concept which refers to all those efforts and sacrifices undergone by various members of the society to produce a commodity. It is also called

‘Social Costs of Production’. In simple words, payment made to factors of production to compensate for the total sacrifice and efforts for the services they rendered is known as real cost.

According to Marshall “The exertion of all the different kind of labour that are directly or indirectly involved in making it, together with the abstinence or rather. The waiting required, for saving the capital used in making it, all these sacrifices together will be called the real cost of production of commodity”. So real cost of production signifies toils, troubles, sacrifice on account of loss of consumption for saving, social effects of pollution caused by factory smoke, automobiles, etc.

4. Concepts of Cost: Time plays an important role in the theory of cost. On the basis of time period, costs are divided into two parts i.e. costs in short run and cost in long run.

Costs in short period: In short period costs are mainly of the following types:

1.  Total cost
2.  Average cost
3.  Marginal cost

1. Total cost: Total cost of production is the sum of all expenditure incurred in producing a given volume of output. In other words, the amount of money spent on the production of different levels of a good is called total cost. Conceptually, total cost includes all types of money costs, explicit as well as implicit.

Total cost = Fixed cost + Variable cost

Fixed cost = The cost which remain fixed at any level of output is known as fixed cost. Fixed costs, in short run, remain fixed because the firm does not change its size and amount of fixed factors employed. Fixed costs or Supplementary costs usually include:

• Payments of rent for building
• Insurance premium
• Depreciation and maintenance
• Administrative expenses— salaries of office and managerial staff
• Interest paid on capital
• Business taxes
• License fees etc.

It is also called Indirect cost, Overhead cost or Supplementary cost. It can be explained with the help of following table no. 1 and figure.

Fixed cost

This table shows that at various quantities of output fixed cost remains fixed at Rs.100. Even a producer produces no output. It can also be shown in following figure. In figure output is shown on OX axis and cost is taken on OY axis. At any level of output fixed cost is fixed.

Variable cost: variable cost refers to those costs which change with the change in the volume of output. So the cost which is incurred on variable factors of production such as raw material, wages, and transport etc. variable cost is also known as direct costs, special costs or prime costs.

The short run variable costs include:

• Prices of raw materials,
• Fuel and power charges,
• Excise duty,
• Sales tax,
• Transport expenditure,
• Wages of labour , etc.

It can be explained with the help of following table no. 2 and figure.

Variable cost

In table as the output increases from 0-40 unit variable cost is increasing at a decreasing rate. When production increases from 50-60 units then variable cost increases at a constant rate and if firm produces more output i.e. from 60-80 units variable cost start to increase at an increasing rate. But when size of production is zero at that time variable cost will also be equal to zero.

In figure output is measured on OX axis and variable cost is measured on OY axis. Variable cost is increasing first at decreasing then constant and then increasing rate.

Fixed, Variable and Total costs in the short –run

In order to determine the total cost of a firm, we aggregate fixed as well as variable costs at different levels of output.

TC = FC + VC

It can be shown with the help of following table no. 3 and figure.

Relationship between fixed, variable, and Total cost

In table 3

TC =TFC + TVC

TFC =TC – TVC

TVC =TC – TFC

In table 3, when output is zero, variable costs are also zero. But fixed costs as well as total costs are 100. As the output increases to 80 units, total costs go up to 720. It means as the output increases fixed costs remain the same, but variable costs increase at diminishing rate and then increasing rate. This relationship has been shown in following figure.

In figure quantity is measured on OX axis and cost on OY axis. FC is fixed cost curve which is parallel to horizontal axis which signifies the fact that at all level of output, fixed cost remain the same. VC is variable cost curve. It is of the shape of reverse S. It means as the output zero variable costs are also zero. TC shows the total cost of production.

2. Average cost: Per unit cost of a commodity is called as Average cost. According to Dooley, “The average cost of production is the total cost per unit of output.” In other words average cost of production is the total cost of production divided by the total number of units produced. For example cost of producing 100 units is Rs. 20,000, the average cost will be:

AC =TC/Q          AC = Average cost        TC = Total cost            Q= quantity

Ac = 20,000/100 = Rs. 200

Another way to calculate average cost is:

AC = AFC + AVC

AC =Average cost, AFC = Average fixed cost, AVC = Average variable cost.

• (a) Average Fixed cost: Average fixed cost is the total fixed cost divided by the number of units of output. It is per unit cost of fixed factors of production. Thus:

AFC = TFC/Q   AFC = Average fixed cost, TFC = Total Fixed cost, Q = Quantity

Since, total fixed cost is a constant quantity, average fixed cost will steadily fall as output increases, and thus, the average fixed cost curve slopes downward with a view to touch the horizontal axis. But it will not be so because AFC can never be zero.

• (b) Average Variable cost: Average variable cost is the total variable cost divided by the number of units of output produced. Thus

AVC = TVC/Q  AVC = Average variable cost, TVC = Total variable cost, Q = Output

Normally, the AVC falls as output increases from zero to the normal capacity output due to the law of increasing returns. But afterward, the AVC will rise because of the operation of the law of diminishing returns. It is always U-shaped.

Relationship among Average cost, Average fixed cost and Average variable cost

Average cost is the sum total of both Average fixed cost and Average variable cost. This is shown with the help of following table and figure.

Relation among AC, AFC, and AVC

This table shows that AC decreases as the volume of output increases from 1 to 7 units and then it start to increase when volume of output increases to 8 to 9 units. Relation among AC, AFC and AVC can be shown in following figure.

It is observed from the figure:

Average cost is a sum total of both AFC and AVC. AVC and AFC both falls with the increase in output.

AVC starts to rise with the increase in output and AFC will fall continuously. AC also falls up to a certain stage.

With the increase in output AVC start to increase beyond a certain point and AFC remain decreasing but AC also start to increase remaining minimum at some stage.

AC curve is ‘U’ shaped.

Why AC curve is ‘U’ shaped

In short period average cost curves are of U shaped, which shows, initially it falls and after reaching the minimum point it starts rising upwards. Following points may justify the U shaped AC curve.

Due to Averages fixed cost and Average variable cost: it is well known, that average cost is the aggregate of average fixed cost and average variable cost (AFC+AVC).in the initial stages as production increases both AFC and AVC falls. When AFC and AVC added then the falling rate of AC will be more. If production continuously increases then AFC will fall and AVC will be minimum at one stage at that time AC will also be minimum. In the last stage with the increase in production AFC goes on falling but AVC start to increase. Adding both the increasing rate of AC will be more than AVC. If we join all three stages of AC then we will get ‘U’ shaped AC curve. It can be seen in following diagram.

Due to Law of Variable proportion: The law of variable proportion states that when variable factors are combined with fixed factors in short run then production in the initial stage will increase at an increasing rates then constant and in last stage production will increase at diminishing rate.

Due to indivisibilities of the factors of production: Another reason due to which the average cost curve forms U shape is the indivisibilities of factors. When in the short period a firm increases its production, due to indivisibilities of fixed factors, it gets various internal economies. In these economies which cause the average cost curve to fall in the initial stage. When these fixed factors are fully utilized by the firm then cost of production began to rise again so AC increases. It can be seen in following figure.

3. Marginal cost: The marginal cost is the addition made to total cost by producing one more unit of output. In other words, marginal cost may be defined as the change in total cost associated with a one unit change in output. It is also an ‘extra unit cost’ or incremental cost, as it measures the amount by which total cost increases when output is expended by one unit. It can also be calculated by dividing the change in total cost by the one unit change in output.

It can be shown with the help of following table and figure.

Marginal cost

It is clear from the table that when 1 unit is produced then total cost is Rs.200 and total cost increases to Rs.280when extra one unit produced. Marginal cost of producing one extra unit is Rs 80 (280-200). It shows MC will fall initially with the increase in production then remains constant and then it starts to increase.

In figure output is taken on OX axis and Marginal cost on OY axis. It is observed that MC id decreasing with the increase in the quantity of output. Then it starts increasing with the increase in the size of production. It is also U- shaped.

Relationship between Average cost and Marginal cost

• Both Average and Marginal cost are calculated from Total cost. As is known, average cost is the ratio of total cost to total output. In the same way marginal cost is also calculated from total cost. It refers to an addition made to total output by producing one more unit of output.
• Initially, both MC and AC curves are sloping downward. When AC curve is falling, MC curve lies below it, as can be seen in figure:

4. When AC is rising, after the point of intersection, MC lies above it
5. When AC is constant MC becomes equal to AC
6. MC cuts AC at its lowest point.

5. SUMMARY

The module ‘Theory of Cost-1’ has focused on the basic concepts of costs. Money cost is the money expenditure on different factors of production. Money cost includes cost of raw material, machinery, and equipment, wages, salaries and supplements, rent on business premises, interest paid on capital, power-fuel charges, insurance premium etc. The implicit cost is the earnings of those resources which belong to owner itself. For decision making both explicit as well as implicit costs are important. The opportunity cost is the return from the second best use of a resource, which the Firm foregoes when taking up the opportunity of its best use. Fixed cost do not vary with the level of output whereas, variable cost change with changes in the level of output. In short period cost curves are always U shaped. It suggests initially falling and eventually rising. Marginal cost is the ratio of change in total cost to a change in output

Few important sources to learn more about Managerial Economics:

• Peterson, Lewis, Managerial Economics, Prentice Hall of India, N. Delhi.
• Salvatore, Managerial Economics in Global Economy; Thomson learning; Bombay.
• EF. Brigham And J,L. Pappas, Managerial Economics, Dryden Press, illinois.
• Dwivedi, D.N. Managerial Economics, Vikas Publishing House, New Delhi.
• Mehta, P.L. Managerial Economics, Sultan Chand, New Delhi.
• http://mms-notes.blogspot.com/2013/07/managerial-economics.html
• https://www.quora.com/What-are-the-roles-managerial-economics-for-a-manager
• http://www.slideshare.net/rathourvikash/intro-to-business-economics
• http://www.freewebs.com/vssriram/SCDL/Managerial%20Economics%20Consolidated.xls