COST ANALYSIS

Cost refers to the amount of expenditure incurred in acquiring some thing

The expenditure incurred to produce an output or provide service

Thus the cost incurred in connection with raw material, labour, other heads constitute the overall cost of production

A managerial economist must have a clear understanding of the different cost concepts for clear business thinking and proper application

Output is an important factor which influences the cost

WHAT IS COST

Where C= CostS= Size of Plant / Scale of operationO= Output levelP= Prices of inputsT= Technology

COST INPUT OUT RELATIONSHIP

),,,( TPOSC

Types of Cost:

• Total fixed costs (TFC)• Average fixed costs (AFC)• Total variable costs (TVC)• Average variable cost (AVC)• Total cost (TC)• Average total cost (ATC)• Marginal cost (MC)

Opportunity Costs and Outlay Cost

COST CONCEPTS

Out lay costs, also known as actual costs or absolute costs. These are the payments made for labour, material, plant, transportation etc. All these are appearing in the books of accounts.

Opportunity cost implies the earning foregone on the next best alternative has the present option been undertaken

0pportunity cost is the cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen). It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive choices.

The short-run defined as that period during which the physical capacity of the firm is fixed and the output can be increased only by using the existing capacity more intensively.

The cost concepts, generally used in the cost behaviour, are total cost, average cost and marginal cost.

TC(Total Cost):Total cost is the actual money spends to produce a

particular quantity of output.Total cost is the summation of fixed and variable

costsTC = TFC+ TVC TFC(Total Fixed Cost):Up to a certain level of production total fixed costs, i.e the

cost of plant, building, equipment etc. remain fixed. TVC(Total Variable Cost):But the total variable cost i.e the cost of labour, raw

material etc with the variation in output.

COST OUTPUT RELATION IN SHORT RUN

Average cost is the total cost per unit. It can be found out as follows

Average Cost=The average fixed cost keeps coming

down as the production increases and the variable cost will remain constant at any level of output. AFC= AVC=

Marginal cost is the additional of product. It can be arrived by dividing the change in total cost by the change in total output. MC=

COST OUTPUT RELATION IN SHORT RUN

Q

TC

Q

TFC

Q

TVC

Q

TC

COST OUTPUT RELATION IN SHORT RUN

1 2 3

Q TFC TVC

0 60 -

1 60 20

2 60 36

3 60 48

4 60 64

5 60 90

6 60 132

4

TC2+3

60

80

96

108

124

150

192

5

AVC3/1

-

20

18

16

16

18

22

6

AFC2/1

-

60

30

20

15

12

10

7

AC4/1

-

80

48

36

31

30

32

8

MC

-

20

16

12

16

26

42

Q

TVC

Q

TFCQ

TC

Q

TC

COST OUTPUT RELATION IN SHORT RUN

1 2 3 4

Q TFC TVC TC2+3

0 60 - 60

1 60 20 80

2 60 63 96

3 60 48 108

4 60 67 124

5 60 90 150

6 60 132 192

COST OUTPUT RELATION IN SHORT RUN

5 6 7 8AVC3/1

AFC2/1

AC4/1

MC

- - - -20 60 80 2018 30 48 1616 20 36 1216 15 31 1618 12 30 2622 10 32 42

Production Rules for the Short-Run1.If expected selling price < minimum AVC (which

implies TR < TVC):– A loss cannot be avoided.– Minimize loss by not producing.– The loss will be equal to TFC.

2.If expected selling price < minimum ATC but > minimum AVC: (which implies TR > TVC but < TC)– A loss cannot be avoided.– Minimize loss by producing where MR = MC.– The loss will be between 0 and TFC.

Contd…3.If expected selling price > minimum ATC

(which implies TR > TC):– A profit can be made.

• Maximize profit by producing where: MR = MC

COST OUTPUT RELATION IN LONG RUN

Long run is a period during which all inputs are variable including the ones which are fixed in short run.

In the long run firm can change its output according to its demand.

Over a long period, the size of the plant can be changed, unwanted building can be sold or let out, and the number of administrative and marketing staff can be increased or reduced.

In the long run the firm has to bring or purchase larger quantities of all in inputs.

In the long term all input factors are variable.

COST OUTPUT RELATION IN LONG RUN

In the long run cost out-put relation therefore implies the relationship between the total cost and the total output.

In the long run, a firm has a number of alternatives in regard to the scale of operations.

In the long run average cost curve is composed of a series of short-run average cost curves.

In the short run average cost (SAC) curve applies to only one plant whereas the long-run average cost (LAC) curve takes into consideration many plants.

To draw an LAC curve we have to start with a number of SAC curves.

COST OUTPUT RELATION IN LONG RUNIn this figure it is assumed that technological

there are only three sizes of plants-small,

medium and large, SAC1, for the small size, SAC2

for the medium size and SAC3 for the large size

plant. If the firm wants to produce OP units or less, it

will choose the smallest plant. For an output OQ, the firm will opt for medium size plant.

COST OUTPUT RELATION IN LONG RUN

It does not mean that the OQ production is not possible with small plant. Rather it implies that cost of production will be more with small plant compared to the medium plant.

For an output OR the firm will choose the largest plant as the cost of production will be more with medium plant. Thus the firm has a series of SAC curves.

The LAC drawn will be tangential to the entire families of SAC curves i.e. the LAC curve touches each SAC curve at one point, and thus it is known as Envelope Curve. And also known as Planning Curve as it series as guide to an entrepreneur in his planning to expand the production in future. 

ECONOMIES OF SCALE

What is economies of scale?• Economies of scale are the cost advantages that a

business obtains due to expansion. When economists are talking about economies of scale, they are usually talking about internal economies of scale. These are the advantages gained by an individual firm by increasing its size i.e having larger or more plants.

What is diseconomies of scale?

• Diseconomies of scale are the disadvantages of being too large. A firm that increases its scale of operation to a point where it encounters rising long run average costs is said to be experiencing internal diseconomies of scale.

Internal and External economies of scale.

• Internal economies of scale :- lower long run average costs resulting from a firm growing in size.

• External economies of scale :- lower long run average costs resulting from an industry growing in size.

Internal and external diseconomies of scale.

• Internal diseconomies of scale :-higher long run average cost arising from a firm growing too large.

• External diseconomies of scale:- higher long run average costs resulting from an industry growing too large

Types of Internal economies of scale.

• Buying economies• Selling economies• Managerial economies• Financial economies• Technical economies• Research and development economies• Risk-bearing economies.

Buying Economies.• These are the best known type. Large firms

that buy raw materials in bulk and place large orders for capital equipment usually receive a discount. This means that they have paid less for each item purchased. They may receive a better treatment because the suppliers will be anxious to keep such large customers.

Selling Economies.• Every part of marketing has a cost – particularly

promotional methods such as advertising and running a sales force. Many of these marketing costs are fixed costs and so as a business gets larger, it is able to spread the cost of marketing over a wider range of products and sales – cutting the average marketing cost per unit.

Managerial Economies.

• As a firm grows, there is greater potential for managers to specialize in particular tasks (e.g. marketing, human resource management, finance). Specialist managers are likely to be more efficient as they possess a high level of expertise, experience and qualifications compared to one person in a smaller firm trying to perform all of these roles.

Financial economies• Many small businesses find it

hard to obtain finance and when they do obtain it, the cost of the finance is often quite high. This is because small businesses are perceived as being riskier than larger businesses that have developed a good track record. Larger firms therefore find it easier to find potential lenders and to raise money at lower interest rates.

Technical Economies.

• Businesses with large-scale production can use more advanced machinery (or use existing machinery more efficiently). This may include using mass production techniques, which are a more efficient form of production. A larger firm can also afford to invest more in research and development.

Research and development economies.

• A large firm can have a research and development department, since running such a department can reduce average costs by developing more efficient methods of production and raise total revenue by developing new products.

Risk-bearing economies.

• Larger firms produce a range of products. This enables them to spread the risks of trading. If the profitability of one of the products it produces falls, it can shift its resources to the production of more profitable products.

Internal Diseconomies of scale.

• Growing beyond a certain output can cause a firms average costs to rise. This is because the firm may encounter a number of problems including difficulties :-

• controlling the firm.• communication problems.• poor industrial relations.

Difficulty controlling the firm. It can be hard for those managing

a large firm to supervise everything that is happening in the business.

Management becomes more complex and meetings are necessary quite often.

This can increase administrative costs and make the firm slower in responding to changes in marketing conditions.

Communication problems.

• Difficult to ensure that everyone is aware about their duties in a large firm and available opportunities like training etc.

• The may not get a chance to exchange their views and innovative ideas to the management team.

Poor industrial relations.

• Higher risk for larger firms as there will be more conflicts and diverse opinions.

• Lack of motivation of workers, strikes will be seen at certain situations in larger firms due to poor industrial relations.

External economies of scale.• A skilled labour workforce – A firm

can recruit workers who have been trained by other firms in the industry.

• A good reputation – An area can gain a reputation for high quality production.

• Specialist suppliers of raw materials and capital goods – When an industry becomes large enough, it can become worthwhile for other industries, called subsidiary industries to set up for providing for the needs of the industry.

External economies of scale. • Specialist services – Universities and

colleges may run courses for workers in large industries and banks and transport firms may provide services, specially designed to meet the particular needs of firms in the industry.

• Specialist markets – Some large industries have specialist selling places and arrangements such as corn exchanges and insurance markets.

• Improved infrastructure – The growth of an industry may encourage a govt and private sector firms to provide better road links, electricity supplies, build new airports and develop dock facilities.

External Diseconomies of scale.

• Just as a firm can grow too large, so can an industry.

• Larger firms -> transportation increase -> increased journey time -> high transport cost -> reduced workers productivity.

• Growth of industry may increase competition for resources, pushing up the price of key sites, capital equipment and labour.

Revenue Theory

• Revenue is the income that a firm receives from selling its products, goods and service over a certain period of time.

Measurement of Revenue

Total Revenue(TR)

Average Revenue(AR)

Marginal Revenue(MR)

Total Revenue(TR)

• TR is the total amount of money that a firm receives from selling its goods and services in a given time period.

TR= p x q

Average Revenue(AR)

• AR is the revenue that a firm receives per unit of its sale.

TR AR= ----- = P q

Marginal Revenue(MR)

• MR is the extra revenue that a firm gains when it sells one more unit of a product in a given time period

TR• MR= -----------• q

Total Revenue and Output

• TR when price does not change.(Horizontal demand curve)

• The firm does not have to lower the price to sell more output.

• If PED=perfectly elastic, then• P=AR=MR=D• TR curve is upward sloping.

Total Revenue and Output

• TR when price change as output increase.(downward sloping demand curve)

• Firm has to lower price to sell more.• PED falls as output increases.

Relationship between TR, AR, MR and PED.

• TR rises at first but will eventually falls as output increases.

When PED is elastic, to increase revenue, lower the price.

When PED is inelastic, to increase revenue, raise the price.

When PED is unity, to increase revenue, leave the price unchanged.