COST CONCEPTS

DISTINCTION BETWEEN MAIN COST DISTINCTION BETWEEN MAIN COST CONCEPTSCONCEPTS

Explicit costs: are those expenses Explicit costs: are those expenses which are actually paid by the firm which are actually paid by the firm (paid-out costs).(paid-out costs).

Implicit or Imputed costs: are Implicit or Imputed costs: are theoretical costs in the sense that theoretical costs in the sense that they can go unrecognized by the they can go unrecognized by the accounting system.accounting system.

DISTINCTION BETWEEN MAIN COST DISTINCTION BETWEEN MAIN COST CONCEPTSCONCEPTS

Accounting costs: These are the Accounting costs: These are the actual or outlay costs. These costs actual or outlay costs. These costs point out how much expenditure has point out how much expenditure has already been incurred on a particular already been incurred on a particular process or on production as such.process or on production as such.

Economic costs: These costs relate to Economic costs: These costs relate to future. They are in the nature of the future. They are in the nature of the incremental costs.incremental costs.

Measuring Cost:Measuring Cost:Which Costs Matter?Which Costs Matter?

For a firm to minimize costs, we must For a firm to minimize costs, we must clarify what is meant by clarify what is meant by costscosts and and how to measure themhow to measure them• It is clear that if a firm has to rent It is clear that if a firm has to rent

equipment or buildings, the rent they equipment or buildings, the rent they pay is a costpay is a cost

• What if a firm owns its own equipment What if a firm owns its own equipment or building?or building?

How are costs calculated here?How are costs calculated here?

Measuring Cost:Measuring Cost:Which Costs Matter?Which Costs Matter?

Accountants tend to take a Accountants tend to take a retrospective view of firms’ costs, retrospective view of firms’ costs, whereas economists tend to take a whereas economists tend to take a forward-looking viewforward-looking view

Accounting CostAccounting Cost• Actual expenses plus depreciation charges Actual expenses plus depreciation charges

for capital equipmentfor capital equipment Economic CostEconomic Cost

• Cost to a firm of utilizing economic Cost to a firm of utilizing economic resources in production, including resources in production, including opportunity costopportunity cost

Measuring Cost:Measuring Cost:Which Costs Matter?Which Costs Matter?

Economic costs distinguish between Economic costs distinguish between costs the firm can control and those costs the firm can control and those it cannotit cannot• Concept of opportunity cost plays an Concept of opportunity cost plays an

important roleimportant role Opportunity costOpportunity cost

• Cost associated with opportunities that Cost associated with opportunities that are foregone when a firm’s resources are foregone when a firm’s resources are not put to their highest-value useare not put to their highest-value use

Opportunity CostOpportunity Cost

An ExampleAn Example• A firm owns its own building and pays no A firm owns its own building and pays no

rent for office spacerent for office space• Does this mean the cost of office space is Does this mean the cost of office space is

zero?zero?• The building could have been rented The building could have been rented

insteadinstead• Foregone rent is the opportunity cost of Foregone rent is the opportunity cost of

using the building for production and using the building for production and should be included in the economic costs should be included in the economic costs of doing businessof doing business

Measuring Cost:Measuring Cost:Which Costs Matter?Which Costs Matter?

Although opportunity costs are Although opportunity costs are hidden and should be taken into hidden and should be taken into account, sunk costs should notaccount, sunk costs should not

Sunk CostSunk Cost• Expenditure that has been made and Expenditure that has been made and

cannot be recoveredcannot be recovered• Should not influence a firm’s future Should not influence a firm’s future

economic decisionseconomic decisions

Sunk CostSunk Cost

Firm buys a piece of equipment that Firm buys a piece of equipment that cannot be converted to another usecannot be converted to another use

Expenditure on the equipment is a Expenditure on the equipment is a sunk costsunk cost• Has no alternative use so cost cannot be Has no alternative use so cost cannot be

recovered – opportunity cost is zerorecovered – opportunity cost is zero• Decision to buy the equipment might Decision to buy the equipment might

have been good or bad, but now does have been good or bad, but now does not matternot matter

DISTINCTION BETWEEN MAIN COST DISTINCTION BETWEEN MAIN COST CONCEPTSCONCEPTS

Actual costs: These are the costs Actual costs: These are the costs which the firm incurs while producing which the firm incurs while producing or acquiring a good or a service .or acquiring a good or a service .

Opportunity costs: These are the Opportunity costs: These are the return from the second-best use of return from the second-best use of the firm’s resources which the firm the firm’s resources which the firm forgoes in order to avail of the return forgoes in order to avail of the return from the best use of resources.from the best use of resources.

DISTINCTION BETWEEN MAIN COST DISTINCTION BETWEEN MAIN COST CONCEPTSCONCEPTS

Sunk Costs: These are the costs that Sunk Costs: These are the costs that are not altered by a change in the are not altered by a change in the quantity and cannot be recovered.quantity and cannot be recovered.

Outlay costs: It means the actual Outlay costs: It means the actual expenditure incurred for producing or expenditure incurred for producing or acquiring a good or serviceacquiring a good or service

DISTINCTION BETWEEN MAIN COST DISTINCTION BETWEEN MAIN COST CONCEPTSCONCEPTS

Book costs: are those business costs Book costs: are those business costs which do not involve any cash which do not involve any cash payments but for them a provision is payments but for them a provision is made in the books of account.made in the books of account.

Out of pocket costs: are those Out of pocket costs: are those expenses which are current cash expenses which are current cash payments to outsiders.payments to outsiders.

DISTINCTION BETWEEN MAIN COST DISTINCTION BETWEEN MAIN COST CONCEPTSCONCEPTS

Private costs: are those which are Private costs: are those which are actually incurred or provided for by actually incurred or provided for by an individual or a firm for its business an individual or a firm for its business activity.activity.

Social costs: is the total cost to the Social costs: is the total cost to the society on account of production of a society on account of production of a good. Ex leaving waste water into good. Ex leaving waste water into riversrivers

DISTINCTION BETWEEN MAIN COST DISTINCTION BETWEEN MAIN COST CONCEPTSCONCEPTS

Direct costs: are the costs that have direct Direct costs: are the costs that have direct relationship with a unit of operation like a relationship with a unit of operation like a product, process or a department of the product, process or a department of the firm.Ex. Variable cost firm.Ex. Variable cost

Indirect costs: are those whose source Indirect costs: are those whose source cannot be easily and definitely traced to a cannot be easily and definitely traced to a plant, a product, a process or a plant, a product, a process or a department. Ex. Fixed costdepartment. Ex. Fixed cost

DISTINCTION BETWEEN MAIN COST DISTINCTION BETWEEN MAIN COST CONCEPTSCONCEPTS

Controllable costs: are those which Controllable costs: are those which are capable of being controlled or are capable of being controlled or regulated by executive vigilance and regulated by executive vigilance and therefore, can be used for assessing therefore, can be used for assessing executive efficiency.executive efficiency.

Non-controllable costs: are those Non-controllable costs: are those which cannot be subjected to which cannot be subjected to administrative control and administrative control and supervision.supervision.

DISTINCTION BETWEEN MAIN COST DISTINCTION BETWEEN MAIN COST CONCEPTSCONCEPTS

Replacement costs: states the cost Replacement costs: states the cost that the firm would have to incur if it that the firm would have to incur if it wants to replace or acquire the same wants to replace or acquire the same asset now.asset now.

Historical costs: states the cost of Historical costs: states the cost of plant, equipment and materials at plant, equipment and materials at the price paid originally for them.the price paid originally for them.

DISTINCTION BETWEEN MAIN COST DISTINCTION BETWEEN MAIN COST CONCEPTSCONCEPTS

Marginal costs: are the incremental or Marginal costs: are the incremental or additional costs incurred when there is a additional costs incurred when there is a small addition to the existing output of small addition to the existing output of goods and services.goods and services.

Average cost: is the cost per unit of Average cost: is the cost per unit of output, assuming that production of each output, assuming that production of each unit of output incurs the same cost.unit of output incurs the same cost.

Total cost: is the sum-total of all the Total cost: is the sum-total of all the explicit plus implicit expenditures incurred explicit plus implicit expenditures incurred for producing a given level of output.for producing a given level of output.

DISTINCTION BETWEEN MAIN COST DISTINCTION BETWEEN MAIN COST CONCEPTSCONCEPTS

Fixed costs: is that part of the total Fixed costs: is that part of the total cost of the firm which does not vary cost of the firm which does not vary with variations in output, e.g. rent of with variations in output, e.g. rent of land and buildings, property taxes land and buildings, property taxes etc.etc.

Variable costs: are directly Variable costs: are directly dependent on the volume of output dependent on the volume of output or service.or service.

DISTINCTION BETWEEN MAIN COST DISTINCTION BETWEEN MAIN COST CONCEPTSCONCEPTS

Short-run costs: are the costs that Short-run costs: are the costs that can vary with the degree of can vary with the degree of utilization of plant and other fixed utilization of plant and other fixed factors.factors.

Long-run costs: are costs that can Long-run costs: are costs that can vary with the size of the plant and vary with the size of the plant and with other facilities normally with other facilities normally regarded as fixed in the short-run.regarded as fixed in the short-run.

ANALYSIS OF ECONOMIES ANALYSIS OF ECONOMIES OF SCALEOF SCALE

Internal economies of scale are those Internal economies of scale are those which arise from the firm increasing which arise from the firm increasing its plant size.its plant size.

External economies of scale arise External economies of scale arise outside the firm, from improvement outside the firm, from improvement (or deterioration) of the environment (or deterioration) of the environment in which the firm operates.in which the firm operates.

ECONOMIES OF SCALEECONOMIES OF SCALE

INTERNALECONOMIES

EXTERNALECONOMIES

Real economies Pecuniary economies

Production Economies

Marketing Economies

Managerial Economies

Transport and Storage Economies

LABOR•Division of labor economies •Cumulative labor economies

TECHNICAL•Specialization•Indivisibilities•Economies of large machines•General purpose machinery•Initial fixed cost

INVENTORY•Economies of massed resources

Advertisingeconomies

Exclusive dealers with after sales serviceobligations

Economies of variationsin models and designs

Specialization

Team workexperience

Decentralization

Introduction ofModern managerialAnd organizationaltechniques

Bulk buying of materialsat a competitive price

Lower cost of capital

Advertising at large scale at lower rate

Less per unit rate oftransportation

Lower wages and salariesdue to monopoly power and prestige associatedwith large firms

DISECONOMIES OF SCALEDISECONOMIES OF SCALE

Reasons for diseconomies of scale:Reasons for diseconomies of scale: Technical factorsTechnical factors Human and behavioral problems of Human and behavioral problems of

managing a large enterprisemanaging a large enterprise Morale and motivation problemsMorale and motivation problems

COST FUNCTIONCOST FUNCTION

Cost function expresses the relationship between Cost function expresses the relationship between cost and its determinants like size of plant, level cost and its determinants like size of plant, level of output, input prices, technology etc.of output, input prices, technology etc.

C= f(P,O, S,T,…)C= f(P,O, S,T,…)

Where C refers to cost,Where C refers to cost,

P refers to price of inputs used in P refers to price of inputs used in productionproduction

O refers to level of output, O refers to level of output,

S refers to size of plant,S refers to size of plant,

T refers to the nature of technologyT refers to the nature of technology

DETERMINANTS OF COST DETERMINANTS OF COST FUNCTIONFUNCTION

Size of plantSize of plant Output levelOutput level Price of inputsPrice of inputs TechnologyTechnology Managerial efficiencyManagerial efficiency

Short-Run Cost FunctionsShort-Run Cost Functions

Total Cost = TC = f(Q)

Total Fixed Cost = TFC

Total Variable Cost = TVC

TC = TFC + TVC

Short-Run Cost FunctionsShort-Run Cost Functions

Average Total Cost = ATC = TC/Q

Average Fixed Cost = AFC = TFC/Q

Average Variable Cost = AVC = TVC/Q

ATC = AFC + AVC

Marginal Cost = TC/Q = TVC/Q

Short-Run Cost FunctionsShort-Run Cost Functions

Q TFC TVC TC AFC AVC ATC MC0 60 0 60 - - - -1 60 20 80 60 20 80 202 60 30 90 30 15 45 103 60 45 105 20 15 35 154 60 80 140 15 20 35 355 60 135 195 12 27 39 55

Relationships among AVC, ATC Relationships among AVC, ATC and MCand MC

All three cost measures first fall, then All three cost measures first fall, then remain constant and eventually rise remain constant and eventually rise as output increasesas output increases

The rate of change in MC is greater The rate of change in MC is greater than that in AVC and hence the than that in AVC and hence the minimum MC is at an output lower minimum MC is at an output lower than the output at which AVC is than the output at which AVC is minimum minimum

The ATC falls for a longer range of output The ATC falls for a longer range of output then the AVC and hence the minimum ATC then the AVC and hence the minimum ATC is at a larger output than the minimum is at a larger output than the minimum AVCAVC

When MC is below AVC, AVC is fallingWhen MC is below AVC, AVC is falling When MC is above AVC, AVC is risingWhen MC is above AVC, AVC is rising When MC is below ATC, ATC is fallingWhen MC is below ATC, ATC is falling When MC is above ATC, ATC is risingWhen MC is above ATC, ATC is rising Therefore, MC crosses AVC and ATC at the Therefore, MC crosses AVC and ATC at the

minimums i.e., at minimums i.e., at ‘H’‘H’ and and ‘J’‘J’ respectively respectively (in the diagram)(in the diagram)• The Average – Marginal relationshipThe Average – Marginal relationship

Short-Run Cost FunctionsShort-Run Cost Functions

Average Variable Cost

AVC = TVC/Q = w/APL

Marginal Cost

TC/Q = TVC/Q = w/MPL

Long-Run Cost CurvesLong-Run Cost Curves

Long-Run Total Cost = LTC = f(Q)

Long-Run Average Cost = LAC = LTC/Q

Long-Run Marginal Cost = LMC = LTC/Q

Derivation of Long-Run Cost Curves

Relationship Between Long-Run and Short-Run Average Cost Curves

Possible Shapes ofthe LAC Curve