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Cost concepts
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Definition
The Amount of expenditure,
notional or actual, attributable to athing or product.
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Cost of Production
Business Decisions are generallytaken on the basis of the moneyvalue of the inputs and outputs.
Input multiplied by the respectiveprices is the cost of production. It isotherwise called as money value of
the inputs.
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Cost Function
Cost is the function of output c=f(X)
C=f(X, T, ,K)
WHEREC=TOTAL COST
X=outputT=technologyK=price of factors = FIXED FACTORS(S)
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Determinants Of Cost
(1) Rate of output (i.e., utilization of fixed plant)
(2) Size of plant
(3) Prices of input factors (materials and labor)
(4) Technology
(5) Stability of output
(6) Efficiency (of management as well as labor)
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Elements of cost
MATERIAL
LABOUR
OTHER EXPENSES
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Accounting and Economic Cost
The cost concepts are categorizedon the basis of purpose and nature.
Cost Concepts used in accountingpurposes
Cost concepts used in economicanalysis of business activities
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Accounting Cost Concepts
Opportunity Cost and Actual Cost
Business Cost and Full Cost
Explicit Cost and Implicit cost.
Out of pocket and Book cost.
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Economic Cost Concepts
Fixed and Variable Cost
Total , Average and Marginal Costs
Short Run and Long Run costs
Incremental Costs and Sunk Cost.
Historical and Replacement Cost.
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Actual Cost
The actual expenditure incurred forproducing a commodity. These costare recorded in the books ofaccounts. It is otherwise called asoutlay cost or absolute cost.
Eg: Wages paid
Cost of materials purchased
Interest paid.
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Opportunity Cost
The cost of the best alternativeforegone.
It is revenue earned or incomewhich could have been earned byemploying a commodity in someother alternative use.
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Eg:
One hectare of land, lets assume
one can grow either paddy, wheat orsugarcane. If one decides to growpaddy as against either sugarcane orwheat. the benefit foregone by not
producing sugarcane is theopportunity cost of growing paddy.
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Business cost
All expense which are incurred tocarry out a business is business cost.
It includes all payments andcontractual obligations made by thefirm together with the book cost ofdepreciation on plant and equipment.
These cost concepts are used forcalculating business profits and lossesfor filling returns of income tax .
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Full Cost
The concept of full cost includesbusiness cost, opportunity cost andnormal profit.
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Explicit Cost
Explicit cost are those which fallunder the actual or business costwhich are entered in the books ofaccounts.
Eg: Payment of wages and salaries
Materials
License fee
Insurance Premium
Depreciation.
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Implicit Cost
Implicit cost are those which do nottake the form of the cash outlays, orthey do not appear in the accountingsystem.
Eg: Opportunity cost.
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Out of Pocket cost
The items Which involves cashpayments or cash transfers bothrecurring and non recurring.
Eg: Explicit cost
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Book cost
Certain actual business cost which donot involve cash payments, but theprovisions are made in the books ofaccounts are book cost.
Eg: Interest unpaid
Depreciation allowances.
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Economic Cost
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Fixed cost
In a short period there are factorsthat are fixed and some variable.
The fixed factors are Machinery andplant , Factory building.
The cost incurred for the fixed factorsare called as fixed cost.
Fixed cost do change in the long run.
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Fixed Cost Curve
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Variable Cost
Variable cost vary with every changein Output.
Variable Cost increase as the volumeof the Production Increases.
Variable Cost include cost of rawmaterials , wages of labor, Fuel ,
Electricity.etc.
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Variable Cost Curve
VC
Output
Cost
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Total Cost
Total Expenditure incurred on theproduction of goods and service.
It includes both Fixed and Variablecost.
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Total Cost
TC = TFC + TVC
TVC
Output
Cost
TC
TFC
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Average Cost
Average Fixed Costs (AFC)
The total fixed costs divided by output.
Average Variable Costs (AVC)
The total variable costs divided by output.
Average Total Costs (ATC)
The total costs divided by output.
The summation of average fixed costs and
average variable costs, i.e., ATC=AFC+AVC.
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Average Fixed costAVC = TFC / No. of units (Fixed cost per Unit)
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AC and MC
$
Y
ATC
MC
AVC
AFC
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Marginal Costs
Marginal Cost is the addition to thetotal cost , when the production ofgood is increased by one unit.
The cost involved in producing oneunit is Marginal cost.
It is otherwise called as Incremental
Cost or Differential Cost.
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The change in total costs divided bythe change in output.
TC/Y
The change in total variable costsdivided by the change in output.
TVC/Y
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Marginal Cost & AC
Output
Cost MC
AC
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Incremental, Marginal and SunkCosts
Incremental Cost
Incremental cost is the change in costtied to a managerial decision.
Fixed cost and variable cost changes
Marginal cost
Additional cost of producing one
additional unit of output Only the variable cost changes
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Shut down & AbandonmentCosts
Shutdown cost Expenses of temporaryclosure
Abandonment cost Expenses ofpermanent closure
Is an expenditure that cannot be
recovered Sunk costs are irrelevant to presentdecisions.
Sunk Cost
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Avoidable and Unavoidablecost
Cost that can be avoided byeliminating a product ordepartment is avoidable and thatwhich cannot be, is unavoidable.
Ex. Rent of factory is unavoidableif a product is discontinued
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Historical, Current andReplacement Cost
Historical Versus Current Costs
Historical cost is the actual cash outlay.
Current cost is the present cost ofpreviously acquired items.
Replacement Cost
Cost of replacing productive capacity
using current technology.
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Short-run and Long-run Costs
How Is the Operating PeriodDefined? At least one input is fixed in the short run.
All inputs are variable in the long run.
Fixed and Variable Costs
Fixed cost is a short-run concept.
All costs are variable in the long run.
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Cost Concepts
Total Fixed Costs (TFC)
The summation of all fixed and sunk costs toproduction.
Total Variable Costs (TVC) The summation of all variable costs to
production.
Total Costs (TC)
The summation of total fixed and total variablecosts.
TC=TFC+TVC
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Marginal Cost
Output
Cost MC
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Typical Average &
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Typical Average &Marginal Cost Curves
AFC is alwaysdeclining at adecreasing rate.
ATC and AVC declineat first, reach aminimum, thenincrease at higherlevels of output.
The differencebetween ATC andAVC is equal to AFC.
MC is generallyincreasing.
MC crosses ATC andAVC at their minimum
point. If MC is below the
average value:
Average value will bedecreasing.
If MC is above theaverage value:
Average value will beincreasing.
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Long-Run cost curves
Nothing is fixed everything isvariable.
The long run average cost curve
is called as the envelope curve
L R A C t
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Long-Run Average CostCurve