COST

The sacrifice involved in performing an activity, or following a decision or course of action. It may be expressed as the total of opportunity cost (cost of employing resources in one activity than the other) and accounting costs .

o Fixed cost

Decomposing Total Costs as Fixed Costs plus Variable.

In economics, fixed costs are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be time-related, such as salaries or rents being paid per month, and are often referred to as overhead costs. This is in contrast to variable costs, which are volume-related (and are paid per quantity produced).

In management accounting, fixed costs are defined as expenses that do not change as a function of the activity of a business, within the relevant period. For example, a retailer must pay rent and utility bills irrespective of sales.

o Variable cost

Decomposing Total Costs as Fixed Costs plus Variable Costs.

Variable costs are expenses that change in proportion to the activity of a business. Variable cost is the sum of marginal costs over all units produced. It can also be considered normal costs. Fixed costs and variable costs make up the two components of total cost. Direct Costs, however, are costs that can easily be associated with a particular cost object. However, not all variable costs are direct costs. For example, variable manufacturing overhead costs are variable costs that are indirect costs, not direct costs. Variable costs are sometimes called unit-level costs as they vary with the number of units produced.

Direct labor and overhead are often called conversion cost, while direct material and direct labor are often referred to as prime cost.

o Explanation
o For example, a manufacturing firm pays for raw materials. When activity is decreased, less raw material is used, and so the spending for raw materials falls. When activity is increased, more raw material is used and spending therefore rises. Note that the changes in expenses happen with little or no need for managerial intervention. These costs are variable costs. o A company will pay for line rental and maintenance fees each period regardless of how much power gets used. And some electrical equipment (air conditioning or lighting) may be kept running even in periods of low activity. These expenses can be regarded as fixed. But beyond this, the company will use electricity to run plant and machinery as required. The busier the company, the more the plant will be run, and so the more electricity gets used. This extra spending can therefore be regarded as variable. o In retail the cost of goods is almost entirely a variable cost; this is not true of manufacturing where many fixed costs, such as depreciation, are included in the cost of goods. o Although taxation usually varies with profit, which in turn varies with sales volume, it is not normally considered a variable cost. o For some employees, salary is paid on monthly rates, independent of how many hours the employees work. This is a fixed cost. On the other hand, the hours of hourly employees can often be varied, so this type of labor cost is a variable cost.

o Total cost

In economics, and cost accounting, total cost (TC) describes the total economic cost of production and is made up of variable costs, which vary according to the quantity of a good produced and include inputs such as labor and raw materials, plus fixed costs, which are independent of the quantity of a good produced and include inputs (capital) that cannot be varied in the short term, such as buildings and machinery. Total cost in economics includes the total opportunity cost of each factor of production as part of its fixed or variable costs.

The rate at which total cost changes as the amount produced changes is called marginal cost. This is also known as the marginal unit variable cost.

If one assumes that the unit variable cost is constant, as in cost-volume-profit analysis developed and used in cost accounting by the accountants, then total cost is linear in volume, and given by: total cost = fixed costs + unit variable cost * amount.

The total cost of producing a specific level of output is the cost of all the factors of input used. Conventionally economist use models with two inputs capital, K. and labor, L. Capital is assumed to be

the fixed input meaning that the amount of capital used does not vary with the level of production. The rental price per unit of capital is denoted r. Thus the total fixed costs equal Kr. Labor is the variable input meaning that the amount of labor used varies with the level of output. In fact in the short run the only way to vary output is by varying the amount of the variable input. Labor is denoted L and the per unit cost or wage rate is denoted w so the total variable costs is Lw. Consequently total cost is fixed costs (FC) plus variable cost (VC) or

TC = FC + VC

Average Cost:

o
o

Definition and Explanation:

The entrepreneurs are no doubt interested in the total costs but they are equally concerned in knowing the cost per unit of the product. The unit cost figures can be derived from the total fixed cost, total variable cost and total cost by dividing each of them with corresponding output.

Types/Classifications:

o Average Fixed Cost (AFC): o

Average fixed cost refers to fixed cost per unit of output. Average fixed Cost is found out by dividing the total fixed cost by the corresponding output.

o Formula: AFC = TFC output (Q) o

For instance, if the total fixed cost of a shoes factory is $5,000 and it produces 500 pairs of shoes, then the average fixed cost is equal to $10 per unit. If it produces 1,000 pairs of shoes, the average fixed cost is $5 and if the total output is 5,000 pairs of shoes, then the average fixed cost is $1 pair of shoe. From the above example, it is clear, that the fixed cost, i.e., $5,000 remains the same whether the output is 1,000 or 5,000 units.

o Behavior of Average Fixed Cost (AFC): o

The average fixed cost begins to fall with the increase in the number of units produced, In our example stated above, average fixed cost in the beginning was $10. As the output of the firm

increased, it gradually came down to $1. The AFC diminishes with every increase in the quantity of output produced but it never becomes zero.

o Diagram/Curve:

The concept of average fixed cost can be explained with the help of the curve, in the diagram (13.4) the average fixed cost curve gradually falls from left to right showing the level of output. The larger the level of output, the lower is the average fixed cost and smaller the level of output, the greater is the average fixed cost. The AFC never becomes zero.

(2) Average Variable Cost (AVC): o

Average variable cost refers to the variable expenses per unit of output Average variable cost is obtained by dividing the total variable cost by the total output. For instance, the total variable cost for producing 100 meters of cloth is $800, the average variable cost will be $8 per meter.

o Formula:
AVC = TVC (Q)

o Behavior of Average Variable Cost: o

When a firm increases its output, the average variable cost decreases in the beginning, reaches a minimum and then increases. Here, a question can be asked as to why AVC decreases in the beginning reaches a minimum and then increases. The answer to this question is very simple.

When in the beginning, a firm is not producing to its full capacity, then the various factors of production employed for the manufacture of a particular commodity remain partially absorbed. As the output of the firm is increased, they are used to its fullest extent. So the AVC begins to decrease. When the plant works to its full capacity, the AVC is at its minimum. If the production is pushed further from the plant capacity, then less efficient machinery and less, efficient labour may have to be employed. This results in the rise of AVC. It is in this way we say that as the output of a firm increases, the AVC decreases in the beginning, reaches a minimum and then increases. The AVC can also be represented in the form of a curve.

o Diagram/Curve:

The shape of the average variable cost curve (Fig. 13.5) is like a flat U-shaped curve. It shows that when the output is increased, there is a steady fall in the average variable cost due to increasing returns to variable factor. It is minimum when 500 meters of doth are produced. When production is increased to 600 meters, of cloth or more, the average variable cost begins to increase due to diminishing returns to the variable factor.

(3) Average Total Cost (ATC):

Average total cost refers to cost (both fixed and variable) per unit of output. Average total cost is obtained by dividing the total cost by the total number of commodities produced by the firm or when the total sum of average variable cost and average fixed cost is added together, it becomes equal to average total cost.

o Formula:
ATC = Total Cost (TC) Output (Q)

o Behavior of Average Total Cost:

As the output of a firm increases, average total cost like the average variable cost decreases in the beginning reaches a minimum and then it increases. The reasons for decline of ATC in the beginning are that it is the sum of AFC and AVC. Average fixed cost and average variable costs have both the tendency to fall as output is increased. Average total cost will continue falling so long average variable cost does not rise. Even if average variable cost continues rising, it is not necessary that the average total cost will rise. It can be due to the fact that the increase in average variable cost is less than the fall in average fixed cost. The increase in average variable cost is counterbalanced by a rapid fall of average fixed cost. If the rise in the average variable cost is greater than the fall in average fixed cost, then the average total cost will rise. The tendency to rise on the part of average total cost-in the beginning is slow, after a certain point it begins to increase rapidly.

o Diagram/Curve:

The average total cost is represented here by a shaped curve in Fig. (13.6). The average total cost curve is also like a U-shaped curve. It shows that as production increases from 100 meters to 200 meters of cloth, the cost falls rapidly, reaches a minimum but then with higher level of output, the average fixed cost begins to increase.

4)Marginal Cost (MC):

o
o

Definition:
Marginal Cost is an increase in total cost that results from a one unit increase in output. It is defined as:

"The cost that results from a one unit change in the production rate".

Example:

For example, the total cost of producing one pen is $5 and the total cost of producing two pens is $9, then the marginal cost of expanding output by one unit is $4 only (9 - 5 = 4). The marginal cost of the second unit is the difference between the total cost of the second unit and total cost of the first unit. The marginal cost of the 5th unit is $5. It is the difference between the total cost of the 6th unit and the total cost of the, 5th unit and so forth. Marginal Cost is governed only by variable cost which changes with changes in output. Marginal cost which is really an incremental cost can be expressed in symbols.

Formula:
Marginal Cost = Change in Total Cost = TC Change in Output q

The readers can easily understand from the table given below as to how the marginal cost is computed:

Schedule:
Units of Output 1 2 3 4 5 6 Total Cost (Dollars) 5 9 12 16 21 29 Marginal Cost (Dollars) 5 4 3 4 5 8

Graph/Diagram:

MC curve, can also be plotted graphically. The marginal cost curve in fig. (13.8) decreases sharply with smaller Q output and reaches a minimum. As production is expanded to a higher level, it begins to rise at a rapid rate.

o
o

Long Run Marginal Cost Curve:

The long run marginal cost curve like the long run average cost curve is U-shaped. As production expands, the marginal cost falls sharply in the beginning, reaches a minimum and then rises sharply.

o
o

Relationship Between Log Run Average Cost and Marginal Cost:

The relationship between the long run average total cost and log run marginal cost can be understood better with the help of following diagram:

It is clear from the diagram (13.9), that the long run marginal cost curve and the long run average total cost curve show the same behavior as the short run marginal cost curve express with the short run average total cost curve. So long as the average cost curve is falling with the increase in output, the marginal cost curve lies below the average cost curve. When average total cost curve begins to rise, marginal cost curve also rises, passes through the minimum point of the average cost and then rises. The only difference between the short run and long run marginal cost and average cost is that in the short run, the fall and rise of curves LRMC is sharp. Whereas In the long run, the cost curves falls and rises steadily.

o Relation of Average Variable Cost and Average

Total Cost to Marginal Cost:

o
Before we explain, the relation of average variable cost (AVC) and average total cost (ATC) to marginal cost (MC), it seems necessary that the various types of costs and their relationship should be shown in the form of a table. This is illustrated in the table below:

Schedule:

Units of Total Fixed Output Cost (TFC) ($) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 30 30 30 30 30 30 30 30 30 30 30 30 30 30 30 30

Total Variable Cost (TVC)

Average Total Cost (ATC)

Marginal Cost Average Average Fixed Cost Variable Cost (MC) (AFC) (AVC) ($) 30 15 10.1 7.5 6 5 4.3 3.7 3.3 3 2.7 2.5 2.3 2.1 2 1.9 ($) 15 8.4 6.1 4.8 4.0 3.7 3.6 3.7 4 4.3 5.5 7.5 9.6 11.8 14.8 16.7 ($) 15 1.9 1.5 1 0.6 2 3 5 6 7 17 30 35 40 45 60

($) 15 16.9 18.4 19.4 20 22 25 30 36 43 60 90 125 165 210 270

($) 45 23.4 16.1 12.3 10 8.7 7.8 7.5 7.3 7.3 8.2 10 11.9 13.9 16 18.7

From the table, the reader can understand the relation of various types of costs to each other. We take, first of all, the relation of average total cost to marginal cost. As production increases, the average total cost and the marginal cost both begin to decrease. The average total cost goes on decreasing up to the 9th unit and then after 10, it begins to rise. The marginal cost goes on falling up to 5th unit and then it begins to increase. So long as the average total cost does not rise, the marginal cost remains below it. When average total cost begins to increase, toe marginal cost rises more than the average total cost. Summing Up: (1) When average cost is falling, the marginal cost is always lower than the average cost. (2) When average cost is rising, marginal cost lies above AC and rises faster than AC.

(3) The marginal cost curve must cut the average cost curve at the minimum point of AC.

Average Variable Cost and Marginal Cost:

The relation of average variable cost and marginal cost is also very clear from the diagram given below. The AVC goes on falling up to the 7th unit, and then it steadily moves upwards. On the other hand the marginal cost falls up to the 5th unit and then rises more rapidly than average variable cost.

o Diagram/Figure:

In the diagram (13.10) AFC, AVC, ATC and MC curves are shown. Here, units of production are measured along OX and cost along OY. ATC and AVC both fall in the beginning, reach a minimum point and then begin to rise. So is the case with the marginal cost curve. It first falls and then after rising, sharply crosses through the lowest point of average variable cost and average total cost and rises.

Short Run and Long Run Average Cost Curves:

Relationship and Difference: Short Run Average Cost Curve:
In the short run, the shape of the average total cost curve (ATC) is U-shaped. The, short runaverage cost curve falls in the beginning, reaches a minimum and then begins to rise. The reasons for the average cost to fall in the beginning of production are that the fixed factors of a firm remain the same. The change only takes place in the variable factors such as raw material, labor, etc.

As the fixed cost gets distributed over the output as production is expanded, the average cost, therefore, begins to fall. When a firm fully utilizes its scale of operation (plant size), the average cost is then at its minimum. The firm is then operating to its optimum capacity. If a firm in the short-run increases its level of output with the same fixed plant; the economies of that scale of production change into diseconomies and the average cost then begins to rise sharply.

Long Run Average Cost Curve:

In the long run, all costs of a firm are variable. The factors of production can be used in varying proportions to deal with an increased output. The firm having time-period long enough can build larger scale or type of plant to produce the anticipated output. The shape of the long run average cost curve is also U-shaped but is flatter that the short run curve as is illustrated in the following diagram:

o Diagram/Figure:

In the diagram 13.7 given above, there are five alternative scales of plant SAC SAC , SAC , SAC and, 5 SAC . In the long run, the firm will operate the scale of plant which is most profitable to it.

For example, if the anticipated rate of output is 200 units per unit of time, the firm will choose the 1 smallest plant It will build the scale of plant given by SAC and operate it at point A. This is because of the fact that at the output of 200 units, the cost per unit is lowest with the plant size 1

which is the smallest of all the four plants. In case, the volume of sales expands to 400, units, the size of the plant will be increased and the desired output will be attained by the scale of plant 2 represented by SAC at point B, If the anticipated output rate is 600 units, the firm will build the 3 size of plant given by SAC and operate it at point C where the average cost is $26 and also the 3 lowest The optimum output of the firm is obtained at point C on the medium size plant SAC .

If the anticipated output rate is 1000 per unit of time the firm would build the scale of plant given 5 by SAC and operate it at point E. If we draw a tangent to each of the short run cost curves, we get the long average cost (LAC) curve. The LAC is U-shaped but is flatter than tile short run cost curves. Mathematically expressed, the long-run average cost curve is the envelope of the SAC curves. In this figure 13.7, the long-run average cost curve of the firm is lowest at point C. CM is the minimum cost at which optimum output OM can be, obtained.