Cost Analysis
6.1
Cost Analysis
Cost analysis refers to the study of behaviour of cost in
relation to one or more production criteria such as size of output, scale of
operation etc.
6.2 Cost Classification
It means segregation of all
types of direct or indirect expenses incurred by a producer to get the
production factors for producing the final output. Such cost also includes
normal profit, needed by a firm to survive in the market.
(i)
Accounting Cost:
Accounting cost (also called
as Explicit Cost/Money Cost) includes all such
expenditures, which are incurred in purchasing or hiring the factors of
production (e.g. Wages workers, cost of fuel and power, rent on building, cost
of raw material, interest on borrowings etc.), excluding implicit cost.
Implicit cost:
It represents
the cost of factors owned by the promoter himself and employed in his own
business (i.e., interest on the entrepreneur’s capital and his salary etc.).
(ii)
Economic Cost: It
is the sum of
Explicit and Implicit cost. Economic costs includes those cost which are
actually incurred by a firm for making payment to the factor owners for the
purchase or hire of services of labour inputs and the cost of self supplied
factors of production, which are actually not recorded into the books of accounts.
(iii)
Outlay Cost: Outlay cost implies the actual outlay or expenditure
incurred by a firm on the production of a commodity. It includes expenditure on
wages and salaries, expenditure on machinery and equipment, materials, power,
fuel, transportation, rents, insurance taxes etc.
(iv)
Opportunity Cost: It
represents the
alternative earning that might have been earned, if the productive capacity or
services had been put to some other alternative. It indicates the advantage lost
due to not using the facility in the manner originally planned. For example,
if an owned building is proposed to be used for a project, the likely rent
of the building is the opportunity cost which should be taken into
considerations at the time of appraisal of the profitability of the project. In
considering opportunity cost, the best alternative (where several alternatives
exist) should be considered.
(v)
Direct Cost: Direct Costs are those, which may be
conveniently identified with particular product (e.g. raw materials used in manufacturing a product).
(vi)
Indirect Costs are those that are incurred for the benefit of a number of products and
cannot be identified with a particular product (e.g. repairing of building, manager’s salaries, depreciation
etc.)
(vii)
Shutdown Cost: Shutdown costs are those which are
incurred in the event of temporary cessation of business activities, and which
could be saved if operation were allowed to be discontinued. Besides fixed
costs, shutdown costs cover the additional expenditure, such as salary of security
guard in looking after the property.
(viii)
Abandonment Costs: It refers to the cost of retiring a fixed asset from use (e.g. old office equipment may
be useless due to the development of new technology). Thus, abandonment cost
involves permanent cessation of activity and may lead to sale of the assets.
(ix)
Fixed Cost: Fixed costs include those costs, which do not alter with changes in the
quantity of production or size of output during the period. They remain
constant during the specified period at any level of output level of production
is totally immaterial. These costs are related to fixed factors of production
Fixed costs e.g. rent, interest payable also known as supplementary cost.
(x)
Variable Cost: Variable costs are those, which
change with the change in the quantity of output or production. These cost rise
with the increase in output and decrease with a decrease in output.
(xi)
Marginal Cost: An addition to the total cost on
the production of an additional unit of a commodity is known as marginal cost
of production of a firm for an additional unit of output. “ Marginal cost at
any level; of output is the extra cost for producing one extra unit more.” These
costs are classified into two categories as: (i) Short-run Marginal Cost
(ii) Long-run Marginal Cost, MC = ⌂TC / ⌂Q
(xii)
Semi-variable Cost: Semi-variable costs include expenses which remain constant upto a
certain level of output and then start rising proportionately. These costs
arise where there is no proper segregation the cost i.e. whether it is a fixed
cost or a variable cost.
(xiii)
Average: It is the ratio between the total cost of production and
the quantity of a given output is the
average cost of production of a given output level for a firm.
6.3 Cost function
(i) The relationship between
the cost of a product and its various cost determinants is termed as cost
function.
(ii) The function may be
mathematically expressed as: Where
C = f (O, T, U, P)
C = Cost of output
O = Size of output
T =
Time under consideration
U =
Utilization of capacity
P = Price of production factors
6.4 Determinants of Cost
There are several factors
which influence the cost, like:
(i) Price of Inputs: The cost of a product is determined
by the prices of production factors, which depends upon the input contribution
made in the total cost of a product.
(ii) Size of plant: The size of plant (or scale
of operation) is inversely related to the cost. If the scale of operation rises,
the cost decline and vice versa.
(iii) Level of output: Total output and total
cost are directly related to each other. If the level of output rises, the
total cost also rises and if the level of output declines, the total cost also declines.
(iv) Technology: The adoption of new
technologies may help to decrease the cost of production to a great extent.
However, in case of rapid developments of technologies, it may become obsolete
over a period of time.
(v) Stability of output: The Cost of a product is
also influenced by the stability of output. Interruption and variations may
increase the cost of production.
(vi) Managerial
efficiency: The efficiency and productivity of input factor may be improved
by efficient supervision and control of cost. This leads to reduction in cost
of production.
6.5.1 Short-Run
Short Run is a period in
which some factors are fixed and some factors are variable. Fixed factor have
fixed cost and variable factor have variable cost. So, law of variable
proportion applies here. In short-run, output can be increased or decreased by
changing variable factors only, but fixed factors cannot be varied.
In the short run if due to
any reason firm cannot cover its total variable cost, it shut down the operation temporarily because firm always
try to meet marginal cost of production,
if it cannot do it, firm will stop production for finding the fault.
6.5.2 Long-Run
Long-Run is a period in
which all factors can be varied. There is only variable cost, it’s doesn’t have
fixed cost. So law of returns to scale applied here. In long-run, output can be
increased or decreased by changing all the factors.
Short-period and
long-period cannot be quantified.
Law of returns to scale is
applicable in the long run.
6.5.3 Total Cost (TC)
Total cost of production is
the sum of all expenditure incurred in producing a given volume of output. In
other words, TC = TFC + TVC, where TC = Total Cost, TFC = Total Fixed Cost, TVC
= Total Variable Cost.
6.5.3.1 Total Fixed Cost (TFC)
Fixed Cost does not change
with changes in the level of output. TFC is parallel to X-axis. Even at zero
output, fixed cost remain the same in the short run (e.g. rent and insurance).
Total fixed cost curve is a
straight line parallel to horizontal axis because with change in output there
is no change in total fixed cost.
6.5.3.2 Total Variable Cost (TVC)
Variable Costs are those
costs that change with changes in level of output. It has inverse ‘S’ shape and
start from origin. Figure given below shows that as output is zero cost is also
zero and as output increases cost increases e.g. raw material, power etc.
|
Output
(Q)
|
TFC
|
TVC
|
TC
|
|
0
|
20
|
0
|
20
|
|
1
|
20
|
16
|
36
|
|
2
|
20
|
26
|
46
|
|
3
|
20
|
32
|
52
|
|
4
|
20
|
40
|
60
|
|
5
|
20
|
52
|
72
|
|
6
|
20
|
70
|
90
|
|
7
|
20
|
94
|
114
|
|
8
|
20
|
106
|
126
|
|
9
|
20
|
120
|
140
|
6.5.4 Average Total Cost (ATC)
Average total cost (ATC) is
the sum of Total Fixed Cost (TFC) and Total Variable Cost (TVC) divided by the
output. So, ATC = TC/Q or ATC = AFC + AVC. The ATC curve first falls, reaches
it’s minimum and then rises. The ATC curve is ‘U’ shape due to law of variable
proportions.
6.5.4.1 Average Fixed Cost (AFC)
Average fixed cost is the
total fixed cost divided by the output. AFC = TFC/Q. The general shape of the
AFC curve is downward sloping. It does not touch the X-axis as AFC cannot be
zero. It is not ‘U’ shape. This curve is also called Rectangular Hyperbola
(R.H.).
6.5.4.2 Average Variable Cost (AVC)
Average variable cost is
the total variable cost divided by the output. AVC TVC/Q. The average cost
curve will first fall, then reach a minimum and then rise again. It has ‘U’
shape.
6.5.5 Marginal Cost (MC)
Marginal cost is the change
in total cost due to change in the output. Or MC = ∆Total Cost / ∆Qty. produced
or MC = ∆Total Variable Cost / ∆Qty. produced. The MC curve is also ‘U’ shape for
example 15 units produced at Rs.200 and 20 units produced at Rs.250, then
calculate MC is computed as:
MC = ∆TC / ∆ unit produced
= (Rs.250 - Rs.200) / (20 units – 15 units) = 50/5 = Rs.10 unit.
Total average cost =
Average Fixed Cost + Average
Marginal cost have a relationship
with average cost. When average cost is falling, marginal cost (MC) is less
than the average cost.
When average cost is
rising, marginal cost is greater than the average cost.
Firm attains equilibrium
point under long run when AR = MR = MC
Short Run Cost Table
|
Output (Unit)
|
Total fixed cost TFC
|
Total variable TVC
|
Total cost
TC
|
Average fixed cost AFC
|
Average Variables AVC
|
Average Total
AC
|
Marginal cost (Rs.) MC
|
|
0
|
20
|
-
|
20
|
-
|
-
|
-
|
-
|
|
1
|
20
|
20
|
40
|
20
|
20
|
40
|
20
|
|
2
|
20
|
36
|
56
|
10
|
18
|
28
|
16
|
|
3
|
20
|
48
|
68
|
6.66
|
16
|
22.66
|
12
|
|
4
|
20
|
56
|
76
|
5
|
14
|
19
|
8
|
|
5
|
20
|
64
|
84
|
4
|
12.8
|
16.8
|
8
|
|
6
|
20
|
76
|
96
|
3.33
|
12.66
|
15.29
|
12
|
|
7
|
20
|
92
|
112
|
2.86
|
13.14
|
16
|
16
|
|
8
|
20
|
112
|
132
|
2.50
|
14
|
16.50
|
20
|
|
9
|
20
|
135
|
155
|
2.22
|
15
|
17.22
|
23
|
6.5.5.1 Why Marginal Cost Curve
|
(i) Marginal cost is an
additional cost incurred for producing one more unit of output. Marginal cost
is the change in total cost due to change in output.
(ii) At initial level, when a
firm enhances its output, the total cost and variable cost start rising at a
decreasing rate, because at initial level of production, the laws of
increasing returns apply. At initial level, the firm enjoys many economies
that cause MC to fall down.
(iii) As the output continues,
marginal cost becomes minimum and then ultimately start increasing due to
operation of Law of Diminishing Returns.
Thus initially MC
declines and after reaching the minimum point, starts increasing. This is the
reason MC curve becomes U shaped.
When average cost curve
is upward moving, marginal cost must also be rising.
|
 |
6.5.6 Long Run Average Cost
(i) A long run cost curve
depicts the functional relationship between output and long run cost of
production. Cost that are fixed in short run can be changed in long run. So, in
the long run, the firm has a choice in the employment of plant which yields
minimum possible unit cost for producing a given output.
(ii) The average cost in long
run is the total cost in long run divided by the level of output.
i.e. Long Run Average Cost
(LAC) = {Long Run Total Cost (LTC)} / {Output (Q)}
(iii) In long run, the firms can
utilise different sizes of plants. The given level of output can be achieved
from the appropriate. Size to obtain at the lowest average cost. The long run
average cost curve can be obtained from the short run average cost curves. It
is tangent to various short run average cost curves.
(iv) The graph shows that for
producing OQ0 level of output the corresponding point on LAC curve
is ‘A’ at which the LAC curve is tangent to Short run Average Cost Curve SAC0.
(v) Thus, if a firm is at will
to produce OQ0 level of output, it has to build a plant
corresponding to SAC0 and will operate the plant at point ‘A’ on
this curve.
6.5.7 Long Run Marginal Cost
Long run marginal cost is
the extra cost on production of one more unit of commodity
It is expressed as LMC =
∆LTC / ∆Q
|
Where
|
LMC
|
= Long run marginal cost
|
|
|
∆LTC
|
= Change in long run
total cost
|
|
|
∆Q
|
= Change in output level
|
Break even point is the NO
profit NO loss position. Until firm’s production level crosses the Break Even,
firm does not earn profit. Firm starts earning operating profits when it
crosses Break Even point.
6.5.8 Break
even point
At break even point revenue
is equal to costs.
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