COST ANALYSIS

  • OBJECTIVES
  • INTRODUCTION
  • MEANING
  • DEFINITIONS
  • TYPES OF COSTS
  • MONETARY COSTS
  • REAL COSTS
  • OPPORTUNITY COSTS
  • ECONOMIC COSTS
  • ACCOUNTING COSTS
  • INCREMENTAL COSTS
  • SUNK COSTS
  • FUTURE COSTS
  • PRIVATE, EXTERNAL AND SOCIAL COSTS
  • FIXED / SUPPLEMENTARY / OVERHEAD COSTS
  • VARIABLE / PRIME COSTS
  • REPLACEMENT COSTS
  • PRODUCTION COSTS
  • SELLING COSTS
  • CONTROLLABLE COSTS
  • DIRECT COSTS
  • INDIRECT COSTS
  • SHORT RUN COSTS CURVES
  • LONG RUN COSTS CURVES

OBJECTIVES

  • To understand the meaning of cost.
  • To discuss different types of costs.
  • To describe in detail the short run and long run costs.
  • To understand the importance of cost in managerial decision-making.

INTRODUCTION

To decide about the quality and quantity of a product depends upon the cost of the cost of the product. In producing a product / service a firm has in incur various costs in form of wages, interest and price of raw – material etc. Hence, from a firm point of view, to estimate correct cost is important for decision-making. An incorrect estimation or a misunderstanding of the costs may have a negative effect on the profit and growth of an organization.

MEANING OF COST

In simple words the payments rent, wage, interest and profit which are made to factors of production (land, labour, capital and entrepreneur) for their services. It means cost includes the value of the factors of production employed. The term costs mean sacrifice(interms of money or comforts) which are made to produce goods and services.

Cost function depends on various factors such as output, technology and price of input, productivity of inputs.

C =f (Q, T, PI, ProI, S)

C = Cost, O = Output, PI = Price of Input, S = Size of Plant, T = Technology, ProI = Productivity of Input

The most important determinant of cost is output. Generally cost of production increases with the increase inOutput. Technology also has effect on the cost of production. If technology is modern, then cost of production will low and vice-versa. Due to rise in the price of input, the cost of production will also rise productivity of input also determines the cost. If productivity of input is high then cost of production will low and vice-versa. Size of plant – As the size of plant increases, costs of production decreases and vice-versa.

DEFINITION

TYPES OF COSTS

  1. Money Cost : Money cost is that cost, in which cost is incurred in terms of money. In simple words, money cost refers to the amount of money which is incurred to produce a good or services. For example – to produce 10 shirts, a producer has to pay Rs.1,000. Hence the money cost is Rs.1000 to produce 10 shirts. Rent, wages, interest, depreciation, packing charges, transport cost, normal profits cost of raw material, selling costs are included in money costs.

J. L. Hanson, “The money cost of producing a certain output of a commodity is the sum of all the payments to the factors of production engaged in the production of that commodity.”

Money cost is of two types –

a)Explicit Costs : Explicit costs are those costs, which are paid to the others for their services and goods. According to Leftwitch, Explicit costs are those cash payments which firms make to outsiders for their services and goods.” These costs are also known as out of packets costs or accounting costs. Explicit costs includes, following items of a firm’s expenditure -

  1. Cost of raw material
  2. Transportation cost
  3. Packing cost
  4. Power changes
  5. Taxes
  6. Rent
  7. Wages
  8. Interest

b)Implicit Costs : Implicit costs are those costs, which are paid by an entrepreneur to his own resources or factors of production (own land, own labour, own capital and own building etc.). Implicit costs are costs of self – owned and self-employed resources.” Implicit cost does not involve a physical cash payment, because it uses the factors which a firm does not buy or hire but already owns. Implicitly money costs are as follows : -

  1. Wages of his own labour
  2. Rent of his own land
  3. Interest on his own capital
  4. Profits for his own entrepreneurial functions.

Total Money Cost = Explicit Costs + Implicit Costs

  1. Real Costs : Real Costs are non quantifiable in money terms. These costs are psychological in nature.

Real costs refers to the payments which are paid to factors of production for their efforts, rain, discomforts, execution and sacrifice, in producing the different products. According to Marshall, “The production of a commodity generally requires many different kinds of labour and the use of capital in many forms. The exertions of all the different kinds of labour that are directly or indirectly involves in making it together with the abstinences or rather the waiting required for saving the capital used in making it – all these efforts and sacrifices together will be called the real cost of production of commodity.” Real costs involves –

  • Compensation package given to employees for the troubles in producing a product.
  • Compensation for sound effects of pollution caused by factory smoke.
  1. Opportunity Costs : Opportunity cost is also known as alternative cost. The concept of opportunity cost was introduced by D.I. Green in 1894, but Prof. Knight made it popular. Factors of production or resources, in an economy are limited and have alternative uses. To produce a particular good the resources has to be withdrawn / sacrificed from the production of other goods. The cost of sacrifice or foregone for the next best use of resource is known as opportunity cost. Ferguson, “The opportunity cost of producing one unit of ‘X’-commodity is the amount of ‘Y’-commodity that must be sacrificed.”

Leftwitch -, “Opportunity Cost of a particular product is the value of foregone alternative products that resources used in its production, could have produced.”

For example, in an economy two goods X and Y are produced. The quantity of X good is OX and Y good is OY. If the quantity of Y commodity has to increase from OY to YY’, then the quantity of X commodity has increased from OX to OX’.

  1. Economic Costs: Economic costs includes the payments such as rent, wages, interest and profit, which are paid to factors of production – land, labour, capital and entrepreneur for their services. Hence, economic costs include normal profits which are paid to an entrepreneur for his managerial and entrepreneurial skills. It means economic costs refer to the payment costs which are paid to factors of production. (outside resources) for their services as well as payments for owned factors. In simple words, economic costs include explicit and implicit costs.

Economic Costs = Explicit Costs + Implicit Costs

Or

Economic Costs = Accounting Costs + Implicit Costs

  1. Accounting Costs: -An accountant’s view is differed from an economists view on cost. Accounting costs refer to only cash payments which are made to factors of production for their services. Hence, an accountant will include only explicit costs. It means accounting costs include rent, wage and interest but not the profits.

Accounting Costs = Explicit Costs

Or

Accounting Costs = Rent + Wage + Interest

  1. Incremental Costs: - Incremental costs refer to the additional cost that a firm has to incur as a result of implementing a major managerial decision. Examples of incremental costs are purchasing new company, hiring new staff.
  1. Sunk Costs: - Sunck costs are the historical costs which are made in past. These costs are irrelevant while making decisions.
  1. Future Costs:Future costs are also known as planned or budgeted costs. These costs are incurred in the future for making financial, managerial, business decisions.
  1. Private, External and Social Costs: - Private costs are the costs which are incurred by a firm for the production of a commodity. Whereas social costs are the costs which are incurred by the society as a whole. The cost which is incurred by others in society is known as external cost.

Social Cost = Private Cost + External Cost

  1. Fixed Cost / Supplementary / Overhead Costs:– Fixed / Supplementary/ Overhead costs are those costs which do not change with the change in level of output. It means if the output of firm is zero, even than a producer has to pay it and this cost remain fixed with the increase in the level of output. Examples payments of rent for a building, insurance premium, interest on capita etc.

Output / Fixed Cost
0 / 10
1 / 10
2 / 10
3 / 10
4 / 10
5 / 10
  1. Variable / Prime Costs: - Variable / Prime costs are the costs which change with the change in level of output when output is zero, the variable cost also zero. It will increase with the increase in level of output. Examples are expenses on raw material, electricity changes, telephone charges.

Output / Fixed Cost
0 / 0
1 / 5
2 / 12
3 / 14
4 / 15
5 / 20
  1. Replacement Costs: - Replacement cost is also known as depreciation cost. With the continue utilization of fixed assets such as tools, equipments and machinery, they depreciated. Hence, there is need to replace these assets. The cost at which these assets are replaced is known as replacement cost.
  1. Production Costs: - Production costs are the costs which are incurred to increase the level of output of a firm. The payments which are made to factors of production are known as product costs.
  1. Selling Costs: - Selling costs are incurred t increase the sale of available products. Examples are commission paid to salesman, advertisement of different products.
  1. Controllable Costs: - Controllable Costs are controlled by the management of a firm. For example cost of quality control, fringes benefits to employees.
  1. Uncontrollable Costs: - These types of costs are beyond the control of the management of a firm. For example – price of raw material.
  1. Direct Costs: - Direct costs refers to those costs which can be attributed to any particular activity.
  1. Indirect Costs: - These types of costs can not be attributed to a particular activity.

Figure 10.1

According to ‘Time Period’ Cost is of two types : -

a)Short Run Cost

b)Long Run Cost

a)Short Run Cost : In short run, some factors remain fixed and other are variable. In short run, costs are of three types: -

i)Total Costs

ii)Average Costs

iii)Marginal Costs

i)Total Costs : - Total cost is the aggregate of money, which is spend by a firm in the production of a commodity. For example, if a firm is spending Rs.1000 on the production of 500 units. Then total cost is Rs.1000. In other words total cost is the sum of the fixed and variable cost.

TC=TFC + TVC

Or

TC = FC + VC

TC = Total Costs

TFC=Total Fixed Costs

TVC=Total Variable Costs

FC=Fixed Costs

VC=Variable Costs

Dooley, “Total cost of production is the sum of all production is the sum of all expenditure incurred in producing a given volume of output.

Total costs are of two types: -

a)Total Fixed or Supplementary Costs : - Total Fixed Cost is the cost of fixed factors which are used to produce goods in short time period. Firm spends on plant, fittings, equipments etc. even starting the production. It means fixed costs do not change with the change in output.

If the production is zero, even than a firm has to pay fixed cost. As the quantity of output increases, the fixed costs do not change. Fixed Costs are also known as, supplementary cost, indirect costs overall costs or plant costs.

  1. Anatol Murod, “Fixed costs are cost which do not change with changes in the quantity of output.”
  2. Benham, “The fixed costs are those costs that do not vary with the size of its output.

Rent, depreciation, normal profit, license fee, insurance premium are the expenses included in fixed costs.

Figure 2 indicates that fixed costs remain fixed whatever the level of output. Fixed cost is parallel to OX axis. It reveals that fixed cost remain same either output is zero or 10. It means fixed costs remain same irrespective of the volume of output.

b)Total Variable or Prime or Special Costs : - Total variable or prime or special costs refer to those costs which change with the change in volume of level of production.

Dooley, “Variable costs is one which varies as the level of output varies.”

If output increases, variable costs also increase and as the output decreases, Costs also decrease. When output zero, these costs are also zero. The short run variable costs are – Prices of raw material, wages of temporary labour, excise duties and sales tax, wear and tear expenses, transport costs etc.

Table 2, shows that costs increase with the increase in level of output, When output is zero, total variable costs are also zero. When Output is 1 unit, cost is Rs.12 and when it reaches 10 units the variable costs are Rs.74.

Table 10.2

Total Variable Costs

Output / Total Variable
0 / 0
1 / 12
2 / 20
3 / 26
4 / 30
5 / 32
6 / 32
7 / 40
8 / 48
9 / 58
10 / 70

Figure 3, shows that the shape of total variable costs is inverse S shape. The shape of total variable cost is determined by the Law of Returns. Initially when factors are employed then variable factor brings in more than proportionate returns, hence cost increases at diminishing rate. At the point of optimum capacity, the returns of variable factors remain constant, hence cost is also constant. At last, after optimum point every additional unit of variable factor yields only less than proportionate return, hence cost increase. Variable cost curve is sloping upwards at diminishing, constant and increasing rate.

IR=Increasing Returns

CR=Constant Returns

DR=Decreasing Returns

Relationship between Total, Fixed and Variable Cost

In short time period, total costs is the aggregate of total fixed costs and total variable costs.

1)TC=TFC + TVC

OR

TC =FC + VC

2)VC=TC – FC

3)FC=TC – VC

TC =Total Costs

VC=Variable Costs

FC=Fixed Costs

TFC=Total Fixed Costs

TVC=Total Variable Costs

Table 10.3

Total Costs

Output / Fixed Costs (Rs.) / Variable Costs (Rs.) / Total Costs (Rs.)
0 / 10 / 0 / 10
1 / 10 / 12 / 22
2 / 10 / 20 / 30
3 / 10 / 26 / 36
4 / 10 / 30 / 40
5 / 10 / 32 / 42
6 / 10 / 34 / 44
7 / 10 / 40 / 50
8 / 10 / 48 / 58
9 / 10 / 58 / 68
10 / 10 / 72 / 82

Table 3, shows that when output is zero, fixed cost is rs.10 and variable cost is Rs. Zero, while total cost is [FC(10+VC(0) = Rs. 10]. It reveals that total costs are the sum of fixed and variable costs. When output increases to 8 units total costs go up Rs. 58 (Rs.10+Rs.48).

Figure 4 shows the relationship between total costs, fixed costs and variable costs. Total costs are the sum total of fixed and variable costs.

At point O, output is zero and variable cost is also zero but fixed cost Rs.10, hence total costs is also Rs.10. Total Cost and variable cost curves are parallel to each other.

2)Average Costs : - Average cost is the per unit cost of a commodity.

Dolley, “The average cost of production is the total cost per unit of output.”

Ferguson -, “Average cost is total cost divided by output.”

Hence AC can be calculated as following

AC=TC

Q

AC=Average Cost

TC=Total Cost

Q=Quantity

The other method to calculate average cost is

AC=AFC + AVC

AC=Average Cost

AFC=Average Fixed Cost

AVC=Average Variable Cost

AFC=AC – AVC

AVC=AC – AFC

Table 10.4

Average Cost

Output / Total Cost (Rs.) / Average Cost (Rs.)
0 / 10 / ∞
1 / 22 / 22
2 / 30 / 15
3 / 36 / 12
4 / 40 / 10
5 / 42 / 8.4
6 / 44 / 7.3
7 / 50 / 7.1
8 / 58 / 7.2
9 / 68 / 7.5
10 / 82 / 8.2

Table 10.4 depicts that average cost can be calculated by dividing total costs with output. In the beginning average cost is high and then it diminishing. At unit 7, AC is minimum, after this point as the level of output increases, AC also increasing.

Figure 5, shows the shape of AC is ‘u’ shaped. In the beginning, as the level of output increases, AC diminishes and reach at ‘M’ point which shows minimum cost. After point ‘M’ average cost again rises.

a)Average Fixed Cost : - Average Fixed Cost, can be calculated by dividing total fixed cost with the level of output. As the level of output increases, the average fixed cost decreases.

AFC=TFC

Q

AFC=Average Fixed Cost

TFC=Total Fixed Cost

Q=Quantity

Table 10.5

AverageFixed Costs

Output / Total Fixed Cost (Rs.) / Average Fixed Cost (Rs.)
0 / 10 / ∞
1 / 10 / 10
2 / 10 / 5
3 / 10 / 3.3
4 / 10 / 2.5
5 / 10 / 2
6 / 10 / 1.7
7 / 10 / 1.4
8 / 10 / 1.2
9 / 10 / 1.1
10 / 10 / 1

Table 5 conveys that as level of output is increasing the Average Fixed Cost diminishing.

Figure 6, shows that the slope of average fixed cost is downward sloping, it means as the level of output increases the average fixed costs diminish. Average Fixed Cost curve is a rectangular hyperbola, because the total area under the curve at different points will be the same.

b)Average Variable Costs : - Average Variable Cost is the per unit cost of the variable factors of production. It can be calculated dividing total variable cost by output.

AVC=TVC

Q

AVC=Average Variable Cost

TVC=Total Variable Cost

Q=Output

Table 10.6

AverageVariable Costs

Output / Total Fixed Cost (Rs.) / Average Fixed Cost (Rs.)
0 / 0 / 0
1 / 12 / 12
2 / 20 / 10
3 / 26 / 8.6
4 / 30 / 7.5
5 / 32 / 6.4
6 / 34 / 5.6
7 / 40 / 5.7
8 / 48 / 6
9 / 58 / 6.4
10 / 72 / 7.2

Table 6, conveys that if output is zero, total variable cost is also zero, hence average variable cost is also. Upto 6 units of output, average variable cost is falling, but it begins to increase from the seventh units. This is happened because of implication of law of variable proportion.

In Figure 7, Output is shown on OX-axis and costs is shown on OY axis. The shape of AVC is ‘U’ shaped.

It shows that upto 6 units of output, AVC is falling because as the output is increasing, AVC is diminishing. From 7 units onward, AVC begins to increase, which implies that AVC is increasing with increase in output.

Relation between AC, AFC and AVC : -

AC is the aggregate of AFC and AVC.

AC=AFC + AVC

AC=TC/Q

AFC=TFC/Q

AVC=TVC/Q

AFC=AC – AVC

AVC=AC - AFC

Table 10.7

Relation between AC, AFC AVC

Output / AFC (Rs.) / AVC (Rs.) / AC = AFC+AVC (Rs.)
0 / ∞ / 0 / ∞
1 / 10 / 12 / 22
2 / 5 / 10 / 15
3 / 3.3 / 8.6 / 12
4 / 2.5 / 7.5 / 10
5 / 2 / 6.4 / 8.4
6 / 1.7 / 5.6 / 7.3
7 / 1.4 / 5.7 / 7.1
8 / 1.2 / 6 / 7.2
9 / 1.1 / 6.4 / 7.5
10 / 1 / 7.2 / 8.2

Table 7 shows that at zero output AFC is ∞ and AVC is zero, hence AC is equal to ∞. Then at 7 units AFC is Rs.1.4 and AVC is Rs.5.7, hence AC is Rs.7.1, here AC is at minimum. After 7 units AC is increasing.

Figure 8 reveals that

  • AC is obtained by adding of AFC and AVC.
  • AC curve tends to come close to AVC but it never touches the latter.
  • On point ‘A’ AC is falling. Hence a firms AC is minimum because it making full use of its available resources and output is maximum, i.e. OQ1. After A point there is only rise is cost but not in production. AVC minimum point is ‘B’, when level of output is less i.e. OQ as compare to OQ1.
  • The combination of AFC and AVC at point F gives U shape and exactly above this point AC curve is showing in U shape. It reveals that AC is ‘U’ shaped but also is the combination of AFC and AVC.

Causes of AC is ‘U’ shaped.