COST ANALYSIS

CONCEPT OF COST OF PRODUCTION

1. The Cost Of Production Theory Of Value is the theory that the price of an
object or condition is determined by the sum of the cost of the resources that
went into making it.
2. The cost can compose any of the factors of production (including labor,
capital, or land) and taxation.
3. Production costs are those which must be received by resource owners in order
to assume that they will continue to supply

TYPES OF ECONOMIC COSTS

1. Accounting Cost. Actual expenses plus depreciation.

2. Economic Cost. Cost to a firm of using resources in production. Also called
opportunity cost, the most valuable forgone alternative

1. EXPLICIT COST
1. Also called Money Cost or Accounting Cost
2. A cost that is represented by lost opportunity in actual cash payments.
3. It is the cost of factors of production and/or services that entrepreneur has to
buy directly.
4. It includes Wages, Salary, Expenses Of Factors Of Production, Fuel,
Advertisement, Transportation Taxes and Depreciation Charges.
 2. IMPLICIT COST
1. A cost that is represented by lost opportunity in the use of a company's own
resources, excluding cash
2. For example, the time and effort that an owner puts into the maintenance of
the company rather than working on expansion
3. The implicit cost begins and ends with foregoing the benefits and satisfaction
4. Opportunity Cost Without Payment Or Transaction: an opportunity cost for
which no payment is made nor any asset value reduced

Explicit Cost Vs. Implicit Cost

1. Explicit cost can be counted in terms of money whereas implicit cost can not
be traded and therefore can not be counted in terms of money.
2. Explicit cost is a direct tangible cost whereas implicit cost is indirect
intangible cost.

4. NOMINAL COST
1. Nominal Cost is the money cost of production. It is also called Expenses Of
Production
2. Producer must make sure that he covers expenses of factors of production in
producing the good in long term.

5. REAL COST
1. Also called Opportunity Cost
2. The cost of an opportunity forgone (and the loss of the benefits that could be
received from that opportunity); the most valuable forgone alternative.
3. The value of the next best alternative foregone as the result of making a
decision. Opportunity cost analysis is an important part of a company's
decision-making processes but is not treated as an actual cost in any financial
statement.
4. Money Cost and Real Cost do not coincide
 PROFIT

ACCOUNTING PROFIT
1. Accounting profit is the difference between price and the costs of bringing to
market whatever it is that is accounted as an enterprise (whether by harvest,
extraction, manufacture, or purchase) in terms of the component costs of
delivered goods and/or services and any operating or other expenses.
2. The difference between a business's revenue and it's accounting expenses.
3. A business is said to be making an accounting profit if its revenues exceed the
accounting cost of the firm.

ECONOMIC PROFIT
1. Economic Profit is the difference between a company's Total Revenue and its
Opportunity Costs.
2. It is the increase in wealth that an investor has from making an investment,
taking into consideration all costs associated with that investment including
the opportunity cost of capital.
3. The value that remains after all costs, including the opportunity costs of the
operator’s labor and capital, have been subtracted from gross income. Same
as the return to management.
4. An economic profit arises when revenue exceeds the opportunity cost of
inputs, noting that these costs include the cost of equity capital that is met by
"normal profits."

Normal Profit

1. Normal profit is a component of the firm's opportunity costs.

2. The time that the owner spends running the firm could be spent on running
another firm.
3. The return the entrepreneur can expect to earn or the profit that the business
owners considers necessary to make running the business worth his/her while
4. Normal profits arise in circumstances of perfect competition when economic
equilibrium is reached. At equilibrium, average cost equals marginal cost at
the profit-maximizing position. Since normal profit is economically a cost,
there is no economic profit at equilibrium

Supernormal Profit

1. Positive economic profit is sometimes referred to as Supernormal Profit or as

Economic Rent
2. In a single-goods case, a Positive Economic Profit happens when the firm's
average cost is less than the price of the product or service at the profit-
maximizing output. The economic profit is equal to the quantity of output
multiplied by the difference between the average cost and the price.

Social Profit

1. The social profit from a firm's activities is the normal profit plus or minus any
externalities that occur in its activity.
2. A firm may report relatively large monetary profits, but by creating negative
externalities their social profit could be relatively small.

Profitability

1. Profitability is a term of economical efficiency. Mathematically it is a relative

index – a fraction with profit as numerator and generating profit flows or
assets as denominator.

SHORT-RUN AND LONG-RUN COSTS

1. The long run and the short run do not refer to a specific period of time such as
3 months or 5 years.
2. The difference between the short run and the long run is the flexibility
decision makers have.
3. The Short Run is a period of time in which the quantity of at least one input is
fixed and the quantities of the other inputs can be varied
4. In other words, in Short Run, a firm cannot build another plant or abandon
one
5. The Long Run is a period of time in which the quantities of all inputs can be
varied
6. There is no fixed time that can be marked on the calendar to separate the
short run from the long run

SHORT RUN COSTS

1. Total Variable Costs (TVC)

1. Some costs vary more or less proportionately with the output, known as Prime
or Variable Costs
2. Variable Costs are expenses that change in proportion to the activity of a
business
3. In other words, variable cost is the sum of marginal costs. It can also be
considered normal costs
4. When period is short (Short Run), distinction between fixed and variable cost
can be made, but in a longer period (Long Run) all fixed costs are changed
into variable costs

2. Fixed Costs (TFC)

1. Some costs are fixed and do not vary with variation in output, these are known
as Supplementary, Overhead or Fixed Costs
2. In economics, Fixed Costs are business expenses that are not dependent on
the activities of the business
3. Supplementary or fixed costs must be paid even though production has been
stopped temporarily.
4. They include Land Rent, Salaries, Interest On Capital etc
 3. Total Costs (TC)

1. 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
2. Sum of TFC and TVC
 AVERAGE COST

Average Fixed Cost (AFC)

1. It is fixed cost per unit of output

2. Mathematically [Q = Quantity Of Output]

3. Average fixed cost is a per-unit measure of fixed costs. As the total number of
goods produced increases, the average fixed cost decreases because the same
amount of fixed costs are being spread over a larger number of units.

Average Variable Cost (AVC)

1. It is variable expenses per unit of output

2. Average variable cost (AVC) is an economics term to describe a firms variable
costs (labor, electricity, etc.) divided by the quantity (Q) of total units of
output.
3. Mathematically

4. AVC decreases with increase in output, but after a point it starts to increase.
It is because firm was not producing efficiently

Average Total Cost (ATC)

Or Average Cost (AC)

1. Average total cost is the sum of all the production costs divided by the number
of units produced.
2. Average Cost is equal to total cost divided by the number of goods produced
(the output quantity, Q).
3. It is also equal to the sum of average variable costs (total variable costs
divided by Q) plus average fixed costs (total fixed costs divided by Q).
4. Mathematically:

Or AC = AFC + AVC

MARGINAL COST (MC)

1. Marginal Cost is the increase or decrease in costs as a result of one more or
one less unit of output
2. Note that the marginal cost may change with volume, and so at each level of
production, the marginal cost is the cost of the next unit produced

LONG RUN COSTS

LONG RUN AVERAGE COST (LRAC)

1. The long-run average cost curve depicts the per unit cost of producing a good
or service in the long run when all inputs are variable.
2. The curve is created as an envelope of an infinite number of short-run average
total cost curves. The LRAC curve is U-shaped, reflecting economies of scale
when negatively-sloped and diseconomies of scale when positively sloped.
3. LRAC are normally U shaped but will be relatively flatter then short run curves

LONG RUN MARGINAL COST (LRMC)

1. In the beginning, LRMC falls sharply
2. After reaching minimum it starts to rise sharply
3. It has U shaped curve
 RELATIONSHIPS BETWEEN COSTS

MARGINAL AND AVERAGE COSTS

1. When declining, marginal cost is always below average cost
2. At the point when MC crosses AVC/ATC, AVC/ATC stops declining
3. When increasing, marginal cost is always above average cost
 4.

MARGINAL AND TOTAL COSTS

1. When total cost is increasing at increasing rate marginal cost is increasing
2. When total cost is increasing at decreasing rate marginal cost in decreasing
3. When total cost has reached maximum marginal cost is 0