COST ANALYSIS

The economic goal of the firm is to maximize profits.

Total Cost, Total Revenue and Profits
• Total Revenue
– The amount a firm receives for the sale of its output.
• Total Cost
– The market value of the inputs a firm uses in production.
• Profit is the firm’s total revenue minus its total cost.

Profit = Total revenue - Total cost

Classification of Costs
1. Opportunity cost: Cost of next best alternative foregone.
• When one course of action is chosen over other, the possible benefit lost from the
rejected alternative is the opportunity cost.
• A theoretical concept. Not incurred cost. Not entered in the book of accounts.
2. Real Cost &Money Cost:
• Real cost refers to the exertion of labour,sacrifice involved in the abstinence from
present consumption by savers to supply capital and social effects of production like
pollution,congestion,environmental degradation etc. Measurement is difficult.
Money Cost is the monetary expenditure on inputs of various kinds like raw
material,labour etc.It can be measured easily
3. Explicit &Implicit Cost:
• Explicit Cost: Actual money expenditure of a firm on factors of production which do
not belong to it.
E.g:Expenditure on raw materials,labour etc.
• Implicit Cost: Opportunity cost of the use of factors which a firm does not buy or hire,
but already owns.
• E.g - Interest on capital supplied by entrepreneur
- Rent of land and premises belonging to the entrepreneur himself and used in
production.
4. Marginal Costs
• Marginal Costs: Addition to total cost due to the production of an additional unit of
output.
• For example, if a firm can produce 150 units of a product at a total cost of $5,000 and
151 units for $5,100, the marginal cost of the 151st unit is $100.

5.Fixed & Variable Costs

Fixed Cost :Costs incurred on fixed factor inputs. It remains constant irrespective of
the level of output.
Variable Costs: Costs incurred on variable factors. It depends on the level of output

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 6. Sunk Cost
In economics, a sunk cost is any past cost that has already been paid and cannot be
recovered.
Examples
Marketing study. A company spends $50,000 on a marketing study to see if its new
product will succeed in the marketplace. The study concludes that the product will not
be profitable. At this point, the $50,000 is a sunk cost. The company should not
continue with further investments in the project, despite the size of the earlier
investment.
Research and development. A company invests $2,000,000 over several years to
develop a particular product. Once created, the market is indifferent, and buys no
units. The $2,000,000 development cost is a sunk cost, and so should not be
considered in any decision to continue or terminate the product.

Cost – Output Relations

1. Short Run (a period during which some factors are fixed and some are variable)
2. Long Run (All factors are variable)
Short Run Cost Curves

Total Fixed Cost(TFC)

Total Cost(TC)

Total Variable
Costs(TVC)

Average Fixed
Short Run Costs
Cost(AFC)

Average Cost(AC)

Average Variable
Cost(AVC)

Marginal Costs(MC)

Short Run Cost Concepts

• Total Cost: Total expenditure incurred on fixed and variable factors.
• Total Fixed Cost: Expenditure incurred on fixed factors. Remains constant
irrespective of the level of output.

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 • Total Variable Cost: Expenditure incurred on variable factors. Changes with level of
output.

• TC = TFC + TVC
• TVC = TC – TFC
• TFC = TC-TVC
Total Cost Curves

Q TFC TVC TC AFC

0 $60 $0 $60 -
1 60 20 80 $60
2 60 30 90 30
3 60 45 105 20
4 60 80 140 15
5 60 135 195 12
For 0 unit TC and TFC are the same
Change in TC happens due to change in TVC

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Average Costs

Q TFC TVC TC AFC AVC ATC MC

0 $60 $0 $60 - - - -
1 60 20 80 $60 $20 $80 $20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55
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AFC Curve
• AFC goes on declining continuously.
• Reason: As the output increases,TFC gets spread over a larger and larger level of
output and therefore AFC declines.
• AFC multiplied by the corresponding level of output gives a constant number i.e TFC.

AVC Curve
• Declines in the initial stages as output expands, reaches the minimum when optimum
factor combination is reached and increases when the output exceeds the optimum
combination.
• Represents different stages in the law of variable proportion.
AC Curve
• U’ Shaped curve
• AC = AFC + AVC
• Behaviour of AC is determined by the behaviour of AFC &AVC.
• Initially both AFC &AVC decline and as result AC also declines.

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 • AC reaches the minimum when the optimum combination between fixed and variable
factor is reached.
• After the minimum point AC starts rising, as the rise in AVC is greater than the fall in
AFC.
MC Curve
• U’ Shaped curve.
• As fixed cost remains the same in short run,MC can be calculated using TC or TVC.
• According to the LVP,the MP of an input rises at low levels of output and then falls
with expansion of output. The opposite happens in the case of MC.
• Declines with increase in outpt,reaches the minimum and then starts increasing.
MC & AC Relationship

MC & AC Relationship Simplified

Sachin Tendulkar has scored 250 runs in 5 one day matches. So his average works out to be
250/5 = 50.
In the sixth match he scores 40 and his marginal score is 40 and total score is 290.After 6
matches his average is 290/6 =48.33
When marginal score is less than average score, average falls.
If his marginal score(6th match) was 60,total score would be 310 and average would be 51.66.
When marginal is more than average, average increases.
Long Run Cost Curves
Two Types of Long Run Cost Curves
1. LAC
2. LMC

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Derivation of LAC
LAC derived from Short Run Average Cost Curves(SACs).Each SAC shows different plant
capacity.

Empirical Studies and shape of LAC

• Theoretically LAC is a ‘U’ shaped curve.
• But based on empirical studies economists have observed three other types of LAC.
1. Saucer shaped LAC
2. L shaped LAC
3. Downward Sloping LAC

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Why LAC remain constant or falling?
• Improvement in technology helps in reducing average cost.
• Learning curve effect: The more experience a person attains, he learns to do things in
a better way than before.
• Development of Appropriate management techniques will reduce the managerial
diseconomies of scale associated with an expansion of the firm.
• If at all there are managerial diseconomies,it will be more than offsetted by the
technical and production economies.