COST CONCEPT

Fixed and Variable cost-

Fixed cost are those cost which are incurred even when the output is zero, it does not vary
with change in output such cost are interest on loan, rent, salaries to top management etc.
Variable cost is cost which changes with change in output. It increases with increase in
output and decrease with the decrease in output e. g. cost of raw material, labour, sales
commission etc.

T C (Total cost)

C
O TVC
S
T (Total variable cost)

B TFC
(Total fixed cost)

O OUTPUT
Short run period
Short run period is a time period, when we have some fixed cost and some variable cost.
Fixed cost can not be changed in this period but variable cost can be increased and
decreased. It is not possible to tell how long a short run will last, for a painting firm it
may be 2 days but for a steel making firm it may last for 4 years. Long run period is a
period which is long enough to change all the factors of production, which means there
are no fixed factors; all the factors are variable factors. This is the time when business
decisions are made except on the level of technology.

Short run cost curves

The short run cost curves are divided into Total Fixed cost (TFC) and Total Variable cost
(TVC).
TC is the total cost incurred in producing units which includes advertisement, raw
material, wages, taxes etc.
TFC is total fixed cost, the cost which will not change with output even if the output is
zero. TFC has to be incurred; it includes maintenance expenses, insurance, rent etc
TVC is the total variable cost which changes directly with the change in output. When the
output increases the TVC will also increase and vice versa, it includes cost of labour, raw
material, power etc.

Average Cost Curves (AC)

In short run period not only total cost but even average costs are important. A unit of
output which a firm produces does not cost the same but these units are sold at the same
price. Therefore firm should have knowledge about per unit cost or average cost.

Average fixed cost (AFC) is equal to fixed cost at each level of output divided by the
number of units produced.
Short run average variable cost (SAVC) is TVC at each level of output divided by
number of units produced.
Short run average total cost (SATC or SAC) is average cost of producing a given output

LAC is derived from SAC. LAC is also called planning curve and envelope curve.
According to Prof. Chamberlin LAC is planning curve as firms plan to expand its scale of
production only in long run. It is called envelop curve as it envelops all the SAC curves.
 SMC
SATC
SAVC
C
O
S
T

AFC

O
OUTPUT
Importance of cost concept in Management decision making
With the age of more competition, changing technology and increasing customer’s
expectation, it is difficult for the firm to increase profit margins by increasing prices. The
best way to increase profit margin is to cut down the cost. Now a day’s one can see cost
cutting is done by out sourcing their work to low wages Asian countries and mergers.
Companies find some ways to cut their cost and remain in competition.
Reduction in Cost through IT - In 1990s, ERP (Enterprise Resource Planning) started
which enables a company to deliver right product to the customers on time and in
efficient way. Now days there are software which integrate planning, synchronizing,
tracking and scheduling of entire production process for the companies.
Re-location to lower wage countries - Many American companies outsource their jobs to
Asian countries, as the wages are low which decreases their cost of production.

Meaning of Production Function

Production is an activity, which transforms in put into output. A car manufacturer will
need labour and machinery (input) to manufacture car. Production function is technical
relationship between input and output. Production function expresses the relationship
between quantity of output produced and quantity of input required. In real life any
commodity is produced by various inputs and with different methods of production. But
here to express production function we consider a single production process which
utilizes two inputs, labour and capital.

Law of variable proportion or Law of diminishing returns

These terms are important to understand the law better.

Total Product (TP) – Total quality of output produced by a firm.

Average Product (AP) – The total produced by a firm divided by the quantity of variable
factors used to produce.
Marginal Product (MP) – Change in TP caused as a result of additional unit of Variable
factor employed to the combination of Fixed Factor.
Law of variable proportion is also called Law of Diminishing Returns. It examines the
production function when one factor varies keeping the quantities of other fixed factors
constant. That is how the output varies when Variable Factors are employed to the fixed
factors.
The law states;
When Variable Factors are increased in equal doses keeping the Fixed Factor constant,
the total product will increase. But after a certain point it will increase at a diminishing
rate and finally total product starts decreasing.

Assumption
This law is subject to certain assumptions
1. The state of technology is given
2. Only one factor of production must be variable. In the example illustrated below
we have taken it as labour.
3. There are some inputs which are kept constant or fixed.
 B

TOTAL I
PRODUCT
TP
TOTAL PRODUCT

1 2 3

LABOUR

MARGINAL
PRODUCT
AND
AVERAGE
PRODUCT

D E

AVERAGE
AP PRODUCT

O M LABOUR

MP

MARGINAL PRODUCT
Stage I- Increasing Returns
Stage II- Diminishing Returns
Stage III-Negative Returns

Stage I- Increasing returns:

In this stage, the TP increases at an increasing rate till point I in the above figure,
where AP and MP reaches its maximum point at point E and D respectively. This
stage is called the stage of increasing returns. At this stage, TP is rising rapidly, as
here the land is too much compare to the labour, the reason behind increasing returns
is that the fixed factors(land) is intensively used an so the production increases
rapidly when the variable factor (labour) are under-utilised. The law of increasing
returns operates, when variable factors are applied on the fixed factors.

Stage II – Diminishing returns:

This is an important stage as the AP reaches its maximum point E, in the figure given
above. These stage workers are increased from 5 to 6 to cultivate the given land and it
is used intensively. In this stage MP is below AP. This stage is called the economic
stage as every producer likes to be in this phase for two reasons, firstly this is the
stage when the TP reaches its maximum point and secondly both the factors variable
and fixed are completely utilized. Any producer who is investing in the factors of
production will be satisfied only if all the factors of production are properly utilized.

Stage III-Negative Returns:

In this stage TP starts declining and MP becomes negative as the variable factors are
too much compared to the fixed factors, workers are many in comparison to the land
available and it becomes impossible to cultivate.

IMPORTANCE IN MANAGEMANT DECISION MAKING

Law of Variable Proportion is an old economic principle which was firstmost
redefined version of Marshall. Most of the examples of Production function, seen
involve manufacturing sectors and agriculture. But this law is universal which says
that the proportion of factors of production is disturbed by increasing only variable
factors in relation to the fixed factors this may be due to scarcity of one in relation to
the other factor. Here we take an example of a BPO, which has grown rapidly. In this
example, output is the number of data processed by analyst and input is, the number
of process analyst. Where there are fixed number of process analyst and the number
of data to be processed is variable factors, which keeps pouring in. Initially when
these analyst have very few contracts to work on, they are at stage I, but when more
and more contracts start coming, they are occupied and they reach the stage II, then
finally when these contracts increase, the manager thinks of adding up to more
analyst and some factors like computer gets overloaded and the stage III starts.

Law of Returns to Scale

This is also called the long run production function.
The short run production shows what happens when one factor of production changes
keeping the other factors constant. The Law of Returns to Scale will show the change
in the output when all the factors of production are increased together. It describes the
relationship between output and scale of input.

Assumption
All factors of production are variable
Technological changes are absent

M
A
R
G
I
N
A
L
R C II D
E
T
U
R I
N III
S

R S

SCALE OF PRODUCTION

The law states

 When there is increase in all inputs in same proportion by the firm it results in
increase in output at increasing rate than the increase in input, which is called the
increasing returns to scale. When the increases in output are in the same proportion as
the increase in input, this stage is called the constant returns to scale. Finally when
increase in the output is in less to the proportion of increase in input, this stage is
called the diminishing returns to scale
.
Stage I Increasing Returns to Scale:
In this stage, all the factors of production are doubled so the output increases by more
than double resulting in increase in returns to scale. The reason is that indivisibility of
factors of production like machine, finance, labour etc cannot be available in smaller
size, they are available only in a minimum size and they can be used to their utmost
efficiency. As the scale of production increases the scope for specialization, division
of labour increases, this in turn increases the efficiency and productivity and the firm
starts enjoying the internal economies. they can employ better machinery, efficient
managers to work etc this helps in increasing returns to scale.

Stage II- Constant Returns to Scale

Increasing returns to scale cannot increase indefinitely. In this stage returns increases
in the same proportion as the increase in input and gets constant returns on a large
range of output, which is shown by the horizontal line CD in the above figure. In this
stage internal economies and diseconomies get neutralized and the output increases in
the same proportion.

Stage III Diminishing Returns to Scale

A constant return to scale is a passing phase and ultimately returns to scale starts
declining. Business may become unwieldy and may face some problems of
supervision, control and rigidity and thus its leads to diminishing returns. This stage
the diseconomies of scale sets in

Economies of Scale
Economies of scale exist when larger output is associated with low per unit cost. It has
been classified into Internal Economies and External Economies. (Here economies are
advantages which a firm or industry will enjoy when they increase the scale of
production)

Internal Economies- Economies are internal to a firm, when it expands in its size. It is
open only for the firm, independent to the action of other firms.

External Economies- they are external to the firms, which are available when output of
whole industry expands. It is shared by number of firms or industry, when the scale of
production increases in any industry.

Internal Economies of Scale

Under Internal Economies of scale there are more categories
 • Real
• Pecuniary

Real Internal Economies of Scale- Real Internal Economies of Scale which arises from
the expansion of the firm are
1. Technical Economies- in order to produce a commodity in large scale the firms
will install up to date machinery. A large firm can utilizes the waste material as by
product by installing a plant for this purpose e.g. molasses left over in
manufacturing sugar can be used to produce spirit .They can have advantage of
linked processes e.g. sugar producing firm can have their own farms with their
own transport bringing the sugarcane to the factory and their own distribution
system to send it to the market. Thus they enjoy the economies of linked
processes.
2. Marketing Economies- a firm enjoys the advantage of buying and selling, as the
requirement is in bulk because they are able to get favourable terms, in form of
better quality input, transport concessions etc. These economies are due to large
scale of production as they have strong bargaining power.
3. Managerial Economies- a large firm can afford specialist to managers and
supervisors for all the departments like sales manager for sales department,
production manager dealing with the production department and so on. This
brings more efficiency and leads to functional efficiency.
4. Risk Bearing Economies- large firms are in better position to spread risk. They
can diversify their products and counter balance the loss in one product by gains
from the other product. They can even diversify their market by selling their
product in many markets and counter the loss in market by gains in the other
market.
5. Economies of Welfare- many firms provide welfare facilities to their workers and
provide better working conditions in and out of factory by providing canteen,
crèche for the infants of women workers, recreational club, health and medical
facilities to the families of the workers

Pecuniary Internal Economies

This is also called monetary internal economies. This happens due to reduction in market
price of its inputs, when the inputs are given in lower price due to purchase in bulk. It
happens even when the firm gets low interest rate on loans due to the goodwill,
concession in advertisement and transportation cost due to good reputation.

EXTERNAL ECONOMIES
In external economies of scale again we have two categories
• Real
• Pecuniary

Real External Economies of Scale- it represents how a firm is benefited in an industry

through technological interdependence of firms. The external economies are
 1. Technical Economies- when any industry expands, firms in that industry start with
different types of processes and the whole industry is benefited. E.g. in textile
industry, some firms start specializing in manufacturing thread, some in printing,
some in dying others in shirting etc
2. Economies of information- an industry is in better position to set up research
laboratories as they are able to gather large resources. The work of the research
may be some new invention and the information about it is given to all the firms
through the journals. The industry can have their own information centre which
gives information regarding the export potentials, modern technology and
information, which can be useful for the firms by publishing in the journals. This
helps the efficiency and productivity of the whole industry.
3. Economies of By-Product- many industries turn out large waste materials which
can be used as input in process of manufacturing like iron-scarps in steel industry,
molasses in the sugar industry etc. New firms can enter the industry and use these
waste materials to produce by products. They can purchase the raw material at
reasonable rates. It gives them the advantage of waste management, the expenses
of disposing off waste and they can earn certain amount by selling their waste
material.

Pecuniary External Economies of Scale

These economies arise when the firms in an industry enjoy reduction in the factor price.
This may arise due to having a institute training labour in the skill which is needed for all
the firms in that industry, transportation can be made according to the needs of the
industry, electricity board can supply power at a concessional rates etc.

DISECONOMIES OF SCALE

Diseconomies arise when large output leads to higher per unit cost. There is always a
limit to expand the scale of production, it cannot continue indefinitely, a time comes
when economies are taken by diseconomies .There are both internal and external
diseconomies of scale

Internal Diseconomies
When a firm expands beyond its optimum level, it faces many problems like lack of co-
ordination, management, marketing etc. some internal diseconomies are
1. Managerial Diseconomies – there may be failure on the part of management to
supervise, control and run the business properly. Work is not done efficiently,
decision making becomes difficult and per unit cost increases.
2. Technical Diseconomies- when the firm expands beyond its optimum limits, there
may be repeated breakdown in machinery and equipments.
3. Marketing Diseconomies- the firm may face some marketing problems due to
insufficient supply of raw material due to scarcity or decrease in demand as the
taste of the people changes, market organization may fail to forecast the changes
 in the market condition and the firms are not prepared for the risk. An error of
judgment by sales or production manager may affect the sales and production and
lead to huge loss.

External Diseconomies of Scale

External Diseconomies of scale arises when the prices of factors increase due to the
increase in demand, it in turn increases the per unit cost. Due to overgrowth there is
shortage of labour, power, transportation, raw materials and other factors of production