Analysis of costs

P sivakumar
Economics faculty
Introduction
The amount of money spent in order to
produce commodity is known as cost of
production
Cost = wages + rent + interest +profit
Cost determines the price, profit, supply
of the product
cost function is derived function from
production
Types of Cost
Opportunity Cost
Implicit & Explicit Cost
Economic Cost
Marginal, Incremental & Sunk Cost
Direct & Indirect Cost
Fixed & Variable Cost
Cost concepts
Total cost = total fixed cost + total
variable cost
TFC the amount of money spent on
fixed factors
TVC- the amount of money spent on
variable factors
Output Fixed
Costs
Variable
Costs
Total
Costs
0 10 0 10
1 10 10 20
2 10 18 28
3 10 24 34
4 10 28 38
5 10 32 42
6 10 38 48
7 10 46 56
8 10 62 72
VC
TC
10
20
30
40
50
60
OUTPUT X
Y
COST (Rs.)
70
80
FC
Cost concepts
Average cost the cost per unit
AC = TC/Q
= AFC + AVC
Average fixed cost is fixed cost per unit
Average variable cost is variable cost per
unit of output
Marginal cost
Addition made to the total cost by
producing one more unit of output
MC =TCn TC(n-1)
=TC/ Q
MC is influenced by variable cost
MC cuts AC from below at the lowest
point

Short-Run Costs
Total Cost = Total Fixed Cost + Total
Variable Cost
TC = TFC + TVC
Average Fixed Cost (AFC ) = TFC/Q
Average Variable Cost (AVC) = TVC/Q
Average Cost (AC) = TC/Q = AFC +
AVC
Marginal Cost (MC) = TC/Q

Cost and Production Function
A cost function determines the behavior
of costs with the change in output.
Cost Function :
C = f(Q)
Cost function gives the least cost
combination for the production of
different levels of output.
Q TC TFC TVC ATC AFC AVC MC
1 120 100 20 120 100 20 --
2 138 100 38 69 50 19 18
3 151 100 51 50.3 33.3 17 13
4 162 100 62 40.5 25 15.5 11
5 175 100 75 35 20 15 13
6 190 100 90 31.7 16.7 15 15
7 210 100 110 30 14.3 15.7 20
8 234 100 134 29.3 12.5 16.8 24
9 263 100 163 29.2 11.1 18.1 29
10 300 100 200 30 10 20 37
Short Run Cost Function

Shot run cost
function help in
determining the
relationship
between output
and costs
Q
Minimum
ATC
E AVC
SATC
MC
O X
Y
Quantity
Costs
AFC
Long Run Cost Function

In the long run,
the firm chooses
the combination of
inputs that
minimize the cost
of production at a
desire level of
output.

O X
Y
Quantity
Costs
SAC
1
SAC
2
SAC
3
SAC
4
SAC
5
SAC
6
E
LAC
Q
Work out

TC = 10 + 15Q 2Q
2
+ 0.1Q
3

Find TVC, AC, AVC, MC
Total variable cost = 15Q 2Q
2
+ 0.1Q
3


AC = TC/Q = (10 + 15Q 2Q
2
+ 0.1Q
3)
---------------------------------------------

Q
= 10/Q + 15 2Q +0.1Q
2
TFC = 10, AFC = 10/Q
AVC = TVC/Q =15 - 2Q + 0.1Q
2
Marginal cost = C/ Q
= /Q X (10 + 15Q - 2Q
2
+ 0.1Q
3
)
= 15 4Q + 0.3Q
2


The minimum point of AC is the
BEPof the firm.To find that
differentiate AC function with
respect to Q& set the equation = 0
= (AC) / Q = /Q X (10/Q +15
2Q +0.1Q
2
) = 0

= -10Q
-2
-2 + 0.2Q + 0






Multiplying both sides of the equation by
Q
2
& dividing by 0.2 we have
Q
3
10Q
2
-50 = 0

Economies of Scale
Economies of Scale
Real Economies Pecuniary Economies
Production
Labor Economies
Technical Economies
Inventory Economies
Selling & Marketing
Managerial
Transportation & Storage
Reduction in price or
Raw Material
Low wages and
salaries
Low rate of Interest
Low Advertising Cost
Labor Economies
Specialization

Time saving

Automation of production process

Cumulative volume economies

Technical Economies
Specialization & excess capacity of fixed
factors
Set-up costs- multi purpose machinery
Technical volume/input relations
R & D lab
Selling or Marketing Economies
Advertising economies
Special arrangements with dealers
Model change economies
Managerial Economies
Specialization of management

Decentralization of decision making

Mechanization of managerial functions

Break Even Analysis
It studies the inter-relationship among the
firms revenues, cost and operating profit at
various levels of production.
It measures the effect of changes in selling
prices, fixed costs and variable cost on output
level.
It is used for determining the financial
viability of new marketing plans and product
line.
Cont..
Break Even Analysis
It is used for managerial decision
making.
It is used for dealing with unknown
variable like demand.
Break Even Analysis
O
X
Y
Quantity
Costs
TFC
TR
TC
Q
1
Q
2
Q
3
Profit
Loss
A
B
D
C
Maximum
Profit at
output level
Q
2
Break Even
Point Q
1
&

Q
3


TQ TR TFC TVC TC
0 0 300 0 300
100 400 300 300 600
200 800 300 600 900
300 1200 300 900 1200
400 1600 300 1200 1500
500 2000 300 1500 1800
600 2400 300 1800 2100
TR
TC
1200
300 TQ
TR ,TC
BEP
Formula to find BEP
BEP = TFC / P AVC
Target profit
Sales = TFC + Profit/ P - AVC
Numerical Example
The fixed cost of a firm is Rs. 2,50,000. The selling price for
each unit of product is Rs. 500. The variable cost is Rs. 50.
What will be the break-even quantity and revenue.
Solution:
Quantity required for break-even = Fixed Cost / P AVC
= 2,50,000 / 500 50
= 2,50,000 / 450
= 555.56 or 556 Units
Break-even Revenue = Break-even quantity X Selling Price
= 556 x 500
=Rs. 2,78,000
Merits and Demerits of
Break-Even Analysis
Merits
a) It is an inexpensive
method.
b) It helps in designing
product
specification.
c) Break-even point
can be estimated
Demerits
a) It assumes selling
price and variable
cost per unit is
known but it is not
real.
b) No proper
evaluation of cash
flows.

Shut Down Point
In short run
if AVC<P
then firm has
to shut down
In the long
run if ATC<P
then firm has
to shut down
E AVC
ATC
MC
O X
Y
Quantity
Costs,
Price
Q
1
Q

P
1
P

E
1