Theory of Cost concepts its type and curve

Cost Analysis

• Cost Analysis refers to the Study of Behaviour of Cost in relation to one or more Production Criteria like size of Output, Scale of Operations, Prices of Factors of Production.

• In other words, Cost Analysis related to the Financial Aspects of Production Relations against Physical Aspects.

Cost Concepts 

  1. Accounting Cost & Economic Cost
  2. Fixed Cost & Variable Cost
  3. Outlay Cost  & Opportunity Cost
  4. Direct Cost & Indirect Cost

Cost Concept
Accounting Costs

• Accounting  Costs  are  those  Costs  which  are actually incurred   & recorded in the Books of Accounts by the Firm in Payment for Various Factors of Production.

• For Example, Wages to workers employed; Rent for the Building he hires; Prices of the Raw Materials; Fuel & Power, etc.

• Also Called as Explicit Cost.

Economic Costs

• It includes:

– The    Normal    Return    on    Money    Capital invested by the Entrepreneur himself in his own Business. (Implicit Cost)

– The   Wages   &   Salary   not   Paid   to   the Entrepreneur but could have been Earned if the Services had been Sold somewhere else.

• Economic Cost = Accounting Cost + Implicit Cost

Outlay Costs

• Involves Actual Expenditure of Funds e.g. Wages, Rent, Interest, etc.

• Outlay  Costs  are  recorded  in  the Books   of   Accounts   as   it   involves Financial Expenditure at some Time.

Opportunity Costs

• The Opportunity Cost is the Return Expected from the Second Best use of the Resources, which is Foregone for availing the Gains from the Best use of the Resources.

• It is not recorded in the Books of Accounts.

• It is very useful in Long Term Cost Calculations e.g.,  In  calculating  the  Cost  of  Higher Education, it is not the Tuition Fee & Books but the earning foregone that should be taken into account.

Direct Costs & Indirect Costs

• Direct   Costs   are   Costs   that   are   readily identified and are Traceable to a particular Product, Operation or Plant. E.g., Manufacturing Costs to a Product Line.

• Indirect Costs are Costs that are not readily identified   and   are   not   Traceable   to   a particular Product, Operation or Plant. E.g., Electric Power, Salary to Gatekeeper, etc. Although not Traceable but bears Functional Relationship to productions.

Fixed Costs & Variable Costs

• Fixed  Costs  require  a  Fixed Expenditure  of  Funds irrespective   of   the   Level   of   Output   e.g.   Rent, Interest on Loans, Depreciation, etc.
• Fixed Cost does not vary with the Volume of Output within a Capacity Level.
• Fixed  Cost  may  disappear  on  the  Complete  Shut Down of Business.
• Variable  Costs  are  costs  that  are  a  Function  of Output in the Production Period e.g. Wages & Cost of Raw Materials.
• Variable    Costs    vary    Directly    or    sometimes Proportionately with Output.

Cost Function

• The Cost Function refers to the Mathematical relation between Cost of a Product and the various Determinants of Costs.

C = f(Q, T, Pf, K)


C = Total Cost
Q = Quantity Produced i.e. Output
T = Technology Pf = Factor Price K = Capital


  1. Short Run Cost funtion C = f(Q)
  2. Long Run Cost funcion C = f(Q, T, Pf, K)



Short Run Costs

  1. Fixed Cost        
  2. Variable Cost
  3. Total Cost


Short Run Fixed Cost (FC)

• Fixed   Costs   are   those   costs   which   are Independent of Output i.e. they do not change with changes in Output.

• They are a "Fixed Amount" incurred by the Firm, irrespective of Output.

• In case of Firm Shut Down for some time, Fixed Costs are to be borne by the Firm.

• For Example, Contractual Rent, Property Tax, Interest on capital employed etc

Short Run Variable Cost (VC)

• Variable Costs are those costs which changes with changes in Output.

• Includes Payments such as Wages of Labour, Price of Raw Material, etc.

• In case of Firm Shut Down for some time, Variable Costs does not occur and hence avoided by the Firm.

Short Run Total Cost (TC)

• Total  Cost  is  defined  as  the  Total Actual Cost that must be incurred to Produce a given Quantity of Output.

• Total  Costs  is  the  sum  of  the  Total Variable Costs and the Fixed Costs.




Short Run Average Fixed Cost (AFC)

• Average  Fixed  Cost  is  Total  Fixed  Cost  (TFC) divided by the Number of Units of Output Produced. AFC = TFC/Q

• Referred to as "Fixed Cost per unit of Output".

• AFC steadily falls as Output Increases meaning thereby,  it  slopes  Downwards  but  does  not touch X- Axis as AFC ≠ 0

Short Run Average Variable Cost (AVC)

• Average  Variable  Cost  is  Total  Variable  Cost (TVC) divided by the Number of Units of Output Produced.


• Referred   to   as   "Variable   Cost   per   unit   of Output".

• AVC normally falls as Output Increases from O to Normal Capacity of Output du

Short Run Average Variable Cost (AVC)

• AVC  normally  falls  as  Output  Increases from O to Normal Capacity of Output due to occurrence of Increasing Returns.

• Beyond  Normal  Capacity  of  Output,  AVC rises  steeply  as  Diminishing  Returns occurs.

• AVC first Falls, reaches its Minimum and then rises again.

Short Run Average Total Cost (ATC)

• Average  Total  Cost  is  the  Sum  Total  of Average  Variable  Cost  &  Average  Fixed Cost.


• It is referred to as "Total Cost per unit of Output".

• Behaviour   of   ATC   depends   upon   the Behaviour of AVC & AFC.


• Since  in  beginning,  Both  AFC  &  AVC Falls, therefore, ATC Curve also falls.

• When AVC ↑ , AFC ↓, ATC continues to fall as AFC > AVC.

• As Output Increases, AVC ↑ and thus AVC > AFC and hence ATC ↑.

• ATC is a "U" Shaped Curve.

Short Run Marginal Cost (MC)

• Marginal Cost is the addition made to the Total Cost by Production of an Additional Unit of Output.

MC = TCn – TCn-1

• Marginal Cost is Independent of Fixed Cost.

• As    Marginal    Product    first    rises,    reaches maximum & then declines, thus, Marginal Cost first declines, reaches minimum & then rises.

• MC curve of a Firm is "U" Shaped.


Relationship of MC & AC

• When  Marginal  Cost  is  below  Average Cost, it is pulling Average Cost down.

• When  Marginal  Cost  is  above  Average Cost, it is pulling Average Cost up.

• When Marginal Cost just equals Average Cost, Average Cost is neither rising nor falling & is at its Minimum. Hence, at the bottom of a U-shaped Average Cost, MC = AC = Minimum AC

Long Run Average Cost Curve

• Long Run is a period of Time during which the Firm can vary all of its Inputs.

• The Firm moves from one plant to another in Long Run. To Increase the Output, Firm acquires Big Plant & vice versa.

• Long   Run   Cost   of   Production   is   the   least possible Cost of Producing any given level of Output when all Individual Factors are Variable.
• The  Minimum  Point  on  LRAC  Curve  is  the "Minimum Efficient Scale".



• Long   Run   Cost   Curve   depicts   the   Functional relationship between Output & the Long Run Cost of Production.

• It   envelopes   the   set   of   U-Shaped   Short-Run Average Cost Curves Corresponding to different Plant Sizes.

• LRAC Curve is "U-Shaped", reflecting Economies of Scale (or Increasing Returns to Scale) when Negatively Sloped and Diseconomies of Scale (or Decreasing Returns to Scale) when Positively Sloped.

• Every  Point  on  the  Long  Run  Average  Cost Curve is a Tangency Point with some Short Run AC Curve.


• LAC Curve is not a Tangent to the minimum points of the SAC Curves.

• LAC Curve is called as "Planning Curve" as a Firm Plans to Produce any Output in the Long Run by choosing a Plant on the Long Run Average Cost Curve corresponding to the given Output.

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