Theory of Cost concepts its type and curve
• 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.
- Accounting Cost & Economic Cost
- Fixed Cost & Variable Cost
- Outlay Cost & Opportunity Cost
- Direct Cost & Indirect Cost
• 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.
• 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
• 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.
• 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.
• 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
- Short Run Cost funtion C = f(Q)
- Long Run Cost funcion C = f(Q, T, Pf, K)
Short Run Costs
- Fixed Cost
- Variable Cost
- 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.
TC = TFC = TVC
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.
AVC = TVC/Q
• 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.
ATC = AFC + AVC
• 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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