AI Detectorby SciSpace

COST OF PRODUCTION -Daksh Duneja.pdf 15 October 2023

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 COST OF PRODUCTION
Cost Function refers to the relationship between input costs and output. In simple terms, the
functional relationship between cost and output is referred to as the cost function. It is written as:

C = f(q)

Where,

C = Cost of Production;

q = Quantity of Production; and

f = Functional Relationship

Types of cost

The following are the various types of costs:-

1. Direct costs or explicit costs

2. Indirect costs or implicit costs

3.Short Run Cost

i Fixed costs

iiVariable costs

4. Total costs

5. Average costs

6. Marginal costs

1.DIRECT COST OR EXPLICIT COST

“An explicit cost is a direct expense that is paid in money to others or creditors
during the production of goods.”

Uses of explicit costs

1. It shows the expenditure incurred on production of the commodity which is considered for
pricing strateg

2. It also helps in calculating profits

3. It helps in decision – making

2.IMPLICIT COST

“An implicit cost is the factor of production sacrificed by the producer for an alternative factor
production. The opportunity foregone is the implicit cost.”

Uses of implicit cost:

1. It helps in decision making

2. It helps to ascertain opportunity costs

3. They directly impact profitability of the firm

Difference between Explicit Cost and Implicit Cost

EXPLICIT COST IMPLICIT COST

1. Explicit costs are those costs that are met
by cash payments.
2. It is a direct cost.
3. It is an expenditure incurred for production.
4 There is outflow of money.
5. Examples: Salaries and wages, rent paid,
purchase of Raw Materials, etc.
Implicit costs are those costs that are not met
by cash payments.
It is a indirect cost.
It is an opportunity sacrificed to employ
other factor of production.
There is no outflow of money.
Examples: Salary to proprietor, interest on
owned capital, etc.

3.SHORT RUN COST

I. Fixed costs Or Total Fixed Cost(TFC):

“A fixed cost is the cost that remains the same and fixed irrespective of the production of goods.”

Uses of fixed cost: 1. Useful in evaluating break – even analysis;

2. Helps in pricing strategy;

3. Helps in decision – making;

4. Helps in controlling variable costs;

TFC remains constant with respect to change in the level of output. Therefore, the slope of
TFC curve is a horizontal straight line.

II. Variable Cost Or Total Variable Cost (TVC)

“A variable cost is the expenditure incurred on the production of goods and therefore is ever
changing.”

Uses of variable cost:

1. Helps to set prices for the commodity

2. Helps to plan profits

3. Helps in decision making

4. Helps in cost control

It can be seen that TVC curve changes with the change in the level of output.

Difference between Fixed Cost and Variable Cost

Fixed cost Variable Cost

1. The cost which remains same,
regardless of the volume produced, is
known as fixed cost.
2. It is time related
3. It remains constant for a given period
of time.
4. Fixed cost changes in unit,
5. Examples: Depreciation, Rent, Salary,
Insurance, Tax etc.
The cost which changes with the change in
output is considered as a variable cost.
It is volume related
It changes with the change in the output level.
Variable cost remains same, per unit.
Examples: Material Consumed, Wages,
Commission on Sales, Packing Expenses, etc.

4.TOTAL COST

Total cost is the total expenditure incurred by the producer to produce his goods. Total cost is
also the summation of total fixed costs and total variable costs.

Total Cost = Total Fixed Cost (TFC) + Total Variable Cost (TVC)

TC also changes with the changes in the level of output as there is a change in TVC.
It should be noted that both TVC and TC increase initially at decreasing rate and then they
increase at increasing rate Here, decreasing rate implies that the rate at which cost increases
with respect to output is less, whereas increasing rate implies the rate at which cost
increases with respect to output is more.

5.AVERAGE COST

“Average cost is the expense incurred by the producer to produce one unit of the
total production.”

Average cost is also the summation of average fixed cost and average variable cost.
Average cost is evaluated as follows:-

(i) Average cost = Total Cost Quantity produced

(ii) Average cost = Average fixed cost (AFC) + Average variable cost (AVC)

n = Number of units produ

I. Average Fixed Cost (AFC):

The per unit fixed cost of production is known as Average Fixed Cost. The formula
for calculating Average Fixed Cost is:

AFC = TFC/Output
In Figure AFC curve is shown as a declining curve, which never touches the
horizontal axis. This is because fixed cost can never be zero. The curve is also
called rectangular hyperbola, which represents that total fixed costs remain
same at all the levels.

II. Average Variable Costs (AVC):

Average Variable Cost (AVC) refers to the per unit variable cost of production.

It is calculated as:

AVC = TVC/ Output

Initially, AVC decreases as output increases. After a certain point of time, AVC increases
with respect to increase in output.

Thus, it is a U- shaped curve

5.MARGINAL COST

Marginal cost refers to addition to the total cost when one or more unit of output is
produced..

Marginal cost is calculated as:

MC = TCn = TCn-1 OR

MC = ∆TC/∆Output

MC curve is also a U-shaped curve as marginal cost initially decreases as

output increases and afterwards, rises as output increases. This is because TC
increases at decreasing rate and then increases at increasing rate.
Important Relationship between Various Types of Costs
1. RELATIONSHIP BETWEEN AC and MC

The relationship between MC and AC is as follows :

(i) When MC < AC, then AC falls.

(ii) When MC = AC, then AC is constant (or minimum).

(iii) When MC > AC, then AC rises.

(iv) MC curve always intersects AC curve at its minimum point.

2.RELATIONSHIP BETWEEN TC and MC

 (i) When MC is rising, TC increases at an increasing rate.
(ii) When MC is falling, TC increases at a diminishing rate.
(iii) When MC is constant, TC increases at a constant rate.

3.Relationship between AC, AVC and MC:

1. When MC is less than AC and AVC, both of them fall with increase in the output.

2. When MC becomes equal to AC and AVC, they become constant. MC curve cuts AC curve
(at ‘A’) and AVC curve (at ‘B’) at their minimum points.

3. When MC is more than AC and AVC, both rises with increase in output.
4.Relationship between AC and AVC:

The relationship between AC and AVC

1. AC is greater than AVC by the amount of AFC.

2. The vertical distance between AC and AVC curves continues to fall with increase in output
because the gap between them is AFC, which continues to decline with rise in output.

3. AC and AVC curves never intersect each other as AFC can never be zero.

4. Both AC and AVC curves are U-shaped due to the Law of Variable Proportions.

5. MC curve cuts AVC and AC curves at their minimum points.

6. The minimum point of AC curve (point A) lie always to the right of the minimum point of
AVC curve (point B).