Production and Costs : Unit 4

• Cost Concept
Cost concept is a fundamental idea in economics and business that refers to the various
expenses a company incurs to produce and sell goods or services. It plays a critical role in
financial decision-making and helps businesses understand their expenditures to manage
and optimize their resources effectively.

At its core, cost concept involves identifying, measuring, and recording all costs associated
with production, including direct costs like raw materials and labor, as well as indirect costs
such as utilities, rent, and administrative expenses. By understanding these costs,
businesses can set appropriate prices for their products, determine profitability, and make
informed decisions about production levels and resource allocation.

Overall, the cost concept is essential for effective financial management, helping businesses
thrive in competitive markets by providing a clear picture of where money is spent and how
to maximize efficiency and profitability.

• Cost – Short Run and Long Run

Short Run Cost of Production: The short run is a period of time in which at least one input
or factor of production is fixed, usually capital or plant capacity, while other inputs can be
varied. In the short run, a firm can only make adjustments to the variable inputs, such as
labour and raw materials, to change its level of production.

Short run costs can be divided into 2 types:-

1. Total Fixed Cost - Fixed costs are those which are independent of output, that is, they do
not change with changes in output. These costs are a ‘fixed’ amount which must be incurred
by a firm in the short run, whether the output is small or large. Even if the firm closes down
for some time in the short run but remains in business, these costs have to be borne by it.
Fixed costs are also known as overhead costs, supplementary cost, indirect cost, general
cost, unavoidable cost, and include charges such as contractual rent, insurance fee,
maintenance costs, property taxes, etc. Thus fixed costs are those which are incurred in
hiring the fixed factors of production whose amount cannot by altered in the short run.
2. Total Variable Cost - Variable costs, on the other hand, are those costs which are incurred
on the employment of variable factors of production whose amount can be altered in the
short run. Thus, the total variable costs change with changes in output in the short run, i.e.,
they increase or decrease when output rises or falls. These costs include payments to
labour employed, the prices of the raw materials, fuel and power used, the expenses
incurred on transportation and the like. If a firm shuts down for sometime in the short run,
it will not use the variable factors of production and will not therefore incur any variable
costs. Variable costs are made only when some amount of output is produced and the total
variable costs increase with the increase in the level of production. Variable costs are also
called prime costs or direct costs.

Total Cost = Total Fixed Cost + Total Variable Cost

Example Table :-

TFC, TVC, TC curve :-

Short Run Average and Marginal Curves:
• Average Fixed Costs – Average fixed cost is the total fixed costs divided by the number of
units of output produced.
AFC = TFC/Q

• Average Variable Costs - Average variable cost is the total variable cost divided by the
number of units of output produced.
AVC = TVC/Q
• Average Total Cost - Average variable cost is the total variable cost divided by the number
of units of output produced.
ATC = TC/Q
Example Table -

• Short Run Marginal Cost – (SMC or MC) - The concept of marginal cost occupies an
important place in economic theory. Marginal cost is addition to the total cost caused by
producing one more unit of output.
MC = ∆TC/∆Q
Table showing computation of Marginal Cost:

Curve showing AFC, AVC, ATC, SMC:

Long Run Cost of Production: The long run is a period of time in which all inputs or factors
of production can be varied. Firms have the flexibility to adjust the scale of their operations,
such as acquiring or selling assets, expanding or reducing plant capacity, and changing the
size of their workforce.
In the long run, costs are not fixed as they can be adjusted according to the firm’s needs.
The long run cost curve is determined by the least-cost combination of inputs needed to
produce a given level of output.

Long run costs can be divided as:

1. Economies of Scale – Economies of scale occur when a firm experiences cost advantages
due to an increase in the scale or size of its operations. As the firm expands production, it
can benefit from lower average costs per unit of output. This can be due to factors such as
increased specialization, better utilization of resources, and improved technology.

2. Diseconomies of Scale – Diseconomies of scale occur when a firm experiences cost

disadvantages as it becomes too large. If a firm grows beyond a certain point, it may face
increased coordination and communication challenges, bureaucracy, and inefficiencies. As a
result, average costs per unit of output may start to increase.

3. Constant Returns to Scale – Constant returns to scale occur when a firm’s average costs
remain constant as it expands its scale of operations. In this case, the cost per unit of output
remains unchanged regardless of the size of the firm.
• Profit and Revenue Maximization
Revenue Maximization - Revenue maximization focuses on generating the highest possible
income from selling goods or services. To achieve this, firms aim to increase their total
revenue, which is calculated by multiplying the price per unit by the number of units sold
(Total Revenue = Price x Quantity).

In the short run, businesses may prioritize revenue maximization to build market share,
attract customers, or establish a strong brand presence. For instance, a company might
lower prices temporarily to increase sales volume, thus boosting total revenue. However,
it's important to note that while higher revenue is beneficial, it doesn't necessarily translate
to higher profits if costs increase disproportionately.

Profit Maximization - Profit maximization is the process of achieving the highest possible
profit, which is the difference between total revenue and total costs (Profit = Total Revenue
- Total Costs). Unlike revenue maximization, profit maximization considers both income and
expenses.

To maximize profits, firms focus on cost management and efficiency. This involves producing
goods or services at the lowest possible cost while maintaining or increasing quality.
Businesses analyse their production processes to identify areas where costs can be reduced
without affecting output. This can include optimizing the use of raw materials, improving
labour productivity, and investing in technology that enhances efficiency.

For example, a car manufacturer might streamline its assembly line to reduce labour and
material costs, thus lowering the overall production cost per unit. Simultaneously, the
company can focus on marketing strategies that allow them to sell cars at higher prices,
boosting total revenue. The combination of lower costs and higher revenue leads to
increased profits.

Balancing Both Objectives:

While revenue and profit maximization are distinct, successful businesses often strive to
balance both. Revenue maximization helps grow the business and expand its customer
base, while profit maximization ensures long-term sustainability and financial health.
By understanding the relationship between production, costs, and these financial goals,
firms can make informed decisions that enhance their overall performance. This involves
continuously monitoring costs, adjusting production strategies, and finding the optimal
balance between increasing revenue and controlling expenses.

• Economies of Scale & Diseconomies of Scale

Economies of Scale – Economies of scale occur when a business’s production costs per unit
decrease as it produces more units. This happens because fixed costs, like rent and salaries,
are spread over a larger number of goods. Additionally, bulk purchasing of raw materials can
lead to discounts, and improved efficiency can result from specialized equipment and skilled
labour. For example, a car manufacturer producing 10,000 cars annually can afford
advanced machinery and negotiate lower prices for bulk steel purchases. As production
scales up, the cost per car decreases, leading to higher profit margins. Economies of scale
benefit companies by allowing them to reduce costs, compete more effectively, and
potentially lower prices for consumers, which can further boost demand and sales.

Diseconomies of Scale - Diseconomies of scale occur when a business's production costs per
unit increase as it produces more units. This usually happens because of inefficiencies that
arise when a company becomes too large. For instance, communication problems can
develop as more employees are added, leading to delays and errors. Additionally, managing
a larger workforce often requires more administrative layers, increasing overhead costs. A
company might also face logistical challenges, such as longer shipping times and higher
transportation costs. For example, a tech company expanding rapidly might find that
coordinating between multiple offices across different regions becomes difficult and
expensive. Diseconomies of scale can erode profit margins, making it harder for the
company to compete effectively. Recognizing and managing these challenges is crucial for
businesses to maintain efficiency as they grow.
Graph showing economies of scale & diseconomies of Scale :

LRAC = Long Run Average Cost

Long-run average cost is the long-run total
cost divided by the level of output.

Terminologies Related to Cost:

1. Implicit cost: Implicit costs are the costs that represent the opportunity cost of using
resources owned by the firm for its own operations instead of renting them out or selling
them. These costs are not directly paid out in money but are the benefits foregone by using
the resources internally. For example, if you use your own building for your business, the
rent you could have earned by leasing it to someone else is an implicit cost.

2. Explicit cost: Explicit costs are the actual out-of-pocket expenses that a firm incurs to run
its business. These costs involve direct monetary payments. Examples include wages paid to
employees, rent paid for office space, and utility bills. Explicit costs are easy to identify and
record in the financial statements.
3. Direct cost: Direct costs are expenses that can be directly traced to a specific product,
service, or department. These costs are directly attributable to the production of goods or
services. Examples include raw materials, labour costs for workers directly involved in
manufacturing, and packaging expenses.

4. Indirect cost: Indirect costs, also known as overhead costs, are expenses that are not
directly linked to a specific product or service. These costs are necessary for the overall
operation of the business but cannot be traced back to a single product or department.
Examples include utilities, rent for the office, and salaries of administrative staff.

5. Opportunity cost: Opportunity cost is the cost of the next best alternative that is
foregone when a decision is made. It represents the benefits that could have been received
if a different decision was taken. For instance, if you decide to spend time studying instead
of working, the opportunity cost is the income you could have earned by working.

6. Replacement cost: Replacement cost is the cost that a company would incur to replace
an asset at current market prices. It reflects the cost of acquiring a similar asset with the
same functionality as the one being replaced. For example, if a piece of machinery wears
out, the replacement cost would be the expense of buying a new, similar piece of
machinery.

7. Historical cost: Historical cost refers to the original cost at which an asset was acquired by
a company. It is the actual amount paid to purchase an asset, including any costs necessary
to get the asset ready for use, such as transportation and installation fees. This cost remains
constant on the company’s balance sheet regardless of changes in the asset’s market value
over time.

8. Sunk cost: Sunk costs are costs that have already been incurred and cannot be recovered
or changed. These costs should not affect future business decisions because they will
remain the same regardless of the outcome. For example, money spent on research and
development for a project that was eventually cancelled is a sunk cost.

9. Economic cost: Economic cost includes both explicit and implicit costs. It represents the
total opportunity cost of all resources used in production. This means it considers not only
the actual money spent (explicit costs) but also the value of opportunities foregone (implicit
costs). For example, if a business owner uses their own building for the business, the
economic cost would include the rent they could have earned by leasing it out.

10. Accounting cost: Accounting cost, also known as explicit cost, includes all the out-of-
pocket expenses a business incurs, such as wages, rent, and materials. These costs are
recorded in the financial statements and are used to calculate the company’s profitability.
Accounting costs do not include opportunity costs or any implicit costs.