COST ANALYSIS S .Q 1. What is MC.

2. Define variable cost.

3. What are MC and Average variable cost . 4. What is total fixed cost. L.Q. 1. What do you understand by short run cost output relationship . Describe these in detail . 2. Why are short run and longrun cost curves U shaped ?How are the two related with each other 3. What are the various types of costs in short run and

long run ? Explain in detail .

4. Differentiate between long run and short run cost analysis . 5. Discuss the cost output relationship in long run .
1

What are you required to learn from Cost analysis ?

. Cost function, Cost classification, Types of costs Short run and long run. . Traditional cost theory and relationship between different cost curves.

. Modern Theory of Cost.

. Importance of cost functions in optimal decisionmaking .

Importance of Cost concept in Managerial decision making : COP = Inputs x with their respective prices . From the decision making point of view cost is more important than revenue because the firm can influence cost more easily than revenue . 1. COP is an important factor in business decisions , specially those pertaining to. Locating the weak points in business management. . Minimizing the cost. . Finding the optimum level of output. . Determination of price and dealers margin. .Estimating or projecting the cost of business operation. 2. Study of costs is essential for making a choice from among the competing production plans. 3.The term cost has different meanings under different settings and is subject to varying interpretations. It is therefore, essential that only the relevant concept of costs is used in the business decisions .
3

Characteristics of Economic Costs:

1. Economists define cost in terms of opportunities that are sacrificed when a choice is made. Hence, economic costs are simply benefits lost and, in some cases, benefits are merely costs avoided. 2. Economic costs are subjective. Seen from the perspective of a decision maker and prospective. 3.Economic cost is a stock concept Economic costs are incurred when decisions are made. 4. Economic cost estimates are used for making decisions about pricing, output levels, buying or making, alternative marketing tactics/strategies, product introductions and withdrawals, etc.

Accounting Costs:

.Accountants define cost in terms of resources consumed. Accountants usually define costs as flows. Accounting costs reflect changes in stocks. While using Accounting costs to estimate Economic costs. Ignore costs that will not vary as a result of your decision. . Include all costs that will vary as a result of your decision. 1.The only costs that matter for business decisions are future costs.

2.Actual costs / current / historical costs are useful solely as a bench mark .

Classification of Costs and their Importance in Managerial Decision Making : 1. Economic costs can be calculated at two levels . Money Cost / Actual Cost and Real Cost / Social Cost . . Micro level . Money Cost / Actual Cost. Micro level economic costs relate to functioning of a firm as a production unit. Total money expenses recorded in the books of accounts , actually incurred by the firm. This is also called private cost . . Macro Level Real Cost / Social Cost . Macrolevel economic costs are the ones that are generated by the decisions of the firm but are paid by the society and not the firm . Total costs to the society on account of production of a good ( maybe in the nature of pollution) . Economic costs include both the private and social costs.
6

2. Outlay v s Opportunity Cost .

Outlay Costs mean the actual expenditure incurred for producing or acquiring a good or service . Like , wage bill . These costs are known as Actual costs or absolute costs . They are recorded in the books of account . The opportunity cost of an asset (or, more generally, of a choice) is the highest valued opportunity that must be passed up to allow current use.

3.Implicit v s Explicit cost.

Implicit Cost / Imputed Costs .It is the return foregone on the use of self-owned resources . These are theoretical costs in the sense that they go unrecognized by the accounting system but are definitely important for business decisions . Implicit Costs do not involve a cash transaction, therefore, opportunity cost concept is used to measure them. Explicit Cost. Expenses which are actually paidout by the firm. A cash transaction is involved. These costs appear in the accounting records of the Firm.

The explicit costs are important for calculation of profit and loss account, but for economic decision - making the firm takes into account both the explicit and implicit costs.
8

4. Accounting Costs and Economic. Costs. Accounting costs are the actual or outlay costs. Giving the actual expenditure which has already been incurred on a particular process or on production as such. Since these costs relate to the past, these are sunk costs The accounting costs are useful for managing taxation needs as well to calculate profit or loss of the firm .

5. Economic costs relate to the future . They are in the nature of incremental costs.
Implicit + explicit + opportunity costs . Since the only costs that matter for business decisions are future costs, it is the economic costs which are important. Economic cost includes opportunity cost, which requires that we not only understand actions taken, but also understand actions not taken .
9

6. Sunk Costs and Outlay Costs.

Sunk costs are the costs that are not altered by a change in the quantity and cannot be recovered (depreciation). Sunk costs are a part of Outlay costs . Sunk costs are Irrelevant for business decisionmaking as they do not vary with the changes contemplated for future by the management.

10

7.Incremental / avoidable/ Escapable / Differential.

The incremental Costs are the additions to costs resulting from a change in the nature and level of business activity . They are also called differential costs as they may be regarded as the difference in total costs resulting from a contemplated change . Incremental costs may include fixed costs besides variable costs as a new proposal may involve some expenditure of fixed nature . Whether a particular cost belongs to the category of sunk or incremental cost , depends upon the conditions of each business activity . A particular cost may be sunk cost in one case and incremental cost in the other case.

11

Incremental and Sunk Costs in Decision Analysis :

Incremental cost is the change in cost caused by a particular managerial decision. Thus the increment is at the decision level, and may involve multiple units of change in output or input. Incremental costs may be involved when considering a product or service modification or a change in production process. Sunk costs are those parts of the purchase cost that cannot later be modified through resale or other changes in operations. Sunk costs reflect commitment, or irreversibility, and so are not a part of incremental analysis.

12

8. Direct / Traceable / Assignable Costs and Indirect / Non traceable / Non- assignable . The Direct costs have direct relationship with a unit of operation like a product , a process or a department of the firm. Direct costs are variable , since they are linked to a particular product / process / department and they vary with the changes in them. Indirect costs are those whose course cannot be easily and definitely traced to a plant , a product , a process or a department . Indirect costs may or may not be variable. They may not change as a result of proposed changes in production level , production process or marketing process . Indirect costs are both variable and fixed .It is variable indirect costs that are relevant for decisionmaking.
13

9.Business costs and Full costs.

Business costs are relevant for the firms profit and loss accounts and for legal and tax purposes . Include all the payments and contractual obligations made by the firm together with the book cost of deprecation on plant and equipment . It is similar to Actual or Real cost. Full Cost=Business costs+(Opportunity Cost +Normal Profits ) Normal Profits are the minimum earnings necessary which a firm must earn in order to remain in its present production .This is over and above the Opportunity Costs of current production .

14

10. Total, Marginal and Average Costs.

.Total Cost includes all cash payments made to hired factor of production and all the cash changes imputed for the use of the owners factor of production in acquiring or producing a good or service. .Average cost (AC) is the cost per unit of output. Ac = Total cost / Total Quantity produced.

.Marginal cost (MC) is the extra cost of producing one additional unit.
Total Cost concept is useful in break-even analysis and in finding out whether a firm is making profit or not. The Average cost concept for calculating per unit profit. The Marginal cost and Incremental Cost are needed to find out whether the firm needed to expand production or not.

15

11. Fixed or Variable cost. FC remain the same at a given capacity and do not vary with output. These costs will exist even if no output is produced. Variable cost varies directly as out put is produced. Some costs fall in between two extreme known as semi variable. These costs are used for forecasting the effect of short run changes in volume upon cost and profits. 12.Acquition cost and opportunity cost. Acquition cost means cash out- flow committed to acquire or produce a good or service. Opportunity costs are cash inflows prevented by taking one cause of action instead of other.
16

13.Out Of pocket and Book Cost. Out of pocket cash refer to cost that involve immediate payments to outsiders. Book cost do not require current cash expenditure . 14 .Historical and Replacement cost. The Historical cost of an asset is the actual cost incurred at the time that work was originally acquired. Historical cost indicates market conditions at time of purchase, and is used in tax analysis. Replacement cost is the cost, which will have to be incurred if that asset is purchased now. Replacement Cost, reflects current market conditions, and is more relevant in valuation and cost analysis at the managerial level. It represents the cost of replacing the productive capability of the capital item at current market prices.

17

15. Past and Future Costs.

Past costs are actual costs incurred in the past and they are always contained in the income statement. Future cost are likely to be incurred in future period and based on estimate. 16. Separable and Common Cost. Cost of electricity is common cost. Raw material cost can be a separable cost.

18

Cost and Output Functions: Cost and Output Functions express the relationship between cost and its determinants and is derived from Production Function .

Cost output relationship is a partial relationship.

They describes the available efficient methods of production at any one time . Determinants of cost: C = f ( S , O , P , T ,.) Where C Cost ( unit cost or total cost ).

S
O

Size of plant .
Level of output.

P Price of inputs used in production. T Nature of technology.

19

1. Size of plant. The relation between plant size ( scale of operations) to the unit cost is negative . As the size of the plant increases per unit cost decreases and vice versa . 2. Output Level. Total cost increases with increase in output ,but the rate of increase varies . AC and MC first decline and then increase with increase in output . 3. Price of Inputs. Changes in input prices influence costs , depending on the selective usage of the inputs and relative changes in their prices .When a factor, which is a major component in production becomes relatively costly it raises the cost significantly .

20

4. Technology /Capital output ratio . Modern and efficient technology is certainly cost saving and is, therefore , generally found to have higher capital - output ratio 5.Managerial Efficiency. It is difficult to quantify it . However , a change in cost at two points of time may explain how organizational or managerial changes within the firm have brought labour cost efficiency , provided it is possible to exclude the effect of other factors .

21

Cost Curves : Assumptions of Cost Curves: All the determinants other than the rate of output are held constant while analyzing cost and constructing cost curves . The shape of the cost curve is determined by the nature of underlying Production function . While the level of cost curve is affected by the input prices .

22

Cost Curves Analysis consists of two parts. 1. How the per-unit cost Curves Average and Marginal costs relate to Total costs curves . How long-run cost Curves Total, Average, and Marginal relate to their short-run counterparts. Short Run Cost Function C= f ( X ,T , Pf , K) Where : X Output.

2.

T Technology
Pf Prices of inputs K Fixed Factors
23

Law of Variable Proportions determines the shape of SRC curves . Short Run Costs TC = TFC + TVC AFC = T F C/Q AV C = T V C/Q AC= AFC + AVC or TFC / Output

SAC and SMC relationship

MC = Change in T C/Change in Q Long Run Cost Function. C= f ( X ,T , Pf ,) Economies of Scale determine the shape of the LRC curves .

Long Run Costs .

LTC LAC = LTC / Output LAC and LMC relationship
24

Cost Output Relationship Theories

1.Traditional Cost Theory of Cost Output Relationship.

Long Run Average Cost curve is U shaped .

2. Modern Cost Theory of Cost Output Relationship. Long Run Average Cost curve is L shaped .

25

The Relevance of the Shape of the Cost Curves in Managerial Decision Making : Short-Run and Long-Run Cost Curves. Short Run is the decision-making period during which at least one input is considered fixed. Even if the firm temporarily shuts down, it still continues to incur the fixed cost expense. This is typical of capital loans or facility lease agreements. The manager is selecting levels of variable input and production output to optimize given the constraint of the fixed input. Long Run is a planning horizon that looks beyond current commitments to a future period in which all inputs can be varied. A typical long-run analytical problem is the decision of whether to adjust capacity, seek a larger (or smaller) facility, to change product lines, or to adopt a new technology. At any given time managers must be concerned with both short-run and long-run analysis. Firms must be concerned with both the problems of optimizing in the current (shortrun) situation as well positioning the firm for optimizing in 26 the future (long-run).

Conditions for Consistent Representations of Cost Curves:

For both long-run and short-run curves, the average and marginal curves must derive from the same total cost curve. At the quantity for which long-run and short-run average cost curves are tangent, the accompanying marginal cost curves must intersect. If the long-run average (or total) cost curve is to be an envelope consisting of minimum points on a series of short-run average (or total) curves then The short-run average cost curve must exhibit more curvature than its long-run counterpart (or equivalently the short-run marginal cost curve must intersect its long-run counterpart from below).
27

Short Run Cost Output Relationship: Refer to a particular scale of operation or to a fixed plant size. The relationship between fixed cost and output is the same for all type of business. Fixed Cost and Outputs. By definition fixed cost does not vary with output. Fixed cost is fixed as a total amount. Thus the larger the quantity produced, the lower will be the fixed cost per unit and marginal fixed cost will always be zero AFC decline Monotonically as output increases correspondingly AFC curve is falling continuously. Therefore, AFC increases . approaches the X axis as output

Rectangular Hyperbola. Means that the curve approaches , but does not meet the vertical and the horizontal axis at each end .
28

Variable cost and output. The Total Variable Cost increases as output increases. But the rate of increase is not the same for every unit of increase in

output. .
As output increase TVC increase at a decreasing rate, then at a constant rate and eventually at an increasing rate. Average Variable Cost . As output increases , the proportions of variable cost and fixed cost changes. In the beginning , for some range of output , the average physical product of the variable factors may increase and then remain constant .

But , as output is expanded further , the average physical product of variable factors must diminish ( AVC must start rising ).
On account of the operation of the law of Variable proportions , the AVC is U shaped .
29

Average Cost.

Since , as output increases , VC increases faster relatively to fixed costs , the shape of SAC is governed by AVC .Being dependent on AVC mainly , the SAC is also U shaped. The Relationship among AVC, AC and MC
All three Costs first Fall then remain constant and then rise. A. The rate of change in MC is greater than AVC and hence the minimum MC is at an output lower than the output at which AVC is minimum. B. The ATC falls for a longer range of output than the AVC and hence the minimum ATC is at a larger output than the minimum AVC.

C. AVC= MC, when AVC is least.

ATC = MC, when ATC is the least.
30

Cost Output Relationship:

Diagram 8.1

TFC TVC, TC

Vertical difference between TC and TVC is equal to TFC, which is constant (thus TC and TVC are parallel). 31

Diagram 8.2

Relationship among AVC, AC and MC

32

F. Vertical difference between AC and AVC is equal to AFC. similar to the situation with the total cost relations, but the key difference is that AFC declines (monotonically) as Q rises -- there is more output over which to 'spread' the TFC, and thus AFC declines. G. The MC curve always intersects the AC and SAC curves from below at its minimum point . (purely geometric relationship with no technological reason behind it ) H. SMC helps us in determining the supply of the product of the firm .

33

Why do AC and SMC have a Common MC Curve ? Due to special relationship between SAC and AVC . As output is increased , fixed costs do not change . The change in total costs of the firm is brought out only by variable costs .

As one more unit of output is produced , fixed costs remain constant , while variable costs , and by the same amount , the total costs are increased .

Therefore , the total costs and variable costs may differ in absolute amount , but register the same increment in them as output increases by a unit , MC is common to both.

34

Long Run Cost Output Relationship: The Long Run Average Cost Curve is derived from the Short run Cost Curves. Each point on a Long Run Cost Curve corresponds to a point on a Short Run Cost Curve .

In the long run there is no fixed factor of production and hence there is no fixed cost. The Long Run Average Cost, LRAC, curve of a firm shows the minimum or lowest average total cost at which a firm can produce any given level of output in the long run (when all inputs are variable). LRAC is the lower envelope of the efficient short-run Average Cost Curves for all different scales of operation for a firm.
35

The term 'lower envelope' simply means that at any given production level, in the long run the firm can select the technology appropriate for that production level, and thus placing it on the minimum point on the most efficient short-run average cost curve. There are many plant sizes each suitable for a certain level of output we will get as many SAC curves ,intersecting each other. The intersection points will be so close to each other that we get almost a continuous curve . It is known as the Long Run Average Cost Curve or an Envelope Curve . Thus the LRAC is made up of the minimum points on all the Short-run Average Cost Curves that would be efficient for various possible output levels.

36

Minimum Efficient Scale Minimum efficient scale occurs at the first point where a firm encounters the minimum point on its long-run average cost curve. The Partial Total Cost Function will be: T C= f (x, k) k- stands for the plant size. As k changes TC changes. Thus the long run cost function contains a family of short run cost functions one for each value of k. Relationship is not unidirectional. If the output is small, small plant size will be less than for a large plant size. In short, run variations in output are possible up to extent plant size permit. Thus, we have a family of short run total cost curves. Large plant size is good for large outputs. In long term plant size can change. The concept of long term is only hypothetical.
37

Characteristics of the U LAC curve 1. The LAC curve is tangential to the various SAC curves . It is said to envelope them . NO point on the SAC curve can be below the LAC curve . 2.The LAC curve is U shaped . Reasons. LRVC curve depends upon on the Returns To Scale. . Increasing Returns To Scale bring about a fall in Long run Average Cost of Production as output is increased . . Decreasing Returns To Scale bring about a rise in Longrun Average Cost of Production as output is increased beyond a point . In between the points cost remains constant due to the operation of the Constant Returns to Scale .

38

Implication.

Determines the Optimum size of the Plant.

. There are scale economies as a firm grows in size at first and these economies are overshadowed by scale diseconomies after a point .
The U of the SAC curve is more pronounced than that of a LAC curve because Diminishing returns to increases in proportion of variable factors set in very early as the volume of output is expanded in the short run . Scale economies are not exhausted so easily and early with the expansion in scale . . The longrun AC curve can never cut a SAC curve.

39

Implication.

For any given output , LAC can never be higher than the SAC . Any adjustment that is possible in the short run is also possible in the long run . Whereas scale adjustments that are possible in the longrun are not possible in the shortrun . 4. LAC curve will touch the Optimum plant SAC curve at its lowest point . All other SAC curves will be touched by the LAC curve either to the left or the right of their minimum points .

40

Modern Theory Long run AC .

Why a long run AC curve is likely to be L shaped ? All costs are variable in the long run . The long run costs can be divided into: Production cost and Managerial costs. Production costs fall continuously with increases in output , while Managerial costs may rise at very large scales of output .

41

Reasons for continuously falling production costs:

(a). Economies from further decentralization and improvement in skill . (b). Lower repair costs , which may be attained if the firm reaches a certain size .

(c). Vertical integration . The firm may itself undertake the production of some of the materials and equipment which it needs rather than buying them from the market. Moreover, introduction of new techniques for larger scales of output must be of improved quality and thus cheaper to operate.

42

Managerial Costs. Each management technique is appropriate for a certain level of management and a certain range of output . Therefore, given a managerial Setup , the Average managerial cost initially falls with the expansion of the firm , but eventually rises (though slowly) at very large scales of output . Production costs Fall smoothly.

Managerial costs Rise slowly at very large scales of output. Modern theorists: Fall in Production costs more than offsets the probable rise in Managerial costs. In the long run AC falls smoothly or remains constant at very large scales of output , thus giving rise to an L shaped LAC curve .
43

Revenue Analysis : Meaning of Revenue: Every firm has a dual role to perform. . Producer. . Seller. Minimize cost. Maximize Revenue .

Definition of Revenue:

Prof.Dooley revenue of a firm is its sales receipts or income.

Concepts of Revenue: TR= f (Q) AR =TR/Q MR=TR n TRn-1 TR= P x Q AR = P Change in TR/Change in Q.
44

Significance of the Concept of Revenue in Price Analysis 1. Knowledge of the firms equilibrium . 2. Knowledge about Full Capacity or under Capacity Production . 3. Estimate of Profit and Loss . . If TC < TR .If TC > TR .If TC = TR .If AC < AR .If AC > AR .If AC = AR Super-normal Profits . Sub-normal Profits. Normal Profits . Super-normal Profits. Sub-normal Profits. Normal Profits .
45

. Second Determining Condition is AR and AC

Significance of the Concept of Revenue in Price Analysis 4.Concept of AR explains SHUT- -DOWN POINT . If in the short period AR = AVC firm will be in equilibrium , BUT it will suffer minimum losses. In the short period the firm can not leave the industry . It can only avoid Variable Cost by not operating . And if it is covering its variable cost ,it will continue operating . 5. Change in Price. It is from the concept of Total revenue that the firm can know the effect of rising or lowering the price per unit of the product on the Profits .If TR increases by lowering the price , as in the case of elastic demand , then it will be profitable to lower the same .

.If TR increases by raising the price per unit , as in the case of inelastic demand , then it will be profitable to raise the same .
.If change in price has no effect on Total Revenue , then it will not be worthwhile for the firm either to raise or lower the 46 price .

Relationship between Elasticity of Demand , AR and MR:

E = AR/ AR MR

E= A / A-M

From this we can derive the following two equations : (i). AR = MR E/ E-1 AR = M( E/E-1)

(ii). MR = AR E-1/E

MR= A( E-1/E)

It follows that if we know ED we can calculate MR at different prices . .If the ED on the AR=1 MR = A(1-1/1)=A(0/1)=0 Then MR at this quantity is zero.
47

Relationship between Elasticity of Demand , AR and MR:

. If the ED on AR >unity say 3 MR = A(3-1/3)=2/3 Then MR at this quantity will be Positive. .If the ED of AR curve is <1 say

Then MR at this quantity will be Negative.

4848 IF ED=1 ED> 1 ED< 1 ED = infinity ED=0 MR is Zero MR is Positive MR is Negative MR coincides AR Gap between AR and MR widens .
48