GE04: Fundamental of Business Economics

Lecture 7: Theory of Cost and Relevant Concepts

Presented by
Dr. M. Anwar Ullah, FCMA

The Institute of Cost and Management Accountants of Bangladesh

ICMA Bhaban, Nilkhet, Dhaka – 1205
Email: anwar2023@yahoo.com.sg

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 004.02 : Lecture 7
Business Economics: Theory of Cost and Relevant Concepts

Variable Cost: Costs that change with the amount produced (all variable inputs).

Fixed costs: Costs that do not vary with the amount produced (all Fixed inputs).

Semi-fixed costs: costs that are constant within a defined level of activity but that can
increase or decrease when activity reaches upper and lower levels.

Sunk cost: A cost that has been paid and cannot be undone or reversed. Once the
cost has been paid, it is irretrievable. Examples are the costs of products in inventory
that cannot be sold and fixed assets that are no longer usable.

Imputed cost and Explicit cost:

Imputed cost that is incurred by virtue of using an asset instead of investing it
or undertaking an alternative course of action. An imputed cost is an invisible cost
that is not incurred directly, as opposed to an explicit cost, which is incurred directly.
Imputed cost is also known as "implied cost" or "opportunity cost". For example, Tk.
1 million business that was started 10 years ago may own real estate nearby town
area. The imputed cost for such business is equal to the interest that the business
would earn if those funds were invested
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 Main differences between Variable Cost and Fixed costs

Total amount Cost per Unit

Change in proportion
with output
Variable Costs More output = More Unchanged in
cost relation to output

Change inversely with

output
Unchanged in relation
Fixed Costs More output = lower
to output
cost per unit

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Step cost: A cost that does not change steadily, but rather at discrete
points. For example, cost up to a certain level of activity will remain
steady until higher activity level is reached, at which point the cost will
increase to a new and higher level.

Step-Variable Costs
Total cost remains
constant within a
narrow range of
activity.

Cost
Activity
 Step-Variable Costs
Total cost increases to a
new higher cost for the
next higher range of
activity.

Cost
Activity
 Step-Fixed Costs

Example: Office space is available at a

rental rate of Tk. 84,000 per year in
increments of 1,000 square feet. As the
business grows more space is rented,
increasing the total cost.

Continue
 Step-Fixed Costs

90
Total cost doesn’t
Thousands of Tk.

change for a wide

Rent Cost in

60 range of activity,
and then jumps to a
new higher cost for
30 the next higher
range of activity.

0 0 1,000 2,000 3,000

Rented Area (Square Feet)
 Semivariable Cost
A semivariable cost is partly fixed and partly variable.
Total Electricity Cost

o st Variable
bl ec
ri a Utility Charge
iva
sem
t al
To

Fixed Monthly
Activity (Kilowatt Hours) Utility Charge
 Curvilinear Cost
Curvilinear
Cost Function
Total Cost

Activity
 Profit
• Profit = Total Revenue (TR) – Total Cost (TC)

• Normal Profit – the minimum amount required to keep a business

in a particular line of production

• Abnormal/Supernormal Profit – the amount over and above the amount needed to
keep a business in its current line of production
 Cost-Volume-Profit (CVP) Analysis

CVP analysis is:

The study of the effects of changes in costs and
volume on a company’s profit.
Important to profit planning.
Critical in management decisions such as:
 determining product mix,
 maximizing use of production facilities,
 setting selling prices.
 Cost-Volume-Profit (CVP) Analysis

• Break Even Occurs where Total Costs (TC) = Total Revenue (TR)
• Start-up costs fixed costs
• Running costs variable costs

• Revenue stream depends on price charged

• ‘Low’ price – need to sell more to break-even
• ‘High’ price – lower level of sales required before breaking even
 004.02 : Lecture 7
Business Economics: Theory of Cost and Relevant Concepts

Cost behaviour
The idea that fixed costs and variable costs react differently to changes in the
volume of products/services produced.

Cost driver
A variable that causally affects costs over a given time span. It is the most
significant cause of the cost of an activity.

Cost Drivers: Example

Example costs: Example cost drivers:

Labor wages Labor hours
Supervisory salaries No. of people supervised
Maintenance wages No. of mechanic hours
Depreciation No. of machine hours
Energy Kilowatt hours

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 Multiple Classification of Costs

Basis of classification
 Nature
 Function
 Direct & indirect
 Variability
 Controllability
 Normality
 Financial accounting classification
 Planning and control
 Managerial decision making
On the basis of Nature
 Materials
 Labour
 Expenses

On the basis of Function

 Manufacturing costs
 Commercial costs – ADM and S&D Costs

On the basis of Direct and Indirect

 Direct costs
 Indirect costs
On the basis of Function
 Manufacturing costs
 Commercial costs – ADM and S&D
Costs

On the basis of Function

 Direct costs
 Indirect costs
On the basis of Variability
 Fixed costs
 Variable costs
 Semi variable costs

On the basis of Controllability

 Controllable costs
 Uncontrollable costs

On the basis of Normality

 Normal costs
 Abnormal costs
On the basis of Financial Accounts
 Capital costs
 Revenue costs
 Deferred revenue costs

On the basis of Time

 Historical costs
 Pre determined costs

On the basis of Planning and Control

 Budgeted costs
 Standard costs
On the basis of Managerial Decision Making
 Marginal costs
 Out of pocket costs
 Sunk costs
 Imputed costs
 Opportunity costs
 Replacement costs
 Avoidable costs
 Unavoidable costs
 Relevant and irrelevant costs
 Differential costs
Term in Cost Accounting
 Cost unit
 Cost centre
 Cost estimation
 Cost ascertainment
 Cost allocation
 Cost apportionment
 Cost reduction
 Cost control
Methods of Costing

 Job costing
 Contract costing
 Batch costing
 Process costing
 Unit costing
 Operating costing
 Operation costing
 Multiple costing
Types of Costing

 Uniform costing
 Marginal costing
 Standard costing
 Historical costing
 Direct costing
 Absorption costing
 004.02 : Lecture 7
Business Economics: Theory of Cost and Relevant Concepts
Other Examples of Cost drivers (see from previous slides-6)

Number of Machine Hours : Number of Machine hours is different cost driver which can be
used for calculating machine hour rate relating to depreciation, repair and maintenance of
machines.

Number of Direct Labour Hours: Number of direct labour hours is that cost driver which
can be used for calculating supervising cost per unit.

Number of Batches of Material: For calculating, storage cost per batch, we have to make
a cost driver that will be no. of batches of material.

Cost object
Anything for which a measurement of cost is required – inputs, processes, outputs or
responsibility centres. Examples are : individual product, alternative marketing strategies,
geographic segments of the business departments etc.

Cost of quality
The difference between the actual costs of production, selling and service and the
costs that would be incurred if there were no failures during production or usage of
products or services. Example: Rework, Re-inspection, Re-testing, Processing customer
complaints, Customer returns, Warranty claims, Product recalls etc.

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Business Economics: Theory of Cost and Relevant Concepts

Difference between Accounting and Economic cost

• accounting cost is related to legal, financial control, reporting and

auditing while economic cost is related to present and future decision
making purposes.

• accounting cost ignore imputed and implicit cost while economic cost
considerer those costs.

In calculating economic profit, opportunity costs are deducted from

revenues earned. As a result, we can have a significant accounting profit
with little to no economic profit. For example, say you invest Tk1,00,00,000
to start a business, and in that year you earn Tk.120,00,000 in profits. Your
accounting profit would be Tk. 20,00,000. However, say that same year you
could have earned an income of Tk. 45, 00,000 had you been employed.
Therefore, you have an economic loss of Tk. 25,00, 000 (1,20,00,000 –
1,00,00,000 – 45,00,000).

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 004.02 : Lecture 7
Business Economics: Theory of Cost and Relevant Concepts
What Does Accounting Profit Mean?
A company's total earnings, calculated according to Generally Accepted Accounting
Principles (GAAP), and includes the explicit costs of doing business, such as
depreciation, interest, taxes, etc.
What Does Economic Profit (Or Loss) Mean?
The difference between the revenue received from the sale of an output and the
opportunity cost of the inputs used. This can be used as another name for "economic
value added" (EVA).
What Does Standalone Profit Mean?
The profit associated with the operation of a single project or division of a firm.
When measuring standalone profit, values are only included if they are directly
generated from the activities of the project or firm. Standalone profits offer a
method of valuing subsets of a business or the independent value of a project. It
looks at the self-contained earning power of an entity by incorporating revenues
and costs directly associated with the unit. This method determines the profit of a
company as if it were made up of a series of completely independent operations.
What Does Normal Profit Mean?
When economic profit is equal to zero; this occurs when the difference between total
revenue and total cost (explicit and implicit costs) equals zero. Normal profit is different
than accounting profit because opportunity cost is taken into consideration.
Normal profit is the minimum level of profit needed for a company to remain
competitive in the market. Also known as "economic profit".
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Business Economics: Theory of Cost and Relevant Concepts
Super Profit (extra surplus-value)

It referred basically to above-average enterprise profits, arising in three main

situations:

technologically advanced firms operating at above average productivity in a

competitive, growing market.

under conditions of declining demand, only firms with above-average

productivity would obtain the previous socially average profit rate; the rest
would book lower profits.

monopolies of resources or technologies, yielding what are effectively land

rents, mining rents, or technological rents.

Super profit in Marxist-Leninist theory, is the result of unusually severe exploitation

or super exploitation. Ernest Mandel argues in his book Late Capitalism that the
growth pattern of modern capitalism is shaped by the quest for surplus-profits
in monopolistic and oligopolistic markets, in which a few large corporations
dominate supply. Large corporations are monopolising access to resources,
technologies and markets.

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Business Economics: Theory of Cost and Relevant Concepts
Operating Surplus

An estimated measure of a firm's operating cash flow based on data from the firm's
income statement, and calculated by looking at earnings before the deduction of
interest expenses, taxes, depreciation, and amortization. Also known as Earnings
Before Interest, Taxes, Depreciation and Amortization (EBITDA) or operational cash
flow.

In economics, operating surplus is an accounting concept used in national

accounts statistics and in corporate and government accounts. Operating surplus
is a component of value added and GDP.

Economic surplus

Economic Surplus (also known as total welfare) is the overall benefit a society
composed of consumers and producers receives when a good or service is
bought or sold, given a quantity provided and a price attached. In accounting it is
also denoted as the extent to which assets exceed liabilities. Economic Surplus is
divided into consumer and producer surplus.

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Business Economics: Theory of Cost and Relevant Concepts
Value added
Value added refers to "extra" feature(s) of an item of interest (product,
service, person etc.) that go beyond the standard expectations and provide
something "more" while adding little or nothing to its cost. Value-added
features give competitive edges to companies with otherwise more
expensive products. In economics, the difference between the sale price
and the production cost of a product is the value added per unit. Summing
value added per unit over all units sold is total value added.
Economic shortage
Economic shortage is a term describing a disparity between the amount
demanded for a product or service and the amount supplied in a market.
Specifically, a shortage occurs when there is excess demand; therefore, it
is the opposite of a surplus. Economic shortages are related to price when
the price of an item is set below the going rate determined by supply and
demand, there will be a shortage. In most cases, a shortage will compel
firms to increase the price of a product until it reaches market equilibrium.
Sometimes, however, external forces cause more permanent shortages—in
other words, there is something preventing prices from rising or otherwise
keeping supply and demand unbalanced.

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Business Economics: Theory of Cost and Relevant Concepts
False shortage
A false shortage is a form of artificial scarcity induced by a supplier, often with the
intent to elevate consumer demand above levels that may otherwise be achieved in
the absence of such scarcity. Companies may induce a false shortage to give rise to
a common perception of the rarity or uniqueness of a product or service, when they
are, in reality, neither precious, nor difficult to produce.
Welfare economics
Welfare economics is a branch of economics that uses microeconomic techniques
to evaluate economic well-being, especially relative to competitive general
equilibrium within an economy as to economic efficiency and the resulting income
distribution associated with it. Social welfare refers to the overall welfare of society.

There are two mainstream approaches to welfare economics: the early Neoclassical
approach (by Edgeworth, Sidgwick, Marshall, and Pigou) and the New welfare
economics approach (Pareto, Hicks, and Kaldor).

New welfare approach is based on efficiency aspect and distribution aspect. The
distributive efficiency considered the situation when goods are distributed to the
people who can gain the most utility from them. Many economists use Pareto
efficiency as their efficiency goal. According to this measure of social welfare, a
situation is optimal only if no individuals can be made better off without making
someone else worse off.
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Business Economics: Theory of Cost and Relevant Concepts
Social welfare maximization

Paretian welfare economics

Paretian welfare economics rests on the assumed value judgment
that, if a particular change in the economy leaves at least one
individual better off and no individual worse off, social welfare may
be said to have increased.

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Business Economics: Theory of Cost and Relevant Concepts

What Does Economies Of Scale Mean?

The increase in efficiency of production as the number of goods being produced
increases. Typically, a company that achieves economies of scale lowers the
average cost per unit through increased production since fixed costs are shared
over an increased number of goods.

There are two types of economies of scale:

- External economies - the cost per unit depends on the size of the industry, not the
firm.
- Internal economies - the cost per unit depends on size of the individual firm.

Economies of scale gives big companies access to a larger market by allowing

them to operate with greater geographical reach. For the more traditional (small to
medium) companies, however, size does have its limits. After a point, an increase
in size (output) actually causes an increase in production costs. This is called
"diseconomies of scale".

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Economies of Scope

An economic theory stating that the average total cost of production decrea
ses as a result of increasing the number of different goods produced.

For example, McDonalds can produce both hamburgers and French fries at
a lower average cost than what it would cost two separate firms to produce
the same goods. This is because McDonalds hamburgers and French fries
share the use of food storage, preparation facilities, and so forth during
production.

Another example is a company such as Proctor & Gamble, which produces

hundreds of products from razors to toothpaste. They can afford to hire
expensive graphic designers and marketing experts who will use their skills
across the product lines. Because the costs are spread out, this lowers the
average total cost of production for each product

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