Cost of Production or Total Cost (TC)

Costs are defined as those expenses faced by an organization when producing a good or service for a
market. In the short run a firm will have fixed cost (FC) and variable costs (VC) of production. Total cost
is made up of fixed costs and variable costs.

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

Fixed Costs (FC)

The cost of all fixed inputs in a production process. Another way of saying this: production costs that do
not change with the quantity of output produced changes.

These costs relate do not vary directly with the level of output. Examples of fixed costs include:

1. Rent paid on buildings and business rates charged by local authorities.

2. The depreciation in the value of capital equipment due to age.
3. Insurance charges.
4. The costs of staff salaries e.g. for people employed on permanent contracts.
5. Interest charges on borrowed money.
6. The costs of purchasing new capital equipment.
7. Marketing and advertising costs.

Variable Costs (VC)

The cost of all variable inputs in a production process. Variable costs vary directly with output. I.e. as
production rises, a firm will face higher total variable costs because it needs to purchase extra resources
to achieve an expansion of supply. Examples of variable costs for a business include the costs of raw
materials, labor costs and other raw materials used directly in the production process.

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Average Fixed Cost (AFC)

Average fixed cost (AFC) is measured by dividing Total Fixed cost (TFC) by the total number of output
(Q).

It is the fixed cost of per unit of output (Q).

¿
AFC = Total ¿ Cost (TFC ) Total Output (Q)

As output increases AFC Starts to fall because Total Fixed Cost (TFC) is constant (fixed) but the
denominator which is output (Q) is increasing, so the result is also decreasing. That’s why AFC curves has
downward slope.

Average Variable Cost (AVC)

Average variable cost (AVC) is measured by dividing Total Variable cost (TVC) by the total number of
output (Q).

Total Variable Cost (TVC )

AVC =
Total Output (Q)

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AVC is U-shaped because it begins with relatively high but falling cost for small quantities of output,
reaches a minimum value, then has rising cost at large quantities of output.
The U-shapes of the average variable cost curve is directly or indirectly the result of increasing marginal
returns for small quantities of output (production Stage I) followed by decreasing marginal returns for
larger quantities of output (production Stage II). The decreasing marginal returns in Stage II result from
the law of diminishing marginal returns.

Marginal Cost (MC)

Marginal cost (MC) is the change in total cost that arises when the quantity produced changes by one
unit. That is, it is the cost of producing one more unit of a good. In general terms, marginal cost at each
level of production includes any additional costs required to produce the next unit.

∆ TC
MC =
∆Q

Average Total Cost (ATC or AC)

Average total cost is the summation of average fixed cost (AFC) and average variable cost (AVC). It
measures per unit total cost of production. It is measured by dividing the total cost (TC) by the number
of output (Q).

TC
ATC or AC = ∨ A FC + AVC
Q

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ATC or AC is U-shaped because it begins with relatively high but falling cost for small quantities of
output, reaches a minimum value, then has rising cost at large quantities of output.
The U-shapes of the average variable cost curve is directly or indirectly the result of increasing marginal
returns for small quantities of output (production Stage I) followed by decreasing marginal returns for
larger quantities of output (production Stage II). The decreasing marginal returns in Stage II result from
the law of diminishing marginal returns.

Another reason of the U-shape of Ac is, we know that AC includes both AFC and AVC. As output
increases AFC decreases always and initially AVC also decreases. At a certain point AVC reaches at its
minimum level and then again start to rise. After this level the rate of increase of AVC is more than the
rate of decrease of AFC. So increasing force of AVC gets stronger, that’s why ATC or AC also starts rising
and get a shape of U.

The Average-Marginal Relation

The average total cost (ATC or AC), average variable cost (AVC), and marginal cost (MC) curves depict
the basic mathematical relation that exists between any average and the corresponding marginal.

 Average Variable Cost: First, note the relation between the average variable cost (AVC) curve
and the marginal cost curve (MC). The marginal cost curve intersects the average variable cost
curve at its minimum value. Moreover, when average variable cost is declining (the average
variable cost curve is negatively sloped), marginal cost is less than average variable cost. And
when average variable cost is rising (the average variable cost curve is positively sloped),
marginal cost is greater than average variable cost.

 Average Total Cost: Second, the average-marginal relation is also seen with the average total
cost curve. The marginal cost curve intersects the average total cost curve at its minimum value,
as well. When average total cost is declining (the average total cost curve is negatively sloped),
marginal cost is less than average total cost. When average total cost is rising (the average total
cost curve is positively sloped), marginal cost is greater than average total cost.

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Note that the minimum values of the average total cost curve and the average variable cost curve occur
at different quantities. This results because: (1) marginal cost intersects each average curve at its
minimum value, (2) the marginal cost curve has a positive slope, and (3) there is a gap between the two
average curves, which is average fixed cost.

Opportunity Cost

This is the value of the next best alternative use of a resource or good. It is the value sacrificed when a
choice is made.
For example, if you run a business then you need to be involved in your business and usually you don’t
count your salary as an expense or you don’t take money as salary from your business. Instead of doing
business (giving time in your own business) you could join in any other organization and could get salary.
So when you have decided to start business you had to decline (forgo) the opportunity of joining in
other organization and getting salary. So the opportunity cost of doing business is the salary from other
organization that you could get by doing job.

Sunk Costs
In economics and business decision-making, sunk costs are retrospective (past) costs that have already
been incurred and cannot be recovered. Sunk costs are sometimes contrasted with prospective (future)
costs, which are future costs that may be incurred or changed if an action is taken. Both retrospective
and prospective costs may be either fixed (that is, they are not dependent on the volume of economic
activity, however measured) or variable (dependent on volume).

In traditional microeconomic theory, only prospective (future) costs are relevant to an investment
decision. Traditional economics proposes that an economic actor not let sunk costs influence one's
decisions, because doing so would not be rationally assessing a decision exclusively on its own merits.

Sunk costs should not affect the rational decision-maker's best choice.

Often many companies allocate budget and spends on research and development activities of for the
future products or to improve the existing products. Expenses for research and development works are
also sunk cost.

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Explicit Cost
A business expense that is easily identified and accounted for. Explicit costs represent clear, obvious
cash outflows from a business.
Good examples of explicit costs would be items such as wage expense, rent or lease costs, and the cost
of materials that go into the production of goods. With these expenses, it is easy to see the source of
the cash outflow and the business activities to which the expense is attributed.

Implicit Cost
In economics, an implicit cost, also called an imputed cost, implied cost, or notional cost, is the
opportunity cost equal to what a firm must give up in order to use factors which it neither purchases nor
hires. It is the opposite of an explicit cost.

However, these costs are small compared to the value of the time it takes to attend class, do homework,
etc. The amount that the student could have earned if she had worked rather than attended school is
the implicit cost of attending college. Implicit costs are costs that do not require a money payment.

Opportunity Cost involves both money payment and implicit cost which doesn’t involve money
payment.

Explicit Cost vs. Implicit Cost

a) Explicit cost can be counted in terms of money whereas implicit cost can not be traded and therefore
can not be counted in terms of money.
b) Explicit cost is a direct tangible cost whereas implicit cost is indirect intangible cost.

Accounting Profit
The accounting profit is the difference between total revenue and total cost (only explicit cost).

Accounting Profit = Total Revenue (TR) – Total Explicit Cost

Economic Profit
Economic Profit is slightly different than accounting profit, it measures by deducting total explicit cost
and opportunity cost from the total revenue.

Economic Profit = Total Revenue – Total Explicit Cost – Opportunity Cost

As economic profit involves opportunity cost, economic profit is less than accounting profit.

Economies of Scale
Economies of scale, refers to the cost advantages that a business obtains due to expansion (out put
increase). There are factors that cause a producer’s average cost per unit to fall as the scale of output is
increased. "Economies of scale" is a long run concept and refers to reductions in unit cost as the size of a
facility and the usage levels of other inputs increase.