THEORY OF

COST
 CONCEPT OF
COST
Cost is defined as those expenses faced
by a business in the process of supplying
goods and services to consumers.
 TYPES OF
COST
1) Opportunity Cost And Actual Cost:
Opportunity Cost is the loss of earnings due to lost opportunities.
The opportunity cost may be defined as the loss of expected
returns from the second use of the resources foregone for availing
the gains from their best possible use.

Actual cost are those, which are actually incurred by the payment
of labour, material, plant building, machinery, etc. The total money
expenses, recorded in the books of accounts are, the actual cost.
 TYPES OF
COST
2) Direct Cost and Indirect Cost:
Direct Costs are the costs that have direct relationship with a unit
of operation, i.e. , they can be easily and directly identified or
attributed to a particular product, operation or plant. For Example:
the salary for a branch manager is a direct cost when the branch is
a costing unit.
Indirect cost are those cost whose source cannot be easily and
definitely traced to a plant, a product, a process or a department.
For example: Stationery, depreciation on building, decoration
expenses etc.
 TYPES OF
COST
3) Incremental Cost And Sunk Cost:
Incremental cost denote the total additional cost associated with
the marginal batch of output. These costs are addition to the costs
resulting from a change in the nature and level of business activity.
A sunk cost is a cost that an entity has incurred, and which it can no
longer recover by any means. Sunk costs should not be considered
when making the decision to continue investing in an ongoing
project, since these costs cannot be recovered.
For Example : A company spends $20,000 to train its sales staff in
the use of new tablet computers, which they will use to take
customer orders. The computers prove to be unreliable, and the
sales manager wants to discontinue their use. The training is a sunk
cost, and so should not be considered in any decision regarding the
computers.
 TYPES OF
COST
4) Explicit Cost And Implicit Cost:
Explicit costs are those payments that must be made to the factors
hired from outside the control of the firm. They are mandatory
payments made by the entrepreneur for purchasing or hiring the
services of various productive factors which do not belong to him.
Such payment as rent, wages, interest, etc.
Implicit costs refers to the payment made to the self owned
resources used in production. They are the earnings of owner’s
resources employed in their best alternatives.
 TYPES OF
5) Historical Cost AndCOST
Replacement Cost:
The historical cost is the actual cost of an asset incurred at the time
the asset was acquired. It means the cost of plant at a price
originally paid for it.
In contrast, replacement cost means the price that would have be
paid currently for acquiring paid for it.
So historical costs are the past costs and replacement costs are
present costs.
For Example, suppose that the price of a machine in 2003 was Rs.
200000 and its present price is Rs. 500000, the actual cost of Rs.
200000 is the historical cost while Rs. 500000 is the replacement
cost.
 TYPES OF
COST Cost:
6) Urgent Cost and Postponable
Urgent costs are those costs that are necessary for the continuation
of the firm’s activities. The cost of raw materials, labour, fuel, etc.,
may be its examples which have to be incurred if production is to
take place.
The cost which can be postponed for some time, i.e., whose
postponement does not effect the operational efficiency of the firm
are called postponable costs.
For example: Maintenance costs can be postponed for the time
being.
 TYPES OF
COST
7) Shut Down Costs and Abandonment Costs:
Shut down costs may be those which would be incurred in the
event of a temporary cessation of business activities and which
could be saved if operations are continued. Shut down cost, in
addition to fixed cost, covers the additional expenses in looking
after the property till not disposed off.
Abandonment costs on the other hand, are the cost of retiring a
fixed asset from its use. If, for example, the costs related to
discontinuance of a plant. Therefore, abandonment, thus involves
permanent cessation of activity.
 TYPES OF
COST
8) Fixed Costs and Variable Costs:
Fixed costs are those, which are fixed in volume for a certain given
output. Fixed cost does not vary with the variation in the output
between zero and a certain level of output. The costs that do not
vary for a certain level of output are known as fixed cost. The fixed
costs include:
i) Cost of managerial and administrative staff,
ii) Depreciation of machinery
iii) Maintenance of land etc.
Variable costs are those, which vary with the variation in the total
output. Variable costs include cost of raw materials, direct labour
charges, etc.
 TYPES OF
9) Total Cost, AverageCOST
Cost, and Marginal Cost:
Total Cost (TC) represents the value of the total resources
requirements for the production of goods and services.
Average Costs (AC) It is obtained by dividing the total costs (TC) by
the total output (Q), i.e. AC= TC/Q
Marginal Costs (MC) is the addition to the total cost on account of
producing an additional unit of the product or, marginal cost is
the cost of marginal unit produced. It may be defined as:
MC= TC/ Q
 TYPES OF
COST
10) Short Run Costs and Long Run Costs:
Short run cost are the cost, which vary with the variations in
output, the size of the firm remains the same.
Long run cost, in the other hand, are the cost, which are incurred
on the fixed asset, like plant, building, etc. such costs have long run
implications, the long run simply refers to a period of time during
which all inputs can be varied.
 COST FUNCTION
The concept of cost function refers to mathematical relation
between cost of a product and the various determinants of cost.
In cost function the dependent variable is unit cost or total cost and
the independent variable are the price of factor, the size of the
output or nay other relevant phenomenon.
C = f (O, S, T, P,…)
C = Cost
O = Level of Output
S = Size of Plant
T = Time under Consideration
P = Price of the factor of production
 DETERMINANTS OF COST
FUNCTION
1. Level of Output:
There is positive relationship between total output and total cost. As the
output increases the total cost also increases. The cost may rise or fall by
different rates in different periods of time.

2. Size of Plant:
Size of plant or scale of operation is inversely related to cost. As the scale
of operation increases the cost declines but only up to a certain point.
DETERMINANTS OF COST FUNCTION

3. Price of Inputs:
The cost also depends on the price of factors of production. Any
increase in prices of input will also increase the cost.

4. Managerial Efficiency:
Managerial efficiency has direct bearing on cost function. With the
increase in efficiency the cost declines and productivity increases,
and economies the cost.
DETERMINANTS OF COST FUNCTION

5. State of Technology:
State of technology also influences the cost. Better the technology
better is the technological efficiency. How best we can produce with
the available technology determines the level of costs.
COST – OUTPUT
RELATIONSHIP
COST OUTPUT RELATIONSHIP
The theory of cost deals with the behaviour of cost in relation to
change in output. In other words, the cost theory deals with the
cost output relationship.
The basic principle of the cost behaviour is that the total cost
increases with the increase in output.
But the specific form of cost function depends on whether the time
framework chosen for cost analysis is short – run or long – run.
It is important to know that some costs remains constant in the
short run while all costs are variable in the long run.
COST – OUTPUT RELATIONSHIP
IN THE SHORT - RUN
 COST OUTPUT RELATIONSHIP IN THE
SHORT - RUN
Short run is the period wherein only some of the factors are held
constant and some are variable. Therefore, the costs associated with
both fixed and variable inputs form part of the short period costs.
Short – Run Total Cost:
TC = TFC + TVC
The costs which are found in the short period:
1) Total Fixed Cost
2) Total Variable Cost
3) Total Cost
4) Average Cost :
a) Average Variable Cost b) Average Fixed Cost c) Average Total Cost
5) Marginal Cost
 TOTAL FIXED COST
(TFC)
Total fixed cost is the sum of fixed cost which remains same
irrespective of the level of output.
This is the expenditure incurred by the firm on the fixed
factors of production.
For example, the money incurred on land, building,
machinery, etc. remains the same whatever is the amount
of output.

They are also called Overhead Costs.

 TOTAL FIXED COST
Output Level
(TFC)
Fixed Cost

costs
(Q) (Rs.)

100 2000

200 2000

2000
TFC

300 2000

400 2000

500 2000 O Q
100 200 300 400 500
TFC Curve is a horizontal curve parallel to the X-axis which tells us
that total fixed cost remains the same at all levels of output.
 TOTAL VARIABLE COST
(TVC)
Total variable costs are those costs of production that
change directly with output.
These rise when output increases, and falls when output
declines.
If there is no output the total variable cost will be zero.
These include expenses on raw materials, power, taxes,
advertising, etc.
Marshall has called variable cost as ‘Prime Cost’ or
‘Avoidable Cost’.
 TOTAL VARIABLE COST
Output Level
(TVC)
Variable Cost
(Q) (Rs.)

0 0

1 50

2 90

3 120
4 150

5 190

6 270
 TOTAL VARIABLE COST
(TVC)
In the short run cost diagram shows that total variable cost
varies directly with the volume of output.
TVC curve starts from the origin, upto a certain range it
remains concave from below and then it becomes convex.
If taken from a different angle we can say that initially the
variable cost rises but with diminished rate and later the
variable cost rises with increased rate.
This makes the TVS curve inversely S-shaped.
 TOTAL
COST
Total costs are the(TC)
total expenses incurred by a firm in
producing a given quantity of a commodity.
When we add TFC and TVC it becomes total cost (TC).
They include payment for rent, interest, wages, and
expenses on raw materials, electricity, water, etc.
 RELATION BETWEEN TFC, TVC
AND TC
• In order to determine the total costs of a firm, we aggregate
fixed as well as variable costs at different levels of output
i.e.
• TC = TFC + TVC
• TFC = TC – TVC
• TVC = TC – TFC
RELATION BETWEEN TFC, TVC
AND TC
 RELATION BETWEEN TFC, TVC
AND TC
• In the figure TFC is parallel to X-axis. This curve starts from
the point on the Y-axis meaning thereby that fixed cost will
be incurred even if the output is zero.
• On the other hand, total variable cost curve rises upward
showing thereby that as output increases, total variable
cost also increases. This curve starts from the origin which
shows that when the output is zero, variable costs are also
nil.
• The total cost curve has been obtained by adding vertically
total fixed cost curve and total variable cost.
 SHORT – RUN
AVERAGE COST
The concept of average cost is more relevant from the point
of view of a firm because per unit cost helps in explaining
the pricing of a product in a better way rather than the total
cost.
The concept of average cost is divided into two
(a) Average Fixed Cost
(b) Average Variable Cost
 AVERAGE FIXED
COST
Average fixed cost is the total fixed cost divided by the
number of units of output produced.
Thus:
 AVERAGE FIXED
COST
Since, total fixed cost is a constant
quantity, average fixed cost will steadily fall
as output increases, thus, the average
fixed cost curve slopes downward
throughout the length.

In Figure the average fixed cost curve

slopes downward with a view to touch the
horizontal axis. But it will not be so
because AFC can never be zero. Thus, it is
clear that as output increases, average
fixed costs go on diminishing.
 AVERAGE VARIABLE
COST

Average variable cost is the total variable cost divided by

the number of units of output produced.
AVC = TVC / Q
AVC = Average variable costs.
TVC = Total variable costs
Q = Output
 AVERAGE VARIABLE
COST
• Generally, the AVC falls as output
increases from zero to the normal
capacity output due to the law of
increasing returns. But beyond the
normal capacity output, the AVC
will rise steeply because of the
operation of the law of diminishing
returns.

• In Figure the average variable cost

curve assumes the U- shape.
Initially, the AVC curve falls, after
having the minimum point the
curve starts rising.
 AVERAGE TOTAL COST/
AVERAGE
“The average cost ofCOST
production is the total cost per unit of
output.” In other words average cost of production is the
total cost of production divided by the total number of units
produced.
Suppose, the total cost of producing 500 units is Rs. 1000,
the average cost will be:
AVERAGE TOTAL COST/
AVERAGE COST
 MARGINAL
COST
• Marginal cost is an addition to the total cost caused by
producing one more unit of output. For instance, the total
cost for the production of 100 units is Rs. 5000. Suppose
the production of one more unit costs Rs. 5000. It will be
called the marginal cost.
FEW PROBLEMS TO
PRACTICE
 EXAMPL
E1
The output and total cost data for a firm is given below.
Work out the following costs: TFC,TVC,AFC,AVC,ATC & MC at
various level of output.

Units of 0 1 2 3 4 5 6
Output
Total 120 180 200 210 225 260 330
Cost
 SOLUTI
Remember: ON
(i) At zero output, TC=TFC. Therefore, TFC = Rs. 120
(ii) MC is the additional cost of producing an additional unit of output. So, MC of 1
unit of output equals 60 (180-120).

Units of TC TFC TVC AFC AVC ATC MC

Output (TC-TFC) TFC/Q TVC/Q TC/Q TCn - TCn-1
0 120 120 0 - - - -

1 180 120 60 120 60 180 60

2 200 120 80 60 40 100 20

3 210 120 90 40 30 70 10

4 225 120 105 30 26.25 56.25 15

5 260 120 140 24 28 52 35

6 330 120 210 20 35 55 70

 EXAMPL
Complete the following E 3
table:
Units of TFC TVC TC AVC ATC MC
Output
0 60 - - - - -

1 - 30 - - - -

2 - - 100 - - -

3 - - - - - 5

4 - - - - 28.75 -

5 - - - 15 - -

6 - - - - - 45
 SOLUTI
ON
i) Zero output row: At zero output TFC =TC= 30
ii) One unit output row: TFC + TVC = 60 +m 30 = 90m = TC
iii) Two units output row: TC – TFC = 100 – 60 = 40 = TVC
iv) Three units output row: TC of 2 Units=100.MC of 3rd unit = 5. so,TC of 3units = 110+5 =105
v) Four units output row: ATC X Q = 28.75 X 4 = 115 = TC
vi) Five units output row: AVC X Q = 15 X 5 = 75 = TVC
vii) Six units of output row: TCof 5units= 135, MC of 6th unit= 45, So, TC of 6units =135+45 =180
Units of TFC TVC TC AVC ATC MC
Output TFC + AVC
0 60 0 60 - - -
1 60 30 90 30 90 30
2 60 40 100 20 50 10
3 60 45 105 15 35 5
4 60 55 115 13.75 28.75 10
5 60 75 135 15 27 20
6 60 120 180 20 30 45