COST ANALYSIS

Unit 4
 Concepts of Cost
EXPLICIT COST
• A direct payment made to others in the course
of running a business, such as wages, rent, and
materials, as opposed to implicit costs, which are
those where no actual payment is made.
IMPLICIT COST
• The opportunity cost equal to what a firm must
give up in order to use factors which it neither
purchases nor hires.
Economic Cost
• The difference between the total revenue received
by the firm from its sales and the total opportunity
costs of all the resources used by the firm.
Accounting Cost: The total revenue minus costs,
properly chargeable against goods sold.

Accounting profit is the monetary costs a firm pays

out and the revenue a firm receives. It is the
bookkeeping profit, and it is higher than economic
profit.

Accounting Profit = Total Monetary Revenue- Total Costs

 Short Run Cost analysis
• In the short run, the quantity of at least one input is
fixed and the quantities of the other inputs can be
varied.
• In the short-run period, factors, such as land and
machinery, remain the same.
• On the other hand, factors, such as labor and
capital, vary with time. In the short run, the
expansion is done by hiring more labor and
increasing capital. The existing size of the plant or
building cannot be increased in case of the short
run.
 TOTAL FIXED COST
• the costs that remain fixed in the short period.
These costs do not change with the change in the
level of output. For example, rents, interest, and
salaries. In the words of Ferguson, “Total fixed
cost is the sum of the ‘short run explicit fixed
costs and implicit costs incurred by the
entrepreneur.”
• These costs are also called supplementary costs,
indirect costs, overhead costs, historical costs, and
unavoidable costs.
 TOTAL FIXED COST

• As shown in Figure, TFC curve is horizontal to x- axis. From

Figure, it can be seen that TFC remains the same at all the
levels with respect to change in the level of output.
 Total Variable Costs (TVC)

• costs that change with the change in the level

of production. For example, costs incurred on
purchasing raw material, hiring labor, and
using electricity. According to Ferguson, “total
variable cost is the sum of amounts spent for
each of the variable inputs used” If the output
is zero, then the variable cost is also zero.
These costs are also called prime costs, direct
costs, and avoidable costs.
 Total Variable Costs (TVC)

• In Figure, it can be seen that TVC curve changes

with the change in the level of output.
 Total Cost (TC):

• Involves the sum of TFC and TVC.

• It can be calculated as follows:

• Total Cost = TFC + TVC
• TC also changes with the changes in the level
of output as there is a change in TVC.
 Total Cost (TC):

• It should be noted that both TVC and TC increase initially at

decreasing rate and then they increase at increasing rate Here,
decreasing rate implies that the rate at which cost increases with
respect to output is less, whereas increasing rate implies the rate at
which cost increases with respect to output is more.
 Average Fixed Costs (AFC):

• Refers to the per unit fixed costs of production.

In other words, AFC implies fixed cost of
production divided by the quantity of output
produced.
• It is calculated as:

AFC = TFC/Output
TFC is constant as production increases, thus
AFC falls.
 Average Fixed Costs (AFC):

In Figure, AFC curve is shown as a declining curve, which never

touches the horizontal axis. This is because fixed cost can never
be zero. The curve is also called rectangular hyperbola, which
represents that total fixed costs remain same at all the levels.
 Average Variable Costs (AVC):
• Refer to the per unit variable cost of
production. It implies organization’s variable
costs divided by the quantity of output
produced.
It is calculated as:
AVC = TVC/ Output
Initially, AVC decreases as output increases.
After a certain point of time, AVC increases
with respect to increase in output.
 Average Variable Costs (AVC):

• Thus, it is a U- shaped curve, as shown in

Figure.
 Average Cost (AC):

• Refer to the total costs of production per unit

of output.
• AC is calculated as:
AC = TC/ Output
• AC is also equal to the sum total of AFC and
AVC. AC curve is also U-shaped curve as
average cost initially decreases when output
increases and then increases when output
increases.
Average Cost (AC):
 Marginal Cost:

• Refer to the addition to the total cost for

producing an additional unit of the product.
• Marginal cost is calculated as:
MC = TCn = TCn-1
n= Number of units produced

It is also calculated as:

MC = ∆TC/∆Output
 Let us learn the aforementioned cost concepts
numerically with the help of Table
UNITS FIXED COST VARIABLE TOTAL AVERAGE MARGINAL AVERAGE AVERAGE
FIXED COST VARIABLE
(Q) (FC) COST (VC) COST (TC) COST (AC) COST (MC)
(AFC) COST
(AVC)

0 50 0 50 - - - -

1 50 20 70 70 20 50 20

2 50 30 80 40 10 25 15

3 50 32 82 27.3 2 16.6 10.6

4 50 34 84 21 2 12.4 8.5

5 50 40 90 18 6 10 8

6 50 58 108 18 18 8.3 9.6

7 50 83 133 19 25 7.1 11.9

 Marginal Cost:

• MC curve is also a U-shaped curve as marginal cost

initially decreases as output increases and afterwards,
rises as output increases. This is because TC increases at
decreasing rate and then increases at increasing rate.
 LONG RUN COST ANALYSIS
• In the long run, all the factors of production used by
an organization vary. The existing size of the plant or
building can be increased in case of long run.
• There are no fixed inputs or costs in the long run.
Long run is a period in which all the costs change as
all the factors of production are variable.
• There is no distinction between the Long run Total
Costs (LTC) and long run variable cost as there are
no fixed costs. It should be noted that the ability of
an organization of changing inputs enables it to
produce at lower cost in the long run.
 Long Run Total Cost:

• Long run Total Cost (LTC) refers to the minimum

cost at which given level of output can be
produced. According to Leibhafasky, “the long
run total cost of production is the least possible
cost of producing any given level of output when
all inputs are variable.” LTC represents the least
cost of different quantities of output. LTC is
always less than or equal to short run total cost,
but it is never more than short run cost.
 Long Run Total Cost:

• As shown in Figure, short run total costs curves; STC1,

STC2, and STC3 are shown depicting different plant sizes.
The LTC curve is made by joining the minimum points of
short run total cost curves. Therefore, LTC envelopes the
STC curves.
 Long Run Average Cost:

• Long run Average Cost (LAC) is equal to long run

total costs divided by the level of output. The
derivation of long run average costs is done from
the short run average cost curves. In the short
run, plant is fixed and each short run curve
corresponds to a particular plant. The long run
average costs curve is also called planning curve
or envelope curve as it helps in making
organizational plans for expanding production
and achieving minimum cost.
 Derive Long Run Average Cost:
• Suppose there are three sizes
of the plant and no other size
of the plant can be built. In
short run, the plant sizes are
fixed thus, organization
increase or decrease the
variable factors. However, in
the long run, the organization
can select among the plants
which help in achieving
minimum possible cost at a
given level of output.
• From Figure, it can be noted that till OB amount of
production, it is beneficial for the organization to operate
on the plant SAC2 as it entails lower costs than SAC 1. If the
plant SAC2 is used for producing OA, then cost incurred
would be more. Thus, in the long run, it is clear that the
producer would produce till OB on plant SAC 2. On SAC2, the
producer would produce till OC amount of output. If an
organization wants to exceed output from OC, it will be
beneficial to produce at SAC3 than SAC2.

• Thus, in the long run, an organization has a choice to use

the plant incurring minimum costs at a given output. LAC
depicts the lowest possible average cost for producing
different levels of output. The LAC curve is derived from
joining the lowest minimum costs of the short run average
cost curves.
• It first falls and then rises, thus it is U- shaped
curve. The returns to scale also affect the LTC
and LAC. Returns to scale implies a change in
output of an organization with a change in
inputs. In the long run, the output changes with
respect to change in all inputs of production.
• In case of increasing returns to scale (IRS),
organizations can double the output by using
less than twice of inputs. LTC increases less than
the increase in the output, thus, LAC falls. In case
of constant returns to scale (CRS), organizations
can double the output by using inputs twice.
 Long Run Marginal Cost:
• Long run Marginal Cost (LMC) is defined as
added cost of producing an additional unit of a
commodity when all inputs are variable. This
cost is derived from short run marginal cost.
On the graph, the LMC is derived from the
points of tangency between LAC and SAC.
• If perpendiculars are drawn from point A, B, and C,
respectively; then they would intersect SMC curves at
P, Q, and R respectively. By joining P, Q, and R, the
LMC curve would be drawn. It should be noted that
LMC equals to SMC, when LMC is tangent to the LAC.
• In Figure, OB is the output at which:
SAC2 = SMC2 = LAC = LMC
We can also draw the relation between LMC
and LAC as follows:

• When LMC < LAC, LAC falls

• When LMC = LAC, LAC is constant
• When LMC > LAC, LAC rises
ECONOMIES OF SCALE
 What is economies of scale?
• Economies of scale are the cost advantages that a business
obtains due to expansion. When economists are talking
about economies of scale, they are usually talking about
internal economies of scale. These are the advantages
gained by an individual firm by increasing its size i.e having
larger or more plants.
 What is diseconomies of scale?
• Diseconomies of scale are the disadvantages
of being too large. A firm that increases its
scale of operation to a point where it
encounters rising long run average costs is said
to be experiencing internal diseconomies of
scale.
 Internal and External economies of scale.

• Internal economies of scale :- lower long run

average costs resulting from a firm growing in
size.

• External economies of scale :- lower long run

average costs resulting from an industry growing
in size.
 Internal and external diseconomies of scale.

• Internal diseconomies of scale :-higher long run

average cost arising from a firm growing too large.

• External diseconomies of scale:- higher long run

average costs resulting from an industry growing
too large
 Types of Internal economies of scale.

• Buying economies
• Selling economies
• Managerial economies
• Financial economies
• Technical economies
• Research and development economies
• Risk-bearing economies.
 Buying Economies.
• These are the best known type. Large firms that
buy raw materials in bulk and place large orders
for capital equipment usually receive a discount.
This means that they have paid less for each item
purchased. They may receive a better treatment
because the suppliers will be anxious to keep
such large customers.
 Selling Economies.
• Every part of marketing has a cost – particularly
promotional methods such as advertising and running a
sales force. Many of these marketing costs are fixed
costs and so as a business gets larger, it is able to spread
the cost of marketing over a wider range of products
and sales – cutting the average marketing cost per unit.
 Managerial Economies.
• As a firm grows, there is
greater potential for managers
to specialize in particular tasks
(e.g. marketing, human
resource management,
finance). Specialist managers
are likely to be more efficient
as they possess a high level of
expertise, experience and
qualifications compared to one
person in a smaller firm trying
to perform all of these roles.
 Financial economies
• Many small businesses find it hard
to obtain finance and when they
do obtain it, the cost of the
finance is often quite high. This is
because small businesses are
perceived as being riskier than
larger businesses that have
developed a good track record.
Larger firms therefore find it
easier to find potential lenders
and to raise money at lower
interest rates.
 Technical Economies.
• Businesses with large-scale production can use
more advanced machinery (or use existing
machinery more efficiently). This may include
using mass production techniques, which are
a more efficient form of production. A larger
firm can also afford to invest more in research
and development.
Research and development economies.
• A large firm can have a research and
development department, since running such
a department can reduce average costs by
developing more efficient methods of
production and raise total revenue by
developing new products.
 Risk-bearing economies.
• Larger firms produce a range of products. This
enables them to spread the risks of trading. If
the profitability of one of the products it
produces falls, it can shift its resources to the
production of more profitable products.
 Internal Diseconomies of scale.
• Growing beyond a certain output can cause a
firms average costs to rise. This is because the
firm may encounter a number of problems
including difficulties :-
• controlling the firm.
• communication problems.
• poor industrial relations.
 Difficulty controlling the firm.
 It can be hard for those managing
a large firm to supervise
everything that is happening in
the business.
 Management becomes more
complex and meetings are
necessary quite often.
 This can increase administrative
costs and make the firm slower in
responding to changes in
marketing conditions.
 Communication problems.
• Difficult to ensure that everyone is aware
about their duties in a large firm and available
opportunities like training etc.
• The may not get a chance to exchange their
views and innovative ideas to the
management team.
 Poor industrial relations.
• Higher risk for larger firms as there will be
more conflicts and diverse opinions.
• Lack of motivation of workers, strikes will be
seen at certain situations in larger firms due to
poor industrial relations.
 External economies of scale.
• A skilled labour workforce – A firm
can recruit workers who have been
trained by other firms in the
industry.
• A good reputation – An area can
gain a reputation for high quality
production.
• Specialist suppliers of raw
materials and capital goods –
When an industry becomes large
enough, it can become worthwhile
for other industries, called
subsidiary industries to set up for
providing for the needs of the
industry.
 External economies of scale.
• Specialist services – Universities and
colleges ma run courses for workers in
large industries and banks and transport
firms may provide services, specially
designed to meet the particular needs of
firms in the industry.
• Specialist markets – Some large
industries have specialist selling places
and arrangements such as insurance
markets.
• Improved infrastructure – The growth of
an industry may encourage a govt and
private sector firms to provide better
road links, electricity supplies, build new
airports and develop dock facilities.
 External Diseconomies of scale.
• Just as a firm can grow too
large, so can an industry.
• Larger firms ->
transportation increase ->
congestion -> increased
journey time -> high
transport cost -> reduced
workers productivity.
• Growth of industry may
increase competition for
resources, pushing up the
price of key sites, capital
equipment and labour.
Law of variable proportion
 Law of variable proportion
• The law of variable proportions states that as the
quantity of one factor is increased, keeping the
other factors fixed, the marginal product of that
factor will eventually decline. This means that up
to the use of a certain amount of variable factor,
marginal product of the factor may increase and
after a certain stage it starts diminishing. When
the variable factor becomes relatively abundant,
the marginal product may become negative.
 Assumptions of the Law

• Only one factor is variable while others are held

constant.
• All units of the variable factor are
homogeneous.
• There is no change in Technology.
• It is possible to vary the proportions in which
different inputs are combined.
• The products are measured in physical units,
i.e., in quintals, tonnes etc.
Total Product or Output (TP):
• It refers to the total volume of goods produced
during a specified period of time.
• Total product (TP)can be raised only by
increasing the quantity of variable factors
employed in production.
Average Product (AP):
• Average product can be known by dividing
total product by the total number of units of
the variable factor.
• TP/Q
• Eg- 450/5=90
 Marginal Product or Output (MP)
• It is output derived from the employment of
an additional unit of variable factor unit.
• The rate at which total product increases
is known as marginal product.
• Addition to the total product resulting
from a unit increase in the quantity of the vari
able factor.
Relationship between AP and MP
• When AP rises as a result of an increase in the
quantity of variable input, MP is more then the
average product.
• When AP are maximum then MP is equal to AP.
The MP curve cuts the AP curve at its
maximum.
• When AP falls as a result of decrease in quantity
of variable input, MP is less than the AP.
 Illustration of the Law:
The law of variable proportion is illustrated in the following table and
figure. Suppose there is a given amount of land in which more and
more labour (variable factor) is used to produce wheat.

Units of Total Product Marginal Average Product

labour product

1 2 2 2
2 6 4 3
3 12 6 4
4 16 4 4
5 18 2 3.6
6 18 0 3
7 14 -4 2
8 8 -6 1
 Three Stages of the Law of Variable
Proportions:
These stages are illustrated in the following figure where labour is measured on the X-axis and
output on the Y-axis.
• Stage 1. Stage of Increasing Returns:
• In this stage, total product increases at an increasing rate up to a
point. This is because the efficiency of the fixed factors increases
as additional units of the variable factors are added to it.
• In the figure, from the origin to the point F, slope of the total
product curve TP is increasing i.e. the curve TP is concave
upwards up to the point F, which means that the marginal
product MP of labour rises. The point F where the total product
stops increasing at an increasing rate and starts increasing at a
diminishing rate is called the point of inflection.
• Corresponding vertically to this point of inflection marginal
product of labour is maximum, after which it diminishes. This
stage is called the stage of increasing returns because the
average product of the variable factor increases throughout this
stage. This stage ends at the point where the average product
curve reaches its highest point.
Stage 2. Stage of Diminishing Returns:
• In this stage, total product continues to increase but
at a diminishing rate until it reaches its maximum
point H where the second stage ends. In this stage
both the marginal product and average product of
labour are diminishing but are positive. This is
because the fixed factor becomes inadequate relative
to the quantity of the variable factor. At the end of the
second stage, i.e., at point M marginal product of
labour is zero which corresponds to the maximum
point H of the total product curve TP. This stage is
important because the firm will seek to produce in
this range.
Stage 3. Stage of Negative Returns:
• In stage 3, total product declines and
therefore the TP curve slopes downward. As a
result, marginal product of labour is negative
and the MP curve falls below the X-axis. In this
stage the variable factor (labour) is too much
relative to the fixed factor.
LAW OF RETURN TO SCALE
 LAW OF RETURN TO SCALE
• In the long run all factors of production are
variable. No factor is fixed. Accordingly, the
scale of production can be changed by
changing the quantity of all factors of
production.
• Definition:
• “The term returns to scale refers to the
changes in output as all factors change by the
same proportion.” Koutsoyiannis
• Returns to scale are of the following three
types:

• 1. Increasing Returns to scale.

• 2. Constant Returns to Scale
• 3. Diminishing Returns to Scale
Explanation:
• In the long run, output can be increased by
increasing all factors in the same proportion.
Generally, laws of returns to scale refer to an
increase in output due to increase in all factors
in the same proportion. Such an increase is
called returns to scale.

Suppose, initially production function is as

follows:
P = f (L, K)
After considering all the above assumptions, the changes in inputs
at the same level led to proportional changes in the production
process during the long term at the same level of technology. The
input changes can lead to three types of proportional output:
constant, increasing, or decreasing/diminishing returns to scale.
INCREASING RETURN TO SCALE
Increasing Returns to Scale
The Causes of Increasing Returns To Scale

1. Technical and managerial indivisibilities

2. Higher degree of specialization
3. Dimensional relations
CONSTANT RETURN TO SCALE
Constant returns to scale
 Constant returns to scale
• When the change in output is proportional to
the change in inputs, it exhibits constant
returns to scale.
 Constant returns to scale
• The constant returns to scale are attributed to
the limits of the economies of scale. With
expansion in the scale of production,
economies arise from such factors as
indivisibility of fixed factors, greater possibility
of specialization of capital and labor, use of
labor saving techniques of production, etc.
DECREASING RETURN TO SCALE
Decreasing returns to scale
 Decreasing returns to scale
• The firms are faced with decreasing returns to
scale when a certain proportionate change in
inputs, k & l, lead to less than proportionate
change in output.
 Causes of Diminishing return to scale
• The decreasing returns to scale are attributed
to the diseconomies of scale. The most
important factor causing this is ‘the
diminishing return to management’. Another
factor is the exhaustibility of natural
resources.
 REVENUE
• The term revenue refers to the income obtained by
a firm through the sale of goods at different prices.
In the words of Dooley, ‘the revenue of a firm is its
sales, receipts or income’.
• The revenue concepts are concerned with Total
Revenue, Average Revenue and Marginal Revenue.
• 1. Total Revenue:
• The income earned by a seller or producer after
selling the output is called the total revenue. In
fact, total revenue is the multiple of price and
output. The behavior of total revenue depends
on the market where the firm produces or sells.
• Average Revenue:
• Average Revenue (AR) can be defined as revenue per unit
of output. In the words of McConnell, “Average revenue is
the per unit revenue received from the sale of a
commodity.”
• AR is calculated as:
• AR = TR/Q
• Therefore, from the aforementioned equation, it can be
said that AR is the rate at which output is sold, where rate
refers to the price of the product.
• We know that TR equals P*Q, thus,
• AR = (P*Q)/Q
• AR = P
• Hence, it can be said that AR is nothing, but price of the
product.
• Marginal Revenue:
• Marginal revenue (MR) can be defined as additional revenue gained from
the additional unit of output. In the words of Ferugson, “Marginal revenue
is the change in total revenue which results from the sale of one more or
one less unit of output.”
• It can be calculated as follows:
• MR = ∆TR/ ∆Output
• Or
• MR = TRn – TRn-1
• Let us understand the concept of MR with the help of an example. For
instance, if 10 units of a good are sold for Rs. 100 and 11 units for Rs. 108.
Calculate MR.
• It is calculated as:
• Total units sold = n = 11 units
• Total units less last unit sold = n – 1 = 10 units
• MR = TRn – TRn-1
• =TR11 – TR10
• = 108 – 100
• = Rs. 8
Revenue curve under perfect competition:
• Perfect competition is the term applied to a situation
in which the individual buyer or seller (firm) represent
such a small share of the total business transacted in
the market that he exerts no perceptible influence on
the price of the commodity in which he deals.
• Thus, in perfect competition an individual firm is price
taker, because the price is determined by the collective
forces of market demand and supply which are not
influenced by the individual. When price is the same
for all units of a commodity, naturally AR (Price) will be
equal to MR i.e., AR = MR. The revenue schedule for a
competitive firm is shown in the table
• In table, we find that as output increases, AR
remains the same i.e. Rs. 5. Total revenue
increases but at a constant rate. Marginal revenue
is also constant i.e. Rs. 5 and is equal to AR.
Thus,
• TR = AR x Q
• Also TR = MR x Q [Since AR = MR]
In the above figure, output and revenue are measured on, the X – axis and
the Y – axis respectively. TR is the total revenue curve sloping upward, left to
right at 45. It indicates that the total revenue varies directly and positively
with the sales quantity. AR and MR are average revenue curve and marginal
revenue curves respectively.
Both curves slope horizontal or parallel to the X–axis. MR coincides with AR.
AR is the firm’s demand curve and it is perfectly elastic (i.e. ep = ∞). The
slope of these curves indicates that both AR and MR remain unchanged at
each increasing level of output.
Revenue Curve under Imperfect Competition:

• When a firm is working under conditions of monopoly or

imperfect competition, its demand curve or AR curve is
less than perfectly elastic, the exact degree of elasticity
being different in different market situations depending
upon the number of sellers and the nature of product.
• In other words, the demand/AR curve has a negative
slope and the MR curve lies below it. This is because the
monopolist seller ordinarily has to accept a lower price
for his product, as he increases his sales.
• Under imperfect competition conditions, total revenue
increases at a diminishing rate. It becomes maximum
and then begins to decline.
 The position of various revenue curves is
shown in Table

In table 7, 2 units can be sold at a unit price of Rs. 5, bringing in total

revenue of Rs. 10. When 3 units are sold, the price per unit is lowered to
Rs. 4 to make it possible for larger quantity to be sold. The total revenue in
this case is Rs. 12.

The marginal unit is not bringing in Rs. 4 which is its price, but only Rs. 2.
This is because the additional one unit is sold at Re. one less and the first 2
units which could have been sold for Rs. 5 are also sold at Rs. 4. i.e., Re.
one less.
Fig. A shows that as additional units are sold when price comes down not only for
the marginal units but also for other previous units. As a result, marginal units do
not bring revenue equal to its price. In fig. 10 B. TR increases at a diminishing rate,
becomes maximum at point N and then begins to decline. This has been
represented by the curve TR. AR at any point on the TR curve is given by the slope
of straight line joining the point to the origin. For instance, AR at any point N on TR
curve is given by the slope of line