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Cost Concepts

Have some review of the following:

Legend/ Symbols Meaning of the Acros Formula to Solve Prescriptions

them
Q Quantity or Output Usually these are Cost analysis and Decision
given
P Price Usually these are Cost analysis and Decision
given
LI Labor Input Usually these are Cost analysis and Decision
given
TFC Total Fix Cost TC- TVC Cost analysis and Decision
TVC Total Variable Cost TC-TFC Cost analysis and Decision
AFC Average Fix Cost TFC/Q Cost analysis and Decision
AVC Average Variable Cost TVC/Q Cost analysis and Decision
TC Total Cost TFC + TVC Cost analysis and Decision
ATC Average Total Cost TC/Q Cost analysis and Decision
MC Marginal Cost ∆Q/∆LI Cost analysis and Decision
TR Total Revenue P*Q Cost analysis and Decision
TPr or Total Loss Total Profit if positive TR - TC Cost analysis and Decision
(+,-) Total Loss id negative

Costs play a very important role in managerial decisions involving a selection between alternative
courses of action. It helps in specifying various alternatives in terms of their quantitative values. The kind
of cost to be used in a particular situation depends upon the business decisions to be made.

Costs enter into almost every business decision and it is important to use the right analysis of cost.
Hence, it is important to understand what these various concepts of costs are, how these can be defined
and operationalised. This requires the understanding of the two things, namely, (i) that cost estimates
produced by conventional financial accounting are not appropriate for all managerial uses, and (ii) that
different business problems call for different kinds of costs.

Future and Past Costs

Futurity is an important aspect of all business decisions. Future costs are the estimates of time adjusted
past or present costs and are reasonably expected to be incurred in some future period or periods. Their
actual incurrence is a forecast and their management is an estimate. Past costs are actual costs incurred
in the past and they are always contained in the income statements. Their measurement is essentially a
record keeping activity.

Incremental and Sunk Costs

Incremental costs are defined as the change in overall costs that result from particular decisions being
made. Incremental costs may include both fixed and variable costs. In the short period, incremental cost
will consist of variable cost — costs of additional labour, additional raw materials, power, fuel, etc. —
which is the result of a new decision being taken by the firm. Since these costs can be avoided by not
bringing about any change in the activity, incremental costs are also called avoidable costs or escapable
costs. They are also called differential costs. Sunk cost is one which is not affected or altered by a change
in the level or nature of business activity. It will remain the same whatever the level of activity.

Example: The most important example of sunk cost is the amortisation of past expenses, e.g.,
depreciation.

Out-of-Pocket and Book Costs

Out-of-pocket costs are those that involve immediate payments to outsiders as opposed to book costs
that do not require current cash expenditure.

Example: Wages and salaries paid to the employees are out-of-pocket costs while salary of the owner
manager. If not paid, it is a book cost. The interest cost of owner's own fund and depreciation cost are
other examples of book costs. Book costs can be converted into out-of-pocket costs by selling assets and
leasing them back from the buyer.

Replacement and Historical Costs

Historical cost of an asset states the cost of plant, equipment and materials at the price paid originally
for them, while the replacement cost states the cost that the firm would have to incur if it wants to
replace or acquire the same asset now.

Managerial Economics

Notes

Example: If the price of bronze at the time of purchase, say, in 1974, was 15 a kg and if the present price
is 18 a kg, the original cost of 15 is the historical cost while 18 is replacement cost. Replacement cost
means the price that would have to be paid currently for acquiring the same plant.

Explicit Costs and Implicit or Imputed Costs (Accounting Concept of Cost and Economic Concept of Cost)

Explicit costs are those expenses which are actually paid by the firm (paid-out-costs). These costs appear
in the accounting records of the firm. On the other hand, implicit costs are theoretical costs in the sense
that they go unrecognised by the accounting system. These costs may be defined as the earnings of
those employed resources which belong to the owner himself.

Actual Costs and Opportunity Costs

Actual costs mean the actual expenditure incurred for acquiring or producing a good or service. These
costs are the costs that are generally recorded in books of account, for example, actual wages paid, cost
of materials purchased, interest paid, etc.

Notes The concept of opportunity cost occupies a very important place in modern economic analysis.
The opportunity costs or alternative costs are the returns from the second best use of the firm's
resources which the firm forgoes in order to avail itself of the returns from the best use of the resources.
To take an example, a farmer who is producing wheat can also produce potatoes with the same factors.
Therefore, the opportunity cost of a quintal of wheat is the amount of the output of potatoes given up.
Thus, we find that the opportunity cost of anything is the next best alternative that could be produced
instead by the same factors or by an equivalent group of factors, costing the same amount of money.
Two points must be noted in this definition. Firstly, the opportunity cost of anything is only the next best
alternative foregone. Secondly, in the above definition it is the addition of the qualification "or by an
equivalent group of factors costing the same amount of money".

Direct (or Separable or Traceable) Costs and Indirect (or Common or Non-traceable) Costs

There are some costs which can be directly attributed to the production of a unit of a given product.
Such costs are direct costs and can easily be separated, ascertained and imputed to a unit of output.
This is because these costs vary with the output units. However, there are other costs which cannot be
separated and clearly attributed to individual units of production. These costs are, therefore, classified
as indirect costs in the accounting process.

Shut-down and Abandonment Costs

Shut-down costs are required to be incurred when the production operations are suspended and will
not be necessary if the production operations continue. When any plant is to be permanently closed
down, some costs are to be incurred for disposing off the fixed assets. These costs are called
abandonment costs.

Private and Social Costs

Economic costs can be calculated at two levels: micro-level and macro-level. The micro-level economic
costs relate to functioning of a firm as a production unit, while the macro-level economic costs are the
ones that are generated by the decisions of the firm but are paid by the society and not the firm. Private
costs are those which are actually incurred or provided for by an individual or a firm for its business
activity. Social cost, on the other hand, is the total cost to the society on account of production of a
good. Thus, the economic costs include both private and social costs. Above are the some concepts of
costs. But the important cost concepts which play crucial role in managerial decision-making are as
follows:

8.2 Fixed and Variable Costs

There are some inputs or factors which can be adjusted with the changes in the output level. Thus, a
firm can readily employ more workers if it has to increase output. Likewise, it can secure and use more
raw materials, more chemicals, without much delay, if it has to expand production. Thus, labour, raw
materials, chemicals are the factors which can be readily varied with the change in output. Such factors
are called variable factors.

On the other hand, there are factors such as capital equipment, building, top management personnel
which cannot be readily varied— it requires a comparatively long time to make variations in them. The
factors such as capital equipment, building, which cannot be readily varied and require a comparatively
long time to make adjustment in them are called fixed factors.

Therefore, fixed costs are those which are independent of output, i.e., they do not change with changes
in output. These costs are a "fixed" amount which must be incurred by a firm in the short run, whether
the output is small or large. Fixed costs are also known as overhead costs and include charges such as
contractual rent, insurance fee, maintenance costs, property taxes, interest on the capital invested,
minimum administrative expenses such as manager's salary, watchman's wages, etc. Thus, fixed costs
are those which are incurred in hiring the fixed factors of production whose amount cannot be altered in
the short run.

Variable costs, on the other hand, are those costs which are incurred on the employment of variable
factors of production whose amount can be altered in the short run. Thus, the total variable costs
change with changes in output in the short run. These costs include payments such as wages of labour
employed, the price of the raw material, fuel and power used, the expenses incurred on transporting
and the like. Variable costs are also called prime costs. Total cost of a business firm is the sum of its total
variable costs and total fixed costs. Thus, TC = TFC+TVC.

Output is measured on the X-axis and cost on Y-axis. Since the total fixed cost remains constant
whatever the level of output, the total fixed cost curve (TFC) is parallel to the X-axis. This curve starts
from a point on the Y-axis meaning thereby that the total fixed cost will be incurred even if the output is
zero.

On the other hand, the total variable cost curve (TVC) rises upward showing thereby that as the output
is increased, the total variable costs also increase. The total variable cost (TVC) starts from the origin
which shows that when output is zero the variable costs are also nil. It should be noted that total cost is
a function of the total output, the greater the output, the greater will be the total cost. In symbols, we
can write: TC = f(q)

Short Run Total Cost Curve

Total cost curve (TC) has been obtained by adding up 'vertically' the total fixed cost curve and total
variable cost curve because the total cost is a sum of total fixed cost and total variable cost. The shape of
the total cost curve (TC) is exactly the same as that of total variable cost curve (TVC) because the same
vertical distance always separates the two curves.

Short Run and Long Run Costs

The short run is a period of time in which the output can be increased or decreased by changing only the
amount of variable factors such as labour, raw materials, chemicals, etc. In the short run the firm cannot
build a new plant or abandon an old one. If the firm wants to increase output in the short run, it can
only do so by using more labour and more raw materials. It cannot increase output in the short run by
expanding the capacity of its existing plant or building a new plant with larger capacity. Long run, on the
other hand, is defined as the period of time in which the quantities of all factors may be varied. All
factors being variable in the long run, the fixed and variable factors dichotomy holds good only in the
short run. In other words, it is that time-span in which all adjustments and changes are possible to
realise.

Short run costs are those costs that can vary with the degree of utilization of plant and other fixed
factors. In other words, these costs relate to the variation in output, given plant capacity. Short run costs
are therefore, of two types: fixed costs and variable costs. In the short run, fixed costs remain
unchanged while variable costs fluctuate with output. Long run costs in contrast are costs that can vary
with the size of the plant and with other facilities normally regarded as fixed in the short run. In fact, in
the long run there are no fixed inputs and therefore, no fixed costs, i.e., all costs are variable.

8.3.1 Short Run Average Costs and Output

The cost concept is more frequently used both by businessmen and economists in the form of cost per
unit or average cost rather than as totals. We, therefore pass on to the study of short run average cost
curves.
Short Run Average Fixed Cost (AFC)

Average fixed cost is the total fixed cost divided by the number of units of output produced. Therefore,
TFCAFC Q where Q represents the number of units of output produced.

Thus, average fixed cost is the fixed cost per unit of output. Since total fixed cost is a constant quantity,
average fixed cost will steadily fall as output increases. Therefore, average fixed cost curve slopes
downward throughout its length. As output increases, the total fixed cost spreads over more and more
units and, therefore, average fixed cost becomes less and less.