Managerial Economics

Final Term

Cost Analysis

anupam|Lecturer|DMS|CU
What you will learn in this chapter :

Having gone through this unit, you will be expected to::

1. Be familiar with the theory of production costs
2. Expand your knowledge of the theory of costs
3. Estimate the costs of business operations
4. Cost – Output relations with respect to short-run and
long-run.
5. Apply cost functions in the minimisation of costs of
production.
6. Optimum plant size and long-run cost curves.
7. Analysis of Break-even point.
anupam|Lecturer|DMS|CU
 INTRODUCTION

Business decisions are generally taken based on the

monetary values of inputs and outputs. Note that the quantity
of inputs multiplied by their respective unit prices will give the
monetary value or the cost of production. Production cost is an
important factor in all business decisions, especially those
decisions concerning:

(a) the location of the weak points in production

management;
(b) cost minimization
(c) finding the optimal level of output;
(d) determination of price and dealers’ margin; and,
(e) estimation of the costs of business operation.

“Cost” has different meaning under different setting and is subject

to varying interpretations.
anupam|Lecturer|DMS|CU
 The Theory of Production Costs/
The Business Cost Concepts

The cost concepts are theoretically grouped under two

over-lapping categories on the basis of their nature and
purpose

(i) Concepts used for accounting purposes; and,

(ii) Analytical cost concepts used in economic analysis of
business activities.

It is important to note here that this classification of

cost concepts is only a matter of analytical convenience.

anupam|Lecturer|DMS|CU
 Some Accounting Cost Concepts

The accounting cost concepts include:

1.Opportunity Cost and Actual Cost

Opportunity cost can be seen as the expected returns

from the second best use of an economic resource which is
foregone due to the scarcity of the resources. Some scholars
refer to opportunity cost as alternative cost. There would be
no opportunity cost if the resources available to the society
were unlimited.

For example- a firm wants to buy two machine: A-10000 , B-

10000 and rate of return are 1000 and 1500. If the
businessman choose second option, the opportunity cost of B is
1000.

anupam|Lecturer|DMS|CU
 Continuted…

Associated with the concept of opportunity cost is the

concept of economic rent or economic profit. Economic rent is
the excess of earning from investment over and above the
expected profit. The business implication of this concept is that
investing in a given project will be preferred so long as its
economic rent is greater than zero or positive.

Additionally, if firms know the economic rent of various

alternative uses of their resources, it will aid them in the choice
of the best investment avenue.

The actual costs are those which are actually incurred by the
firm in payment of labour, materials, machine, plant, building,
equipment, travelling , transport and other factors of
production.

anupam|Lecturer|DMS|CU
 Continued…

2.Business Costs and Full Cost

All the expenses incurred to carry out a business are

referred to as business costs. These are similar to actual or real
costs, and include all the payments and contractual
obligations made by the firm, together with the book cost of
depreciation on plant and equipment. Business costs are those
used in calculating business profits and losses and for filing
returns for income tax and for other legal purposes.

Full costs include business costs, opportunity costs and

normal profit, while normal profit represents a necessary
minimum earning in addition to the opportunity cost, which a
firm must receive to remain in business.

anupam|Lecturer|DMS|CU
 Continued…

3. Explicit and Implicit/Imputed Costs

Explicit Costs are those falling under actual or business

costs and are those entered in the books of accounts. Payments
for wages and salaries, materials, insurance premium,
depreciation charges are examples of explicit costs. These costs
involve cash payments and are recorded in accounting
practices.

On the contrary, Those costs that do not involve cash

payments and do not appear in the business accounting system
are referred to as implicit or imputed costs. Implicit costs are
not taken into account while calculating the loss or gains of the
business. The explicit and implicit costs together (explicit +
implicit costs) form the economic cost.

anupam|Lecturer|DMS|CU
 Continued…

3. Out-of-Pocket and Book Costs

Expenditure items that involve cash payments or cash

transfers, both recurring and non-recurring, are referred to in
economics as out-of pocket costs. All the explicit costs
including wages, rent, interest, cost of materials, maintenance,
transport expenditures, and the like are in this classification.

On the contrary, there exists some actual business costs

which do not involve cash payments, but a provision is made in
the books of account and they are taken into account while
finalizing the profit and loss accounts. Such costs are known as
book costs. These are somehow, payments made by a firm to
itself.

anupam|Lecturer|DMS|CU
 Some Analytical Cost Concepts

The analytical cost concepts include:

1.Fixed and Variable Costs

Fixed costs (FC) are those costs that are fixed in volume
for a certain level of output. They do not vary with output. They
remain constant regardless of the level of output. Fixed costs
include:

(i) Cost of managerial and administrative staff;

(ii) Depreciation of machinery;
(iii) Land maintenance, and the like.

Fixed costs are normally short-term concepts because,

in the long-run, all costs must vary.

anupam|Lecturer|DMS|CU
 Continued…

Variable Costs (VC) are those that vary with variations in

total output. These include:
(i) Cost of raw materials;
(ii) Running costs of fixed capital, such as fuel, repairs,
routine maintenance expenditure, direct labour charges
associated with output levels; and
(iii) the Costs of all other inputs that may vary with the
level of output.

2.Total, Average, and Marginal Costs.

The Total Cost (TC) refers to the total expenditure on

the production of goods and services. It includes both explicit
and implicit costs. The explicit costs themselves are made up of
fixed and variable costs. For a given level of output, the total
cost is determined by the cost function.
anupam|Lecturer|DMS|CU
 Continued…

The Average cost (AC) is of statistical nature- it is not

actual cost and obtained by dividing total cost (TC) by total
output (Q). TC
AC 
Q

Marginal Cost (MC) is the addition to total cost on

account of producing one additional unit of a product. It is the
cost of the marginal unit produced.

Marginal cost of output can be computed as TCn – TCn-

1, where n represents the current number of units produced,
and n-1 represents the previous number of units produced. MC
can also be computed by the following relationship:

 TC Change in cos t
MC  
Q Change in quantity
anupam|Lecturer|DMS|CU
 Continued…

3. Short-Run and Long-Run Costs.

Short-Run Costs are costs which change as desired

output changes, size of the firm remaining constant. These
costs are often referred to as variable costs. It is important to
note that the running cost and depreciation of capital assets
are included in short-run or variable cost.

Long-Run costs, on the other hand are costs incurred

on the firm’s fixed assets, such as plant, machinery, building,
and the like. In the long-run, all costs become variable costs as
the size of the firm or scale of production increases. Put
differently, long-run costs are associated with changes in the
size and type of plant.

anupam|Lecturer|DMS|CU
 Continued…

4. Incremental Costs and Sunk Costs

Conceptually, incremental costs are closely related to

the concept of marginal cost, but with a relatively wider
connotation. While marginal cost refers to the cost of extra or
one more unit of output, incremental cost refers to the total
additional cost associated with the decision to expand output
or to add a new variety of product.

The concept of incremental cost is based on the fact

that, in the real world, it is not practicable to employ factors for
each unit of output separately due to lack of perfect divisibility
of inputs.

anupam|Lecturer|DMS|CU
 Continued…

Incremental costs also arise as a result of change in

product line, addition or introduction of a new product,
replacement of worn out plant and machinery, replacement of
old technique of production with a new one, and the like.

The Sunk costs are those costs that cannot be altered,

increased or decreased, by varying the rate of output.

For instance, once management decides to make

incremental investment expenditure and the funds are
allocated and spent, all preceding costs are considered to be
the sunk costs since they accord to the prior commitment and
cannot be reversed or recovered when there is a change in
market conditions or a change in business decisions..

anupam|Lecturer|DMS|CU
 Continued…

5.Historical and Replacement Costs

Historical cost refers to the cost an asset acquired in

the past whereas replacement cost refers to the outlay made
for replacing an old asset. These concepts derive from the
unstable nature of price behavior. When prices become stable
over time, other things being equal, historical and replacement
costs will be at par with each other.

Historical cost of assets is used for accounting purpose,

in the assessment of the net worth of the firm. The
replacement cost figures in business decisions regarding the
renovation of the firm.

anupam|Lecturer|DMS|CU
 Continued…

6. Private and Social Costs

Private and social costs are those costs which arise as a

result of the functioning of a firm, but neither are normally
reflected in the business decisions nor are explicitly borne by
the firm. Costs in this category are borne by the society. It
follows that the total cost generated in the course of doing
business may be divided into two categories:

(i) those paid out by the firm; and,

(ii) those not paid or borne by the firm,
including the use of resources that are
freely available.

anupam|Lecturer|DMS|CU
 Continued…

Costs under the first category are known as private

costs. Those of the second category are known as external or
social costs. Examples of such social costs include: water
pollution from oil refineries, air pollution costs by mills and
factories located near a city, and the like.

From a firm’s point of view, such costs are classified as

external costs, and from the society’s point of view, they are
classified as social costs.

The relevance of the concept of social costs is more

pronounced in the cost-benefit analysis of the overall impact of
a firm’s operation in the society as a whole, and in working out
the social cost of private gains.

anupam|Lecturer|DMS|CU
 The Theory of Cost: The Cost-Output Relations

The theory of costs basically deal with costs in

relation to output changes. In other words, they deal with cost-
output relations. The basic economic principle states that total
cost increases with increase in output. However, what is
important from a theoretical and marginal point of view is not
the absolute increase in total cost, but the direction of change
in the average cost (AC) and the marginal cost (MC). The
direction of changes in AC and MC will depend on the nature of
the cost function.
A cost function is a symbolic statement of the
technological relationship between the cost and output.
Generally, cost functions take the following form:

C = TC = f(Q), and ΔTC /ΔQ > 0,

where Q represents output level.

anupam|Lecturer|DMS|CU
 The Short-Run Cost-Output Relations

Cost-output relations are normally determined

by the cost function and are exhibited by cost curves. The
shape of cost curves depends on the nature of the cost
function which are derived from actual cost data. Cost
functions may take a variety of forms, yielding different kinds of
cost curves, including linear, quadratic, and cubic cost curves
arising from the corresponding functions. The functions are as
illustrated below: The basic analytical cost concepts are

TC  TFC  TVC
TC TFC  TVC TFC TVC
AC      AFC  AVC
Q Q Q Q
In short  run , TC  TVC , where Q  1, MC  TVC

TC  TC
MC  
Q Q
anupam|Lecturer|DMS|CU
 The Short-Run Cost Functions & Cost Curves

Cost-output relations are normally determined

by the cost function and are exhibited by cost curves. Cost
functions may take a variety of forms, yielding different kinds of
cost curves, including linear, quadratic, and cubic cost curves
arising from the corresponding functions.

1. Linear Cost Function:

TC = C = a + bQ
2. Quadratic Cost Function:
TC = C = a + bQ + Q2

3. Cubic Cost Function:

TC = C = a + bQ - cQ2 + Q3

anupam|Lecturer|DMS|CU
 Some Important Cost Relationships

a) Over the range of output AFC and AVC fall, AC also falls.

b)When AFC falls but AVC increases, change in AC depends

i) If decrease in AFC > Increase in AVC, then AC falls
ii) If decrease in AFC = Increase in AVC, then AC constant
iii) If decrease in AFC < Increase in AVC, then AC increase

c)The relationship between AC and MC is a varied of nature

i) When MC falls, AC follows
ii) When MC Increases, AC also increases
iii) MC intersects AC at its minimum.

anupam|Lecturer|DMS|CU
 Critical Values & Cost Minimisation

In its simplest form, the critical value of output

(Q) in respect of the average variable cost (AVC) is the value
that minimizes average variable cost (AVC). The average
variable cost will be at its minimum when its rate of change
{d(AVC)} = 0.

The same argument can be made for average

total cost (ATC). Given the ATC function, you can set the
derivative with respect to Q { (d(ATC) } = 0,

Output Optimization In Short-run

The optimum level of output in the short-run is the
level of output for which the average cost (AC) of
production equals the marginal cost (MC). That is, for
optimum output, AC = MC in the short-run.

anupam|Lecturer|DMS|CU
 PROBLEMS

1.The cost function of firm is given by the following equation

C = 300x - 10x2 + x3/3
Calculate: i) Output at which MC is minimum
ii) Output at which AC is minimum
iii) Output at which AC = MC.
2. Firm has the following short run total cost function
C (Q) = Q3 – 9Q2 + 30Q + 25
i) Derive the AVC function and show that when AVC is
minimum, MC = AVC
ii) Derive the ATC function and check that when Q = 5,
ATC is minimum and MC = ATC.
anupam|Lecturer|DMS|CU
3. The marginal cost function of producer is given by
MC = f(x) = 10 - 0.01x – 0.0009x2
Find the total cost function and the average cost
function, if the cost of producing 10 units is tk. 105.

4.You are given the following information of firms total fixed

cost is tk. 100, variable cost varies of a constant rate of tk. 10
per unit in response to output. If price for the firms product is
tk. 15 per unit then calculate BEP.
5. Firm has the following short run total cost function
C (Q) = 0.05Q3 – 0.9Q2 + 6Q + 10
i) Derive the AVC function and show that when AVC is
minimum, MC = AVC
ii) Derive the ATC function and check that when Q = 10,
ATC is minimum and MC = ATC.

anupam|Lecturer|DMS|CU
Dear AllThank you for sharing your valuable views.
I think we can concentrate on:
1. economic concept of costs
2. cost functions (both short run and long run)
3. Profit contribution analysis
4.estimate the short run cost functions

We can also advice our students to prepare the following questions and
problems from the text:

Questions: 7-1, 7-8, 

Problems: 7-1, 7-2, 7-3, 7-4, 7-5, 7-7, 7-8, 7-16, 7-17, 7-18, and 7-19

Hope this will be ok. 

Thanks and regards.... 
Hasmat