COST ANALYSISS

The concept of cost forms an integral part of economics. In fact it is one of the
important forces that influence the volume of output, supply, sales and price of goods of a
firm or an industry.

What do you mean by cost of production? Or explain cost of production.

The term cost of production means the expenses incurred in the production of a
commodity. This refers to the total amount of money spent on the production of the
commodity. The term cost of production may be used in three different senses. It may mean
money cost, real cost and opportunity cost.

What are the various types of cost? Or explain the different kinds of cost.
Money cost:
Money cost is the total expenses incurred to produce a commodity. It includes the
rent of the land, wage and salaries of labour, interest of the capital, profit of organization, cost
of raw materials and expenditure on machines, equipments and so on.
Explicit cost and implicit cost:
The total money cost of producer of a firm includes both explicit cost and implicit
cost.
Explicit cost are those expenses incurred by a firm by way of paying remuneration to
the factors, prices for materials of all kinds, charges for maintenance and so on. In other
words, explicit costs are paid-out costs.
Implicit costs, on the other hand, refers to the costs of self owned or self employed
resources and services of an entrepreneur or proprietor. E.g., salary for proprietor, return for
his investment.
Fixed cost and variable cost:
The cost that remains fixed for all output is known as fixed cost. It has to be incurred
whether there is production or not in a firm. It does not change with change in output upto
certain level. It includes the rent of the factory building, interest on invested capital, salaries
for permanent employees etc. This cost is also known as over-head costs.
Variable costs on the other hand vary with the output. It increases as output of a firm
increases, diminishes as output decreases and becomes zero as the production of a firm is
stopped. It includes the cost of raw materials and the cost of casual labour etc.
Real cost:
Real cost of production is a subjective concept. It expresses the trouble, turmoil and
sacrifices involved in producing a commodity. The efforts and sacrifice of the factors or its
owners is the real cost.
Opportunity cost:
In the words of Benham,” the opportunity cost of anything is the next best alternative
that could be produced instead by the same factor or by an equivalent group of factors,
costing the same amount of money”.
Private cost and social cost:
Private cost is the cost of producing a commodity by an individual producer.
Economic optimum is the basis of private cost.
Social costs are the costs which are incurred by the society in producing commodities
and services. It is a cost incurred by the society in the form of resources that are used in
order to produce commodities and services. Social optimum is the basis for social cost.
Out of pocket cost:
 Out of pocket cost denotes immediate current payment. Hence, it is called cash cost.
For ex, the cost of raw material or the wages to labour require immediate payment.

Book cost:
Book cost is one which need not be immediately made. For instance, depreciation
does not require immediate cash payment and it is not taken into the current expenditure
account.
Incremental cost:
Incremental cost refers to the addition cost incurred due to a change in the level or
nature of activity. A change in the activity connotes addition of a product, change in
distribution channel, expansion of market etc. Incremental costs are also known as
differential costs. Incremental cost measures the difference between old and new total costs.
Sunk cost:
Sunk cost is the costs which remain unaltered even after a change in the level or
nature of business activity. These are known as specific costs. The best example of the sunk
cost is depreciation.

What are the factors determine the cost of production of a product?

When we study cost of production of any good or service, we observe that there are
several factors that influences the cost. Cost function expresses the relationship between cost
and its determinants. Like the size of plant, level of output, input prices, technology etc. In a
mathematical form it can be expressed as,
C = f ( s,o,p,t…………..)
Where,
C = refers to cost
S = refers to size of plant
O = means level of output
P = denotes the prices of inputs used in production.
T = refers to the nature of technology.
Now we shall discuss the determinants of cost of production.
Size of plant:
Plant size is an important variable influencing cost. The relation between scale of
operation or size of plant to the unit cost is negative in the sense that, as the former increases
per unit cost decreases and vice versa. Such a relationship gives step – type downward
sloping cost function, steps depending upon the different size of plants taken into account.
Such a cost gives primarily engineering estimates of cost.
Output level:
Level of output and total cost are obviously related – total cost increasing with
increase in output. But the average and marginal costs first decline and then increase with the
increase in output.
Price of inputs:
Obviously, changes in input price influences costs, depending on the selective usage
of the inputs and relative changes in their prices, When a factor, which is a major component
in production, becomes relatively costly it raises the cost significantly.
Technology:
Technology is often quantified as capital output ratio. Modern and efficient
technology is certainly cost saving and is, therefore, generally found to have higher capital –
output ratio.
Managerial efficiency:
 Though cost is influenced a great deal by managerial efficiency, it is difficult to
quantify it. However, a change in cost at two points of time may explain how organizational
or managerial changes within the firm have brought labour cost efficiency, provided it is
possible to exclude the effect of other factors.

Geographical location:
Costs may be affected by geographical location of the plant when factor prices, tax
regimes and government incentives vary from place to place.
Firms discretionary policies:
Costs also depend upon wide range of firm’s discretionary policies. The examples
are;
 Nature and design of the product being manufactured.
 Level of service provided to customers;
 Package of human resource policies adopted regarding pay, incentive schemes,
employee benefits, training etc.
Productivities of factors of production:
Productivity of a factor of production refers to the output per unit of that factor. The
higher the productivity of a factor of production, the lower the cost per unit of the input
factor. Thus, an increase in factor productivities would reduce the total production cost for
producing a given output.

Explain the nature of cost curves in the short run.

According to Prof. Viner, ”short term is a period which is long enough to permit any
desired change of output technologically possible without altering the scale of plant, but
which is not long enough to permit any adjustment of scale or plant”.
The scale and size being fixed, the firm in the short run can change its output by
incurring fixed cost and variable cost. The total cost of the firm then is the sum total of total
fixed cost and total variable cost
i.e., TC= TFC+TVC.
It is to be noted that in the short run, the total fixed cost remain fixed for all output,
while the total variable cost varies with the output.

OUTPUT IN TOTAL FIXED TOTAL TOTAL

UNITS COST IN (RS) VARIABLE COST COST(TFC+TVC)
IN (RS) IN (RS)
0 500 0 500
1 500 300 800
10 500 500 1000
100 500 1500 2000
500 500 4500 5000
1000 500 9500 10000
As the table reveals the total fixed cost remain fixed for all output starting from zero
to 1000 units. But the variable cost increases as the output increases.
 In the figure, TFC is the total fixed cost. TC is the total cost and TVC is the total
variable cost. As the output increases, the total variable cost increases but the total fixed cost
remain the same. The total cost increases on the total of TFC+TVC increases.

Explain the concept Average fixed, Average variable and Average total costs.
Average cost (average total cost):
Average total cost is the sum of average fixed cost and average variable cost i.e.,.
ATC = AFC+AVC. It is obtained by dividing the total cost by total output, i.e., AC =
TC/TQ. In other words,
AC=TC/TQ i.e., TFC+TVC/TQ
Average fixed cost:
Average fixed cost is nothing but the fixed cost per unit of output. It is obtained by
dividing the total fixed cost by the total output. In other words AFC = TFC/TQ. Since total
fixed cost remain the same for all output, the average fixed cost (AFC) falls as output
increases. Therefore, AFC curve slopes downward to the right and is a rectangular
hyperbola.
Average variable cost:
It refers to the variable cost per unit of output. It is found by dividing the total
variable cost by the total output. Thus, AVC = TVC/TQ. Average variable cost is U shaped.
As the output increases up to certain level, AVC declines due to economies (internal and
external). But once the firm begins to produce beyond its normal capacity, AVC rises
sharply. This is because of diseconomies (internal and external ) setting in the firm.

TOTAL
OUTPUT IN TFC TVC TC AFC AVC AC MC
UNITS
0 30 0 30 30 0 0 0
1 30 30 60 30 30 60 30
2 30 40 70 15 20 35 10
3 30 45 75 10 15 25 5
4 30 50 80 7.5 12.50 20 5
5 30 60 90 6 12 18 10
6 30 72 102 5 12 17 12
7 30 89 119 4.3 12.71 17.5 17
8 30 110 140 3.7 13.75 16-85 21
9 30 135 165 3.3 16 19.33 25
10 30 200 230 3 20 23 65

In the figure,
AFC – Average Fixed Cost
AVC – Average Variable cost
AC – Average cost and
 MC – Marginal Cost.
Marginal cost:
It is defined as the addition made to total cost by the production of one additional unit
of output. In other words, it is the additional cost added to the total because of producing one
extra unit of output. Therefore, MC= Change in TC/ Change in Q.

Relation between AC and MC:

There is a direct relation between AC and MC. It is stated as follows.
In the first phase both AC and MC falls. Here MC is just below AC, this is because
of the fact that the fall in MC is attributed to once unit of commodity. This is due to
increasing returns to scale.
In the second phase, even if the firm extends its output further, both the costs will be
equated (AC=MC). This is due to constant Return to scale.
In the third phase, both the cost curves are rising. Here MC is greater than AC. The
rise in both the curves is due to the application of diminishing return to scale. The fall in MC
is due to the fact that it is attributed to one unit.

Why is short run AC is U shaped? Or explain the U shaped AC in the short run.
The short run AC is U shaped. In the beginning the average costs are high at low
levels of output because both AFC and AVC are large. But as production increases, the AC
falls more sharply due to both AFC and AVC jointly falling. The AC continuous to fall till it
reaches minimum point with the optimum output. Its fall may be attributed to the
indivisibility of factors and internal and external economies. But if the production is pushed
beyond the optimum capacity AC rises and rises quickly. This is due to the over utilization
of equipments and diseconomies in production. This is how the AC takes U shaped in the
short run.

Long run cost curves:

Long run is a period which permits for all types of changes. All costs are variable in
the long. To increase the output in the short run, amount of raw materials and labour are to
be increased. Short run does not permit any type of changes in plant and machinery.
But in the long run, fixed plants and machinery can also be altered. Thus, long run
costs are the costs of producing different levels of output by changes in the size of plants or
scale of production.
The long run average cost curve can be obtained with the help of short run cost curve.
In the above figure, LAC is the long run average cost curve. To draw the LAC a
number of several short run average cost (SAC) are to be drawn. Each SAC represent a
particular scale or size of the plant, including the optimum scale. LAC should be drawn
afterwards. The LAC touches SACs at one point.
The LAC is U shaped. It implies low average cost up to the optimum level. Then AC
rises. Fall in LAC is due to the economics of scale and rise is due to the diseconomies of
scale.
In the long run, an industry may be working at different cost conditions, decreasing,
constant or increasing. In other words, there may be increasing, constant and decreasing
returns to scale in the long run. The concept of ‘optimum firm’ is more appropriate in the
long run. An optimum scale of output is that which is produced at the lowest average cost. A
firm adopting such a scale is known as the ‘optimum firm’.
Different names of LAC:
Envelope curve:
LAC is also known as envelop curve because it envelops all the SAC curves. It
indicates that LAC cannot exceed SAC. It will not cut SAC curves or rise upward.
Planning curve:
LAC is also known as planning curve. With its help, a firm can plan as to which plant
it should use to produce different quantities of output. So that production is obtained at
minimum cost.

Relationship between LAC and SAC:

 The LAC cannot be higher than the SAC for a given output.
 The LAC curve cannot cut any SAC curve but they will only be tangential to each
others.
 The LAC curve not tangent to the SAC curve at the minimum point except in the case
of lowest SAC curve.
 Both the LAC and SAC are U shaped. But LAC is said to be boat shaped rather than
U shaped.
 It is not possible to produce a given output in the cheapest way in the short run. But in
the long run it is possible.
 Some costs are fixed and some are variable in the short run. All costs are variable in
the long run.

BREAK EVEN ANALYSIS:

What is Break Even Analysis? Or explain the concept of Break Even Analysis.
Break even analysis is a study of cost, revenue and sales of a firm and finding out the
volume of sales where the firm’s cost and revenues will be equal.
According to Martz, Curry and Frank,” a break even analysis indicates at what level
cost and revenue are in equiliburium”.
The break even point is that level of sales where the net income is equal to zero. The
break even point is the zero or no – profit and no – loss as the costs equals revenue.
Break even analysis is a graphical techniques meant for illustrating the profit- volume
relationship.
The break even point may, therefore be taken as the one indicating the minimum level
of production / sales, which the company has to undertake in order to be economically viable.

Determinants of BEP:
The BEP of a firm can be found out in two ways.
 In terms of physical units and
 In terms of sales value.
BEP in terms of physical units:
This method is convenient for a firm producing a single product. The BEP is the
number of units of the commodity that should be sold to earn enough revenue just to cover all
the expenses of production. The firm does not earn any profit nor does it incur any loss. It is
the meeting point of TR and TC of the firm.
The break even point is illustrated by means of a schedule and a graph.
TOTAL
OUTPUT REVENUE (TR) TOTAL
IN PRICE RS. 4 PER TFC(RS) TVC(RS) COST(TC)
UNITS UNIT (RS)
 0 0 300 0 300
100 400 300 300 600
200 800 300 600 900
300 1200 300 900 1200
400 1600 300 1200 1500
500 2000 300 1500 1800
600 2400 300 1800 2100

It is clear from the table that when the output is zero the firm incurs only fixed cost.
When the output is 100 the TC is Rs. 600 and TR is Rs. 400. The firm incurs a loss of Rs.
200. Similarly, when the output is 200 units, the firm incurs a loss of Rs. 100. It is at the
level of 300 units, total revenue is equal to total cost (RS. 1200). This is the BEP. From the
level of 400 units of output, the firm is making profit. It is illustrated in the following figure.
In the break even analysis figure, the BEP lies at 300 unit of output. Upto 300 units
of output the firm will be incurring loss in all units of output as TC is at a higher level than
TR. This is called loss zone. Beyond 300 units of output, the firm is realizing profit as TR
exceeds TC. All 300 units of output the firm is neither incurring loss nor realizing any profit.
It is the BEP or no profit or no loss point of production.
BEP in terms of sales value:
The BEP in terms of physical output is suitable only in the case of single product
firm. If the firm is producing many products, the BEP can be approached only in terms of
money value or total sale value or total revenue. Here also the principle of total contribution
margin is made equal to total fixed cost, but the contribution margin is expressed as a ration
to sales.
Contribution Margin= Total Revenue – Total Variable Cost / Total Revenue
BEP= Total Fixed Cost/ Contribution Ratio.
Assumptions:
 The volume of production and the volume of sales are equal.
 The price is assumed to be constant
 All revenue is perfectly variable with the physical volume of output and
 All costs are either perfectly variable or absolutely fixed over the entire range of
volume of production.
 Operating efficiency will not undergo any changes.
 Semi variable costs can be segregated into variable and fixed components.
Managerial uses of BEA:
The main advantage of using break even analysis in managerial decision-making can
be state below;
 It helps in determining the optimum level of output, below which it would not be
profitable for a firm to produce.
 With the help of the break-even analysis, the firm can determine minimum cost for a
given level of output.
 It helps in deciding which products to be produced and which to be bought by the
firm.
 Plant expansion or contraction decisions are often based on the break even analysis of
the perceived situation.
 Impact of changes in prices and costs on profits of the firm can also be analyzed with
the help of break-even techniques.
  Sometimes a management has to take decisions regarding dropping or adding a
product to the product line. The break even analysis comes very handy in such
situations.
 The break-even analysis can be used in finding the selling price which would prove
most profitable for the firm.
Limitations:
 It is static in character.
 Projection of future with the past is not correct.
 The assumption that cost- revenue – output relationship is linear is true only over a
small range of output.
 The profits are a function of not only output but also other factors like technological
change, improved management etc.
 BEA if not an effective tool for long range use and its use should be restricted to the
short run only (i.e., calendar year).
Margin of safety (Safety Margin):
The excess of actual sales over the break even sale is known as the margin of safety.
It is usually expressed as a percentage of sales. Thus the margin of safety is,
(Actual sales – break even point)
MOS= -------------------------------------------- × 100
Actual sales
The margin of safety refers to the extent to which sales may fall before the firm starts
incurring a loss. Larger the margin of safety, the safer the firm. If the margin of safety is
dropping over a period of time, it means that the firm’s resistance capacity to avoid losses is
becoming poorer. A high margin of safety means that the break-even point is much below
the actual sales so that even if there is a slight fall in sales, still there will be profit. A margin
of safety can be negative as well. In such case, it indicates the increase in sales necessary to
reach the BEP so as to avoid losses.