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# COST CURVES

Unit of Output 1 2 3 4 5 6 7 8

Total Cost
(Rs. Crs)

Average Cost 150.0 95.0 73.3 59.0 54.0 54.0 59.3 72.3

## Relationship of Average Cost (ATC/AC) & Marginal Cost (MC).

Average Cost is the cost of producing one unit of output. AC reflect the influence of both the AFC and AVC. At first ATC are high at low levels of output both because both AFC and AVC are large. As output increases, the ATC falls sharply because of the steady decline of both AFC and AVC till they reach the minimum point. This results from the internal economies. , better utilization of existing plant, labor, etc. After a point, ATC starts rising because of rising AVC (internal diseconomies)

A fundamental concept for the determination of the exact level of output of a firm is the marginal cost. Marginal Cost is the addition to total cost by producing an additional unit of output. Marginal cost curve as it would be clear is U shaped. This implies that the MC first slopes downward and then at the point where MC is minimum, it starts sloping upward because MC after decreasing with increases in output at low output levels, increases with further increases in output. The shape of MC curve is attributed to Law of variable proportions. According to the law, the Marginal product of the variable input rises at low output levels and then falls with the expansion in output. Hence, the MC curve will first fall and then rise.

Diagram:_________. Long Run AC Curve (LRAC): LRAC=LRTC/total output. FLATTER U SHAPE. The Reasons for flatter U Shape of LRAC Curve: Fixed factors become variable in Long run: -more machinery, more land, borrow more capital, etc. Greater divisibility of factors of production: - reduce labor with machines-more output- more departments and divide the work- train labor part time labor, etc. Scale of operations can be changed: - because of returns to scale, change in plant capacity is possible. Diseconomies can be avoided in long run:- higher cost can be avoided.

LRAC curve is based on different short run cost curves. LRAC curves are also called as Envelope Curve or Planning Curve or Tangential Curves of the firm. Envelope because it a group of SRACs. Planning because it helps to select the least unit cost of producing each possible level of output. (maximum profit). Tangent because it joins all the points of different SRACs.

LRAC is falling, it touches the falling portion of SRAC curve and when LRAC is rising, it touches the raising portion of SRAC curve. Like wise, the minimum point of LRAC touches the minimum point of SRACs. LRMC is derived just like the SRMC curves. By joining all the minimum SRMCs, the LRMC also is of FLATTER U shape. As output expands, the MC also increases. Up to a certain stage, the LRMC declines, but later on the MC in long run increases. In short run MC may be high for a certain level of output, but at the same level of output the Long run MC will be lower.

Long Run is the perspective view of various short run course of actions. LRAC denotes the least unit cost of producing each possible level output and the size of the plant in relation to the LAC curve. The behavior of LRAC shows all the return phases. LRAC was observed L-shape when technical progress is rapid.

## BREAK EVEN ANALYSIS

BEA is very important and a simple tool for managerial decisions making. It is also known as CVP Analysis (Cost-Volume-Profit Analysis) Scientific Technique to forecast Profit. BEA is used for evaluating the financial viability of new marketing plans and product lines. It helps to know the operating condition that exists when a company breaks-even, that is when sales reach a point equal to all expenses incurred in attaining that level of sales. The BREAK EVEN POINT indicates at what level of costs and revenue are in an equilibrium (the point of no profit, no loss).

The Revenue-Output and Cost-Output functions form the basis of BEA. To show BEA in a chart, we require TR (sales) and TFC and TC curves. Revenue is the product of the number of units sold and (TR) the price per unit. Total Cost comprises of both fixed and variable cost components.

DIAGRAM: The BREAK EVEN POINT indicates at what level of costs and revenue are in an equilibrium (the point of no profit, no loss). At this Point, the level of sales is break even. If the sales increases further after the point, it means firm is enjoying profits. That is MARGIN OF SAFETY increases.

The difference between the total revenue and the total cost is the profit generated the firm. In the figures, the vertical distance between the curves of total revenue (TR) and total cost (TC) determines the total profits at any level of production. The point where the total cost equals the total revenue is known as the break even point. (TR=TC is BEP).

Formula of BEP:
It can be calculated as per output / per

sales.
Break Even Point (in terms of

output/sales) = Fixed cost / selling price per unit variable cost per unit. Examples:

Shut down point: If the firm cannot cover its variable costs in the short run then the firm has to shut down. The price fixed for the product should cover the AC of the firm, if not it will be in losses and leads to shut down. Shut down point is PRICE = AVC.

Usefulness of BEA
BEA is useful for decision making in regard to pricing, cost control, product mix, channels of distribution, etc. BEA provides microscopic view of the profit structure of the firm. Analysis helps to control cost. BEA provides for profit prediction and is also a tool for profit making. BEA is used for determining the SAFETY MARGIN regarding the extent to which the firm can permit a decline in sales without causing losses. Useful for business decision making pricing policy, sales projection, capital budgeting, etc. Should be used cautiously (it is not beneficial in long run sometimes).

## End of the COST Analysis

By Thirumagal Pillai.