PRESENTATION BY MANOJ KUMAR SUNUWAR MAHENDRA AADARSHSA VIDHYASHRAM CAMPUS SATDOBATO, LALITPUR NEPAL

Date: 2069-08-15

BASIC CONCEPT OF COST In the process of production of goods and services it requires the use of various factors of production such as land, labour, capital and entrepreneur/organization. These factors of production helps in production process and as a reward they get payment for their services. Producer has to pay prices to these factors of production such as rent for land, wages for labour, interest for capital and profit for entrepreneur.

 The sum of these payment made for various

factors of production is known as cost of production. In conclusion, the sum of the prices paid to the inputs like rent, wages, interest and profit by the producer to produce goods and services is known as cost of production. The term cost of production can be analyzed under the following sub headings: 1. Money Cost: - The payment made in terms of money to the inputs used in production in the form of rent, wages, salaries, allowances, profit, interest and price of raw materials is known as money cost.

 Cost of production generally refers to the money

cost and it is also known as Nominal Cost. 2. Real Cost: - Real cost is subjective phenomenon so we can not calculate it in terms of monetary value. - It is the sacrifice made by the producer while producing goods and services. Such as discomfort, disutility, pain are the example of real cost. - Thus real cost is the total addition of all the efforts, sacrifices, exertions etc. involve in the production process. This concept was propounded by Prof. Marshall.

3. Explicit Cost: - Producer does not possess all factors of production required in the process of production of goods and services. - At that time producer borrows factors of productions from external sources and pays the remuneration for their services. - The payment made for those factors of production which are borrowed from external sources in terms of money is called explicit cost. - All explicit costs are written in the Book of Accounts, which is very important in keeping profit and loss account.

 The price of raw materials, wages of labourers,

salaries of officials, rent of land and buildings, advertisement expenses, insurance expenses, tax expenses etc. are the examples of explicit cost. 4. Implicit Cost: -Implicit cost is the contribution made by producer himself and his family member but not paid them in monetary terms. -For example: producer may use his own land, capital, building, cooperation of his family members, but the producer does not make any payment in monetary term for their contribution.

 If he uses, these factors for somebody else, he

gets remuneration for their services. Therefore, economist calculate the costs of the factors of production of ones own possession even when they are used in own production process. This cost is calculated on the basis of opportunity cost and in this cost capital consumption allowances is also included. This cost is not included in Book of Account but play vital role in business decisions. 5. Opp0rtunity Cost: This cost is known as the next best alternative cost which is sacrificed by producer.

 For example: let us suppose that a farmer can

produce 300 kg of rice in one hector land by using certain factors. If the farmer produces maize at that land he can produce 200 kg of maize only by using same factors as before. Here, cost of producing rice and maize is same. In this situation, if farmer produce maize, then his opportunity cost of producing 200 kg maize is 300 kg rice. And similarly, if he produce rice, then his opportunity cost of producing 300 kg of rice is 200 kg maize. 6. Accounting Cost: The cost which are necessary for accounting purpose is known as accounting cost.

 It includes only direct cost or payment

made in-terms of money to the factors of production. It does not include real cost and the opportunity cost of self owned resources or self employed resources. For example: rent paid for land, factory buildings, wages paid for labourers, interest for capital, prices for raw materials, fuels, transportation etc. in form of cash are the example of accounting cost.

7. Economic Cost: Economic cost is the aggregate cost of explicit and implicit cost. Such cost covers both monetary cost and other services provide by the producer including normal profit. i.e. Economic Cost = Accounting Costs + Implicit Costs. Question: What is cost and define various types of costs.

CONCPET OF FIXED AND VARIABLE COST In the process of production, a producer employs or used various factors of production such as land, labour, capital, organization, raw materials etc. These factors of production can be classified into two categories. There are some factors which can be used for a longer period for producing more than one batch of goods and services. These factors do not change their form in one use are called fixed factors of production. The fixed factors capital like machinery, land and building and permanent staff are included in this category.

 There are some other factors which can have

only one use, these are called variable factors of production. The raw materials are included in this category. Hence, the cost of production is composed of two cost fixed cost and variable cost. 1. Fixed Cost: The amount of money value paid to the fixed factors of production used in production process is known as fixed cost. This cost is also known as supplementary cost or overhead cost.

 Fixed cost do not change with any change in

output. Fixed cost are made in the initial phase of production so it must be paid even if the firms output is zero. Salary paid to the permanent staff, managerial cost, rental payment, interest and some portion of depreciation charge are the examples of fixed cost. 2. Variable Cost: Variable cost is the price or money value paid to the variable factors of production used in the production process.

 Variable

cost are directly related to the production. So, variable cost remains zero at zero level of production and it increases with the increase in level of output. It includes the payments made for raw materials, fuel, power, transportation, wages and other similar variable resources. The main difference between variable and fixed costs is only a short run phenomenon. Nothing remains fixed in long run. That means all factors of production became variable in long run. Because, change would occur in the staff and amount of capital.

CONCEPT OF SHORT RUN COST AND LONG RUN COST 1. CONCEPT OF SHORT RUN COST: Price or money value paid to the fixed and variable factors of production in short run is called short run cost. Short run is that period where all factors of production can not be changed. That means some factors of production remains fixed and some factors of production are changed. Fixed cost remains unchanged along with change in production of goods and services and the variable cost changes along with change in production of goods and services.

 Short run cost can be classified into following

three headings: A. Short-Run Total Cost B. Short-Run Average Cost and C. Short-Run Marginal Cost A. Short Run Total Cost: There are three types of cost falls under short run total cost, which are as follows: i. Short-Run Total Fixed Cost (STFC) ii. Short-Run Total Variable Cost (STVC) iii. Short-Run Total Cost (STC)

i. Short-Run Total Fixed Cost (STFC): The total amount of price or money value paid to the fixed factors in the process of production in a short period is known as total fixed cost. Total fixed cost remains constant/unchanged, whatever be level of output. To derive the TFC curve let us take help following table:
Quantity of Output (Q) 0 1 2 3 4 5 TFC in Rs. 45 45 45 45 45 45

 In the above table total cost is Rs. 45 when

output is zero and the in output increase being 1, 2, 3, 4, 5 units but total fixed cost remains unchanged i.e. Rs.45. By using above information we can derive short run total fixed cost curve as follows: TFC Graphically,

45

STFC

OUTPUT

 In the above figure along x axis we plot level of out

put, along y axis we plot total fixed cost. STFC represent the short run total fixed cost curve which is horizontal and parallel to x axis. It shows that STFC remains constant over the different level of output. i.e. STFC 45 along with change in the level of output from 0 to 1, 1 to 2, 2 to 3, 3 to 4 and 4 to 5 respectively. ii. Short-Run Total Variable Cost (STVC): Total amount of money value or price paid to the variable factors of production in short period of time or in short run is known as total variable cost (TVC).

 It is calculated by adding all successive

variable cost. Or multiplying the average variable cost by units of output. Symbolically, TVC= AVC Q Where, AVC= average variable cost Q= units of output produced TVC changes directly with level of output. That means increase in output leads to increase in TVC and Vice-versa and cost will be zero if there is no production.

 TVC curve is inverse S-shaped from origin, which

due to operation of law of variable proportion. It can be represent with the help of following table: Short Run Variable Cost
Quantity of Output 0 1 2 3 4 5 6 7 Total Variable Cost (TVC) in Rs. 0 35 45 50 53 55 65 80

 In the above table when output is zero total variable cost is also zero. When output level increases variable cost also increases. In the table, variable cost is equal to Rs. 35 when only 1 unit of output is produced and they rise to Rs.80 when 7 units of output are produced.
Graphically,
TVC 90
80
70 60

Total Variable Cost (TVC) in Rs.

TVC Curve

50
40 30 20 10 0 0 1 2 3 4 5 6 7 8

Total Variable Cost (TVC) in Rs.

Output

 In the above figure, along x-axis we plot level of

output and along y-axis we plot TVC. Total variable cost is represented by TVC curve. It start from origin and increasing upward from left to right. TVC curve seems like inverse S. iii. Total Cost (TC): Total Cost is the sum of total fixed cost and total variable cost at each level of output or production. i.e. TC= TFC + TVC At zero level of output, TC is equal to the firms TFC. Then for each unit of output TC varies by same amounts as varies in the variable cost.

 Short run total cost can be represent by following table:

Short Run Total Cost

Quantity of Output 0 1 2 3 4 5 TFC 45 45 45 45 45 45 TVC 0 35 45 50 53 55 TC 45 80 90 95 98 100

6 7
8

45 45
45

65 80
100

110 125
145

 In the above table, TC increase at the same

direction of the increase in TVC because total cost is the sum of TFC and TVC. From above table we can derive the short run total costCost curve, which is shown below:
160 140

TC

120

100

TVC
TFC TVC TC

80

60

40

TFC

20

0 0 1 2 3 4 5 6 7 8 9

Output

 In the above figure, we plot output along x-

axis and we plot cost along y-axis. Where we clearly see that TC is same shaped as of TVC. TC curve starts above the origin because of TFC. Inverse S-shaped TC signifies that TC curve is explained by the law of diminishing returns in production. Question: 1. Define and draw TFC, TVC and TC curves. 2. Define fixed cost and variable cost with the example.

SHORT RUN PER UNIT COSTS There are four types of short run per unit costs, which are as follows: 1. Short Run Average Fixed Cost (SAFC): Average Fixed Cost (AFC) is the per unit fixed cost of production. AFC at each level of production can be obtained by dividing the TFC by corresponding level of output (Q). i.e. AFC = TFC/Q Total fixed cost is independent of output, so AFC declines as long as production increases but never became zero. In graphical representation AFC curve is rectangular hyperbolic.

 To derive AFC curve, let us take help of following table:

Average Fixed Cost

Quantity of Output (Q)
0 1 2 3

TFC
45 45 45 45

AFC
45 22.5 15

4
5 6 7

45
45 45 45

11.2
9 7.5 6.4

 In the above table, as increase in output TFC

remains same but AFC decreases continuously as increase in output but never be zero. Graphically, AFC/TFC
50 45 40 35 30 TFC 45 25 20 15 10 5 0 0 1 2 3 4 5 6 7 8 AFC 0

TFC

AFC OUTPUT

 In the above figure, along x-axis we plot output

and along y-axis we plot AFC and TFC. As increase in output AFC continuously falls downward from left to the right but never touches both axis. Which means, at very low level of output AFC is very high but it declines continuously as production increases but remains positive. 2. Short Run Average Variable Cost (SAVC): Average variable cost (AVC) is the per unit variable cost of production. It is calculated by dividing total variable cost (TVC) by the corresponding level of output.

 Initially AVC decreases and it reaches to

minimum point and finally it increases. hence,, it is U shaped. AVC curve can be derived with the help of following table: Average Variable Cost
Quantity of Output (Q) 0 1 2 3 4 5 6 7 8 9 10 TVC 0 35 60 75 80 90 105 130 180 250 340 AVC 35 30 25 20 18 17.5 18.6 22.5 27.8 34

 In above table as output increases, AVC is

initially decreases it reaches to minimum point and then it starts to increase. If we relate it with the average productivity of labour than as increase in average productivity of labour AVC falls and when average productivity of labour reaches to maximum point then AVC reaches to minimum point and finally when average productivity of labour decreases then after AVC increases. Above all facts shows that AVC curve is U shaped. It is due to the operation of law of variable proportion or law of diminishing returns.

 Graphical derivation of AVC curve:

400
350 300 250

TVC

TVC

200

150
100 50 0 0 40 35 30 2 4 6 8 10

TVC

12

AVC

OUTPUT

AVC

25
20 15 10 5 0 0 2 4 6 8 10 12 AVC -

OUTPUT

 In the above figure, along x-axis we plot output and

along y-axis we plot cost. In the figure initially average cost falls downward from left to right it reaches to minimum point and finally it starts to rise upward from left to right. Initially average variable cost is declining due to the operation of law of increasing returns and AC goes on decreasing due to operation of law of decreasing returns. Due to this reason AVC curve is U shaped as shown in the figure above. 3. Short Run Average Cost (AC): Average cost is the per-unit cost of production. It is obtained by dividing total cost of production by total output produced.

 Total cost (TC) is the sum of total fixed cost (TFC)

and total variable cost (TVC). So, the average cost is the sum of average fixed cost (AFC) and average variable cost (AVC). i.e. AC=TC/Q = (TFC+TVC)/Q = TFC/Q + TVC/Q = AFC+AVC Where, TC= Total Cost Q= Total Output Produced Short run AC curve can be explain with the help of table as given below:

Short Run Average Cost

Quantity of Output 0 1 2 3 4 5 6 TC 45 80 90 95 98 100 120 AC 80 45 31.67 24.5 20 20

7
8 9

150
180 210

21.43
22.5 23.3

 In the above table, initially average cost is

decreasing it reaches to its minimum point, that is at 5th unit of output AC is minimum and at 6th unit of output AC remains constant and finally starts to increase that is after 8th unit of output AC goes on increasing. Initially average cost is declining due to the operation of law of increasing returns and AC goes on decreasing due to operation of law of decreasing returns. Due to this reason AC curve is U shaped as shown in the figure below.

cost

250

STC CURVE
200

150 TC 45 100 AC

50

SAC CURVE

0 0 1 2 3 4 5 6 7 8 9

output

10

In the above figure initially AC curve declines, it

reaches to a minimum point and subsequently rises again. Thus AC curve is U-Shaped. Which is shown by SAC CURVE in above figure.

4. Marginal Cost: Marginal cost (MC) is the addition to the total cost due to one more extra unit of production. It is the change is total cost due to the change in output by one more unit. i.e. MC = TC/Q or, MCn = TCn TCn-1
where,

= Change TC= total cost Q= quantity output We can explain marginal cost more clearly with the help of following hypothetical table:

Marginal Cost
Quantity of Output 0 1 2 3 4 5 6 7 8 Total Cost (TC) 45 80 90 95 98 100 120 150 185 Marginal Cost (MC) 35 10 5 3 2 20 30 35

In above table, as initially marginal cost goes on declining as increase in output,( that is up to the 3rd unit of output, marginal cost reaches to its minimum point (that is at 5th unit of output and finally it starts to increase after the 6th unit of output.

225

40

300

Cost TVC TC

250

200

150

100

TVC

50

0 0 40 35 1 2 3 4 5 6 7 8 9 10

Output

AVC -

MC

Marginal Cost

30 25 20 15 10 5 0 0 1 2 3 4 5 6 7 8 9 10 AVC -

Output

Why AC Curve is U-Shaped? We clearly observe that AFC curve's shape is rectangular hyperbola, AVC and AC curve's shape is U. The main reasons behind U-shaped AC curve is as follows: 1. Due to Operation of Law of Variable Proportion: Due to the operation of law of variable proportion AVC and AC curves are U shaped. According to this law when output increases at increasing rate at that time cost will increases at decreasing rate, when total product is maximum at that time cost will be minimum and when total product starts to decline at that time at that time cost will increases at increasing rate. Thus, AC curve is U shaped.

2. Nature of AFC and AVC AC is the outcome of summation of AFC and AVC. AC includes AFC and the AFC goes on declining as output expands but AVC initially decreases reaches to minimum point and beyond the minimum point it starts to increase. When both AFC and AVC declines AC also declines, when AVC reaches to minimum point AC reaches to its minimum point and after the minimum point of AVC it starts to increase, AFC continuously falls but the declining rate of AFC is offsets by the increasing rate of AVC as a result AC starts to rise. Hence, AC curve is U shaped.

3. Economies and Diseconomies of Scale: Due to the economies in production average cost declines it reaches its minimum point and finally due to the diseconomies in production average cost increases and hence, AC curve is U shaped. Economies in production refers to the increase in efficiency of technology, efficiency of labor, managerial efficiency, market efficiency and etc. Initially, efficiency of technology, efficiency of labor, managerial efficiency, market efficiency and etc. increases due to which cost declines as a result AC curves slopes down it reaches to its minimum point, beyond the minimum point efficiency starts to decline as a result cost starts to increase and hence, AC curve is U shaped.

Relationship Between Average Cost & Marginal Cost It can be explained with the help of following figure:
MC

AC

MC

MC

1. Both AC and MC are derived from same sources,

i.e. from TC. 2. When AC starts to decline MC declines faster than that of AC. 3. When AC tends to its minimum point MC reaches to its minimum point faster than AC.

3. When AC starts to increase, MC increases faster than that of AC. 4. MC cuts AC from below at its minimum point. 5. Both AC and MC shows similar characteristics i.e. both are initially declines reaches to minimum points and finally starts to increase. That means both curve has similar shape, i.e. U Shape.