M.

COM IV SEMESTER
BUSINESS ANALYSIS AND FORECASTING

Topic- Theory of Cost

By- Dr. Sunita Srivastava

Department of Commerce, University of Lucknow.

THEORY OF COST
MEANING OF COST- Cost may be defined as the monetary value of all sacrifices
made to achieve an objective i.e. to produce goods and services. Cost are very
important in business decision making. Cost of production provides the floor to
pricing. It helps manager to take correct decision, such as what price to quote,
whether to place particular order for inputs or not whether to abandon or add a
product to the existing product line and so on.

Ordinarily, cost refer to the money expenses incurred by a firm in the production
process. Cost also included imputed value of the entrepreneur’s own resources
and services, as well as salary of the owner-manager.

DETERMEAINTS OF COST-

Factors determining the cost are:

(a) Size of plant: There is an inverse relationship between size of plant and
cost. As size of plant increases, cost falls and vice versa.
 (b) Level of Output: There is a direct relationship between output level and
cost. More the level of output, more is the cost ( i. e., total cost) and vice
Versa.

(c) Price of Inputs: There is a direct relationship between price of inputs and
cost. As the price of inputs rises, cost rises and vice versa.

(d) State of technology: More modern and upgraded the technology implies
lesser cost and vice versa.

(e) Management and administrative efficiency: Efficiency and cost are

inversely related. More the efficiency in management and administration
better will be the product and less will be the cost. Cost will increase in case
of inefficiencies in management and administration.

COST CONCEPT-

The concept of cost is central to business decision making. To make effective

business decisions, the business manager needs to be aware of a number of cost
concepts and their respective uses.

Actual cost- Actual cost means the actual expenditure incurred on

producing goods and services. Value of raw material, wages, rent, salaries
paid and interest of borrowed capital etc. are some of the example of
actual cost. Actual cost is also known as absolute cost or out lay cost or
money cost.

Opportunity Cost- The opportunity cost is measured in terms of the

forgone benefits from the next best alternative use of a given resource. For
example the inputs which are used to manufacture a car may also be used
in the productions of military equipment. Main points of opportunity cost
are:

1. The opportunity cost of any commodity is only the next best

alternative forgone.
2. The next best alternative commodity that could be produced with
the same value of the factors, which are more or less the same.
 3. It helps in determining relative prices of factor inputs at different
places.

4. It helps in determining the remuneration to services.

5. It helps the manager to decide what he should produce in the factory.

Explicit cost- An explicit cost is a cost that is directly incurred by the firm,
company or organization during the production. The explicit cost is kept on
record by the accountant of the firm. Salaries, wages, rent, raw material are
few example of the explicit cost. The explicit cost is also known as out-
pocket cost. This cost is handy in calculating both accounting and economic
profit.

Implicit cost- The implicit cost is directly opposite to it, as it is the cost that is
not directly incurred by the firm or company. In implicit cost outflow of cash
doesn’t take place. It is not in the record and is heard to be traced back. The
interest on owner’s capital or the salary of the owner are the prominent
example of the implicit cost. The implicit cost is also known as imputed cost.
Through implicit cost , only the economic profit is calculated.

Incremental cost- Incremental costs are the added costs of a change in the
level of production or the nature of activity. It may be adding a new product or
changing distribution channel, or adding new machinery, etc. It appears to be
similar to marginal cost, but it is not managerial cost. Marginal cost refers to the
cost on added unit of output.

Sunk Cost- Sunk costs are costs which cannot be altered in any way. Sunk costs
are costs which have already been uncured. For example, cost incurred in
constructing a factory. When the factory building is constructed cost have already
been incurred. The building has to be used for which originally envisaged. It can
not be altered when operation are increased or decreased . Investment of
machinery is an example of sunk cost.

Shutdown cost- Shutdown cost are those cost which would be incurred in the
event of suspension of plant operations and which could be saved if operation
were continued. For example cost of sheltering the plant equipment and
construction of sheds for protecting the exposed property, or fixed cost and
maintenance cost etc.

Abandonment cost- Abandonment cost are those cost which are incurred for the
complete removal of the fixed asset from use. These may occur due to obsolesce
or due to improvisation of the firm. Abandonment costs thus involve problem of
disposal of the asset.

Book cost – Book cost are those business cost which don’t involve any cash
payment is made but a provision is made in the books of accounts in order to
include them in the profit and loss account and take tax advantages.

Out of pocket cost- Out of pocket cost are those costs or expenses which are
current payments to the outsiders of the firm. All the explicit costs fall into the
category of out of pocket costs.

Past cost- Past costs are actual costs incurred in the past. These costs are
mentioned in the financial accounts. , since the past costs have already been
incurred, and there is no scope for managerial decision. If the management finds
out that the past costs are excessive, it cannot do anything to rectify it now.

Future cost- Future costs are those costs which are to be incurred in the near
future. This is only a forecast. Future costs matter for managerial decisions
because, the management can evaluate the desirability of that expenditure. In the
case of future costs, if the management considers them very high , it can either
reduce them or postpone the use of them.

Direct cost-Direct costs are related to a specific process or product. They are also
called traceable costs as we can directly trace them to a particular activity,
product or process. They can vary with changes in the activity or product.
Examples of direct costs include manufacturing costs relating to production,
customer acquisition costs pertaining to sales, etc.

Indirect costs- Indirect costs, or untraceable costs, are those which do not
directly relate to a specific activity or component of the business. For example, an
increase in charges of electricity or taxes payable on income. Although we cannot
trace indirect costs, they are important because they affect overall profitability.

Fixed Cost- Fixed cost are the amount spent by the firm on fixed inputs in the
short run. Fixed cost are thus, those costs which remain constant, irrespective of
the level of output. These costs remain unchanged even if the output of the firm
is nil. Fixed costs therefore, are known as Supplementary costs or Overhead costs.

Variable Costs- Variable costs are those cost that change directly as the volume of
output changes. As the production increases variable cost also increases, and as
the product decreases variable costs also decreases, and when the production
stops variable cost is zero.

Semi Variable Cost- This type of cost lies in between fixed and variable cost. It is
neither perfectly variable nor perfectly fixed in relation to changes in output. This
type of costs include a portion of fixed cost and a portion of variable cost, this is
known as semi variable cost. For example- electricity bill generally include both a
fixed charge (meter rent) and a variable charge(charge based on units consumed)
and the total payment made is semi variable cost.
Stair Step Cost- Certain expenses increase in a stair step manner, i.e. remaining
constant over a range of output but rising suddenly to a new higher level as
output passes beyond. The given level. For example- up to a point the attendants
salary may remain fixed as output increases but beyond that point further
increase in output may require an additional attendant leading to a sudden jump
in supervision expenses.

Total cost-Total cost is the total expenditure incurred in the production of goods
and services.

TC= TFC+TVC

Average cost- Average cost is not actual cost, It is obtained by dividing the
total cost by the total output.

AC= Total Cost/Units Produced

Marginal cost- The cost incurred on producing one additional unit of commodity
is known as marginal cost. Thus it shown a change in total cost when one more or
less unit is produced.
 MC= TCn – TC(n-1 )

Cost function-

The cost output relationship plays an important role in determining the

optimum level of production.

TC=F(Q)

Where,

TC= Total cost

Q= Quantity produced

F= Function

The cost function can be classified as:

Short run cost- Short run is a period where the time is too short to expand the
size of industry and the increased demand has to be met within the existing size
of industry because there are certain factors which cannot be changed in short
run. So short run costs are those which vary with output when fixed plant a
capital equipments remain unchanged.

Long run costs- In the long run the size of an industry can be expanded to meet
the increased demand for products such as in long run all the factors of
production can be increased according to need. Hence long run costs are those
which vary with output when all input factors including plants equipment vary.

Cost output relationship in short run-

In the short-run a change in output is possible only by making

changes in the variable inputs like raw materials, labour etc. Inputs
like land and buildings, plant and machinery etc. are fixed in the
short-run. It means that short-run is a period not sufficient enough
to expand the quantity of fixed inputs. Thus Total Cost (TC) in the
short-run is composed of two elements – Total Fixed Cost (TFC) and
Total Variable Cost (TVC).
 TFC remains the same throughout the period and is not
influenced by the level of activity. The firm will continue to incur
these costs even if the firm is temporarily shut down. Even though
TFC remains the same fixed cost per unit varies with changes in the
level of output.
On the other hand TVC increases with increase in the level of
activity, and decreases with decrease in the level of activity. If the
firm is shut down, there are no variable costs. Even though TVC is
variable, variable cost per unit is constant.
So in the short-run an increase in TC implies an increase in
TVC only. Thus:
TC = TFC + TVC
TFC = TC – TVC
TVC = TC – TFC
TC = TFC when the output is zero.
The graph below shows Short-run cost output relationship.

In the graph X-axis measures output and Y-axis measures

cost. TFC is a straight line parallel to X-axis, because TFC does not
change with increase in output.
TVC curve is upward rising from the origin because TVC is
zero when there is no production and increases as production
increases. The shape of TVC curve depends upon the productivity of
the variable factors. The TVC curve above assumes the Law of
Variable Proportions, which operates in the short-run.
TC curve is also upward rising not from the origin but from
the TFC line. This is because even if there is no production the TC
is equal to TFC.
It should be noted that the vertical distance between the TVC
curve and TC curve is constant throughout because the distance
represents the amount of fixed cost which remains constant. Hence
TC curve has the same pattern of behavior as TVC curve.

Short-run Average Cost and Marginal Cost

The concept of cost becomes more meaningful when they are
expressed in terms of per unit cost. Cost per unit can be computed
with reference to fixed cost, variable cost, total cost and marginal
cost.

The following Table and diagram illustrates cost output relationship

in the short-run, with reference to different concepts of cost.
Average Fixed Cost (AFC): Average fixed cost is obtained by
dividing the TFC by the number of units produced. Thus:

AFC = TFC/Q where, ‘Q’ refers

quantity of production.

Since TFC is constant for any level of activity, fixed cost per
unit goes on diminishing as output goes on increasing. The AFC
curve is downward sloping towards the right throughout its length,
with a steep fall at the beginning.

Average Variable Cost (AVC): Average Variable Cost is obtained by

dividing the TVC by the number of units produced. Therefore:

AVC = TVC / Q

Due to the operation of the Law of Variable Proportions AVC

curve slopes downwards till it reaches a certain level of output and
then begins to rise upwards.

Average Total Cost (ATC): Average Total Cost or simply Average

Cost is obtained by dividing the TC by the number of units
produced. Thus:

ATC = TC / Q
 The ATC curve is very much influenced by the AFC and AVC
curves. In the beginning both AFC curve and AVC curve decline and
therefore ATC curve also declines. The AFC curve continues the
trend throughout, though at a diminishing rate. AVC curve
continues the trend till it reaches a certain level and thereafter it
starts rising slowly. Since this rise initially is at a rate lower than
the rate of decline in the AFC curve, the ATC curve continues to
decline for some more time and reaches the lowest point, which
obviously is further than the lowest point of the AVC curve.
Thereafter the ATC curve starts rising because the rate of rise in the
AVC curve is greater than the rate of decline in the AFC curve.

Marginal Cost (MC): Marginal Cost is the increase in TC as a result

of an increase in output by one unit. In other words it is the cost of
producing an additional unit of output.

MC is based on the Law of Variable Proportions. A downward

trend in MC curve shows decreasing marginal cost (i.e. increasing
marginal productivity) of the variable input. Similarly an upward
trend in MC curve shows increasing marginal cost (i.e. decreasing
marginal productivity). MC curve intersects both AVC and ATC
curves at their lowest points.
The relationship between AVC, AFC, ATC and MC can be
summed up as follows.
1. If both AFC and AVC fall ATC will also fall because ATC = AFC +
AVC
2. When AFC falls and AVC rises (a) ATC will fall where the drop in
AFC is more than the rise in AVC (b) ATC remains constant if the
drop in AFC = the rise in AVC, and (c) ATC will rise where the drop in
AFC is less than the rise in AVC.
3. ATC will fall when MC is less than ATC and ATC will rise when
MC is more than ATC. The lowest ATC is equal to MC.

Cost output relationship in the long run-

In order to study the cost output relationship in the long run it is
necessary to know the meaning of long run. As known in the long
run the size of an industry can be expanded to meet the increased
demand for products as such in the long run all the factors of
production can be varied according to the need. Hence long run
costs are those which vary with output when all the input factors
including plant and equipment vary.

T
As per the above figure suppose that at a given time the firms
operate under plant SAC2 and produces output OQ. If the firm
decides to produce output OR and continues with the current plant
SAC2 its average cost will be uR. But if the firm decides to increase
the size of the plant to plant SAC3 its average cost of producing OR
output would then be TR. Since cost TR is less than the cost on old
plant uR, therefore new plant SAC3 is preferable and should be
adopted. Thus the long run cost of producing OR output will be TR
which can be obtained by increasing the plant size.
Features of LAC curve
To draw long run average cost curve(LAC) we start with a number of
short run average cost(SAC) curves, each such curve representing a
particular size of plant including the optimum plant. One can now
draw a LAC curve which is tangential to all SAC curves. In this
connection following features are highlighted:
1- The LAC curve envelopes the SAC curves and is therefore
called as envelope curve.
2- Each point of the LAC is a point of tangency with the
corresponding SAC curve.
3- The points of tangency on the falling part of SAC curve for
points lying to the left of minimum point of LAC.
4- The points of tangency occur on the rising part of the SAC
curves for the points lying to the right of minimum point of
LAC.
5- The optimum scale of plant is a term applied to the most
efficient of all scales of plants available. This scale of plant is
the one whose SAC curve forms the minimum point of LAC
curve. It is SAC3 in our case which is tangent to LAC curve at
its minimum point at R.
6- Both LAC ad SAC curves are U shaped but the difference
between the two U shapes is that the U shape of the LAC curve
is flatter or lesser pronounced from bottom. The main reason
for this is that in the long run such economies are possible
which cannot be had in the short run, likewise some of the
diseconomies which are faced in short run may not be faced in
the long run.