COST PRINCIPLES

Production costs and cost curves

Production costs play an important role in the decisions made by the farmers. Cost of
production often becomes a policy issue when producers complain that the prices they receive for
their product do not cover the cost of production. Cost of production here means the expenses
incurred per unit of output.
Costs in farming can be divided into two main categories - fixed and variable.
Fixed cost (or) over head charges (or) sunk cost
A resource or input is called a fixed resource if it’s quantity cannot be varied during the
production period and in general, Costs associated with fixed inputs are called fixed costs. Fixed
costs have to be incurred even when the production is not undertaken. e.g., taxes, rent, interest,
electricity, water charges, insurance, depreciation, labour hired on annual basis, etc. In short run,
some costs are fixed and others can be varied, however with the long run all costs become variable.
Variable costs
An input is a variable input if it’s quantity can be varied during the period of production and the
costs associated with variable inputs are called variable costs. Variable costs vary with the level of
production. These costs will not be incurred in the absence of production. e.g., seed, tractor fuel,
repairs, feed, fertilizer cost, etc. Labour if hired on daily basis is also included in variable costs.
Total costs of production will include both fixed and variable costs.
Cash costs (explicit cost)
Cash costs are incurred when resources are purchased and used immediately in the
production process. Cash costs result from purchases of non-durable inputs such as fertilizers, fuel
oil, and casual labour which do not last more than one production process.
Non-cash costs (implicit costs)
Non-cash costs consist of depreciation and payments to resources owned by the farmer. e.g.,
Depreciation on tractor, equipment, buildings, payments made to the farmer himself or family labour,
management and owned capital.
Opportunity cost of an output is defined to be the income it can earn in the next best alternative use.
For eg., a farmer with 25 kg concentrate feed which can either be fed to his cows or sold. If he gives the
feed to his cows, the opportunity cost is the amount of money for which the feed can sold to others. If
he sells the feed, the opportunity cost is the amount of extra income, which can be obtained by giving
this feed to his animals. Opportunity cost is defined to be the real cost of input.
COST FUNCTION
Production of output requires input, which cost money, and therefore there exist a
relationship between output and cost. The total cost curve or cost function represents the
functional relationship between output and total cost.
Cost function can be presented arithmetically (tabular form), geometrically (graphic form) and
algebraically (equation form).
a) Tabular form Output TFC TVC TC
0 10 0 10
2 10 2 12
5 10 4 14
9 10 6 16
13 10 8 18
17 10 10 20
22 10 12 22

b) Algebraic form
C = f(Y). Where, C-total cost and Y-output
c) Graphic form
The nature of cost curve depends on the nature of the corresponding production function.
Hence, when cost is portrayed on X-axis and the product on Y-axis, the total cost curve will have
the same shape as total product curve.

Cost TC

TVC
TFC

0 Out put

Relationship between TFC, TVC, and TC

TFC - is represented by a straight line parallel to X-axis and TFC - remains unchanged for all
output levels in a time period. TVC- is zero, when output is zero. It increases as output increases. The
shape of TVC curve depends on the shape of the production function. TC is the sum of TFC and TVC.
When no variable output is added, TC is equal to TFC. The TC curve is shaped exactly like the TVC
curve, but is placed above the total variable cost (TVC) curve.
UNIT COST CURVES
Unit costs are Average Fixed cost (AFC), Average Variable Cost (AVC), Average Total Cost or
Average Cost (ATC or AC) and Marginal Cost ( MC). These unit costs are more important than
total costs in decision making process. Plotting these, we get unit cost curves.

TC AFC AVC ATC MC

Y TFC TVC
(TFC+TVC) (TFC/Y) (TVC/Y) (TC/Y) (DTC/DY)
0 30 0 30 - - - -
1 30 10 40 30 10 40 10
2 30 18 48 15 9 24 8
3 30 24 54 10 8 18 6
4 30 32 62 7.5 8 15.5 8
5 30 50 80 6 10 16 18
6 30 72 102 5 12 17 22

Average Fixed Cost is worked out by dividing TFC by the amount of outputs. It is fixed cost/unit of
output. AFC will vary for each level of output. As output increases, AFC continues to decline. When
output is zero, AFC=TFC. AFC always slopes downwards regardless of production function.
AFC = TFC/Y

Average Variable Cost is calculated by dividing TVC by the amount of output. AVC decreases,
reaches a minimum and increases thereafter. AVC cannot be computed when output is zero.
AVC = TVC/Y

Average Total Cost can be computed by dividing TC by output. ATC, as AVC, first decreases, attains
a minimum and increases thereafter. ATC is the cost of producing one unit of output. ATC could also be
obtained by simply adding AFC and AVC.
ATC = TC/Y

Marginal Cost is the change in Total Cost in response to an unit increase in output. It is found out by
dividing change in total cost (or total variable cost because TFC is not going to change) by change in
output.
MC curve decreases first, reaches its minimum point and then raises upwards and
passes through AVC and AC (ATC) at their minimum points. In other words, AVC and AC will slope
downwards and keep falling as long as MC is below them.
 UNIT COST CURVES

COST Break even point

MC

ATC

AVC

AFC
0 OUTPUT
Shut down point
Break-Even Point is the minimum of average total cost. Exactly at this point, the MC will be equal to
the ATC and the producer neither gains nor losses anything. Whatever income he gets above this point
is his profit. Suppose the farmer is operating below this point he will be incurring loss towards the fixed
cost.
In short-run, the farmer will continue to operate even below this profit. e.g., broiler farms.
In the long-run, the producer has to operate above this point to remain in the business.

Shut-Down Point is the minimum point of Average variable cost. Exactly at this point, the MC will
be equal to the AVC and the producer will be in a position to meet the expenses towards the
variable cost alone. If he operates below this point, he will not be in a position to meet even the
variable expenses.
In short run, the producer must be able to operate at least above this point in order to sustain
the business.
Long run is a period of time during which the quantities of all factors, both variable and fixed, can be
adjusted.
Short run is a period of time, within which the firm can vary its output by varying only the amount of
variable factors such as labour and raw materials. Fixed factors such as capital, equipment, top
management personnel cannot be varied.

Relationship between Average variable cost and Average product

AVC = TVC/Y = X . Px/Y = Px . X/Y = Px . 1/AP
AVC µ 1/AP
Therefore, AVC is inversely related to AP, i.e., when AP increases, AVC decreases. When AP
is maximum, AVC attains its minimum point and when AP decreases, AVC increases. As on a
production function, AP measures the efficiency of variable input, for cost curves AVC provides the
same measure.
Relationship between marginal cost and marginal product
Marginal Product Marginal Cost
Increasing Decreasing
At maximum At minimum
Decreasing Increasing

BREAK EVEN ANALYSIS

In any business, there is a point where total costs become equal to total revenues and that
point is called as Break Even point and the corresponding output is known as Break Even output
(BEO). This means that at this point, the business is making no profit/no loss. Break even point is the
minimum point of average total cost. A farmer must produce atleast this amount of product to cover the
total cost of production. Whatever is produced above this point will be the profit for the farmer. The
point where the farmer recoups his investment is the Break even point. The investment is in the form of
fixed cost and variable cost which constitutes the total cost. When the total cost is equal to total
revenue it is Break even point. It can be calculated by,

The Break even point nearer to the origin indicates less loss and more profit zones. The Break
even point away and away from the origin indicates more and more loss zone and less and less profit
zone. Nearness of Break even point to the origin also indicates whatever the farmer is producing is
market worthwhile. Due to this the farmer will recoup his investment even by producing less number of
units of output.
The Break even point away from the origin indicates to recoup the investment the
farmer has to produce larger number of units of output which is an indication that whatever the farmer is
producing is not so market worthwhile.
There are two approaches namely.,
Linear and Curvilinear approach
Linear Approach: Here the sale price of output remains constant for all the output sales. Here the total
cost curve and the total revenue curve are linear that is these two curves are straight lines, where the
total revenue curve cuts the total cost curve in the Break even point and the corresponding output is
known as Break even output .

Total Fixed Cost

Break even point =
(Output in units) (Selling price/unit of output) – (Variable cost/unit of output)

Total Fixed Cost

Break even point =
(Amount in Rs.) Variable cost/unit of output
1-
Selling price/unit of output

Margin of safety
The margin of safety of a farmer is the difference between its normal capacity and break even
output. Margin of safety indicates the shock absorbing capacity of the farmer in times of risk and
uncertainty. In other words it reflects the financial strength of the enterprise.
Margin of safety = Normal capacity – Break even output
Margin of safety in monetary terms = Revenue of the – Revenues from Break
total output even output
Curvilinear approach: Here the total revenue changes over the period of time, since the some price
changes, one output sales to the other. Generally the curvilinear approach is used for perennial crops
and also in business where the gestation period is very long.

Shut down point

Shut down point is the minimum point of average variable cost. A farmer must produce atleast
this amount so that he will be able to cover the variable cost of production. If the total revenue curve
goes below this point, it is better to close the business instead of incurring losses. So this point is called
as Shut down point.