The Theory Of Cost

• Business decisions are generally taken based on the

monetary values of inputs and outputs. Note that
the quantity of inputs multiplied by their respective
unit prices will give the monetary value or the cost
of production.
Analytical Cost Concepts Used in Economic
Analysis of Business Activities.
• The analytical cost concepts include:
1. Fixed and Variable Costs. Fixed costs are those
costs that are fixed in volume for a certain level of
output. They do not vary with output. They remain
constant regardless of the level of output
 Fixed costs include:
(i) Cost of managerial and administrative staff;
(ii) Depreciation of machinery;
(iii) Land maintenance, and the like. Fixed costs are
normally short-term concepts because, in the
long-run, all costs must vary.
• Variable Costs are those that vary with variations in output.
These include: (i) Cost of raw materials; (ii) Running
costs of fixed capital, such as fuel, repairs, routine
maintenance expenditure, direct labor charges
associated with output levels; and (iii) the Costs of
all other inputs that may vary with the level of
output.
2. Total, Average, and Marginal Costs. The Total Cost (TC) refers to the
total expenditure on the production of goods and services. It includes
both explicit and implicit costs. The explicit costs themselves are made
up of fixed and variable costs. For a given level of output, the total cost
is determined by the cost function. The Average cost (AC) is obtained by
dividing total cost (TC) by total output (Q). Thus,
AC = TC………………………………….. (1)
Q
• Marginal Cost (MC) is the addition to total cost on account of producing one
additional unit of a product. It is the cost of the marginal unit produced.
Marginal cost of output can be computed as TCn – TCn-1, where n
represents the current number of units produced, and n-1 represents the
previous number of units produced. MC can also be computed by the
following relationship:
MC = Change in TC = ΔTC……………………………..(2)
Change in Q ΔQ
• If the total cost (TC) is in a functional form, MC can be computed by
the derivative:
MC = dTC ……………………………………..(3)
dQ
3. Short-Run and Long-Run Costs. Short-Run
Costs are costs which change as desired output
changes, size of the firm remaining constant.
These costs are often referred to as variable
costs. Long-Run costs, on the other hand are costs
incurred on the firm’s fixed assets, such as plant,
machinery, building, and the like.
• In the long-run, all costs become variable costs
as the size of the firm or scale of production
increases. Put differently, long-run costs are
associated with changes in the size and type of
plant.
4. Incremental Costs and Sunk Costs. Conceptually, incremental
costs are closely related to the concept of marginal cost, but with a
relatively wider connotation. While marginal cost refers to the cost
of extra or one more unit of output, incremental cost refers to the
total additional cost associated with the decision to expand output
or to add a new variety of product. The concept of incremental
cost is based on the fact that, in the real world, it is not practicable
to employ factors for each unit of output separately due to lack of
perfect divisibility of inputs. Incremental costs also arise as a result
of change in product line, addition or introduction of a new
product, replacement of worn out plant and machinery,
replacement of old technique of production with a new one, and
the like.
• The Sunk costs are those costs that cannot be altered, increased or decreased,
by varying the rate of output. For instance, once management
decides to make incremental investment expenditure and the funds
are allocated and spent, all preceding costs are considered to be the
sunk costs since they accord to the prior commitment and cannot
be reversed or recovered when there is a change in market
conditions or a change in business decisions.
5. Historical and Replacement Costs. Historical
cost refers to the cost an asset acquired in the past,
whereas, replacement cost refers to the outlay made for
replacing an old asset.
• These concepts derive from the unstable nature of
price behavior. When prices become stable over
time, other things being equal, historical and
replacement costs will be at par with each other.
6. Private and Social Costs. Private and social costs
are those costs which arise as a result of the
functioning of a firm, but neither are normally
reflected in the business decisions nor are explicitly
borne by the firm
Costs in this category are borne by the society. It
follows that the total cost generated in the course of
doing business may be divided into two categories: (i)
those paid out by the firm; and, (ii) those not paid or
borne by the firm, including the use of resources that
are freely available plus the disutility created in the
process of production. Costs under the first category
are known as private costs. Those of the second category are
known as external or social costs. Examples of such social costs
include: water pollution from oil refineries, air pollution
costs by mills and factories located near a city, and the
like. From a firm’s point of view, such costs are
classified as external costs, and from the society’s point of view,
they are classified as social costs.
• The relevance of the concept of social costs is
more pronounced in the cost-benefit analysis of
the overall impact of a firm’s operation in the
society as a whole, and in working out the social
cost of private gains.
Cost-output Relations
• The theory of costs basically deal with costs in
relation to output changes. In other words, they
deal with cost-output relations. The basic
economic principle states that total cost increases
with increase in output. However, what is important
from a theoretical and marginal point of view is
not the absolute increase in total cost, but the
direction of change in the average cost (AC) and
the marginal cost (MC). The direction of
changes in AC and MC will depend on the
nature of the cost function.
• A cost function is a symbolic statement of the
technological relationship between the cost and
output. Generally, cost functions take the
following form:
C = TC = f(Q), and ΔQ > 0,
where Q represents output level. In addition, the
specific form of the cost function depends on
the time framework for cost analysis: short-or
long-run. Thus, there exists short-run cost
function and long-run cost function.
Accordingly, cost-output relationship are
analyzed in short-run and long-run frameworks.
 The Cost Functions
The Short-Run Cost Function.
• Cost-output relations are normally determined by the cost function
and are exhibited by cost curves. The shape of cost curves depends
on the nature of the cost function which are derived from actual cost
data. Cost functions may take a variety of forms, yielding different
kinds of cost curves, including linear, quadratic, and cubic cost curves arising
from the corresponding functions. The functions are as illustrated
below:
1. Linear Cost Function. A linear cost function is of the form:
TC = C = a + bQ.................................(1)
where a = Total Fixed Cost (TFC)
bQ = Total Variable Cost (TVC)
• The Average and Marginal cost functions can be obtained from the
Total Cost Function (equation 1) as follows:
Average Cost (AC) = TC = a + bQ = a/Q + b
Q Q
Marginal Cost (MC) = dTC = b
dQ
2. Quadratic Cost Function. The quadratic cost function is of
the form:
TC = C = a + bQ + Q2 ...................(2)
• From the quadratic cost function (equation 2), we can obtain
the Average and Marginal cost functions as follows:
AC = TC = a + bQ + Q 2 = a/Q + b + Q
Q Q
MC = dTC = b + 2Q
dQ
Example, if TC = C = 150 + 10Q + Q2
Then, AC = 150 + 10Q + Q2
Q
= 150/Q + 10 + Q
MC = dTC = 10 + 2Q
dQ
3. Cubic Cost Function. The cubic cost function is of the
form:
TC = C = a + bQ – cQ2 + dQ3………………………
(3)
The corresponding Average Cost (AC) and Marginal Cost
(MC) functions can be derived as:
AC = TC = a + bQ – cQ 2 + dQ 3
Q Q
= a/Q + b – cQ + dQ2
MC = dTC = b – 2cQ + 3dQ2
dQ
Assume that the cost function is empirically and explicitly
estimated as:
TC = 10 + 6Q – 0.9Q2 + 0.05Q3……. (4)
And,
TVC = 6Q – 0.9Q2 + 0.05Q3 ……………..(5)
• Using equations (4) and (5), you can derive the
behavioral equations for the average fixed cost
(AFC), average variable cost (AVC), average total
cost (ATC), and marginal cost (MC) as follows:
AFC = FC/Q = 10/Q
AVC = TVC/Q = 6Q – 0.9Q 2 + 0.05Q 3
Q
= 6 – 0.9Q + 0.05Q2
• ATC = TC/Q = 10 + 6Q - 0.9Q 2 + 0.05Q 3
Q
= 10/Q + 6 – 0.9Q + 0.05Q2
MC = dTC = 6 – 1.8Q + 0.15Q2
dQ
Table 1: Cost-Output Relations

Q FC TVC TC AFC AVC AC MC

0 10 0.0 10.00 - - - -
1 10 5.15 15.15 10.00 5.15 15.15 5.15
2 10 8.80 18.80 5.00 4.40 9.40 3.65
3 10 11.25 21.25 3.33 3.75 7.08 2.45
4 10 12.80 22.80 2.50 3.20 5.70 1.55
5 10 13.75 23.75 2.00 2.75 4.75 0.95
6 10 14.40 24.40 1.67 2.40 4.07 0.65
7 10 15.05 25.05 1.43 2.15 3.58 0.65
8 10 16.00 26.00 1.25 2.00 3.25 0.95
9 10 17.55 27.55 1.11 1.95 3.06 1.55
10 10 20.00 30.00 1.00 2.00 3.00 2.45
Cost Minimization
In its simplest form, the critical value of output (Q) in
respect of the average variable cost (AVC) is the value
that minimizes average variable cost. The average variable
cost will be at its minimum when its rate of change
{d(AVC)} = 0. This can be
dQ
accomplished by differentiating the AVC function with
respect to output (Q). Thus, from our examples,
AVC = 6 – 0.9Q + 0.05Q2
d(AVC) = -0.9 + 0.10Q
dQ
• Setting this equal to zero, you get:
-0.9 + 0.10Q = 0
0.10Q = 0.9
Q=9
• It follows that critical value of output (Q) in
respect of the average variable cost is 9 units.
From table 1, we observe that at the output level
Q = 9, the minimum average variable cost is
1.95.
• The same argument can be made for average
total cost (ATC). Given the ATC function, you
can set the derivative with respect to Q
{(d(ATC) } = 0,
dQ
and solve for Q to obtain the level of output
that minimizes average total cost.
 Output Optimization in the Short-Run
• The optimum level of output in the short-run is the
level of output for which the average cost (AC) of
production equals the marginal cost (MC). That is,
for optimum output,
AC= MC in the short-run.
• Suppose the short-run cost function is given by:
C = 200 + 5Q + 2Q2 …………..(1)
AC = 200 + 5Q + 2Q 2
Q
= 200/Q + 5 + 2Q……………… (2)
MC = dC = 5 + 4Q…………………. (3)
dQ
• By using AC = MC at optimum, and solving for Q,
you will obtain the optimum level of output.
• Thus, (AC = MC)
200
+ 5 + 2𝑄 = = 5 + 4Q
𝑄
200/Q = 2Q
2Q2 = 200
Q2 = 100
Q = 10
• Thus the optimum level of output in this
example is 10 units.
Long-run Cost-output Relations And Breakeven
Analysis
By definition, the long-run is a period for which all
inputs change or become variable. This is based on
the assumption that in the long-run, supply of all
inputs, including those held constant in the short-
run, becomes elastic. Firms are therefore, now in a
position to expand the scale of production by
increasing all inputs.
• It follows that the long-run cost output relations
imply the relationship between the changing
scale of a firm and the firm’s total output,
whereas in the short-run, this relationship is
essentially one between the total output and the
variable costs such as, labor and raw materials.
In this unit, we discuss the long-run cost-output
relations especially with specific reference to the
firm’s break-even conditions.
 1. The Long-Run Cost-Output Relations
Figure 1: The Long-Run Total Cost Curve (LTC)
LRC
Total cost

STC3

STC2
STC1

Output(Q)
Q Q Q
1 2 3
• Figure 1 assumes that the firm has only one
plant, with the corresponding short-run cost
curve given by STC1, Suppose the firm decides
to add two more plants with associated two
more short-run cost curves given by STC2 and
STC3. The long-run total cost curve (LTC) is then
drawn through the minimum of the short-run cost curves,
STC1, STC2, and STC3.
Long-Run Cost

The long-run average cost

curve LAC is the envelope of
the short-run average cost
curves SAC1, SAC2, and SAC3.
With economies and
diseconomies of scale, the
minimum points of the short-
run average cost curves do not
lie on the long-run average cost
curve.
Optimum Plant Size and Long-Run Cost
Curves.
• The short-run cost curves are extremely helpful
in the determination of the optimum utilization of
a given plant, or in the determination of the least-cost-
output level. Long run cost curves, on the other
hand, can be used to show how a firm can
decide on the optimum size of the firm.
Consequently, the optimum size of the firm is
one which ensures the most efficient utilization
of the resources. In practical terms, the
optimum size of a firm is one in which the long-
run average cost (LAC) is minimized.
Break-Even Analysis: Linear Cost and Revenue
Functions.
• Traditionally, the basic objective of any business
firm is to maximize profit. The maximum profit
does not necessarily coincide with the minimum
cost, according to the traditional theory of the firm.
• Nevertheless, firms plan their production activities
much better if the level of production for which
total cost and total revenue break even is known.
This implies the profitable and non-profitable range
of production. The breakeven analysis, or what is often
referred to as profit contribution analysis is an important
analytical technique used in studying the
relationship between total cost, total revenue, and
total profits and losses over the whole range of
stipulated output.
• The break-even analysis is a technique of
previewing profit prospects and a tool of profit
planning. It integrates cost and revenue
estimates to ascertain the profits and losses
associated with different levels of output.
• In order to exemplify the break-even analysis
under linear cost and revenue conditions, you
can assume a linear cost function and a linear revenue
function as follows:
 Cost function: C = 100 + 10Q……………………… (1)
Revenue function: R = 15Q…………………………… (2)
• The cost function (equation 1) implies a total fixed cost (TFC) of 100.
Its variable cost varies at a constant rate of 10 per unit in response to
increases in output. The revenue function (equation 2) implies that the
market price for the firm’s product is 15 per unit of sale. Given
equations 1 and 2, the break-even output can be computed
algebraically in the following way:
At the break-even point,
• Total Revenue (R) = Total Cost (C), so that in this example,
15Q = 100 + 10Q
5Q = 100
Q = 20.
• It follows that the break-even level of output is 20 units. This result
can be illustrated graphically in figure 1 below.
Figure 1: Break-Even Analysis: Linear Functions

Cost and TR Operating Profit

Revenue
LRC
500
} TC
Operating Loss
400
TVC
300

200

TFC
100
{
50

Output(Q)
10 20 30
40
 Break-Even Analysis: Non-Linear Cost and
Revenue Function
• The break-even analysis under non-linear cost and
revenue functions is best demonstrated by the
following graph. As shown in figure 1 below, the
total fixed cost (TFC) line shows the fixed cost at
OF, and the vertical distance between TC and TFC
measures the total variable cost (TVC). The curve,
TR, shows the total sales or total revenue at
different output levels and at different prices. The
vertical distance between the TR and TC measures
the profit or loss for various levels of output.
• You will observe from figure 1 that the TR and TC
curves intersect each other at two points, P1 and P2.,
where TR = TC. These represent the lower and
upper break-even points. For the whole range of
output between OQ1 (corresponding to the break-
even point, P1) and OQ2 (corresponding to the
break-even point, P2),
TR > TC. This implies that a firm producing more
than OQ1 and less than OQ2 will be making profits.
Put differently, the profitable range of output lies
between OQ1 and OQ2 units of output. Producing
less or more than these limits will give rise to losses.
Figure 1: Break-Even Analysis: Non-Linear Functions

TR & TR TC

P2

TR

P1
F TFC

Output(Q)
0 Q Q
1 2
The Profit Volume (PV) Ratio.
• The PV ratio is another useful tool for finding the Break-Even Point
(BEP) of sales, especially for multi-purpose firms. The PV ratio is
defined by the following formula:
PV Ratio = S – V x 100
S
Where S = Selling price; and, V = average Variable cost.
For instance, if the selling price, S =birr 5 per unit, and average variable
cost, V =birr 4 per unit, then:
PV Ratio = 5 – 4 x 100
5
= 20 percent
• The Break-even point (BEP) in sales value is calculated by dividing
the fixed expenses (F) by the PV ratio.
Thus, BEP (Sales value) = Fixed Expenses = F /S – V
PV Ratio S
 Practical work
1. Explain with illustration the distinction between the following.
A. Fixed cost and variable cost
B. Actual and opportunity cost
C. Marginal and incremental cost
2. Which of the following statements are true?
A. Economic rent is the same as economic profit.
B. Imputed cost is the rent of hired building.
C. Sunk costs should be considered whenever business decisions are made.
D. Running costs and depreciation of the capital assets are included in the long
run cost.
3. How do you define the term 'cost'?
4. From the following table calculate:
TVC, TFC, AFC, AVC, TAC & MC

Q TVC TFC TC AFC AVC ATC MC

0 $150 - - - -

6 200

16 250

29 300

44 350

55 400

60 450

62 500
1. Which of the following statements are true?
A.When AC = MC, AC is minimum
B. Output is optimum when AC = MC
C. Marginal Cost = VC/Q
D.LAC intersects LMC when the later is at its minimum
2. When the law of diminishing returns begins to operate, then
A.TVC begins to fall at an increasing rate
B. TVC falls at a decreasing rate
C. TVC rises at a decreasing rate
D.TVC rises at an increasing rate
E. TVC remains constant
3.The Engineering department of a chemical
product company has developed the following TC
function for a proposed new plant that produce
ammonium sulfate fertilizer.
𝑇𝐶 = 1016 – 3.36𝑄 + 0.021𝑄2
a) Determine the output rate that will minimize
AC and the per unit cost at the rate of output.
b) The current market price of this fertilizer is
$5.5 per unit and is expected to remain at the
level for the foreseeable future. Should the
plant be built?
4. Three business school graduates decide to open a business, and all
three devote their full time to its management. What cost would you
assign to their time? Is this an explicit or implicit cost?
5. Which of the following statement is true when output is zero?
A.TC = TVC
B. TC > TVE
C. TC < TVC
6. Suppose Z company estimates the following total cost function from
cost output data: 𝑇𝐶 = $135,000 + $250𝑄 + $1.5𝑄2
• Find the optimum level of output that makes the company efficient
and per unit cost (AC) at the rate of output.