COST

PRESENTED BY-
TRILOK,JASWANT,GIRISH,
LALIT,MOHIT
 INTRODUCTION
Production decisions are not possible without their
respective cost considerations. The firm will have
to analyze these sacrifices or costs whenever it
decides to use the resources.
Cost and revenue are the two major factors with
which the profit-maximizing firms need to deal
carefully. It is the difference between revenue and
cost that determines the firm’s overall
profitability. From the decision making point of
view, cost is even more important than revenue
because the firm can influence cost more easily
than revenue.
 DEFINITION
The total spent for goods or services including
money and time and labor.

TYPES OF COSTS-
(1.) Economic Cost:  Also known as the
"opportunity cost" is a payment made to obtain
the services of a resource which is at least equal
to what that resource can earn elsewhere. 
cont.
(2.)Opportunity cost: It is the net return that
could be realized if a resource were put to its next
best use. It is "what we give up" from "the road not
taken." 
(3.) Implicit costs:  The monetary income that a
firm gives up when it uses a resource that it owns
rather than buying it from the market.  In other words
implicit costs are opportunity costs of owner owned
resources including the services of the entrepreneur-
costs that are not paid but must be taken into account
to estimate the total cost 
(4.) Explicit costs:  The monetary payment a
firm must make to an outsider to obtain a resource. 
cont.
(5.)Fixed costs:  Costs of inputs that do not change in a
given period known as the short run.
(6.) Variable costs: Cost of inputs that can change
even in the short run. 
(7.) Total costs:  The costs of all resources paid
(explicit) and not paid (implicit) .
(8.)Relevant costs: These are costs that are
relevant with respect to a particular decision. A
relevant cost for a particular decision is one that
changes if an alternative course of action is
taken. Relevant costs are also called differential
costs. Relevant costs are decision specific,
meaning that a relevant cost may be important in
one situation but irrelevant in another. They are
also called incremental costs by accountants. 
cont.
(9.) Sunk costs: These are costs that were
incurred in the past. Sunk costs are irrelevant for
decisions, because they cannot be changed. Sunk
costs are unrecoverable past expenditures. These
should not normally be taken into account when
determining whether to continue a project or
abandon it, because they cannot be recovered
either way.
(10.) Social costs: These costs are adverse
impacts on human beings, their property and
welfare that cannot be compensated through the
legal system. Social costs also termed "social
externalities”. Adverse effects on property values,
community image, and aesthetics, as well as the
increase of noise, odor, and traffic all contribute
to social costs.
cont.
(11.) Environmental costs: These are the
costs of environmental degradation that cannot be
easily measured or remedied, are difficult to
value, and are not subject to legal liability. To
truly capture all of the important life-cycle cost
elements, some people advocate assessing the
upstream and downstream environmental costs of
resource use, pollution, and waste generated by
providing goods and services.
(12.) Contingent costs: These are costs that
might or might not be incurred at some point in
the future. Examples include the costs of
remediation unknown or future releases of
pollutants, such as leaks from currently operating
municipal landfills. 
cont.
(13.) Semi-variable costs: These costs have
fixed and variable elements. E.g. a person working
for the company may have a fixed salary but may
also earn commission on sales.
(14.) Urgent costs and postponable
costs: Urgent costs are those that must be
incurred so that the operations of the firm continue.
Those costs whose postponement does not affect
the operational efficiency of the firm, are known as
postponable costs.
(15.)INCREMENTAL COSTS: The incremental
costs are the additions to costs resulting from a
change in the nature and level of business activity.
cont.
(16.)Controllable costs: Controllable costs
are those which are capable of being controlled or
regulated by executive vigilance and, therefore ,
can be used for assessing executive efficiency.
(17.)Non-controllable costs: Non-
controllable costs are those which cannot be
subjected to administrative control and
supervision.
(18.)Shutdown costs: Shutdown costs are
those which the firm incurs if it temporarily stops
it operations.
(19.)Abandonment costs: Abandonment
costs are the costs of retiring altogether a fixed
asset from use.
 Relationship Between
Production and Cost
 Marginal Cost has Total
Input TVC
been added to
(L) Q MP (wL) MC
the table.
0 0 0
 When MP is 1 1,000 1,000 500 0.50
increasing, MC is 2 3,000 2,000 1,000 0.25
decreasing. 3 6,000 3,000 1,500 0.17
 When MP is 4 8,000 2,000 2,000 0.25
decreasing, MC is 5 9,000 1,000 2,500 0.50
increasing. 6 9,500 500 3,000 1.00
7 9,850 350 3,500 1.43
8 10,000 150 4,000 3.33
9 9,850 -150 4,500
10
 Relationship Between
Production and Cost
 Plotting TP and TVC illustrates that they are
mirror images of each other.
 When TP increases at an increasing rate, TVC
increases at a decreasing rate.

11
 DETERMINANTS OF A COST
FUNCTION
There are several factors that influence the cost.
Cost function expresses the relationship between
cost and its determinants, like the size of plant,
level of output, input prices, technology, etc. In a
mathematical form it can be expressed as,
C=f (S, O, P, T…)

SHORT RUN COST FUNCTION:

 The Short-Run Cost Function
 For simplicity the following assumptions are made:
 The firm employs two inputs, labor and capital.
 The firm operates in a short-run production period
where labor is variable, capital is fixed.
 The firm uses the inputs to produce a single product.
 The firm operates with a fixed level of technology.
 The firm operates at every level of output in the
most efficient way.
 The firm operates in perfectly competitive input
markets and must pay for its inputs at a given
market rate. It is a “price taker” in the input
markets.
 The short-run production function is affected by the
law of diminishing returns.
 The Short-Run Cost Function
 Standard variables in the short-run cost
function:
 Quantity (Q): the amount of output that a firm
can produce in the short run.
 Total fixed cost (TFC): the total cost of using
the fixed input, capital (K)
 Total variable cost (TVC): the total cost of
using the variable input, labor (L)
 Total cost (TC): the total cost of using all the
firm’s inputs, L and K.
TC = TFC + TVC
 The Short-Run Cost Function
 Standard variables in the short-run cost function:
 Average fixed cost (AFC): the average per-unit cost
of using the fixed input K.
AFC = TFC/Q
 Average variable cost (AVC): the average per-unit
cost of using the variable input L.
AVC = TVC/Q
 Average total cost (AC) is the average per-unit cost
of using all the firm’s inputs.
AC = AFC + AVC = TC/Q
 Marginal cost (MC): the change in a firm’s total cost
(or total variable cost) resulting from a unit change
in output.
MC = TC/Q = TVC/Q
 Fixed costs, Variable cots and
marginal cost
Units Total Total Total Averag Averag Averag Margin
of fixed variabl cost e fixed e e total -al cost
output costs e costs (TC) cost variabl cost (MC)
(TVC) (AFC) e cost (ATC)
(Q) (TFC)
(AVC)
(TC/Q)

0 1000 0 1000 - - - -
10 1000 400 1400 100 40 140 40
20 1000 700 1700 50.0 35 85 30
30 1000 930 1930 33.3 31 64.3 23
40 1000 1100 2100 25.0 27.5 52.5 17
50 1000 1400 2400 20.0 28 48 30
60 1000 1900 2900 16.7 31.7 48.4 50
70 1000 2500 3500 14.3 35.7 50 60
Pesos

TC
(Total Cost)

TVC
(Total Variable Cost)

TFC
(Total Fixed Cost)

0 Q
“TOTAL” COST CURVES
Pesos

AFC=TFC/Q.
As more output is produced, the
Average Fixed Cost decreases.

AFC
(Average Fixed Cost)

0 Q
Pesos The Marginal Cost curve passes
through the minimum point of
the AVC curve.
MC (Marginal Cost)
It is also U-shaped. First it
decreases, reaches a minimum AVC
and then increases. (Average Variable Cost)

Minimum AVC

0 q1 Q
Pesos MC

AC

AVC

AFC

0 q1 Q

The “PER UNIT” COST CURVES

 The Short-Run Cost Function

 Important Observations
 AFC declines steadily over the range of
production.
 When MC = AVC, AVC is at a minimum.
 When MC < AVC, AVC is falling.
 When MC > AVC, AVC is rising.
 The same three rules apply for average
cost (AC) as for AVC.
 The Short-Run Cost Function

 A reduction in the firm’s fixed cost

would cause the average cost line to
shift downward.
 A reduction in the firm’s variable cost
would cause all three cost lines (AC,
AVC, MC) to shift.
 The Short-Run Cost Function
 Alternative specifications of the Total Cost function
 Most commonly: specified as a cubic relationship
between total cost and output
 As output increases, total cost first increases
at a decreasing rate, then increases at an
increasing rate.
 Quadratic relationship

 As output increases, total cost increases at an

increasing rate.
 Linear relationship

 As output increases, total cost increases at a

constant rate.
LONG RUN COST FUNCTION
In the long run, by definition, all factors are
variable so that the entrepreneur has
before him a number of alternative plant
sizes and levels of output which he can
adopt. The long run cost curve is therefore
also called planning curve, in the sense
that it is a guide to the entrepreneur in his
decision to plan the future expansion of
his output.
The Long-Run Cost Function
 In the long run, all inputs to a firm’s
production function may be changed.
 Because there are no fixed inputs, there
are no fixed costs.
 The firm’s long run marginal cost pertains
to returns to scale.
 First, increasing returns to scale.
 As firms mature, they achieve constant returns,
then ultimately decreasing returns to scale.
The Long-Run Cost Function
 When a firm experiences increasing returns to
scale:
 A proportional increase in all inputs increases

output by a greater proportion.

 As output increases by some percentage, total

cost of production increases by some lesser

percentage.
The Long-Run Cost Function
 Economies of Scale: situation where a firm’s long-
run average cost (LRAC) declines as output
increases.
 Diseconomies of Scale: situation where a firm’s
LRAC increases as output increases.
 In general, the LRAC curve is u-shaped.
The Long-Run Cost Function
 Reasons for long-run economies
 Specialization in the use of labor and capital.
 Prices of inputs may fall as the firm realizes
volume discounts in its purchasing.
 Use of capital equipment with better price-
performance ratios.
 Larger firms may be able to raise funds in
capital markets at a lower cost than smaller
firms.
 Larger firms may be able to spread out
promotional costs.
The Long-Run Cost Function
 Reasons for Diseconomies of Scale
 Scale of production becomes so large
that it affects the total market demand
for inputs, so input prices rise.
 Transportation costs tend to rise as
production grows.
 Handling expenses, insurance, security, and
inventory costs affect transportation costs.
COST

LAC
SAC1

0 Q
q0
 Building a larger sized plant (size
2) will result in a lower average
COST cost of producing q0

LAC
SAC1

SAC2

0 Q
q0
 Likewise, a larger sized plant (size 3)
COST will result to a lower average cost of
producing q1

SAC1 LAC
SAC2
SAC3

0 Q
q0 q1
COST

LAC

SAC1

SAC2

0 Q

LONG-RUN AVERAGE COST CURVE

COST

LAC

SAC1

SAC2

Economies of Diseconomies of Scale

Scale
0 Q1 Q

LONG-RUN AVERAGE COST CURVE

 ANY
QUESTION
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