COST THEORIES AN INTRODUCTION

Dr.M.MadhavanAssistant Professor of Economics

Arignar Anna Government Arts CollegeNamakkal – 637 002, Tamil Nadu

Cost

The term cost of production means “expenses incurred in the production of a commodity. This refers the total

amount of money spent on the production of a commodity”

Cost of production Three different senses

  Money cost   Real cost and Opportunity cost

Money Cost of Production

Explicit Cost (Accountant point of view) Wages, interest, rent depreciation charges on

fixed capital, taxes paid and other sundry expenses come under this cost.

Implicit Cost Wages for the work performed by the entrepreneur. Interest on the capital supplied by him Rent of land and buildings belonging to the producer

and used in production

Economic Cost & Profit

Economic Costs = Explicit costs + Implicit costs

Economic profit = Total Revenue - Economic costs.

Real Cost of Production

This is a subjective concept. It expresses the

trouble, turmoil and sacrifices involved in

producing a commodity. The efforts and sacrifices of the factors or its owners is

the real cost.

Opportunity Cost or Alternative Cost

This means that the “cost of using something in a particular venture is the benefit forgone (or opportunity lost) by not using it in its best alternative use’. The opportunity cost of any goods is the next best alternative goods sacrificed.

Commodity – ACost of Production = Rs. 10

Profit = Rs.5 ; Sales = 100 units Profit = Rs.500

Cost of Production = Rs.10Profit = Rs.3 ; Sales = 200 units

Profit = Rs.600

Opportunity Cost or Alternative CostExample

Cost – Output Relationship

The cost of production of a commodity depends on three factors, which are variables. They are : Price paid for procuring the factor or

services of factors The output of the firm The time element involved, i.e., short

period or long period.

Fixed cost

Fixed costs : The fixed capital of the firm, e.g., equipment, machinery, land, buildings, insurance premium,

certain taxes and salaries of permanent staff come with this class. When once

engaged, the factors can be used over a period of time. Some economists include

opportunity cost in fixed costs.

Variable cost

The other inputs which are exhausted by a single use, e.g., raw materials, fuel, etc.In the long period all costs become variable. Fixed costs of a firm are called supplementary cost of production or overhead costs. Variable costs are called prime cost of production or direct costs. The total cost of a business is the sum of its variable cost and fixed cost of a particular level output.

Total Cost

TC = TFC + TVCWhere,

TC = Total CostTFC = Total Fixed CostTVC = Total Variable Cost

The Variable cost will increase with the increase in output. So, the total cost will increase with increase in output, as the total variable cost will increase due to increase in output.

Total Cost, Variable and Fixed Costs Curves

TC

TVC

COST

Output X

TFC

Y

O

Marginal Cost

Marginal cost may be defined as the addition made to the total cost by the production of one additional unit of output. This means marginal

cost is the addition to the total cost of producing n units instead of n-1 units where n is any given

number

MCn = TCn – TC n-1

MARGINAL COSTOUTPUT TOTAL COST MARGINAL COST

0 200 -1 260 602 310 503 350 404 380 305 422 426 472 507 532 608 602 70

Marginal Cost Curve

MARGINAL COST

MCY

0 OUTPUT X

Assumptions for Marginal Cost

The law of variable proportion determines the shape of the cost curve. If increasing returns is in operation, the marginal cost curve will be declining.

The changes in the marginal cost is due to the changes in the variable cost 

The price of the variable factor remains constant as the firm expands its output. Otherwise a change in factor price may disturb our conclusions.

LAC – PLANT CURVES

P1

P2

P3

P4

P5SAC1

SAC2 SAC3

M1 M2 M3O

Y

XOUTPUT

AC

LAC – CONSTANT RETURN

P1P2

SAC1 SAC2 SAC3

M1 M2 M3O

Y

XOUTPUT

ACP3 LAC

LAC at Variable Return

YSAC 6

SAC 5SAC 4

SAC 3

SAC 2

SAC1LACA

VERAGE COST

O M1 M2 Output X

The amount of money that the firm receives by the sale of its output in the market is known as its revenue.       Total revenue TR = q * p       Average revenue TR TR

AR = P = q q

      Marginal revenue MRn = TRn – TRn-1

Revenue

BREAK – EVEN ANALYSIS

Break-even analysis is a study of costs, revenues and sales of a firm and finding out the volume of sales where the firm’s costs and revenues will be equal. The Break-even point is the zone of no-profit and no-loss as the costs equal revenues.

BEP in terms of Physical Unit

Output inUnits

Total RevenuePrice Rs.4/- per

unit

Total Fixed Cost

Total Variable

Cost

Total Cost

0 0 300 0 300

100 400 300 300 600

200 800 300 300 600

300 1200 300 900 1200

400 1600 300 1200 1500

500 2000 300 1500 1800

600 2400 300 1800 2100

Break – Even Point

0300600900

120015001800210024002700

1 2 3 4 5 6 7

TR

TC

Loss Zone

Profit Zone

BEP

ALTERNATIVE METHOD FOR BEP

Total Fixed Cost BEP =

Contribution Margin per unitContribution Margin = Selling price – AVC

300BEP = = 300 4 - 3

BEP (in terms of Sales Value)

Total Fixed Cost BEP =

Contribution Margin per unit (CM)Total Revenue minus Total Variable Cost

CM = Total Revenue Rs.300BEP = = Rs. 1200/- 0.25

BEP

Total Revenue ---- Rs. 1200/-Total Cost ---- Rs.1200/-(TFCRs.300+TVC Rs. 900)

Net Profit / Loss ----- NIL

Sl. No. Particulars Amount In Rs.1.   Salary for the Administrative Staffs 455600

2.   Wages for the workers 1966000

3.   Expenses on raw materials and accessories 35450004.   Electricity 400005.   Fuel for the generator 250006.   Transportation 730007.   Telephone Bill 120008.   Security 10000

9.   Maintenance 17000

10.   Lodging facilities for the buyers & visitors 25000

11.   Advertisement 700000

12.   Rent for the Land & building 12000

13.   Interest for the amount borrowed from ICICI 95500

14.   Interest for capital supplied by the entrepreneur 1250007101100Total

Lakshmi Narashima Garments is producing 25,000 Garments during the month of August 2002. This includes 15,000 Mercerized T-Shirt and rests of them are polo T-shirt. The selling price of mercerized T-shirt is Rs.549.95 and the Polo T-shirt is Rs.175.75.Following is the details of expenditure for the month of August 2002 listed in the accountant book.

Calculate the Break – Even point of the firm as well as the profit earned during the month of August 2002. Give your suggestion for the improvement and modification to be made in the company.

PROBLEM

Sl. No. Particulars TOTAL COST FC VC1.   Salary for the Administrative Staffs 4556002.   Wages for the workers 19660003.   Expenses on raw materials and accessories 35450004.   Electricity 400005.   Fuel for the generator 250006.   Transportation 730007.   Telephone Bill 120008.   Security 100009.   Maintenance 17000

10.   Lodging facilities for the buyers & visitors 2500011.   Advertisement 70000012.   Rent for the Land & building 1200013.   Interest for the amount borrowed from ICICI 9550014.   Interest for capital supplied by the entrepreneur 125000

7101100 715100 6386000Total

AMOUNT IN RUPEES

FIXED COST AND VARIABLE COST IDENTIFICATION

BEP (in terms of Sales Value)

Total Fixed Cost BEP = Contribution Margin per unit (CM)

CALCULATION OF BEP

Total Revenue minus Total Variable CostCM = Total Revenue

Mercerized T shirt = 15,000 X 549.95 = 8249250 Polo T shirt = 10,000 X 175.75 = 1757500

Total Revenue = 10006750

Total Variable Cost = 6386000Total Fixed Cost = 715100

CALCULATION OF BEP

Total Revenue minus Total Variable CostCM = Total Revenue

10006750 –6386000 3620750CM = = = 0.362 10006750 10006750

TOTAL FIXED COST 715100

BEP = = = Rs. 1975414.364 CM 0.362