Lesson 4 COST ANALYSIS
 Cost analysis - assumes a great significance in
all major business decisions because the term ‘cost’ has
different meaning under different settings and is subject
to varying interpretations.
 Analysis of cost is an important factor in almost
all business analysis and business decision making.
 AVERAGE COST - total cost of producing per unit
of commodity. It can be found out as follows
 AC= AFC + AVC
 AC= Total cost/no.of units produced
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COST CONCEPT
 Private costs are those which are actually
incurred by a firm on the purchase of goods and
services from the market. For a firm, all actual costs
both explicit and Implicit are private costs.
 Social Costs refers to the total cost borne by the
society due to production of a commodity
 Incremental costs are closely related to
marginal costs
- refers to the total additional cost associated with the
expansion in output.
 Sunk Costs are those which cannot be altered,
increased or decreased by varying the rate of output.
- defined as expenses that have already been
incurred and cannot be reversed or recovered
 English professor Colin Drury defines sunk costs
"costs that have been created by a decision made in the
past and that cannot be changed by any decision that
will be made in the future" (Drury, 2013).
- expense that has been incurred in the past and
cannot be recovered.
- It is a past investment of resources that offers no
future returns.
EXAMPLE:
1. Salary for employees who have been laid off
2. Research and development costs
3. Advertising and marketing expenses
4. Legal and accounting fees
5. Machinery and equipment
 Short run costs are costs that vary with variation
in output.
- are the same as variable costs
 Long run costs are costs that are incurred on
fixed assets like plant, machinery, etc
 Direct cost are the costs that have direct
relationship with a unit of operation.
- This includes items such as software, equipment,
labor and raw materials.
- Expenses that directly go into producing goods or
providing services
1. Direct Labor
2. Direct Materials
3. Manufacturing
 Indirect cost are those cost whose cost can’t be
easily traced to a product such as electricity stationary
and other office expenses
- General business expenses that keep you operating
1. Rent
2. Utilities
3. General office
 TOTAL COST is the actual money spent to
produce a particular quantity of output.
- It is the summation of fixed and variable costs
TC = TFC + TVC
 TFC (Total Fixed Cost): i.e the cost of plant,
building, equipment etc. remain fixed with a change in
output.
 TVC (Total Variable Cost): i.e the cost of labour,
raw material etc varies with the variation in output.
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AFC (Average fixed Cost) - Fixed cost of
producing per unit of the commodity.
AFC= total fixed cost / no. of units produced.
AVC (Average Variable Cost) - Variable cost of
producing per unit of the commodity.
AVC= total variable cost / no. of units produced.
 MARGINAL COST is the additional to total cost
when one more unit of output is produced .
 MC = change in total cost / change in total output
Cost-output Relationship has 2 aspects:
 Cost-output relationship in the short run,
 Cost-output relationship in the long run
 SHORT RUN - period which doesn’t permit
alterations in the fixed equipment (machinery , building
etc.) & in the size of the organization
 LONG RUN - period in which there is sufficient time
to alter the equipment (machinery, building, land etc.)
- size of the org. output can be increased without
any limits being placed by the fixed factors of production
Cost-output Relationship In The Short Run
Short Run may be studied in terms of
1. Average Fixed Cost
2. Average Variable Cost
3. Average Total Cost
Total, average & marginal cost
1. Total cost (TC) = TFC + TVC, rise as output rises
2. Average cost (AC) = TC / output
3. Marginal cost (MC) = change in TC as a result of
changing output by one unit
Fixed cost & variable cost
1. Total fixed cost (TFC) = cost of using fixed factors;
cost that does not change when output is changed, e.g.
2. Total variable cost (TVC) = cost of using variable
factors ; cost that changes when output is changed,
 Average Fixed Cost and Output
 The greater the output, the lower the fixed cost
per unit, i.e. the average fixed cost.
 Total fixed costs remain the same & do not change
with a change in output.
 Average Total cost and output
 Average total cost, also known as average costs,
would decline first & then rise upwards.
 Average fixed cost + average variable cost.
 Average fixed cost continues to fall with an increase
in output while AVC first declines & then rises.
 So, as AVC declines the ATC will also decline. But
after a certain point the AVC will rise.
Production Rules for the Long Run
 If selling price > ATC (or TR > TC):
 Continue to produce.
 Maximize profit by producing where MR = MC.
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If selling price < ATC (or TR < TC):
There will be a continual loss.
Sell the fixed assets to eliminate fixed costs.
Reinvest money is a more profitable alternative.
Economies of Scale are the cost advantages that a
firm obtain due to expansion.
Specialization Leads to Economies of Scale
 As labor is divided amongst workers, workers are
able to focus on a few or even one task.
 The more they focus on one task, the more efficient
they become at this task, which means that less time
and less money is involved in producing a good.
Other sources of economies of scale
 purchasing in bulk (bulk buying of materials
through long-term contracts)
 managerial (increasing the specialization of
managers)
 financial (obtaining lower-interest charges when
borrowing from banks and having access to a greater
range of financial instruments),
 marketing (spreading the cost of advertising over a
greater range of output in media markets),
 technological (taking advantage of returns to
scale in the production function).
RELATIONSHIP BETWEEN MARGINAL AND
AVERAGE COST
 The marginal costs and average costs are related.
 When marginal cost exceeds average cost,
average cost
must be rising.
 When marginal cost is less than average cost,
average
cost must be falling.
 The position of marginal cost relative to average
total
cost tells us whether average total cost is rising or falling.
Relationship between Marginal Cost and Average
cost
 If MC>ATC, then ATC is rising
 If MC>AVC, then AVC is rising
 If MC< ATC, then ATC is falling
 If MC<AVC, then AVC is falling
 If MC=AVC and MC=ATC, then AVC and ATC are
at there minimum points
LONG-RUN COSTS
 costs over a long period of time.
 They permit for enough change in all factors of
production.
 Thus firms can produce more.
 Supply of a commodity is adjusted to its demand.
LONG RUN COST CURVES
 All costs are variable in the long run.
 There are only average variable cost in long run,
since all factors are variable.
 It is also called as planning curve or envelope or
scale curve.
Diseconomies of Scale:
 Increase in long-term average cost of production as
the scale of operations increases beyond a certain
level.
 After a certain sufficiently large size these
inefficiencies of management more than offset the
economies of scale and thereby bring about the rise in
long run average cost & make the LAC curve upward
sloping.
Determinants of Costs
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 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.
- The more the efficiency in management and
administration the better will be the product and less will
be the cost.
- Cost will rise in case of inefficiencies in
management and administration.
Break-Even Analysis also known as profit
contribution analysis is an important analytical
technique used to study the relationship between the
total costs (TC), Total revenue (TR) and total profits and
losses over the whole range of stipulated output.
Break-even analysis is a technique of having a preview
of profit prospects and a tool of profit planning.
- It integrates the cost and revenue estimates to
ascertain the profits and losses associated with different
levels of output.
To illustrate the break-even analysis under linear cost
and revenue conditions, let us assume linear cost and
linear revenue functions are given as follows.
Cost function: TC = 100 + 10 Q………..eq. (1)
Revenue function: TR = 15 Q……..……eq. (2)
The cost function given in eq. (1) => firm’s TFC (total
fixed cost) = 100 and its variable cost varies at a
constant rate of 10 per unit in response to increase in
output. The revenue function given in fig. implies that
price for the firm’s product is given in the market at 15
per unit of sale.
Firm Behavior Under Perfect
Competition
Firms Maximize Profit at the quantity where the
difference between Total Revenue and Total Cost is
greatest.
At this profit-maximizing level of output, MR = MC.
Firm Behavior
In economics and business, "firm behavior" refers to
the actions and decisions made by a company,
particularly concerning resource allocation,
production, pricing, and market strategies, often
analyzed through the lens of profit maximization and
other objectives.
Economic Perspective:
 Profit Maximization: Firms are often assumed to
act in a way that maximizes their profits, though
behavioral models also consider other factors.
 Resource Allocation: Firms make decisions about
how to allocate their resources (labor, capital, materials)
to achieve their goals.
 The line TFC shows the total fixed cost at 100 for a
Certain level of output.
 The line TVC shows the variable cost rising with a
slope.
 The line TC has been obtained by plotting the TC
function.
 The line TR shows the total revenue.
 The line TR & TC lines intersect at point B
 At point B, Q = 20 ;firm’s total cost =total revenue
 At Q=20, TC breaks-even with TR. Point B,
therefore the break-even point and Q= 20 is break-even
output.
 Below this level of output, TC exceeds TR.
 Vertical difference TC-TR known as operating loss.
 Beyond Q=20, TR>TC and TR-TC is known as
operating profit.
 It may be noted that a firm producing a commodity
under cost and revenue conditions given in above eq.(1)
& (2).
 Must produce at least 20 units to make its total cost
And total revenue break-even.
 At break-even point, TR = TC
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 Production Decisions: Firms decide what to p
roduce, how much to produce, and how to produce it
efficiently.
 Pricing Strategies: Firms determine how to price
their products or services to attract customers and
maximize profits.
 Market Strategies: Firms develop strategies to
enter, compete in, and exit markets.
Market - the concept of a market is any structure that
allows buyers and sellers to exchange any type of goods,
services and information.
- The exchange of goods or services, with or without
money, is a transaction.
1. Goods and service
2. Buyers and sellers
3. A place or region
4. Given price
Perfect Competitiven Market
Classification of Market
Break–even analysis under non-linear function
 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 revenue at different
Output & price.
 The vertical distance between the TR and TC
Measure profit/loss.
 TR & TC curves intersect at two points, B1 & B2,
Where TR = TC.
 OQ1 corresponding to break-even point B1 and
OQ2 corresponding to break-even point B2 ;TR > TC.
 Profitable range lies between OQ1 and OQ2 units
of output
Main features of Perfect Competition Market
 Large no. of buyers and sellers
• Each sellers sell a small portion total
• Single sellers has no influence on market
• Sellers are price taker
 Homogeneous product
• Identical product
• Same price and cost
 Free entry and exit
• There is no government or other control (high cost of
entry; gov't regulations)
The Competitive Firm
 The Firm’s Demand Curve under Perfect
Competition
• Perfectly Elastic (Horizontal)
• Can sell as much as it wants at the market
price.
SHORT RUN PROFIT MAXIMIZATION
Two Approaches...
First:
Total Revenue - Total Cost Approach
The Decision Process:
 Should the firm produce?
 What quantity should be produced?
 What profit or loss will be realized?
The Decision Rule:
Produce in the short-run if the firm can realize
1) a profit (or)
2) a loss less than its fixed costs
DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER
Perfectly Elastic Demand
Price Taker Role
• Total Revenue = P x Q
• Average Revenue = P
• Marginal Revenue = P
SHORT RUN PROFIT MAXIMIZATION
Two Approaches
First: Total Revenue - Total Cost Approach
Second: Marginal Revenue - Marginal Cost Approach
MR = MC Rule
The Competitive Firm
Short-Run Equilibrium for the Perfectly Competitive Firm
• Marginal revenue = Price
• Profit-maximizing level of output: MC = MR
Three Characteristics of MR=MC Rule:
 The rule applies only if producing is preferred to
shutting down
 Rule applies to all markets
 Rule can be restated P=MC
So, a perfectly competitive firm should maximize profit by
producing the output where
•Price = Marginal Cost
•D = MR = AR at all levels of output
•D = MR = AR = MC at the equilibrium level
of output
Why is profit maximised when MR = MC?
 At production levels of MR = MC, the difference
between the total revenue and total cost is maximum which
serves as our requirement for producer’s equilibrium and
leads to profit maximization.
 A firm maximizes profit when marginal revenue (MR)
equalsMarginal cost (MC) because producing an additional
unit where MR > MC adds to profit, while producing where
MR < MC reduces profit, and at the point where MR = MC,
there's no further profit to be gained or lost.
Monopoly Market
Monopoly Market
Pure monopoly exists when a single firm is the sole
producer of a product for which there are no close
substitutes.
Examples: public utilities and professional sports
leagues.
Characteristics of Monopoly
 A single seller: the firm and industry are
synonymous.
 Unique product: no close substitutes for the firm’s
product.
 The firm is the price maker: the firm has
considerable control over the price because it can
control the quantity supplied.
 Entry or exit is blocked.
 Firm and industry: In a monopoly, market, a firm
is itself the industry. Therefore, there is no
distinction between a firm and an industry in such a
market.
Monopoly’s Marginal Revenue
 When a monopoly increases the amount it sells, it
has two effects on total revenue (P x Q).
 The output effect—more output is sold, so Q is
higher.
 The price effect—price falls, so P is lower.
Price and Output Decision of a Simple Monopoly
 A monopoly maximizes profit by producing the
quantity at which marginal revenue equals marginal
cost.
 It then uses the demand curve to find the prices
that will induce consumers to buy that quantity.
Why Monopolies Arise
The fundamental cause of monopoly is barriers to
entry. Barriers to entry have three sources:
 Ownership of key resource
- Exclusive ownership of an important
resource that cannot be readily duplicated is a potential
source of monopoly.
Legal barriers by government
- Patent and copyright laws are a major
source of government-created monopolies.
- Governments also restrict entry by giving a
single firm the exclusive right to sell a particular good in
certain markets.
- This is by far the most common source of a
monopoly.
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Large economies of scale
- An industry is a natural monopoly when a
single firm can supply a good or service to an entire
market at a smaller cost than could two or more firms
- Because of economies of scale, the
minimum efficient scale of one firm’s plant is so large
that only one firm can supply the market efficiently.
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Profit –Maximizing Output
 The MR = MC rule will still tell the monopolist the
profit – maximizing output.
 The monopolist cannot charge the highest price
possible, it will maximize profit where TR minus TC is
the greatest.
 This depends on quantity sold as well as on price.
The Monopolist’s Profit
 The monopolist will receive economic profits as
long as price is greater than average total cost.
(P>ATC)
Demand Curve in Monopoly
 Monopoly demand is the industry or market
demand
and is therefore downward sloping. Price will exceed
marginal revenue because the monopolist must lower
price to boost sales and cannot price discriminate in
most cases.
The marginal revenue curve is below the demand
curve. (MR<D)
Profit –Maximizing Output
 If MR > MC, the monopolist gains profit by
increasing output
 If MR < MC the monopolist gains profit by
decreasing output
 If MR = MC, The monopolists is maximizing
Profit
Monopoly market in short-run
Three situation can be possible for a firm or Industry
in short run
 Super-normal profits = Where P > ATC
 Normal profits = P = ATC
 Losses / minimum losses = P< ATC but P > AVC
 Shut down = Where P < AVC
Monopoly market in Long-run
 In the Long-run, the monopolists can remain in
Business only if he is able to earn super normal profits.
 If he was incurring losses in the short run, he has
Enough time to make changes in his existing plant in the
long run so as to maximize his profits.
 The scale of his plant depends upon the position of
The demand curve (AR) and its corresponding MR curve