Cost of Production
Explicit cost: Includes all tangible expenses that
appear in the account books
- incurred through market transaction
Implicit Cost- Does not appear in account booksown resources of entrepreneur- imputed cost
Accountant’s cost considers only explicit cost
whereas economist’s cost includes both
1
Cost of Production
Private: All expenses including explicit and
implicit costs incurred by a firm for
purchasing or hiring resources
Social: Cost which society bears on account
of the production process- disutility such
as deforestation, pollution…
Externalities- positive and negative
2
Cost of Production
• Short run costs : Costs incurred in the
short run
• Long run costs- Costs arising out of
change in size and kind of output
3
• Fixed cost: Cost incurred on fixed factorsremains constant at different levels of
production-has to be incurred even if there
is no production . E.g., rent, interest
• Variable cost varies with output and is
zero when there is no production E.g.,
material cost, transport cost
4
• Opportunity cost: Cost of next best
alternative foregone
• Arises because of scarcity and versatility
of factors of production
5
• Production costs are the costs which are
incurred to make a product, transport it and
make it available to the consumer- costs of
hiring resources, raw materials, energy,
transport etc
• Selling costs are those that are incurred for
changing the demand and preference of
consumers- on advertising, sales promotion,
displays, free samples, salaries of salesmen etc
6
Short run Costs
Short run Costs
• TFC
• TVC
• TC=TFC+TVC
• AFC= TFC/ No. of Units of output
• AVC= TVC/ No. of Units of output
• AC= TC/ No. of Units of output
• MC= TCn - TC n-1
7
Short run Costs
Quan TFC
tity
TVC
AC=
TC/N
0
TC= MC
TFC+
TVC
55
-
0
55
1
2
3
4
5
6
7
AFC= AVC=
TFC/ TVC/
N
N
55
55
55
55
30
55
75
105
85
110
130
160
30
25
20
30
85.00
55.0
43.3
40.0
55.0
27.5
18.3
13.8
30.0
27.5
25.0
26.3
55
55
55
155
225
215
210
280
370
50
70
90
42.0
46.7
52.9
11.0
9.1
7.9
26.3
37.5
45.0
undefi undefi undefi
ned
ned
ned
8
Short run Cost Curves
TC
y
Total Cost
TVC
TVC
TFC
TFC
o
Output
x
9
Short run Costs
Behaviour of Total Costs:
• TFC is a horizontal straight line, parallel
to X axis as it remains constant
irrespective of output
• TVC slopes upwards as output increases
10
Short run Cost Curves
MC
y
AC
Fixed cost is
spread over a
larger output
Cost
AVC
AFC
o
x
Output
11
Short run Costs
Behaviour of Average Costs:
• AFC: Falls as output increasesrectangular hyperbola- arithmetic result
• AVC, ATC and MC: Decrease first, then
rise
• MC: Determined only by the rate of
change in variable cost - independent of
fixed cost
• For the first unit, AVC= MC
12
Short run Costs
• AVC decreases as firm expands and
approaches optimum level of output. After
plant capacity output is reached, AVC
starts increasing.
• AVC’s slope indicates increasing, constant
and decreasing returns to variable factors
• The lowest point of the U-shaped AVC
occurs where the quantity of output has
the minimum cost
13
Long run Cost Curves
• Firms can change output by altering size
of plant in the long run
• All costs are variable in the long run
• Long run is a relative concept-varies from
industry to industry
• Long period be divided into a number of
short periods
14
Long run Cost Curves
There will
be a new
SAC every
time the
scale is
revised.
Diagram
depicts 3
such
SACs.
Y
C
o
s
t
SAC1
0
SAC 2
SAC 3
X
Output
15
Long run Cost Curves
Envelope curve
because it
envelopes a series
of short run curves
LAC Disk shape because
of phases of
increasing and
diminishing returns
It is also called
planning curve
16
I.Economic vs Accounting Cost
• Consider a garment factory producing 100
shirts, using hired resources as given below:
Labour (at Rs.2900), machines(2100), raw
materials (Rs.1800) electricity (Rs. 700). The
producer uses his own resources as follows:
Land worth Rs. 5000, family labour worth
Rs.3500, and his own truck (cost Rs. 1500) to
transport materials. Work out the economic cost
and accounting cost of producing 100 shirts.
17
Economic vs Accounting Cost
Factors hired
Labour
Machines
Raw Materials
Electricity
Accounting cost
Self owned factors
Family Labour
Land
Transport
Cost in Rs
2900
2100
1800
700
7500
Cost in Rs
3500
5000
1500
10,000
18
Economic vs Accounting Cost
Economic cost of producing a 100 shirts is
Rs. 17500.
Economic cost per shirt: Rs.175
Accounting costs of producing 100 shirts is
only Rs. 7500.
Accounting cost per shirt: Rs.75
•
19
SUM
The cost of attending a private college for
one year is $ 6,000 for tuitions, $ 2000 for
room, $ 1500 for meals, and $ 500 for
books. The student could also have
earned $ 15,000 by getting a job instead of
going to college and 10% interest on
expenses she incurs at the beginning of
the year. Calculate the explicit, implicit and
total economic costs of attending college.
20
Approaches to Cost Reduction
• Philip Young and John McAnley have
categorised Cost Reduction methods as follows
• 1. Budgetary Approach - Actual cost must be
brought in line with the budgeted amountscutting costs to match the fall in revenueApproach involves identifying items in the
budget that are amenable to quick changestravel is frozen, coffee and refreshments no
longer served at meetings, etc
21
Approaches to Cost Reduction
2. Input Reduction Approach:
“Doing more with less”- plant shut downs, early
retirement offers, VRS
3. Input Cost Reduction Approach:
Under this, managers try to reduce input cost in
various ways- reduction of wage costs through
offers of shares of company in exchange for
lower wages; moving into offices costing lower
rent or maintenance; searching for cheaper
suppliers of materials
22
Approaches to Cost Reduction
4. Input Substitution Approach
A company may consider building a plant
in a foreign country to take advantage of
lower wages
5. “Not Made Here” Approach: It may be
decided that an outside vendor of service
can supply at a cheaper rate than what it
costs the company to produce- e.g.,
outsourcing
23
Approaches to Cost Reduction
6. Suggestion Box Approach- from
employees, especially those who are
connected directly with production process
24