Firm level cost concepts 3.

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COST CONCEPTS
Cost concept is one of central area of behavioral analysis of the firm. Cost considerations enter into almost every business decision. The kind of cost concept to be used in a particular situation depends upon the type of economic or business decision to be made. Thus, it is important to understand what these various cost concepts are, and how they are useful in different economic as well as business decision. Major economic cost concepts are as below 1. 2. 3. 4. Fixed Cost & Variable Cost, Total Cost, Average Cost, Marginal Cost, Acquisition Cost & Opportunity Cost Short-run Cost & Long-run Cost,

Fixed Cost & Variable Cost: Fixed Cost (FC): Fixed Cost represent the total dollar expense that is paid out even when no output is produced; Fixed cost is unaffected by any variation in the level of output. Variable Cost (VC): Variable Cost represents expenses that vary with the level of output including raw materials, wages and fuel --- and includes all cost that are not fixed. Total Cost = Fixed Cost + Variable Cost Total Cost, Average Cost, Marginal Cost Total Cost (TC) represent the lowest total dollar expense needed to produce each level of output (q). TC rises as q rises. Average Cost (AC) is the total cost divided by the number of units produced. It is a statistical understanding about the cost of per unit. Marginal Cost (MC) The marginal cost of an additional unit of output is the cost of the additional inputs needed to produce that output. More formally, the marginal cost is the derivative of total production costs with respect to the level of output. Mathematically, the marginal cost (MC) function is expressed as the derivative of the total cost (TC) function with respect to quantity (Q). Marginal cost and average cost can differ greatly. For example, suppose it costs tk.1000 to produce 100 units and tk.1111 to produce 101 units. The average cost per unit is tk.11, but the marginal cost of the 101st unit is tk.111. For better understanding of the above cost concepts the following mathematical and graphhical examples can be taken to the task:. Quantity of Output 0 1 2 3 4 5 Total Fixed Cost 30 30 30 30 30 30 Total Variable Cost 0 20 30 45 80 145 Total Cost 30 50 60 75 110 175 Quantit y of Output 1 2 3 4 5 Average Fixed Cost 30 15 10 7.5 6 Average Variable Cost 20 15 15 20 29 Average Total Cost 50 30 25 27.5 35 Marginal Cost

20 10 15 35 65

The above cost table can be represented graphically as follows:

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Firm level cost concepts 3.2

200 180 160 140 120 Cost
40 50 70

MC TC
60

100 80 60 40 20 0 0 2 Quantity 4 6
0 0 1 2 3 4 5 20

ATC

Cost

30

AVC

FC
1 0

Quantity

ACCOUNTING COSTS & ECONOMIC COSTS: Cost often means different things to different people. Accountant and Economist, for example, tend to look at costs to suit their own particular interests or purposes. Accountants classification of costs are usually set up for legal, financial control and auditing purposes while economists classifications are design to provide decision making guidelines for management to achieve the firms economic goals. The classification of costs into fixed and variable casts, Out of pocket Cost & Book Cost, Separable Cost & Common Cost (Direct Cost & indirect Cost), controllable and uncontrollable costs, urgent and postponable costs, escapable and unavoidable costs, is the accountants classification of the cost. The remaining distinctions into Total Cost, Average Cost, Marginal Cost, Actual Cost & Opportunity Cost, Historical Cost & Replacement Cost, Past and future costs, Short-run Cost & Long-run Cost are based on a view of the cost problem from an economic point of view. Accountants did not originally develop their cost concepts for the same purposes the economists have in mind. The main function of accounting has been that of reporting, stewardship, and control. it reports or records what has happened, present information that will protect the interest of the stock holders, creditors and tax collectors, and provides standards against which performance can be judge. It has only an indirect relationship to decision-making, which is the emphasis of economic costs. Indeed, when it comes to analysis for decision-making, economists and accountants are in close agreement. The simultaneous development of managerial economics and managerial accounting has profited from a close interaction between the two subjects and the two draw upon each other a great deal. Traditional accounting data are not directly suitable for decision-making. For example, in measuring the cost involved in the use of resources such as materials or equipment, the accountant concern himself with the acquisition cost of these resources. But decisionmaking is necessarily concerned with future cost and revenues; the past is not always an accurate guide for the future. Furthermore, the traditional accounting procedure for valuing assets on the balance sheet is at acquisition cost minus depreciation. These values may differ from it true, i.e., current market value for three reasons: current market price of the assets may be different from their past market price,
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Firm level cost concepts 3.2

accounting depreciation may be differ from the true depreciation, the time value of the money is not taken to the account. The managerial economists approach to valuation is to take a look at the future revenues and costs that will result from an asset and to discount that future cash flows to present. In whether to sell an asset or not, it is necessary to compare the price offer for it with present value of its net future returns rather than with acquisition cost net of depreciation. Traditional accounting data ignore the imputed or implicit costs. Surely such cost are relevant to decision making. For example, an investment project may prove to be worth undertaking if the salary of owner entrepreneurs and the interest cost of equity capital are ignored while the same may not be economically viable when such cost are added to explicit costs. Accounting data on overhead costs do not always clearly indicate which of these are fixed cost and which are variable ones. A clear distinction between fixed and variable cost i s essential particularly for short-run decisions. Because of all these limitations, accounting cost data is not directly useful for all managerial decisions. They have to be supplemented by additional data and re-classified for specific uses. DETERMINANTS OF PRODUCTION COST: The followings are determinants of cost: 1. Output level 2. Price of factor of Production 3. Productivity of Factor of production, 4. Technology.

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