Classification of Costs

On the basis of
By traceability: Direct / Indirect
By cost Behaviour: Variable / Fixed / Mixed
By Controllability
By

selection
among
alternatives:
Avoidable
/
Sunk
/
Incremental
/
Opportunity

Direct and Indirect Costs

Direct Costs: is specifically traceable to a

given cost such as product, process,

department or activity for which the
organization wishes to estimate the cost.
Indirect Costs: cannot be traced to a

given cost object without resorting to some

arbitrary method of assignment. They are
distributed over all activities.

Salaries
Supplies
Consultation
Awareness campaign
Patient day

Employee Benefits
Administration
Maintenance
Housekeeping
Catering
Laundry
Depreciation

Not all indirect costs are indirect.

Like, to calculate employee benefits for

specific employees; these costs then could

be charged to the departments in which the
employees work and thus become direct
costs.

Variable / Fixed / Mixed Costs

1. Variable Costs:
.It changes as output or volume changes in

a constant, proportional manner. If output

increases by 10%, costs also should
increase by 10%.
.For instance, supplies were categorized as
variable costs in labs; if the price of
supplies is Rs 10 per patient, for each
additional patient supply costs will increase
by Rs 10.

Variable cost behaviour

Supplies Cost
10,000

1000
Patients

2. Fixed Costs:
.These costs do not change in response to

changes in volume.
.They are a function of the passage of time,
not input.
.If depreciation costs will remain Rs 100
irrespective of output level (i.e no of
patients), hence it will be fixed cost.

 Fixed Cost Behaviour

Depreciation
Costs

100

Patients

3. Semi-fixed Costs (called step-fixed):

These do change with respect to changes in output,
but they are not proportional.
It might be considered variable or fixed, depending
on the size of the steps relative to the range of
volume under consideration.
Eg, it is assumed that the salary cost of the
laboratory is semi-fixed. If the number of patients
(volume of output) were between 600 and 800,
salary cost would be considered fixed at Rs. 60,000.
In other words it is assumed here that additional
units of manpower worth Rs 15000 must be
employed for every increment of 200 patients.

Semi-fixed cost behaviour

Salary
75000
60000
45000
30000
15000
200 400 600 800 1000
Patients

4. Semi-variable Costs:
.It

include elements of both fixed and

variable costs.
.Utility costs are good example.
.There may be basic, fixed requirement per
unit of time (month or year) regardless of
volume.
.But there is also likely to be a direct,
proportional relationship between volume
and the amount of utility cost. As volume
increases, costs go up.

Semi-variable cost behaviour

costs
5000

1000
Patients
1000

Variable
Other

Direct

4,00
0

Employ
ee
benefits

Total

Other 1,0
00

Semifixed
Salaries 750
00

Supplie 10,0
s 00
14,000

Indire
ct

Fixed

H.keepi
ng

1,000

1,50 Depreciat
0
ion
100

Maintena
nce

250

Admin

500

Laundry

100

H.keepin
g

100
700

15,600

1,700

90,00
0

75000

100

1,600

Tota
l

2,650

350
75,350 92,65
0

By Controllability
Total costs charged to the department; the

department manager would view all costs

in the previous 6 categories as controllable.
E.g. Cost of quality control, employee
benefits etc.
Uncontrallable cost are beyond regulation
of management: e.g price of raw material
by supplier.

By selection among alternatives

Avoidable Costs
Sunk costs
Incremental costs
Opportunity Costs

1. Avoidable Costs:
.These can

be eliminated or saved if an activity is

discontinued; they will remain only if the activity
continues.
.For eg if hospital was considering curtaining its volume
by 50% in response to cost containment pressure, what
would it save ?
.Variable costs are almost always a subset of avoidable
costs, but avoidable costs might include some fixed costs.
.E.g. administrative staffing, which is usually regarded as
fixed costs, might be drastically reduced in a hospital if
50% of the beds were taken out of service.

2. Sunk Costs:
.These are unavoidable costs.
.They are affected by the decision under

consideration.
.Large portions of costs, like depreciation,
administrative salaries, insurance and
others are sunk in the proposed 50% cut
in volume in hospital.

3. Incremental costs
.These represent the change in cost that results from a

specific management function.

.For eg, someone might want to know the incremental cost
of adding a new wing to the hospital that would generate
200 new admissions in a year.
.Incremental and avoidable costs, hence can be thought of
as different sides of the same coin the former relates to
increase in volume while the latter is associated with
reduction in volume.
.In above example, incremental costs would include both
fixed and variable costs. However, for decisions involving
only modest changes in output, incremental and variable
costs may be used interchangeably.

4. Opportunity Costs
.These are values foregone by using a resource in a

particular way instead of in its next best alternative way.

.Eg: A hospital is considering expanding its facility and
would use land acquired 20 yrs ago. If land was
purchased at Rs 1 million but had a present market value
of Rs 10 million, what is the opportunity cost of land ?
.Alternatively, hospital might consider converting part of
its acute care facility in a nursing training institute
because of a reduction in demand in facility. If there is no
way that the existing facility can be renovated or if the
facility is not needed for the provision of acute care, its
opportunity cost may be 0.

Total, Average and Marginal

cost

Total Cost
TC = TFC + TVC
Average Total cost (Unit Cost) = Total cost per
unit
ATC = TC/ Q (Q= No. of output units)
ATC = TFC + TVC
Q
= TFC + TVC
Q
Q
ATC = AFC + AVC

Marginal Cost : Rate at which total cost

increases.
Increase in total cost that would result from

the production of one extra unit.

If total cost is increasing slowly as
increases that means that marginal
low.
If total cots is increasing sharply as
increases, that means that marginal
high.

output
cost is
output
cost is

Total Cost Curve

When Q is 0, total cost is positive because even when the

firm is not producing anything it is incurring fixed costs.

OA represents Fixed Cost
At output Qb, TC of producing that output is QbB.
ATC of producing Qb = TC/Qb.
Cost

Total

Cost
B
TCb
A
0
Qb
output

Quantity of

The marginal cost at any point on the total

cost curve is given by the steepness of the

curve at that point.
Where the curve has a steep slope,
marginal cost is high; where the curve is
flatter, the marginal cost is lower.

Total Fixed Cost and Marginal Cost

Suppose TC fell but TVC remained same.
TC curve would retain the same shape but would cross the

vertical axis at C. The new TC curve is parallel to old TC

curve.
TC curve after change in FC: No effect
Cost

Total Cost
B

New Total

Cost
TCb
A
C
Qb
of Output

Quantity

Its steepness at any point representing

marginal cost is unaltered.

Hence, change in fixed cost doesnt affect
marginal cost.
Since MC is cost of producing one extra unit
and whatever the level of activity, the level
of FC can have no impact on the cost of
production of one extra unit.

Average Cost Curve

TFC do not vary with output level, hence AFC

must fall as output increases.

Average Fixed Cost

Cost

AFC
Quantity of
Output

Average Variable Cost

When some factors of production are
fixed, AVC are likely to fall and then to
rise as output increases.
Given fixed capital stock, as the labour
force increases, specialization and the
efficient use of capacity means that
output may well increase quite fast, and
this will drive AVC down.

Average Variable Cost and Average Total Cost

Capacity constraints are reached, extra unit of output may
become expensive to produce.
For e.g. more night shift and weekend working might be
required, hence AVC may well begin to rise, giving an AVC
curve.
ATC curve is calculated by adding the corresponding costs
on the AFC curve and the AVC curve, giving a short-run ATC
curve.
ATC
Cost
AVC

Quantity of output

Average Cost and Marginal Cost

If production of an extra unit of output causes average cost to

fall, then it follows that the cost of producing this extra unit,
the marginal cost, must have been lower than previous
average.
Similarly, if the production of an extra unit of output causes
average cost to rise, then the marginal cost of producing this
extra unit must have been greater than the previous average.
If MC is greater than AC, then the AC must be increasing;
when the MC is less than AC, then AC must be decreasing.
Hence, if AC curve has a minimum point while plotting graph,
then MC curve must intersect the AC curve at the minimum
point of AC curve.

Cost

MC
ATC

Quantity of Output
Over a certain range of output, AVC is constant.
Hence, VC associated with the production of an

extra unit will be the same over that range of

output.
But another way of describing the variable costs
associated with producing one extra unit of
output is MC. Hence, if VC is constant, MC = AVC.

Marginal Cost and Decision Making

2 hospitals A and B quote same average cost for a

service, and are operating at different point on their AC

curves.
It would be more efficient use of resources if patients
were referred to hospital A, because an increase in
activity will lead to a fall in unit costs; rather than
Hospital B, where an average increase in activity will
result in a rise in unit cost.
However, if AC are the only data available, the decision
makers will not be aware of this.
Hence, information about MC would be helpful here.
Since, AC at hospital A are falling, MC is below AC.
Since, AC at hospital B are rising, MC is above AC.
Hence, if data on MC was available, it would be clear that
hospital A was better choice.

Cost
ATC of
Hospital A &
Hospital B

QA
Quantity of Output

QB

Cost and Pricing

The cost of production is an important

determinant of the pricing decision.

If buyers are not prepared to buy at the
price necessary to cover all organizations
costs in the long run, then the organization
will leave the market for that product.
A common approach to pricing in private
sector is to estimate the variable cost per
unit (AVC) and to add on a mark-up to
cover overheads and give satisfactory
profit.

If

VC is Rs 100 per unit and it has been

estimated that a mark up of 50% will cover
fixed costs and provide a satisfactory profit,
then the selling price will be

SP = AVC X (1 + m/100)

m is percentage markup
= Rs 100 X (1 + 50/100)
= Rs 150

What the markup should be if the firm wishes to

maximize its profits ?

The optimum percentage markup on cost is given
by:
m= 1
X 100 (%)
Ep -1
If AVC is constant over a range of output, then over

this range AVC = MC.

Satisfactory Profit = AVC X ( PED)

PED -1

Long Run Costs

In long run the quantities of all factors of

production can be varied, hence there are

no fixed costs.
All costs are variable in long run.
In short run costs are estimated on the
basis of assumption that some of the inputs
are fixed (capital inputs). Output can be
increased in the short run only by
increasing the variable inputs with a given
size or scale of operation.
Long run allows the entrepreneur change
the size of operation

What should be the optimum size of the

organization
framework ?

in

year

planning

For a manager, it is translated as:

How many beds the hospital should run
with ?
When should we stop expansion ?
After a certain stage the expansion of a
hospital becomes counter productive and
disadvantageous.

Economies and Diseconomies of

Scale
If output increases by a larger proportion than the

increase in inputs, there are increasing return to

scale.
E.g. If we increase all inputs of a hospital by 10%,
and find the output has increased by more than
10%, we have increasing returns to scale.
If all inputs are increased by 10%, total cost will
also increase by 10%.
Hence, Average Cost is likely to fall as the scale of
operation
increases
(because
output
has
increased by more than 10%): Situation is called
as Economies of scale, implying advantages in
cost when you expand.
Economies of scale may arise because staff are

Conversely, if output increases by a smaller proportion

than the increase in inputs, these are decreasing

returns to scale. It means that average costs rise as
the scale of operations increase (e.g. increasing all the
inputs by 10% produces less than 10% increase in the
output, therefore the cost per unit produced must be
higher): Situation is called as Diseconomies of scale.
It usually happens when the organization has grown
too far. Becoming larger produces cost disadvantages.
This may be because of problems such as increased
bureaucracy, poorer communications and worse labour
relations which are often encountered in larger
organizations.

Long Run Average Cost Curve

Curve represents the unit cost of production for different scales

of operation.
LRAC curve is falling initially as the size of organization increases
and it benefits from factors producing economies of scale.
Then LRAC is constant as there is no further cost benefits from
increasing size.
Finally organization becomes large, problems with increasing
size create diseconomies of scale and LRAC begin to increase.
Cost
LRAC
Economies
of scale
Output

Diseconomies
of scale

Economies of scope
Suppose 2 hospitals are in a town, one provides only

paediatric care and other only geriatric care.

Would total cost of paediatric and geriatric care be lower
if one single hospital provided both ?
It may be cheaper to combine 2 hospitals and achieve
economies of scale. But point is that it could as well be
cheaper to combine them because the inputs needed for
both types of care interact well together. 2 could support
each other so that the result would be lower total costs.
If so, we say that by producing 2 different outputs jointly
we achieve economies of scope.
E.g. Many physicians who used to practice independently
are now providing services jointly through polyclinic,
reducing total cost.