MCom I Semester Managerial Economics Cost Theory Estimation Study Material Notes

MCom I Semester Managerial Economics Cost Theory Estimation Study Material Notes: Cost of Production in Economics Money cost Real Cost Criticism of the Concept of Real Cost Meaning and Definition of Opportunity Cost Transfer Earnings Criticism of the Concept of Real Cost Imputed Cot Short Run and long-run costs Direct and Indirect costs Or Tractable and Non-Traceable Costs Differential Incremental Cost sand Sunk costs Historical and replacement costs The Traditional Theor of Costs Short Run total costs :

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COST THEORY AND ESTIMATION

COST OF PRODUCTION IN ECONOMICS

Costs are very important in business decision making. Cost of production provides the floor of pricing. It helps managers to take correct decisions.

A firm’s costs determine its supply. Supply along with demand determines price. To understand the process of price determination and the forces behind supply, we must understand the nature and different concepts of cost.

MONEY COST

In production process, a producer has to play for the factors which he employes for production. For example, he pays wages to the workers, prices for raw materials and power, rent for building and interest for money borrowed by him. All these are included in his cost of production. Ordinarily, this cost of production is called money cost but the view of an economist regarding money cost is somewhat different from this. In economic sense, it includes the price of internal factors of production also such as the interest on capital employed by enterpreneure rent of the building owned by enterpreneur and the remuneration of the labour put in by the entrepreneur. Besides, it includes normal profit also. Thus, following three terms are included in money cost :

1 Explicit Costs. Explicit costs are the money expenses incurred on the resources used in the production of a commodity. These costs include wages paid to workers, prices paid for raw materials and fuel, rent paid for premises, interest paid for capital and the expenses paid on the purchses, production, manangement and selling etc.. These costs are also known as paid out costs, expenditure costs and outlay costs. These are the costs that are paid by a producer in cash for the factors of production

2. Implicit Costs. Implicit costs are the costs of self-owned and self-employed resources of production. For example, interest on capital employed by enterpreneur in his, rent of the building owned by enterpreneur which is being used in firm and a reasonable reward for these resources also at market rate. Therefore, economists are of the opinion that these costs should also be included while calculating cost of production of a commodity. These are known as non-expenditure costs also. Though these are not paid in cash to anyone, yet these should be included in money cost.

3. Normal Profit. Normal profit is that level of profit which is necessary to induce an enterpreneur to stay in a particular industry. If the enterpreneur does not get such normal profit, he will not continue to carry on the production of that commodity. Thus, normal profit is the cost of maintaining an enterpreneur in a particular industry. Therefore, economists are of the opinion that normal profit should also constitute the cost of production., Thus,

Cost of Production = Explicit cost + Implicit cost +Normal Profit Or Money Cost

MEANING AND DEFINITION OF OPPORTUNITY COST (TRANSFER EARNINGS)

The concept of opportunity cost is based upon the fact that the productive resources are limited and every productive resource has many alternative uses. When a particular resource is applied for the production of a particular commodity, it looses the opportunity of being used for the production of any other commodity. The cost that induces a particular resource to be used in the production of a particular commodity, is called opportunity cost. In other words, opportunity cost of a commodity is the sacrifice of the commodity or commodities that could have been produced with the help of same productive resources.

1 “The amount of money which any particular unit could earn in its best paid alternative use is sometimes called its transfer earnings.” -Benham

2. “The cost of any unit of factor, from the point of view of one industry is therefore determined by the reward which that unit can earn in some other industry.”

-Mrs. John Robinson Thus, it may be concluded that opportunity cost is the price that is necessary to be paid to the factors of production so that they may be retained in a particular industry. It is the amount that a factor could eam in its best alternative use.

Characteristics of Opportunity Cost

1 Opportunity costs are money costs.

2. The concept of opportunity cost applies to all the resources of production and all the industries equally.

3. Opportunity costs include implicit costs also. Thus, both the explicit and implicit costs must be included for the calculation of opportunity costs.

Importance of the Concept of Opportunity Cost

The importance of this concept can be explained as under:

1 Helpful in the Allocation of Productive Resources.

2. Helpful in Understanding the Various in the Cost of Production.

3. Helpful in the determination of Rent.

Limitations or Criticisms of the Concept of Opportunity Cost

1 The concept does not Apply on specific factors.

2. The assumption of indifference is wrong. 3. The assumption of perfect competition is wrong

REAL COST

The concept of real cost was introduced by classical economists. This concept is a subjective concept. Real cost represents the psychological form of cost. According to classical economists, real cost includes those payments which are made to the factors of production to compensate for the efforts, pains, exertions, problems and abstinence suffered by them. From this point of view, real cost of a commodity can be regarded as its social cost also. According to Prof. Marshall, “The exertions of all the different kinds of labour that are directly or indirectly involved in making it (i.e., a commodity) together with the abstinences or rather the waitings required for saving the capital used in making it. All those efforts and sacrifices together will be called the real cost of production of commodity.” Thus, it can be concluded that:

Real cost = Efforts, pains and exertions of labour + Wait and distinence of enterpreneurs

CRITICISMS OF THE CONCEPT OF REAL COST

1 Real cost is an unreal concept.

2. Measurement of real cost is not possible.

(1) IMPUTED COST

Imputed cost means the cost of those factors of production which are owned by enterpreneurs. These factors of production are known as internal resources also. Imputed cost is not paid to external parties. Interest on capital invested by enterpreneur, rent of the building owned by enterpreneur, depreciation of fully depreciated assets which are still in use, remuneration of the labour and skill employed by enterpreneur are the examples of imputed cost.

The concept of imputed cost is an important concept of economics. This concept plays an important role in estimating real position of profit and loss, selection of best alternative from among different alternatives, deciding whether to accept or reject a particular offer, allocating available resources in most efficient and economical manner.

(I) SHORT-RUN AND LONG-RUN COSTS

Short-run costs : Short-run means the time period during which a firm can change its production only to the extent of available production capacity. A firm cannot change its production capacity during short-run. For example, production capacity of a firm is 10,000 units per year and actual production of the firm is 6,000 units per year. In such case, the firm can increase its production to the level of 10,000 units per year but not beyond 10.000 units per year.

Total cost of a firm can be divided into two parts: Fixed costs and variable costs. Fixed costs remain unchanged during short-run. Fixed costs do not change on a change in the level of production. A firm can increase its production to the level of its production capacity only by increasing the quantity of variable factors of production. Thus, only varibale costs increase in short-run.

Long-run Costs : Long-run means the time period during which a firm can change its production to any extent. During this period, a firm can change its level of production as well as scale of production. All the factors of production are variable in long-run and they can be changed to any extent in any form. During this period, new firms can enter into the market, existing! firms can quit the market, production of new products may be started. production of existing products may be discontinued, and the production may be diversified. During long-run, all the costs are variable.

Difference Between Short-run and Long-run Costs : (i) Short-run costs are the costs which change on a change in the level of production while long-run costs are the cost which change on a change in the scale of production only, (ii) This classification is important only in short-run. In long-run, all the costs are variable, (111) Short-run costs are important in short-run decisions while long-run costs are important in long decisions, (iv) When a firm wants to increase its production by utilising its production capacity, it has to consider short-run costs only. When a firm wants to change its production capacity or diversify its products, it has to consider both the short-run and long-run costs.

(III) DIRECT AND INDIRECT COSTS TOR, TRACEABLE AND NON-TRACEABLE COSTS

Direct or Traceable Costs : Some are the costs which become a part of the goods produced. These costs can be traced and differentiated with the products. These costs are called direct or traceable costs. Direct materials, direct labour and chargeable expenses are the examples of direct or traceable costs. Production overheads can be allocated along with product lines, office and administration overheads can be allocated alongwith sales territories these cost are directly related with particular products or processes or departments.

Indirect or Non-traceable Costs : Some are the costs which cannot be assigned to a particular product or process or department. These costs are incurred in total for whole enterprise or for hole production process. For this reason, these costs are known as indirect or non-traceable costs. These costs are to be apportioned on a certain basis. Examples-Factory overheads, office and administration overheads, Selling and Distribution overheads, etc.

Difference between Direct and Indirect Costs : (i) Direct costs are the costs that become a part of the goods produced while indirect costs are the costs while do not become a part of the goods produced, (ii) Direct costs are traceable while indirect costs are not traceable, (iii) There is no problem of allocation of direct costs while indirect costs are to be allocated on certain basis.

(IV) DIFFERENTIAL (INCREMENTAL) COSTS AND SUNK COSTS

Differential or Incremental Costs : Every business and industrial enterprise wants to increase the level of its operations. Whenever the level of operations is increased, total cost of the enterprise also increases. Increase in total cost on an increase in the level of business activities. For example, a firm increases its production or replaces an existing machine or starts the production of a new commodity or adopts a new channel of distribution or launches its products in a new market, total cost of the firm also increases. Such an increase in cost is called incremental or differential cost. It is also important in this regard that the concept of differential cost may hold turn in case of an existing firm only and not in case of a new firm.

Sunk Costs : Sunk costs are the costs which remain unchanged at all levels of activities. These costs do not change even if the level of activities changes. If business activities are discontinued for some time, these costs do not change. Depreciation (due to lapse of time) and obsolescence loss are the best examples of sunk costs. Besides, Rent of building, Interest on loan, Insurance premium, salary of permanent staff etc. are also sunk costs to a large extent

Difference between Differential costs and Sunk Costs : (i) Differential costs are the additional costs incurred on a increase in the level of business activities while sunk costs are the costs which remain unchanged at all the levels of business activities. (ii) Differential costs are variable and semi-variable in nature while sunk costs are fixed in nature.

Complete study and analysis of both the differential and sunk costs is necessary for efficient and effective decision making. This analysis is very important in the evaluation of different alternatives.

(V) SHUT DOWN COSTS AND ABANDONMENT COST

Shut Down Costs: Shut down costs are the costs that are to be paid by an enterprise only when it discontinues its operations for some time. If an enterprise wants to discontinue its operations for some time, it has to pay some specific costs which may not have to be paid if the enterprise continues to work regularly. Such costs are known as shut down costs. Examples of shut down costs are: Expenses on putting the plant off, expenses on maintaining the plant safe and in good condition, expenses on storing raw materials, expenses on recruitment and training of new workers, if any, and expenses on restarting the plant.

Abandonment Costs : Abandonment costs are the costs incurred on closing down the plant permanently. If an enterprise wants to close down its plant permanently, it has to incurr some expenses on removing and disposing off the plant. Such expenses are known as abandonment costs.

Difference between Shut Down Costs and Abandonment Costs : (i) Shut down costs are the costs which are incurred on discontinuing business activities temporarily for some time while abandonment costs are the costs incurred on closing down the business activities permanently.

(VI) URGENT AND POSTPONABLE COSTS

Urgent Costs. Some are the costs which should be incurred immediately. If these costs are not incurred, production, purchase and sale activities of the enterprise may suffer a set back. These costs are called urgent costs. Raw materials, labour, fuel and power, production overheads, offfice and administration overheads, selling and distribution overheads etc. are the costs which should be paid as and when required. These costs cannot be postponed.

Postponable Costs. Some are the costs which can be postponed for a certain time without affecting business activities. If an enterprise is not in a position to pay for these costs for some time, these costs can be postponed for a certain time. Such costs are called postponable costs. Repair of building, white-washing of building, change of furniture, interior decoration, a huge plan for the welfare of workers etc. are the examples of costs which can be postponed without affecting the efficienty of business enterprise. It is important in this regard that these costs can be postponed only for a certain time and not for ever.

Difference Between Urgent and Postponable Costs. (i) The cost which should be regularly and immediately as and when required, are called urgent costs while the costs which can be postponed, for a certain time, are called postponable costs, (ii) If urgent costs are postponed, it affects business activities adversely while if postponable costs are postponed, it does not affect the efficiency of business activities.

Analysis of costs between urgent and postponable costs is important during the period of economic depression and temporary financial tightness. During such period, management likes to minimise the cost by postponing postponable costs.

(VII) HISTORICAL AND REPLACEMENT COSTS

Historical Cost. Historical cost means the original cost of an asset. It means and includes the price paid for an asset, expenses paid in connection with the purchase of asset, and the expenses paid in connection with the installation of asset. The concept of historical cost is very important, particularly with regards to fixed assets. Fixed assets are always shown at their historical cost less depreciation (written down value). Market value of fixed assets is not considered.

Replacement Cost. Replacement cost means current market price of an asset. It is the cost at which an aset can be replaced. In case of an existing asset, replacement cost means additional money needed to replace it (cost of new asset-sale price of old asset). Under the technique of replacement costing, replacement cost is considered to be the base of depreciation.

Difference Between Historical Cost and Replacement Cost. (i) Historical cost means the original purchase price of an asset (including initial expenses) while replacement cost means additional outlay on the replacement of an asset, (ii) The concept of historical cost is very important particularly regarding fixed assets while the concept of replacement cost is very important particularly regarding current assets, (iii) Historical cost does not consider changes in price level while replacement cost is based upon changes in price level.

THE TRADITIONAL THEORY OF COSTS

The cost-output relation or the traditional theory of costs is discussed under the short-run and long-run cost analysis.

SHORT-RUN TOTAL COSTS

The scale of the organisation being fixed, the short-run total costs (TC) are divided into Total Fixed Cost (TFC) and Total Variable Costs (TVC):

TC = TFC + TVC

FIXED COST

Fixed cost includes the expenses incurred on fixed factors of production Fixed factors are the factors that cannot be changed in short-run. These costs remain unchanged, whatever be the level of production. Fixed costs include the following-rent of premises, interest on capital, wages and salaries of permanent employees, insurance premium, depreciation of machines and furniture etc.

Fixed costs are also known as general costs, supplementary costs and indirect costs. The concept of fixed costs can be illustrated as follows:

In above figure, units of production are shown on x-axis and fixed costs on y-axis. TFC is total fixed costs curve. Figure explains that total fixed costs are constant at all the levels of production and TFC curve is parallel to x-axis.

VARIABLE COST

Variable cost includes the expenses incurred on variable factors of production. Variable factors of production are the factors that change with a change in production. Thus, variable costs are the costs that change with a change in production. Variable costs include the following-Cost of raw materials, wages of workers, cost of fuel etc.

Variable costs are also known as prime costs or direct costs. This concept can be illustrated as follows.

In next figure, units of production are shown on x-axis and variable costs on y-axis. TVC curve is total variable costs curve. Total variable costs are increasing at a diminishing rate in the beginning (due to operation of law of increasing returns) and at an increasing rate at the last (due to operation of law of diminishing returns). Thus, TVC curve moves upwards to the right.

TOTAL COST

Total cost is the sum total of total fixed costs and total variable costs. Total cost curve moves parallel to VC curve because FC remains constant at all the levels. Difference between TC and VC is equal to FC.

Diagramatic Presentation of Fixed, Variable and Total Costs. Total cost is the sum of total fixed costs and total variable costs. These costs can be illustrated with the help of the following cost schedule and curve :

In above diagram, units of production are shown on x-axis and costs on y-axis. TFC is total fixed cost curve. TVC is total variable cost curve and TC is total cost curve. Diagram explains that total costs and variable costs are Increasing on an increase in production but fixed cost remains constant. TC curve moves parallel to TVC curve because difference between TVC and TC is equal to FC which remains constant.

Some Important Conclusions Regarding Fixed and Variable Costs.

1 Production is a joint outcome of both the fixed and variable costs.

2. Variable costs change with a change in the quantity of production. If the quantity of production increases, variable costs will increase and vice-versa. If there is no production, variable costs will also be zero.

3. Fixed costs are not related with the quantity of production. These costs remain constant at all the level of production. These are related with time.

4. Difference between fixed and variable costs applies only in short run because in long run, all the costs tend to be variable.

5. There is no hard and fast line of distinction between fixed and variable costs.

AVERAGE COSTS

Average cost of production is total cost of production divided by the number of units produced. Average cost may be of three types–Average fixed cost, Average variable cost and Average total cost.

AVERAGE FIXED COST

Average fixed cost means total fixed costs divided by number of units produced. Thus,

Total fixed costs Average fixed cost =

No. of units produced

As discussed earlier, amount of fixed costs remains constant at all the levels of production in short-run, therefore, average fixed cost will fall steadily on an increase in production. Average fixed cost curve slopes downwards throughout its length but never touches X-axis because fixed cost can never be zero. Similarly, average fixed cost curve never touches y-axis because total fixed cost will always be a positive figure. Concept of average fixed cost can be illustrated as follows:

RELATIONSHIP BETWEEN AVERAGE COST AND MARGINAL COST

1 Both the average cost and marginal cost are derived from total cost.

2. Average cost is calculated by dividing total cost by the number of units produced while marginal cost is an increase in total cost resulting from an increase of one unit in production.

3. So far as average cost falls, marginal cost is less than average cost. In other words, if average cost if falling, marginal cost will fall more sharply.

4. When average cost increases, marginal cost also increases and is more than average cost. In other words, if average cost is increasing, marginal cost will increase more sharply.

5. Marginal cost begins to rise earlier than average cost. It implies that when average cost is minimum, marginal cost curve intersects average cost curve. When average cost is minimum, it is the point of optimum capacity.

6. Marginal cost reaches its minimum point sooner than average cost.

The relationship between average cost and marginal cost can be illustrated as follows:

In next diagram, units of production have been shown on x-axis and costs on y-axis. AC is average cost curve, MC is marginal cost curve and P is the point at which MC and AC intersect each other. Diagram makes it clear that when AC falls, MC falls more sharply and when AC increases, MC increases

Units of Production Fig. 17.7. Marginal Cost.

8. Explain the relationship between average cost and marginal cost. Use diagram.

Ans. Meaning of Average Cost. Average cost means total cost per unit. It is calculated by dividing total cost by the number of units produced.

Meaning of Marginal Cost. Marginal means cost the cost of producing an additional unit. It is calculated by dividing increase in total cost by the increase in units.

RELATIONSHIP BETWEEN AVERAGE

COST AND MARGINAL COST

1 Both the average cost and marginal cost are derived from total cost.

2. Average cost is calculated by dividing total cost by the number of units produced while marginal cost is an increase in total cost resulting from an increase of one unit in production.

3. So far as average cost falls, marginal cost is less than average cost. In other words, if average cost if falling, marginal cost will fall more sharply.

4. When average cost increases, marginal cost also increases and is more than average cost. In other words, if average cost is increasing, marginal cost will increase more sharply.

5. Marginal cost begins to rise earlier than average cost. It implies that when average cost is minimum, marginal cost curve intersects average cost curve. When average cost is minimum, it is the point of optimum capacity.

6. Marginal cost reaches its minimum point sooner than average cost.

Relationship between average cost and marginal cost can be illustrated as follows:

In next diagram, units of production have been shown on x-axis and costs on y-axis. AC is average cost curve, MC is marginal cost curve and P is the point at which MC and AC intersect each other. Diagram makes it clear that when AC falls, MC falls more sharply and when AC increases, MC increases

In diagram, quantity of production has been presented on x-axis and average cost on y-axis. SAC, SAC2, SAC, SACA, SACS, SAC.. SAC+ are seven short-run average cost curves. A curve is drawn in the manner that it is tangent to each of the short-run average cost curves. This curve is known as long-run average cost curve (LAC) curve. The firm will have to select a particular point on LAC for production. If the firm wants to produce OM quantity, it must select SAC, and its average cost will be AM. To produce OM2 quantity, the firm will select SAC, and its average cost will be BM3. To produce OM4 quantity, the firm will select SAC. and its average cost will be BM4. Since CM3 is the minimum cost of production, the firm must select SACA and produce quantity. It will be the optimum point of production and CM; will be the optimum cost of production.

CHARACTERISTICS OF LONG-RUN AVERAGE COST CURVE

1 LAC is always constructed with the help of SACs.

2. LAC covers all the SACs. Therefore, it is regarded as a cover of SACs also.

3. LAC is always less than SACs. It can never be more than SACs because costs can be reduced only in short run.

4. LAC can never intersect SACs. However, it touches all the SACs.

5.LAC is always ‘U’ shaped. It declines to a certain point, after it, it starts to rise.

6. LAC touches only one SAC at the point of minimum cost and not all the SACs. In above diagram, LAC touches only SACA at the point of minimum cost.

7. The point at which the LAC touches an SAC is always the point of optimum production and minimum cost for the firm.

8. LAC can be regarded as planning curve for a firm also, because it expresses all the optimum possibilities of production.

EXPLANATION OF THE ‘U’ SHAPE OF LONG-RUN AVERAGE COST CURVE

‘U’ shape curve LAC implies that cost of production of a firm declines to a certain level, then remains constant for a while and then starts to rise. It happens due to the operation of laws of returns. LAC declines till the law of increasing returns is applying. It remains flat till the law of constant returns is applying. It starts to rise since the law of diminishing returns starts to operate.

When a firm wants to increase its production, it gets the economies of large scale production. As a result, cost of production starts to decline and the LAC also declines. After a certain point, these economies come to a stagnant stage As a result, cost of production remains constant and the LAC gets flat.