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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 books- own resources of entrepreneur- imputed cost

Accountant’s cost considers only explicit cost whereas economist’s cost includes both

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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

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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

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• Fixed cost: Cost incurred on fixed factors- remains 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

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• Opportunity cost: Cost of next best alternative foregone

• Arises because of scarcity and versatility of factors of production

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• 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

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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

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Short run Costs

Quan

tity

TFC TVC TC=

TFC+TVC

MC AC=

TC/N

AFC= TFC/N

AVC= TVC/N

0 55 0 55 - undefined

undefined

undefined

1 55 30 85 30 85.00 55.0 30.0

2 55 55 110 25 55.0 27.5 27.5

3 55 75 130 20 43.3 18.3 25.0

4 55 105 160 30 40.0 13.8 26.3

5 55 155 210 50 42.0 11.0 26.3

6 55 225 280 70 46.7 9.1 37.5

7 55 215 370 90 52.9 7.9 45.0

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Short run Cost Curves

TC

TFC

TVC

Output

Tot

al C

ost

xo

yTVC

TFC

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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

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Short run Cost Curves

MC

AC

AVC

AFC

Output

Cos

t

xo

y Fixed cost is spread over a larger output

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Short run Costs

Behaviour of Average Costs:• AFC: Falls as output increases-

rectangular 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

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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

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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

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Long run Cost Curves

SAC1 SAC 2SAC 3

Output

Cost

0 X

Y There will be a new SAC every time the scale is revised. Diagram depicts 3 such SACs.

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Long run Cost Curves

Envelope curve because it envelopes a series of short run curves

Disk shape because of phases of increasing and diminishing returns

It is also called planning curve

LAC

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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.

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Economic vs Accounting Cost

Factors hired Cost in RsLabour 2900Machines 2100Raw Materials 1800Electricity 700Accounting cost 7500Self owned factors Cost in Rs Family Labour 3500Land 5000Transport 1500

10,000

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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

•

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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.

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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 amounts- cutting costs to match the fall in revenue-Approach involves identifying items in the budget that are amenable to quick changes- travel is frozen, coffee and refreshments no longer served at meetings, etc

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Approaches to Cost Reduction

2. Input Reduction Approach: “Doing more with less”- plant shut downs, early

retirement offers, VRS3. 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

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Approaches to Cost Reduction

4. Input Substitution ApproachA 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

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Approaches to Cost Reduction

6. Suggestion Box Approach- from employees, especially those who are connected directly with production process