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Various Type of Costs

• There are different type of costs and can beclassified by various ways

• This lecture includes costs classificationsmostly use by economists

• Fixed & Variable Costs, Average Costs & MarginalCosts, Private & Social Costs

• Opportunity Costs• Some other important cost concept you may

come across: Sunk Cost and Sinking funds,Operation & Maintenance Cost (O&M Costs),Life-cycle Costs etc. 1-12

Fixed and Variable Costs

• Fixed Costs: those costs that do not vary with thequantity of output produced.…any example ?

Examples: rent to paid for factory building, interest oninvested capital, maintenance, taxes etc

• Variable Costs: are those costs that do vary with thequantity of output produced

Examples: consumption of fuel for power generation ….itwill vary as the production of a factor increases or decrease

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2

Total Costs

• It maybe noted that Fixed Costs (FC) andVariable Costs(VC) may consist of more thanone component and the sum of all respectivecomponents will make up TFC and TVCrespectively

• Total Costs (TC) is equal to sum of Total FixedCosts (TFC) and Total variable costs (TVC):TC = TFC + TVC 1-14

Average Costs

• Average Costs– Average costs can be determined by dividing the

firm’s costs by the quantity of output it produces– The average cost is the cost of each typical unit of

product

• Average Costs can also be obtained by addingAverage Fixed Costs (AFC) and Average VariableCosts (AVC) …i.e: ATC = AFC + AVC

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3

Average Costs

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Fixed cost

Quantity

FCAFC

Q

Variable cost

Quantity

VCAVC

Q

Total cost

Quantity

TCATC

Q

Example: a firm produce 100 units of output at cost of$1000, what is the average cost of the firm?

= 1000/100 => $10

Marginal Costs

• Marginal Cost– Marginal cost (MC) measures the increase in

total cost that arises from an extra unit ofproduction

– Marginal cost helps answer the followingquestion:• How much does it cost to produce an additional unit of

output?

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(change in total cost)

(change in quantity)

TCMC

Q

4

Private / Social Cost

• Private costs (benefits) of an action– accruing to the actor only

• Social costs (benefits)– total costs of activity including those that accrue

to people other than the actor

• Example: driving a car– Private costs: fuel, maintenance– Social costs include pollution, road wear 1-18

Opportunity Costs

I got a lottery ofworth Rs 10 millions

(1 core)11 22 33

Ranking the Choices

The Next best use is “buying house” that’s Iforgone for paying my Credit card debts so that’s

my Opportunity cost

Opportunity Cost:The Next Best Decision you could make 1-19

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Opportunity Costs• Opportunity cost is the cost of second

best use of the available/usedresources in a certain action

• The opportunity cost of you peoplesitting in this class is …the next bestuse of your this time … in work,recreational activities, sports orfacebooking

• My opportunity cost of teaching youthis Course is …… the time & earningopportunity I forgone to teach you

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Sunk Cost

• Sunk Cost: is the costs thatare incurred in the pastand can not be recoveredby any future action

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• Theory states: ignore sunk costs, because they arepaid in either case, and cannot be recovered

• For example: If you lost the movie ticket worth Rs. 800 - youcan't get it back - if you decide not to buy a second ticket and gohome you won't get the first ticket you lost, back

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Sinking fund

• A sinking fund is a fund established byan economic entity by setting aside revenueover a period of time to fund a future capitalexpense, or repayment of a long-term debt

• Sinking funds can also be used to set asidemoney for purposes of replacing capitalequipment as it becomes obsolete, or majormaintenance or renewal of elements of a fixedasset, typically a building

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Operation and Maintenance Cost(O&M Costs)

• Operation and Maintenance Cost is the group of costsexperienced continually over the useful life of theactivity… any example ?

• This includes costs like, labour costs for operating &maintenance personal, fuel and power costs, spareand repair part costs, costs for taxes etc.

• These costs can be substantial and can exceed the initialcosts

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7

Life-cycle Costs

• Life-cycle - all the time from the initialconception of an idea to the death of aproduct (process)

• Life-cycle costs - sum total of all the costsincurred during the life cycle

• Life-cycle costing - designing a product withan understanding of all the costs associatedwith a product during it’s life-cycle

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Product Life-cycle

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Begin EndTime

Needsassessment

andjustification

Conceptual orpreliminary

design phase

Conceptual orpreliminary

design phase

Detaileddesignphase

Production orConstruction

Phase

OperationalPhase

Decline andretirement

phase

Requirements

OverallFeasibility

ConceptualDesignPlanning

Impact Analysis

Proof ofconcept

PrototypeDevelopmentand testing

Detailed designplanning

Allocation ofresources

Detailedspecification

Componentand supplierselection

Production orconstructionphase

Product,goods andservicebuilt

Allsupportingfacilitiesbuilt

Operational useplanning

Operational Use

Use by ultimatecustomer

Maintenance andsupport

Process,materials andmethods use

Declined andretirementplanning

DecalingUse

Phase out

Retirement

Responsibledisposal

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Cumulative Life-cycle CostsCommitted and Dollars Spent

Definition andconceptual design

Detaileddesign Production Operational use Decline/

Retirement

Life-cycle costs committed

Life-cycle costs spent

Project Phase

Tota

l life

-cyc

le co

st %

100%

80%

60%

40%

20%

0%

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