Chapter: 7

Cost Analysis
Overview of the Chapter
Production and cost are intricately related to each other. This chapter is designed to introduce
and discuss the various cost concepts and the nature of cost curves in detail. On the basis of
these costs the intent of this chapter is to examine relationship between cost and output in short
run and long run and how they can help in managerial decision making.

Introduction:

The cost information system plays an important role in every organization within the decision

making process. The quality and quantity of a product depends upon the cost of the product. In

producing a product a firm has to incur various costs in form of wages, interest and price of raw

material etc. Hence, from a firm’s perspective it is important to estimate the cost of production

for correct decision making. Analyzing the costs related to any decision is at the heart of the

management process. An incorrect estimation or a misunderstanding of the costs may have a

negative effect on the profit and growth of an organization. An important task of management is

to ensure the control over operations, processes, activity sectors, and ultimately on costs. The

detailed analysis of costs, the calculation of production cost, the loss quantification, the

estimating of work efficiency provides a basis for the financial control.

Meaning of Cost:

In general sense, for a firm’s cost is usually a monetary valuation of effort, material, resources,

time and utilities consumed, risks incurred and opportunity foregone in production of gods and

services. In economics the term ‘cost’ is most widely used as the ‘money cost’ of production

which relates to the money expenditure of a firm on the following:

 a) Wages and salaries paid to the labour
b) Payment incurred on machinery and equipment
c) Payment for materials, power, light, fuel, transportation etc.
d) Payments for rent and insurance.
e) Payments to Government by way of taxes.

Cost Function:

Definition:

A cost function is a mathematical formula used to chart how production expenses will change at

different output levels. Management uses this model to run different production scenarios and

help predict what the total cost would be to produce a product at different levels of output. The

cost function equation is expressed as C =f (Q, T, PI, ProI, S), where C = Cost, O = Output, P I =

Price of Input, S = Size of Plant, T = Technology, Pro I = Productivity of Input. The most

important determinant of cost is output. Generally cost of production increases with the increase

in output. Technology also has effect on the cost of production. If technology is modern, then

cost of production will low and vice-versa. Due to rise in the price of input, the cost of

production will also rise. Productivity of inputs also determines the cost. If productivity of input

s is high then cost of production will low and vice-versa. As the size of plant increases, costs of

production decreases and vice-versa. Cost function is a derived function. It is derived from the

production function which captures the technology of a firm. The nature of cost function depends

on the time horizon1.

Relevance/Importance of Cost Function:

a) The production function is the basis for the supply decisions of a firm. Since the cost
function shows the technology of a firm it helps in allocation of resources among various
alternatives. Knowledge of cost theory is essential for making decisions relating to price
and output.

1
Short run and long run
 b) The decision of a firm to produce a new product depends on the evaluation of costs
associated with it and the possibility of earning revenue from it.
c) Decisions on capital investment (e.g., new machines) are made by comparing the rate of
return from such investment with the opportunity cost of the funds used.
d) Short run costs are crucial in the determination of price and output. This is due to the fact
that the basis for cost function is production and the prices of inputs that a firm pays.
e) Long run cost analysis is used for planning the optimal scale of plant size. In other words,
long run cost functions provide useful information for planning the growth as well as the
investment policies of a firm. Growth of a firm largely depends on cost considerations.
f) The position of the U-shaped long run average cost (LAC) of a firm is suggestive of the
direction of the growth of a firm. A firm can take a decision whether to build up a new
plant or to look for diversification in other markets by studying its existence on the long
run AC curve. Further, it is the cost that decides the merger and takeover of a sick firm.
g) Non-profit sector and the government sector must also have knowledge of cost function
for decision-making. For e.g. whether a dam is to be built or not, depends on the
evaluation of the costs and benefits resulting from the dam.
h) Understanding a firm’s cost function is helpful in the budgeting process because it helps
management understand the cost behavior of a product. This is vital to anticipate costs
that will be incurred in the next operating period at the planned activity level. Also, this
allows management to evaluate how efficiently the production process was at the end of
the operating period.

Cost Concepts:

Costs can be classified into different categories for different purposes. Costs may be categorized
according to their:

a) Management function: Accordingly costs can be classified as manufacturing or

nonmanufacturing costs.
b) Ease of Traceability: Accordingly costs can be classified as direct or indirect costs.
c) Timing of charge against Revenue: Accordingly costs can be classified as product costs
and period costs.
d) Behaviour in accordance with activity: Accordingly costs can be classified as variable,
fixed, and mixed costs.
e) Relevance to decision making: Accordingly costs can be classified as relevant cost,
standard costs, opportunity cost, sunk cost, and controllable costs.

Costs concepts can also be analyzed from an accounting or an economic perspective, short run
and long run. The various cost concepts are discussed below in detail.

1. Money Cost:
The money cost is the most commonly used concept in production. The four factors of
production employed in the production and distribution activities add value to the raw and
intermediate2 materials. The value added by land, labour capital and entrepreneur is paid out to
these factors in the form of rent, wages, interest and profit 3. The money costs of production
depend upon the following factors:

a. Factor Prices
b. Proportions in which the factors are combined ( technique of production)
c. Quantities and quality of the factors used
d. Efficiency of the factors of production
e. Scale of output

2. Real Costs:

The real costs of production imply the physical quantities of the factors of production that are
required to produce a given level of output. They are also known as ‘Engineering Costs’ because
they depend on the engineering or technical conditions of production and are not affected by
factor prices. In economics, cost effectiveness of a technique of production implies cost saving in
terms of real costs. Whereas, in business, cost effectiveness implies reduction in pecuniary costs
or money costs which can be achieved by reduction in real costs or by reduction in prices paid
for one or more factors.

3. Actual costs :

These costs are actually incurred by the firm in payment for labour, material, plant, building,
machinery, equipment, travelling and transport, advertisement, etc. The total money expenses,
recorded in the books of accounts are the actual costs. Actual cost comes under the accounting
concept. For e.g. if the firm pays Rs. 150 per day to a worker employed for 10 days, then the cost
of labour is Rs. 1500. The economists call this cost as accounting cost. This is because
traditionally accountants have been primarily connected with collection of historical data which
is the cost actually incurred in reporting a firm’s financial position and in calculating its taxes.
Actual costs are also known as acquisition or outlay costs.

4. Opportunity Costs:

The opportunity cost of a factor is the reward4 that factor could have earned in the next best
alternative occupation. This concept is derived from the fact that in an economy all productive
resources are scarce in nature and so employing a resource in one particular use involves
sacrificing the opportunity of employing that resource for an alternative use. Thus Opportunity

2
Intermediate goods ae goods which are used in the various stages of production leading to the final product.
3
Value added in production = value of output – value of intermediate goods
4
Value
cost refers to the loss of earnings due to opportunities foregone due to scarcity of resources. If
resources were unlimited, there would be no need to sacrifice any productive opportunity and,
therefore, there would be no opportunity cost. The opportunity cost can also be called as
alternative cost. For example, an entrepreneur has a sum of Rs. 1, 00,000 for which he has only
two alternative uses. He can buy either a printing machine or, alternatively, a lathe machine.
From printing machine, he expects an annual income of Rs. 20,000 and from the lathe, Rs.
15,000. If the objective is profit maximization he would invest the money in printing machine
and forego the expected income from the lathe. The opportunity cost of his income from printing
machine is the expected income from the lathe, i.e., Rs. 15,000. Associated with the concept of
opportunity cost is the concept of economic rent or economic profit. For example, economic rent
of the printing machine is the excess of its earning over the income expected from the lathe (i.e.,
Rs. 20,000 – Rs. 15,000 = Rs. 5,000).

The concept of opportunity cost plays a major role in the ‘theory of firm’ when it is applied to
the supply of entrepreneurship as a factor of production. The minimum positive profit that an
entraapreneur must receive in order to remain in business is known as ‘normal profit’. Normal
Profit is the opportunity cost of an entrepreneur. Like other factor earnings normal profits must
also be included in total cost of production. In economics, ‘economic profit’ or ‘super normal
profit’ is used to signify profits that are in excess of normal profits. Thus super normal profits
mean positive economic profit, normal profits mean zero economic profit, and subnormal profits
mean negative economic profits.

The implication of this concept for the firm in the above example is that investing in printing
machine is preferable so long as its economic profit is greater than zero. Also, if firms know the
economic profit of the various alternative uses of their resources, it will be helpful in the choice
of the best investment avenue. With respect to owned or equity capital invested, economists
consider the opportunity cost as imputed interest. In case of labour the opportunity cost can be
zero if the factor is abundant in supply in relation to its demand as alternative opportunities are
not available5.

In assessing the alternative cost, both explicit and implicit costs are taken into account.

5. Explicit Costs:

Explicit costs refer to those which fall under actual or business costs entered in the books of
accounts. The payments for wages and salaries, materials, license fee, insurance premium,

5
In underdeveloped economies the opportunity cost of labour is zero.
depreciation charges are the examples of explicit costs. These costs involve cash payments and
are recorded in normal accounting practices. Thus explicit costs are also referred to
as accounting costs. For example, a firm pays Rs. 100 per day to a worker and engages 15
workers for 10 days; the explicit cost will be Rs. 15000.

6. Implicit Costs:

Implicit costs represent the value of foregone opportunities but do not involve an actual cash
payment. Implicit costs are just as important as explicit costs but are sometimes neglected
because they are not as obvious. For example, a manager who runs his own business fore goes
the salary that could have been earned working for someone else as we have seen in our earlier
example. This implicit cost generally is not reflected in accounting statements, but rational
decision-making requires it be considered. Therefore, an implicit cost is the opportunity cost of
using resources that are owned or controlled by the owners of the firm. The implicit cost is
the foregone return; the owner of the firm could have received had they used their own resources
in their best alternative use rather than using the resources for their own firm’s production. For
instance, suppose an entrepreneur does not utilize his services in his own business and works as a
manager in some other firm on a salary basis. If he starts his own business, he foregoes his salary
as manager. This loss of salary is the opportunity costs of income from his own business. This is
an implicit cost of his own business, because the entrepreneur suffers the loss, but does not
charge it as the explicit cost of his own business. Thus, implicit wages, rent and interest are the
highest wages, rents and interest which owner’s labour, building and capital can respectively
earn from their second best use.

Implicit costs are not taken into account while calculating the loss or gains of the business, but
they form an important consideration in whether or not a factor would remain in its present
occupation. The explicit and implicit costs together make the economic cost.

7. Accounting Costs and Economic costs:

For a long time, there has been a debate among economists and accountants as to how the costs
should be treated. The reason for this difference of opinion is that the two groups use the cist
data for dissimilar purposes. Accountants have alwys been concerned with the firm’s financial
statements. They tend to take a retrospective look at the firm’s finances because they keep trace
of assets and liabilities and evaluate past performances. The accounting costs are useful for
managing taxation needs and to calculate profit and loss of the firm.

On the other hand economists take a forward looking view of the firm. They are concerned
with what the cost is expected to be in the future and how the firm might be able to rearrange its
resources to lower its costs and improve its profitability. Accountants and economists both
include explicit costs in their calculations. For accountants, explicit costs are important because
they involve direct payments made by a firm. These explicit costs are also important
for economists as well because the cost of wages and materials represent money that could be
useful elsewhere. Accountants and economists use the term ‘profits’ differently.
Accounting profits are the firm’s total revenue less its explicit costs. But economists
define profits differently. Economic profits are total revenue less all costs (explicit and implicit
costs). The economist takes into account the implicit costs including normal profit in addition to
explicit costs in order to retain resources in a given line of production.

Therefore, when it is said that a firm is just covering its costs, it implies that all explicit and
implicit costs are being met, and that, the entrepreneur is receiving a return just large enough to
retain his/her talents in the present line of production. If a firm’s total receipts exceed all its
economic costs, the residual accruing to the entrepreneur is called an economic profit, or pure
profit. For e.g. A small store owner has invested Rs. 2 lakhs as equity in the store and inventory.
His annual turnover is Rs. 8 lakhs, from which he must deduct the cost of goods sold, salaries of
hired staff, and depreciation of equipment and building to arrive at annual profit of the store.
Based on his annual income statement an accountant reports the profit to be Rs. 1.5 lakhs,
whereas an economist says that the actual profit is Rs. 75000 only. The difference is because the
economist found that the accountant had underestimated the costs by not including the implicit
costs of the time spent as manager by the store owner and the interest on owner’s equity.

The two income statements are shown below:

Income statement prepared by Income statement prepared by

Accountant Economist
[Link] Rs. 800000 [Link] Rs.
800000
[Link] Costs (a+b+c) Rs. 650000 [Link] Costs (a+b+c) Rs.
650000
[Link] of goods sold Rs.600000 [Link] of goods sold Rs.600000
[Link] Rs. 40000 [Link] Rs. 40000
[Link] Rs.10000 [Link] Rs.10000

3. Implicit Costs (d+e) Rs. 75000

d. Salary to owner manager Rs. 50000
[Link] to owmer’s equity Rs. 25000
Accounting Profit ( 1-2) Rs. 150000 Economic Profit (1-2-3) Rs. 75000

8. Controllable Costs and Non-Controllabe costs:

The concept of responsibility accounting leads directly to the classification of cost as
controllable or uncontrollable. The controllability of a cost depends upon the levels of
responsibility under consideration. A controllable cost may refer to one which is reasonably
subject to regulation by the executive with whose responsibility that cost is being identified.
Thus a cost which is uncontrollable at one level of responsibility may be regarded as controllable
at some other, usually higher level.

The control liability of certain cost may be shared by two or more executives. For e.g. materials
cost where price paid is the responsibility of the purchasing department and the usage is the
responsibility of the production supervisor. This distinction is primarily useful for expense and
efficiency control. Direct material and direct labour costs are usually controllable. Regarding
overhead costs, some costs are controllable and others are not. Indirect labour, supplies and
electricity are usually controllable.

9. Historical Costs and Replacement Costs:

The historical cost of an asset is the actual cost incurred at the time, the asset was originally
acquired. Whereas replacement cost refers to the expenditure which has to be made for replacing
an old asset. The difference between the historical and replacement costs results from
price changes over time. Stable prices over time, other things given, keep historical and
replacement costs on par with each other. Instability in asset prices makes the two costs differ
from each other.

Suppose a machine was acquired for Rs. 50,000 in the year 1995 and the same machine can be
acquired for Rs. 1,20,000 in the year 2001. Here Rs. 50,000 is the historical or original cost of
the machine and Rs. 1,20,000 is its replacement cost. The difference of Rs.70,000 between
the two costs has resulted because of the price change of the machine during the period. In the
conventional financial accounts the value of assets is shown at their historical costs. But for
decision-making, firms should try to adjust historical costs to reflect price level changes. If the
price of the asset does not change over time, the historical cost will be the same as the
replacement cost. If the price rises the replacement cost will exceed historical cost and vice
versa. During periods of substantial price variations, historical costs are poor indicators of actual
costs Historical costs and replacement costs represent two ways of reflecting the costs of assets
in the balance sheet and establishing the costs that are used to determine net income. The assets
are usually shown in the conventional accounts at their historical costs. These must be adjusted
for price changes for a correct estimate of costs and profits. Managerial decisions must be based
on replacement cost rather than historical costs.

10. Private Costs and Social Costs :

Private costs are those that accrue directly to the individuals or firms engaged in the relevant
activity. Social costs, on the other hand, are passed on to persons not involved in the activity in
any direct way i.e., they are passed on to society at large. Thus private costs are opportunity costs
of resources that are borne by the owners of an enterprise while social costs are the opportunity
costs borne by a whole society or community. Suppose there is a firm located on the bank of a
river which dumps the waste into water rather than disposing it of in some other manner. While
the private cost to the firm of dumping is zero, it is definitely harmful to the society. It
adversely affects the people located down current and incur higher costs in terms of treating the
water for their use, or having to travel a great deal to fetch potable water. If these external costs
were included in the production costs of a producing firm, a true picture of real or social costs of
the output would be obtained. Ignoring external costs may lead to an inefficient and
undesirable allocation of resources in society. The relevance of the social costs lies in
understanding the overall impact of firm’s working on the society as a whole and in working out
the social cost of private gains.

11. Incremental Costs and Sunk Costs:

Incremental costs are closely related to the concept of marginal cost but with a relatively wider
connotation. While marginal cost refers to the cost of the marginal unit of output, incremental
cost refers to the total additional cost associated with the marginal batch of output. The concept
of incremental cost is based on the perfect indivisibility of inputs to employ factors for each unit
of output separately. Besides, in the long run, firms expand their production, hire more men,
materials, machinery and equipments. The expenditures of this nature are incremental costs and
not the marginal cost. Incremental costs can also arise due to the change in product lines,
addition or introduction of a new product, replacement of worn out plant and machinery,
replacement of old technique of production with a new one, changing distribution channels, etc.
Sometimes incremental costs are also called as avoidable or escapable costs. Also since
incremental costs may also be regarded as the difference in total costs resulting from a
contemplated change, they are also called differential costs

The Sunk costs are those which cannot be altered, increased or decreased, by varying the rate of
output. For example, once it is decided to make incremental investment expenditure and the
funds are allocated and spent, all the preceding costs are considered to be the sunk costs since
they accord to the prior commitment and cannot be revised or reversed or recovered when there
is change in market conditions or change in business decisions. For example, the money already
paid for machinery, equipment, inventory and future rental payments on a warehouse that must
be paid as part of a long term lease agreement are sunk costs. In general, sunk costs are not
relevant to economic decisions. For example, the purchase of specialized equipment designed
to order for a plant. It is assumed that the equipment can be used to do only what it was
originally designed for and cannot be converted for alternative use. The expenditure on this
equipment is a sunk cost. Also, because this equipment has no alternative use its opportunity cost
is zero and, hence, sunk costs are not relevant to economic decisions. Sometimes the sunk costs
are also called as non-avoidable or non-escapable costs. Sunk costs are irrelevant for decision
making, as they do not vary with the changes contemplated for future by the management.

12. Direct and Indirect Costs:

There are some costs, which can be directly attributed to production of a given product. The use
of raw material, labour input, and machine time involved in the production of each unit can
usually be determined. On the other hand, there are certain costs like stationery and other office
and administrative expenses, electricity charges, depreciation of plant and buildings, and other
such expenses that cannot easily and accurately be separated and attributed to individual units of
production. Thus, whether a specific cost is direct or indirect depends upon the costing unit
under consideration. The concepts of direct and indirect costs are meaningless without the
identification of the relevant costing unit.

13. Short Run and Long Run Costs:

Costs of Production in the Short Run:

The short run is defined as a period in which the supply of at least one element of the inputs
cannot be changed. Thus, in the short run, some inputs are fixed like installed capacity while
others are variable like the level of capacity utilistaion. Short-run cost is relevant when a firm has
to decide whether or not to produce and if a decision is taken to produce then how much more or
less to produce with a given plant size.

In the short run costs are of three types:

 1. Total Costs:

According to Dooley, “Total cost of production is the sum of all expenditure incurred in
producing a given volume of output.” In other words, the amount of money spent on the
production of different levels of a good is called total cost. For instance, if a total sum of Rs.
2500 is spent on the production of 100 bicycles, then the total cost of producing 100 bicycles will
be Rs. 2500. Thus

TC= FC+VC, where

TC=Total Cost

FC= Fixed Cost

VC= Variable Cost

a) Fixed Costs or Supplementary Costs:

The cost that remains fixed at any level of output is known as the fixed cost 6. These costs must
be paid irrespective of whether production has happened or not. In the words of Anatol Murad,
“Fixed costs are costs which do not change with change in the quantity of output.” According to
Benham, “The fixed costs are those costs that do not vary with the size of its output”. These costs
include, depreciation allowance, interest on fixed capital, license fee, salaries to permanent staff
etc.
The following table and diagram explains the fixed costs:
Output (Units) Fixed Cost (Rs.)
1 11
2 11
3 11
4 11
5 11
6 11
7 11
8 11
6
Alternatively refereed as Total Fixed Cost (TFC)
 9 11
10 11

Y
Fixed Costs
Fixed Costs

12-
(Rs.)

F C
10-

8-

6-

4-

O
2- | | | | | | | | | | X
1 2 3 4 5 6 7 8 9
10 Output

In the figure above FC is measured on the OY axis and the output on OX axis. It can be seen that
whether the output is 0 units, 5 units or 10 units, the cost remains fixed at RS. 11. Thus the FC
curve is a straight line parallel to the output axis.
b) Variable costs or Prime Costs:
Variable costs refer to those costs which change with the change in the volume of
output. Marshall called these costs as “Prime Costs”, “Direct Costs” or “Special Costs”. Variable
costs include expenditure on transport, wages of labour, electricity charges, price of raw material
etc. Thus, according to Dooley, “Variable costs are one which varies as the level of output. The
following table and diagram explains the variable costs.
Output Total Variable

0 0

1 12

2 20
 3 26

4 30

5 32

6 32

7 40

8 48

9 58

10 70

Y Total Variable Costs

100- VC
90-
80-
70-
Total Variable Costs

60-
50-
40- D.R.
30-
20- C.R.
10-

I.R.

O | | | | | | | | | |
1 2 3 4 5 6 7 8 9 10 X
The figure here
Output
shows that the
 shape of total variable costs is inverse S shape. The shape of total variable cost is
determined by the ‘Law of Returns’ 7. Initially when factors are employed then variable
factor brings in more than proportionate returns, hence cost increases at diminishing rate.
At the point of optimum capacity, the returns of variable factors remain constant, hence
cost is also constant. At last, after optimum point every additional unit of variable factor
yields only less than proportionate return, hence cost increase. Variable cost curve is
sloping upwards at diminishing, constant and increasing rate. (IR, CR and DR stand for
increasing, constant and diminishing returns).

Relation between Total, Fixed and Variable Costs:

The relationship between the three is explained below:

TC = TFC + TVC

TFC = TC – TVC

TVC = TC – TFC

Output Fixed Costs Variable Costs Total Costs

(Rs.) (Rs.) (Rs.)

0 10 0 10

1 10 12 22

2 10 20 30

3 10 26 36

4 10 30 40

5 10 32 42

6 10 34 44

7 10 40 50

7
Discusssed in the earlier chapter.
 8 10 48 58

9 10 58 68

10 10 72 82

Total Costs
Y
TC VC
100-
90-
80-
70-
60-
50-
Costs

40-
30-
20-
10-

FC

O | | | | | | | | | |
1 2 3 4 5 6 7 8 9 10 X

Output

The figure here shows the relationship between total costs, fixed costs and variable costs. Total
costs are the sum total of fixed and variable costs. At point O, output is zero and variable cost is
also zero but but fixed cost Rs.10, hence total costs is also Rs.10. Total Cost and variable cost
curves are parallel to each other.

Importance of Distinction between Fixed and Variable Costs:

1. Decision to Shut Down the Firm:
The producer may not cover the total costs, if the price of the product is less than the short-run
average cost. Then the distinction between fixed cost and variable costs must be kept in mind.
Fixed costs are incurred even at zero output. They are unavoidable costs. Variable costs are
incurred only when some output is produced.
If the price does not cover average variable costs, the firm prefers to shut down. In other words if
the total revenue (total sale proceeds) does not cover total variable costs, the firm must shut
down. Otherwise, its total loss will be greater than the fixed costs. It will produce something only
when the price covers average variable cost and part of the average fixed costs. The output at
which marginal cost is equal to marginal revenue keeps losses minimum.

2. Break-Even Point:
At times the firm may not make any profit. It just pays to produce a given output where total
revenue is just equal to total cost. The firm has crossed the losses zone and is about to enter the
zero profit zone. The output at which total revenue becomes equal to total cost represents break-
even point.

2. Average Cost:
According to Dooley, “The average cost of production is the total cost per unit of output.” In
other words average cost of production is the total cost of production divided by the total number
of units produced. Thus,

AC = TC

AC = Average Cost

TC = Total Cost

Q = Quantity

The other method to calculate average cost is

AC = AFC + AVC

AC = Average Cost

AFC = Average Fixed Cost

AVC = Average Variable Cost

AFC = AC – AVC

AVC = AC – AFC
For e.g If the total cost of producing 500 units is Rs. 1000, the average cost will be: AC= TC/Q
= 1000/500=2

Output Total Cost Average Cost

(Rs.) (Rs.)

0 10 ∞

1 22 22

2 30 15

3 36 12

4 40 10

5 42 8.4

6 44 7.3

7 50 7.1

8 58 7.2

9 68 7.5

10 82 8.2

The table above shows that the average cost can be calculated by dividing total costs with output.
In the beginning average cost is high and then it diminishing. At unit 7, AC is minimum,
thereafter as the level of output increases, AC also increasing.
 80-
70-
60-
50-

Costs
40- AC
30-
20-
10-
M

O | | | | | | | | | |
1 2 3 4 5 6 7 8 9 10 X

Output

In the following figure the AC is ‘U’ shaped. In the beginning, as the level of output increases,
AC diminishes and reach at ‘M’ point which shows minimum cost. The minimum point of the
AC curve is known as the ‘optimim point’ and the corresponding output as ‘optimum output’.
After point ‘M’ average cost again rises.

a. Average Fixed Cost:

Average fixed cost is the total fixed cost divided by the number of units of output produced.
Since, total fixed cost is a constant quantity, average fixed cost will steadily fall as output
increases, thus, the average fixed cost curve slopes downward throughout the length. Thus,
AFC = TFC

AFC = Average Fixed Cost

TFC = Total Fixed Cost

Q = Quantity

Output Total Fixed Cost Average Fixed Cost

(Rs.) (Rs.)

0 10 ∞

1 10 10
2 10 5

3 10 3.3

4 10 2.5

5 10 2

6 10 1.7

7 10 1.4

8 10 1.2

9 10 1.1

10 10 1

Y Average Fixed Costs

100-
90-
80-
70-
60-
50-
40-
30-
20-
10-

AFC

O | | | | | | | | | |
1 2 3 4 5 6 7 8 9 10 X

Quantity
The above figure shows that the slope of average fixed cost is downward sloping, implying as
the level of output increases the average fixed costs diminish. Average Fixed Cost curve is a
rectangular hyperbola, because the total area under the curve at different points will be the same.

b. Average Variable Cost:

Average variable cost is the total variable cost divided by the number of units of output
produced.

AVC = TVC / Q

AVC = Average variable costs.

TVC = Total variable costs Q = Output

Generally, the AVC falls as output increases from zero to the normal capacity output due to the
law of increasing returns. But beyond the normal capacity output, the AVC will rise steeply
because of the operation of the law of diminishing returns as has been shown below.

Output Total Variable Cost Average Variable

(Rs.) Cost (Rs.)

0 0 0

1 12 12

2 20 10

3 26 8.6

4 30 7.5

5 32 6.4

6 34 5.6

7 40 5.7
 8 48 6

9 58 6.4

10 72 7.2

The table above conveys that if output is zero, total variable cost is also zero, hence average
variable cost is also zero. Up to 6 units of output, average variable cost is falling, but it begins to
increase from the seventh unit. This happens because of implication of the law of variable
proportion.

In the figure below the AVC is ‘U’ shaped. It shows that upto 6 units of output, AVC is falling
because as the output is increasing, AVC is diminishing. From 7 units onward, AVC begins to
increase, which implies that AVC is increasing with increase in output.

Average Variable Costs

Y
100-
90- AVC
80-
70-
60-
50-
40-
30-
20-
10-

O | | | | | | | | | |
1 2 3 4 5 6 7 8 9 10 X

Quantity
Relation between Average Cost, Average Fixed Cost and Average Variable Cost:

AC is the aggregate of AFC and AVC.

AC = AFC + AVC
AC = TC/Q
AFC = TFC/Q
AVC = TVC/Q
AFC = AC – AVC
AVC = AC - AFC
Relation between AC, AFC & AVC

Output AFC (Rs.) AVC (Rs.) AC = AFC+AVC

(Rs.)

0 ∞ 0 ∞
 1 10 12 22

2 5 10 15

3 3.3 8.6 12

4 2.5 7.5 10

5 2 6.4 8.4

6 1.7 5.6 7.3

7 1.4 5.7 7.1

8 1.2 6 7.2

9 1.1 6.4 7.5

10 1 7.2 8.2

The above table shows that at zero output AFC is ∞ and AVC is zero, hence AC is equal to ∞.
Then at 7 units AFC is Rs.1.4 and AVC is Rs.5.7, hence AC is Rs.7.1, here AC is at minimum.
After 7 units AC is increasing. The following figure reveals the relationship.

Relation b/w AC, AFC &

AVC
Y

AC

AVC
A
Costs

B
F
AFC

O Q X
Q1
Quantity
  AC is obtained by adding of AFC and AVC.
 AC curve tends to come close to AVC but it never touches the latter.
 At point ‘A’ AC is falling. Hence a firm’s AC is minimum because it making full
use of its available resources and output is maximum, i.e. OQ 1. After A point
there is only rise is cost but not in production. AVC minimum point is ‘B’, when
level of output is less i.e. OQ as compare to OQ1.
 The combination of AFC and AVC at point F gives ‘U’ shape. Thus AC is ‘U’
shaped and is the combination of AFC and AVC.

Reasons for ‘U’ shape of short run AC curve:

In the short-run average cost curve is ‘U’ shaped. It means, initially it falls and after reaching the
optimum point it starts rising upwards. The nature of the SAC can be attributed to the following
reasons.

1. Basis of Average Fixed Cost and Average Variable Cost:

It is known that average cost is the aggregate of average fixed cost and average variable cost (AC
= AFC + AVC). To begin with, as production increases, initially the average fixed cost and
average variable cost falls. But after a minimum point, average variable cost stops falling but not
the average cost. It is due to this reason that average variable cost reaches the minimum before
AC. After the optimum point, the AC begins to rise upward. The net result is the increase in AC.
Therefore, it is only due to the nature of AFC and AVC that AC first falls, reaches minimum and
afterwards starts rising upward and hence assume the U-shape.

2. Basis of the ‘Law of Variable Proportion’:

The law of variable proportion also results in ‘U’ shape of short run average cost curve. If in the
short period variable factors are combined with a fixed factor, output increases in accordance
with the law of variable proportions. In other words, the law of ‘Increasing Returns’ applies.
Similarly, if more and more variable factors are employed with fixed factors, the law of
Diminishing Returns is said to apply. Thus, it is due to the law of variable proportions that the
average cost curve assumes the shape of U.

3. Indivisibilities of the Factors:

Another reason due to which the average cost curve forms U-shape is the indivisibilities of
factors. When in the short-run a firm increases its production due to indivisibilities of fixed
factors, it gets various Internal Economies. It is these economies which cause the average cost
curve to fall in the initial stage. Generally, there are three types of internal economies which help
to bring down the cost viz., technical economies, marketing economies and managerial
economies.

3. Marginal Cost:
The concept of marginal cost of production is recently developed by Austrian School of
Economics. According to Samuelson, “Marginal Cost at any output level is the extra cost
producing one extra unit more or less.” According to Ferguson, “Marginal Cost is the addition to
total cost due to the addition of one unit of output.”
Thus Marginal cost is an addition to the total cost caused by producing one more unit of output.
So, MC = ∆TC

∆Q

MC = Marginal Cost

∆TC = Change in Total Cost

∆Q = Change in Output

OR

MC = TCn – TCn-1

MC = Marginal Cost

TCn = Total Cost of ‘n’ units

TCn-1 = Total Cost of ‘n-1’ units

For e.g. If the total cost of production of 7 units of a commodity is Rs.100. When 8 units are
produced, change in total cost is Rs.120. Thus the marginal cost is

MC = TCn – TCn-1

MC = 120 – 100

MC = Rs.20/-
 Output TC (Rs.) MC (Rs.)

0 10 -

1 22 12

2 30 8

3 36 6

4 40 4

5 42 2

6 44 2

7 50 6

8 58 8

9 68 10

10 82 4

It is clear from the above table that marginal cost initially falls with the rise in the level of output.
After reaching a minimum level it ultimately rises with the rise in level of output.
The following figure Y
reveals the ‘U’ shape of 20- Marginal Cost MC
18-
MC curve. In the 16-
14- MC
begining MC falls with 12- the
10-

Costs
rise in level of output. At
8-
point ‘M’ MC is 6-
4-
minimum and after ‘M’ 2- M
point MC rises with the rise
in the level of output.

O | | | | | | | | | |
1 2 3 4 5 6 7 8 9 10 X

Output

Reasons for the ‘U’ shape of the MC curve:

Marginal cost means the addition made to total cost on account of producing one more unit of
output. In the beginning, when a firm increases its output, total costs as well as variable costs
start increasing at a diminishing rate. It is only due to the reason that in the initial stage of
production law of increasing returns applies. Moreover, in the initial stage of production, the
firm enjoys many economies which cause the MC to fall. As the output continues, marginal cost
becomes minimum, thus, ultimately starts rising the reason being the operation of the Law of
Diminishing Returns. In short, initially marginal cost falls and after having the minimum point it
begins to rise. Thus, it is how the MC is also of U-shape.

Relationship between Average Cost and Marginal Cost :-

The relation between average and marginal cost can be explained with the help of following
table and diagram.

Output Total Cost Average Cost Marginal Cost

1 15 15 15

2 28 14 13
 3 34 11.3 6

4 39 9.7 5

5 42 8.4 3

6 48 8 6

Main points of the relation are as under:

1) Average Cost and Marginal Cost can be calculated from Total Cost:
Average cost and marginal cost can be calculated from total cost. As is known, average cost is
the ratio of total cost to total output. In other words, AC is calculated by dividing the total cost
by the quantity of output. It means.

AC = TC / Q

In the same way, marginal cost can also be calculated from total cost. It refers to an addition
made to total output by producing one more unit of output. Thus,

MC = TCn – TC n-1
MC = ∆TC / ∆Q

2) When average cost falls (slope of AC is negative), MC<AC:

In this situation, rate of fall in marginal cost is more than fall in average cost. In other words,
when AC curve is falling, MC curve will be below it. The reason behind this is that whereas
average cost is the aggregate of average fixed cost and average variable cost, marginal cost refers
only to change in average variable cost.
(3) When AC rises (slope of AC is positive), MC>AC:
When average cost curve rises, marginal cost too rises, but rate of increase in marginal cost is
more than that of average cost.

(4) MC cuts AC at its Lowest Point:

Marginal cost is equal to average cost when the latter is at its minimum. The minimum point of
marginal cost occurs earlier than the average cost.

(5) When AC is constant MC becomes equal to AC:

When the slope of AC is zero and AC is at its minimum then MC=AC.

Use of MC and AC in Price Determination:

The concept of marginal cost is of great significance in finding out equilibrium output and that of
average cost in finding out profit and loss. Equilibrium output is one at which marginal cost is
equal to marginal revenue.

A firm earns normal profit when its average cost is equal to average revenue. It earns
supernormal profit when average revenue is more than average cost. Moreover, a firm earns
losses when average cost is more than average revenue.

Mutual Interaction between MC and AC:

In the following figure when marginal cost is more than average cost, average cost has a
tendency to rise. It seems as if marginal cost curve is pulling the AC curve upward. On the other
hand, when MC is less than AC, it pulls the AC curve downward. When MC is equal to AC then
the latter is constant.

MC
Costs

AC MC

MC
The relationship between MC and AC explained above is equally applicable to average variable
cost, short run average total cost, and long run average total cost [Link] following figure shows the
relationship between MC, AVC AC and AFC curves. It should be noted that the relationship
which exists between average and marginal cost holds good for the average and marginal values
of any variable like utility, productivity etc.

Costs of production in the Long Run:

Long run is defined as a period in which all inputs, including the size of the plant, are variable.
Long-run costs vary with the size of plant and with other facilities normally regarded as fixed in
the short-run. In fact, in the long-run there are no fixed inputs and therefore no fixed costs, i.e. all
costs are variable. Long-run cost analysis is useful in investment decisions.

Following are the long run costs:

1. Long Run Total Cost:

Long run Total Cost LRTC refers to the minimum cost at which a given level of output can be
produced. According to Leibhafasky, “the long run total cost of production is the least possible
8
Since FC remains constant the concept of MC is not applicable in relation to Total Fixed cost.
cost of producing any given level of output when all inputs are variable.” LRTC represents the
least cost of different quantities of output. LTC is always less than or equal to short run total
cost, but it is never more than short run cost.

Long Run Total Cost

Y

LRTC

D.R.
Costs

C.R.

I.R.

O Q Q1 X

In the figure above , up to OQ level of output returns to scale are increasing at increasing rate,
and so total cost increases at diminishing rate. Q-OQ 1 shows that returns to scale are constant
hence total cost is also constant. Beyond Q1 point shows that returns to scale are decreasing at a
faster rate.

2. Long Run Average Cost:

Long run Average Cost (LAC) is equal to long run total costs divided by the level of output. The
derivation of long run average costs is done from the short run average cost curves. In the short
run, the plant is fixed and each short run curve corresponds to a particular plant. The long run
average costs curve is also called ‘planning curve’ or ‘envelope curve’ as it helps in making
organizational plans for expanding production and achieving minimum cost. According to J. S.
Bain, “The long run average cost curve shows for each possible output, the lower cost of
producing that output in the long run.” According to Robert Awh, “The LAC shows the lowest
AC of producing output when all inputs can be varied freely.”Long run average cost involves
various short run average cost plan.

In long run each firm has various plants and each plant has its short run average cost (SAC),
which helps to estimate about LAC. Plants help a producer to choose that plant whose average
cost is minimum. For e.g a firm has three types of plants. The small plant operates with cost
SAC1, the medium plant operates with the cost SAC 2 and large plant operates with the cost
SAC3. If firm wants to produces OQ1 quantity of output, then it will select the small plant. If it
wants to produce OQ3 quantity of output it will go for large plant. The figure below shows that
the small plant produces at minimum cost up to OU quantity of output. After this point cost will
begin to rise. If demand is likely to exceed OB in future then firm will start medium sized plant
because its quantity is more and cost is less as compare to small size plant i.e. OQ 2 and OC2. If
firm expects that the demand for its product will exceed OC units, then it will install large size
plant. LAC Curve is like a planning device, because it helps a producer to choose optimum scale
of plant.
Long Run Average Cost
SAC1 SAC2
Y
SAC3
C
C1
2

C3
Cost

The following figure shows that the LAC is the tangent to each short average cost curves. The
figure shows that optimum scale of plant for a producer is at M point. At this point long run
average cost and short run average cost are equal to each other .

O u Q1 Q2 v Quantity Q w X
3
Envelope Or Planning Curve 3
Y

SAC1 SAC5
Economies of Scale and the LAC:

The “U” of the LAC is less pronounced as it is more of a dish shaped curve. The LAC Curve is
the mirror image of the returns to the scale in the long run. The returns to scale are based on
economies and diseconomies of scale.

Y
Economies and Diseconomies
and LAC

A LAC
) D
TS
Costs

(IR omies
n
Eco
In the above figure the (DRTS)
point from A to B shows (CRTS) Diseconomies

increasing returns to scale

B C
Economies
which means firm is =
enjoying various Diseconomies

economies. From B to C, O Quantity X the

firm enjoys constant returns to scale which indicates that economies and diseconomies are equal
to each other. After C point there is decreasing returns to scale which means diseconomies are
arising.

3. Long Run Marginal Cost:

Long run Marginal Cost (LMC) is defined as added cost of producing an additional unit of a
commodity when all inputs are variable. This cost is derived from short run marginal cost. On
the graph, the LMC is derived from the points of tangency between LAC and SAC.
Δ LTC
LMC=
ΔQ . The shape of LMC curve has a flatter U-shape shape indicating that due to
increasing scale of production, initially output expands but after certain point it tends to decrease.
LMC is shown in the following figure.

Long Run Marginal Cost

Y

LMC
SMC
Marginal Cost

O X
Quantity
In the figure above if perpendiculars are drawn from point A, B, and C, respectively; then they
would intersect SMC curves at P, Q, and R respectively. By joining P, Q, and R, the LMC curve
would be drawn. It should be noted that LMC equals to SMC, when LMC is tangent to the LAC.

Thus, at OB level of output

SAC2 = SMC2 = LAC = LMC

The relation between LMC and LAC is as follows:

a. When LMC < LAC, LAC falls
b. When LMC = LAC, LAC is constant
c. When LMC > LAC, LAC rises

Case of Economies of Scale and Cost Minimization

A well known, car manufacturing firm in India. Maruti Udyog Limited, has revealed the
importance of economies of scale in business decision making. Due to these economies
the firm could achieve three fold rise in its net profit earnings in the year 2003-04. The
firm has reduced its average fixed cost by increasing its output and sales volume by 30
percent.
Source : MUL Gains from Cost-Saving Measures, Sify India, 18 May, 2004.

Modern approach of cost curves: -

The modern approach to the cost curves was propounded by Sargent, Andrews, Stigler, Florence
and Friedmen etc. According to traditional theory of costs, cost curves are of ‘U’ shape. But
according to modern theory cost curves are of ‘L’ shaped. Like traditional theory, modern theory
is based on two time periods i.e. Short Run and Long Run.

1. Short Run Average Fixed Cost:

Average Fixed cost includes cost such as depreciation of machinery, salaries of permanent staff
members, salaries and other expenses of administrative staff etc. In short run a firm has limited
capacity to increase the level of output but in long run it has largest capacity units, which is
indicated in the figure below by boundary line N. The firm has also limited boundary line L
which is shown in figure.
Short-Run Average Fixed Cost
In case of N boundary line
as per Modern Theory
a firm can expand its short Y
run output upto N by L N
paying overtime to labour
for longer working hours.
In this case AFC is ab line.
A firm can also increase it
c
Cost

output by purchasing
additional machinery. In
d
this case, the AFC shifts a
upwards and starts falling b AFC

again, as shown by the

O X
dotted line cd. Quantity

2. Average Variable Cost:

As per modern theory, the shape of short run average variable costs curve is saucer –shaped, that
is it has a flat stretch over a range of output. Flat stretch represents the built in reserve capacity of
the plant. There are various reasons to have some reserve capacity for a firm :
(a) to meet seasonal and cyclical fluctuations in demand
(b) it gives a freedom to an entrepreneur to increase output upto to desire level
(c) due to change in technology etc.
Figure adjacent, shows that Short Run Average Variable
the falling portion (AB) of Y Cost

SAVC shows reduction in

cost whereas the rising

SAVC
A
D
Costs
portion (CD) of the SAVC shows the increase in cost. The BC portion shows that SAVC is equal
to the marginal cost.

3. Short Run Average Cost Curve:

According to modern theory
Shirt Run Average Cost
AC curve is continuously Y
falling upto a given level of
output. Thereafter AC Curve is
rising upward. It means AC will
rise if output is increased
SAC
Cost

beyond reserved capacity

4. Short – Run Figure - 25

Marginal Cost Y Short Run Marginal Cost

Curve:
Figure here shows that O
Quantity X
initially MC is below to MC
AVC
AVC. From point M to N AVC
Cost

marginal cost is horizontal which

mean AVC=MC. After point MC M N,
N
MC rises above to AVC.

Long Run Cost Curves

O X
Quantity
According to Modern theory long
run average cost curve and long run marginal cost curve are not ‘U’ shaped but ‘L’ – shaped.
 1. Long Run Average Cost Curve:
There are two main causes of L – shape of LAC – (a) Technological Progress and (b) Learning
by doing.
According to modern theory, a
L-Shape of Long Run Average Cost
firm normally makes use of Y 2/3
of its plant’s production
capacity. On the basis of short
run average cost relating to 2/3rd
utilization of plant capacity the
Cost

shape of LAC is L-shaped,

which is shown in figure here

Shape of LMC
Y
LAC

O X
Quantity

2. Long Run marginal Cost Curve:

Cost

The shape of MC is depends upon

the relation between LAC and LMC
Curve is shown in figures here.
LAC

LMC

O X
Figure in upper panel shows that Quantity
when L-shaped LAC curve is falling
then LMC Curve will also be falling. LMC falling portion will be below the falling portion of
LAC Curve.

Shape of LMC
Figure in panel below shows Y that
when LAC Curve is of

LAC
Cost
inverted J-shaped then LMC is below than LAC Curve. When LAC is constant, LMC also
become constant.

Case Study-:1

Estimate of Short-Run and Long-Run Cost Functions:

The results of 16 empirical studies on short run and long run cost functions, as
well as on the method of estimation were reported by A.A. Walters in 1963. The
questionnaire’s method was based on managers’ answers to questions asked by
the researcher on the firm’s production costs. Most studies found that in the short
run MC is constant in the observed range of outputs. Most studies also indicate
the presence of economies of scale at all observed levels of output. Firms,
however, seen to avoid expanding into the range of decreasing returns to scale in
the long run.

Another empirical study on the extent of economies of scale in specific U.S.

industries over the 1967-1970 periods by William G. Shepherd found economies
of scale to be slight in steel, fabric, weaving, shoes, paints, cement, automobile,
batteries and petroleum refining, slight to moderate in beer and refrigerators.
Another study of 29 industries in India by V. K. Gupta in 1968 found that 18
industries had L-shaped LAC Curves, 6 industries had horizontal or nearly
horizontal LAC curves and the remaining 5 industries had U-shaped LAC Curves.
Source : Marginal Economies: Principles and Worldwide Applications by
Salvatore, Dominick.

Case Study :2

Cost Analysis of Bajaj Auto Limited –

In India Bajaj Auto Limited has been the most dominant two wheeler
manufacturer. The goal of the company is to provide the best value for his money
to its customer. Till 1996, Bajaj Auto India had an overall 49 percent share in the
market. Bajaj Scooter, Bajaj Moped and Bajaj three Wheeler had 69 percent, 12
percent and 90 percent share in the market. The company claims to be the lowest
cost producer of scooters in the world and its nearest competitor that LML
charges a price 50percent higher.

In spite of having the most illustrious market profile, the company’s overall
performance has taken a beating. Its profit margin has fallen from 20.24 percent
in 1995-96 to 19 percent in 1996-97. It competitors such as TVS Suzuki, Kinetic
Honda etc have slowly been eating into its 44 percent share in two wheelers,
bringing it down to 41.6 percent in 1996-97 alone. The scooter has dipped to a 6.6
percent share in the market, the moped share down by 2 percent to 10 percent and
three wheeler share down by 5 percent to 85 percent share of the market.

The present plant near Pune and Indore are running to their full capacity
manufacturing one million scooters per year making Bajaj the only company to
the have achieved the feet outside Japan. The new plant coming at Chakan near
Pune and the expansion of capacity at 1999.

Bajaj Auto is a legendary story of optimizing cost to maximize value for the
customer. In its quest to minimize costs it has shown tremendous amount of
professionalism in beating competition not only through cutting down heavily on
manufacturing costs, but also on other indirect farm a part of overheads results
 which show that Bajaj being an Indian company has successfully prevented
foreign giants to invade the Indian markets and capture large market shares.

Relationship between Production and Cost:

As discussed above average product (AP) of an input is equal to the total product or output (Q)
divided by the number of units of variable input (N). Therefore,

AP=Q/N

=> 1/AP = N/Q

Further,

Average variable cost (AVC) = TVC/Q

=>AVC=N×P/Q=P. (N/Q)

Here, ‘P’ is the price per unit of the variable factor.

Substituting equation (11.1) in equation (11.2) we get

AVC = P. (1/AP)

Thus, average variable cost is equal to the price of the input multiplied by the reciprocal of its
average product. Given the price of the variable input (P), the average variable cost is equal to
the reciprocal of the average product. In other words, the average variable cost and average
product vary inversely with each other.

When average product rises in the beginning (as more variable inputs are employed), the average
variable cost must be falling. The level of output at which the average product is maximum the
average variable cost is minimum. Further, when the average product of the variable input falls,
the average variable cost must be rising. The average variable cost (AVC) curve looks like the
average product (AP) curve turned upside down with minimum point of the AVC curve corre-
sponding to the maximum point of AP curve.
Likewise, the marginal cost curve in the short run is a mirror image of the marginal product
curve, expressed in monetary terms. To prove it, assume that price of the variable input is
constant. Now, the change in total variable cost will occur only due to the change in the amount
of the variable input.

Therefore,

MC = d(TVC) /dQ = d(N×P)/dQ

=> MC = P. dN/ dQ

= P/ dQ/dN = P/MP

Thus, marginal cost of production is equal to the price multiplied by the reciprocal of the mar -
ginal product of the variable input. Given the price of the variable input, the marginal cost varies
inversely with the marginal product of the variable input.

The fact that marginal product rises initially, reaches a maximum and then falls ensures that the
marginal cost curve of a firm first declines, then reaches a minimum and finally rises. The
maximum of marginal product corresponds to minimum of marginal cost. The relation between
marginal product and marginal cost is quite similar to the relationship between average product
and average cost.

The relationship between product curves (average product curve and marginal product curve)
and cost curves (average cost curve and marginal cost curve) is graphically shown in Fig. below

While the marginal product intersects average product from above at its maximum point (if AP
rises, MP is greater than AP; if AP falls, MP is less than AP and when AP is at its maximum, MP
is equal to AP), the marginal cost intersects average cost from below at its minimum point.
Average cost and marginal cost are simply the transformation of average product and marginal
product respectively from physical terms into money terms.
Significance of Cost Engineering:

Cost is the collective term for resources such as money and time. These resources are limited
and should be utilized as efficient as possible. That is where the practice of cost engineering
focuses on managing cost throughout the life cycle of any enterprise, e.g project or
programme.
In order to achieve this, a cost engineer relies on sound engineering practices. A cost engineer
applies his engineering skills and experience to forecast the development of a project, seeking
to predict the progress of a project and to spot deviations from the plan early on. To analyze a
deviation in the original design, it is vital to understand what other parameters will be affected
and how this impacts the rest of the design and planning. The effort is to answer the question:
‘where will the current technical developments lead and how will they affect the economic
prospects of this project?’
The activities of a cost engineer can broadly be presented into the following three categories:
Measure
In order to manage resources, they need to be defined and measured. This starts with gathering
the knowledge gained from previous projects. Making sure the knowledge is accessible so that
it can be used for future projects. If stored correctly this information should give a basis from
which to perform an early risk and cost estimates. Risk estimates are used to get an idea of the
threads facing a project. Initially the accuracy of these estimates can vary substantially, but as
the definition of the project scope becomes clearer the accuracy of the estimates will improve
as well. Cost estimates are important to get an idea of the total amount of resources required
for the project and will serve as input for the projects planning.
Control
With the scope of the project defined and the resources allocated accordingly, it is up to the
cost engineer to control the resources. For a cost engineer it is not sufficient to merely track any
deviations from the initial baseline, they ought to prevent them. They need to look for the right
indicators and spot deviations early on. Thereafter they need to find and analyze possible
solutions and support the project manager in decision making, providing him the information
he needs to choose between alternatives.
Improve
Looking back at a project it is important to learn from mistakes and to incorporate the lessons
learned in the working methods and to communicate these findings. Change management is
therefore also a vital part of a cost engineer’s responsibility in order to make sure the entire
company will actually benefit. To ensure their working methods are up to date, cost engineers
should regularly attend training and obtain relevant certifications and share their best practices
among one another. This of course is merely a summary of the cost engineering activities
within a company, but it shows the diversity of the scope within which a cost engineer
operates.

Examples:

1. The short-run cost function of a company is given by C = 190 + 53 Q, where C is the

total cost and Q is the quantity of output.
 a) What is the company’s fixed cost?

b) If the company produces 100 units, what is the average variable cost?
c) What is its marginal cost?
d) What is its average fixed cost function?

Solution:

C = 190 + 53Q

a) Since fixed cost is that part of cost of production which is independent of Q, it is evident
that the company’s fixed cost is 190 (units of money).
b) Since the company’s variable cost is that part of its total cost which is a function of Q,
here the total variable cost (TVC) is

TVC = 53Q

Therefore, if Q = 100, TVC = 5,300

And so , AVC = TVC/Q = 5,300/100 = 53 (units of money)

c) Since, by definition, marginal cost is MC = dC/dQ,

MC = 53 (units of money) = constant.

d) By definition, the average fixed cost function (AFC) is: AFC = TFC/Q

Therefore, here, the AFC function is: AFC = 190/Q

Practice Questions:

1. The short-run production function of a firm is X = – 0.1L3 + 6L2 + 12L where X = output
per week and L = number of persons employed. Find the values of

a) L that would maximise AP

b) L that would maximise MPL,
c) quantity of output at minimum AVC
d) quantity of output at maximum profit. (Ans. 30, 20,

2. Fill in the blanks with suitable answers:

a) Project costs that are borne by persons or entities not directly involved in the project
activity are known as _________________________ costs. ( external)

b) Annika opens a riding stable. She factors in the cost of buying horses, buying riding
tackle, renting space, and the opportunity cost of her time. She does not consider the
effect of the noises and smells from her stable on a nearby, upscale outdoor restaurant.
Annika is considering only the _________________________ costs of her project.
( internal)

c) Ten processes exist to produce widgets. Of these, Process RXQ can make 100 widgets
with less electricity and the same amount of other inputs as the other nine processes.
Process RXQ is said to be _________________________. ( technically efficient)

d) An equation or graph that shows the relationship between types or quantities of inputs
and quantity of the output is known as a(n) _________________________. ( production
function or total product)

e) Applying fertilizer to a crop of beans is associated with diminishing marginal returns.

From this fact, we can deduce that applying fertilizer to beans has
_________________________ marginal costs. ( increasing)

f) When a company's long-run average cost increases with increasing output, that company
is experiencing _________________________ of scale. ( diseconomies)

g) A lawn service decides to get rid of its leaf blowing machines and increase its number of
workers, who will gather and move leaves using regular, non automated rakes. This
decision is an example of input _________________________.( substitution)

3. Examine whether the statements are true or false:

 a) The harmful effects of the pesticide DDT on human health can be considered an external
cost.
b) Cake baking process A uses one hour of the cook’s time and half an hour of the
assistant’s time. Process B takes one hour of the assistant’s time and half an hour of the
cook’s time. Thus, process A is technically efficient compared to process B.
c) The social costs of production include opportunity costs as well as external costs.
d) A process exhibits economies of scale when long-run average cost increases with
increasing output capacity.
e) A paper mill pollutes a local river by discharging waste containing chlorine and other
toxic chemicals. The cost of treating diseases that result from this pollution would be
considered an internal cost of production.
f) A company signs a contract for five years, under which it will pay the same amount every
month for property insurance. This cost, which is independent of the level of production
in any given month, is referred to as a variable cost.
g) In the long run, all inputs are variable.

(Answers)
a) True.
b) False. For technical efficiency, we need to be able to say that one process requires less
than some inputs and no more of others.
c) True.
d) False. Economies of scale are present when long-run average cost declines with
increasing output capacity.
e) False.
f) False. This is a fixed cost.
g) True.

4. Give short answers to the following questions:

a) Suggest a situation in which the economic costs of a project would be lower than the
accounting costs.
b) Which is a better guide in making decisions about what projects to undertake: accounting
cost or economic cost?
c) The relationship between hours spent studying (input) and knowledge of economics
(output) is positive. However, once you have done 20 hours of studying, an additional
hour does not add as much to your knowledge as the first hour did. When you graph the
relationship between studying and knowledge, is the resulting line straight or curved?
Why?
d) Explain the difference between fixed and variable costs.
e) A shoe factory has 500 employees and produces a thousand pairs of shoes per hour.
I. What is the shoe factory’s productivity per worker per hour? __________
II. The factory hires one new worker. Now, the factory produces 1,002 shoes per hour.
III. Then the factory hires one more worker. Production rises to 1,004 per hour. Does the
factory have diminishing, constant, or increasing marginal returns at this level of
production?

5. Production at Julia's call center shows the following relationship between the number of
workers and the number of phone calls handled (per day).

Calculate the marginal return gained from the addition of each worker, filling in the column in
the table. b. Suppose Julie has entered a long term lease for an office space and telephones, and
this is her only fixed cost. The lease costs her $50 (per day). Fill in the Fixed Cost column in the
table. c. Julia pays each worker she hires $80 per day, and this is her only variable cost. Fill in
the Variable Cost column in the table. d. Fill in the column for the Total Cost corresponding to
each level of production.

The information about the costs of a firm is given below.

Output AFC, $ AVC, $

1 50.00 100.00
2 25.00 80.00
3 16.67 66.67
4 12.50 65.00
5 10.00 68.00
 6 8.37 73.33
7 7.14 80.00
8 6.25 87.50

Answer the following questions:

a. What is the firm's fixed cost?

FC = AFC x Q, and it doesn't matter which row of the table we take data from. For instance,
$50 x 1 = $50, and $6.25 x 8 = $50.

b. If the firm produces five units, what is the average total cost?

ATC = AFC + AVC. For 5 units of output, ATC =$10 + $68 = $78.

c. What is the total cost of producing four units?

TC = ATC x Q = (AFC+AVC) x Q. For 4 units of out put, TC = ($12.50 + $65) x 4 = $310.

Another way would be to calculate VC = $65 x 4 = $260 and it to FC = $50 obtained in part a
to get TC = $310.

d. If the firm closes down and produces no output, what will be its total cost?

No output - no variable cost. The firm's cost will then be limited to its fixed cost, TC = FC =
$50.

e. If the firm decides to increase its output from 6 to 7 units, by how much will its total cost
increase?

One way is to calculate the total cost of 6 units and of 7 units following any of the procedures
in part c and then find the difference. A somewhat shorter way is to recognize that FC does
not depend on output, and calculate the marginal cost of the 7th unit as MC(7) = VC(7) -
VC(6) = AVC(7) x 7 - AVC(6) x 6 = $80 x 7 - $73.33 x 6 = $560 - $440 = $120.

1. The sole proprietor of the "Books and More" bookstore receives all accounting profits earned
by her firm and a $28,000-a-year salary she pays herself. She has a standing salary offer of
$35,000 a year if she agrees to work for a large corporation. If she had invested her capital
outside her own company, she estimates that would have returned $22,000 a year. Last year, her
accounting profit was $50,000. What was her economic profit?

In order to calculate her economic profit, we need to subtract her implicit costs from the
accounting profit. By not taking an alternative job, she loses $7,000 ($35,000 - $28,000). This
is the opportunity cost of her time. The opportunity cost of keeping her capital tied up in her
company is $22,000. The economic profit is therefore $50,000 - $7,000 - $22,000 = $21,000.
3. Your firm has discovered a cheap and efficient technology of turning used plastic bottles and
bags into various products. You limit your attention to the following two production
opportunities: you can produce plastic utensils or helmets for Boilermakers' fans. In the first case
your estimated annual revenue is $25,000, while the production will cost you $8,000. However,
in your second option, you expect to sell 2000 helmets every year at $10 each, and the average
total cost of every helmet will be $2.

a. Which production opportunity will you choose and why?

If you produce utensils, your accounting profit would be

TR - Explicit Costs = $25,000 - $8,000 = $17,000
If you make helmets, your accounting profit would be
TR - TC = P x Q - ATC x Q = (P - ATC) x Q = ($10 - $2) x 2000 = $16,000
I will choose making utensils since it gives me higher profit.

b. If you do so, what will be your economic profit?

While calculating economic profit we need to take the opportunity costs into account.
Opportunity cost is the value of the next best alternative. As we decide to make utensils, our
next best alternative is making helmets, with the value $16,000.
[Link] = [Link] - [Link] = $17,000 - $16,000 = $1,000

Q10. Calculate – TFC, TVC, AC, AFC AVC and MC from the following table:

Output 0 1 2 3 4 5 6

Total Cost 40 100 120 130 150 190 210