Managerial Economics

Cost Analysis
Session 5b

Introduction
A

production function tells us how much output

a firm can produce with its existing plant and
equipment. The level of output depends on
prices and costs. The most desirable rate of
output is the one that maximizes total profit
that is the difference between total revenue
and total cost.
Entrepreneurs pay for the input factors- Wages
for labor, price for raw material, rent for
building hired, interest for borrowed money. All
these costs are included in the cost of
production. The economists concept of cost of
production is different from accounting.
2

Cost Determinants
The

cost of production of goods and services depends on

various input factors used by the organization and it
differs from firm to firm. The major cost determinants
are:
1. Level of output: The cost of production varies according to the
quantum of output. If the size of production is large then the
cost of production will also be more.
2. Price of input factors: A rise in the cost of input factors will
increase the total cost of production.
3. Productivities of factors of production: When the productivity
of the input factors is high then the cost of production will fall.
4. Size of plant: The cost of production will be low in large plants
due to
mass production with mechanization.
5. Output stability: The overall cost of production is low when the
output is stable over a period of time.

Cost Determinants

Lot size: Larger the size of production per batch then the cost of
production will come down because the organizations enjoy
economies of scale.
7. Laws of returns: The cost of production will increase if the law of
diminishing returns applies in the firm.
8. Levels of capacity utilization: Higher the capacity utilization, lower the
cost of production.
9. Time period: In the long run cost of production will be stable.
[Link]: When the organization follows advanced technology in
their process then the cost of production will be low.
[Link]: over a period of time the experience in production
process will help the firm to reduce cost of production.
[Link] of range of products: Higher the range of products produced,
lower the cost of production.
[Link] chain and logistics: Better the logistics and supply chain, lower
the cost of production.
[Link] incentives: If the government provides incentives on
input factors then the cost of production will be low.
6.

Types of Cost
There

are various classifications of costs based

on the nature and the purpose of calculation.
But in economics and for accounting purpose
the following are the important cost concepts.
Actual cost/ Outlay cost/ Absolute cost / Accounting
cost: The cost or expenditure which a firm incurs for
producing or acquiring a good or service. (Eg. Raw
material cost)
Opportunity cost: The revenue which could have
been earned by employing that good or service in
some other alternative uses. (Eg. A land owned by
the firm does not pay rent. Thus a rent is an income
forgone by not letting it out)

Types of Cost

Sunk cost: Are retrospective (past) costs that have

already been incurred and cannot be recovered.
Historical cost: The price paid for a plant originally at the
time of purchase.
Replacement cost: The price that would have to be paid
currently for acquiring the same plant.
Incremental cost: Is the addition to costs resulting from a
change in the nature of level of business activity. Change
in cost caused by a given managerial decision.
Explicit cost: Cost actually paid by the firm. If the factors
of production are hired or rented then it is an explicit
cost.
Implicit cost: If the factors of production are owned by a
firm then its cost is implicit cost.
Book cost: Costs which do not involve any cash
payments but a provision is made in the books of
accounts in order to include them in the profit and loss
6
account to take tax advantages.

Types of Cost

Social

cost: Total cost incurred by the society on

account of production of a good or service.
Transaction cost: The cost associated with the
exchange of goods and services.
Controllable cost: Costs which can be controllable by
the executives are called as controllable cost.
Shut down cost: Cost incurred if the firm temporarily
stops its operation. These can be saved by
continuing business.
Economic costs: are related to future. They play a
vital role in business decisions as the costs
considered in decision - making are usually future
costs. They are similar in nature to that of
incremental, imputed explicit and opportunity costs.
7

Determinants of Short run

cost
Fixed

cost: Some inputs are used over a period of time for

producing more than one batch of goods. The costs incurred in
these are called fixed cost. For example amount spent on purchase
of equipment, machinery, land and building.
Variable cost: When output has increased the firm spends more on
these items. For example the money spent on labour wages, raw
material and electricity usage. Variable costs vary according to the
output. In the long run all costs become variable.
Total cost: The market value of all resources used to produce a
good or service.
Total Fixed cost: Cost of production remains constant whatever the
level of output.
Total Variable cost: Cost of production varies with output.
Average cost: Total cost divided by the level of output.
Average variable cost: Variable cost divided by the level of output.
Average fixed cost: Total fixed cost divided by the level of output.
Marginal cost: Cost of producing an extra unit of output.
8

Economies of Scale
Economies

of scale exist when long run average

costs decline as output is increased. Diseconomies
of scale exist when long run average cost rises as
output is increased. It is graphically presented in
the following graph. The economies of scale occur
because of (i) technical economies: the change in
production process due to technology adoption. (ii)
Managerial economies (iii) purchasing economies,
(iv) marketing economies and (v) financial
economies.

Economies

of scale means a fall in average cost of

production due to growth in the size of the industry
within which a firm operates.
9

Factors causing economies of

scale
There

are various factors influencing the economies

of scale of an
organization. They are generally classified in to two
categories as Internal factors and External factors.
Internal Factors:
1. Labour economies: if the labour force of a firm is
specialized in aspecific skill then the organization can
achieve economies of scale due to higher labour
productivity.
2. Technical economies: with the use of advanced
technology they can produce large quantities with
quality which reduces their cost of production.
3. Managerial economies: the managerial skills of an
organization will be advantageous to achieve economies
of scale in various business activities.
10

Factors causing economies of

scale
2

Internal Factors:
4.
5.

6.

7.

8.

Marketing economies: use of various marketing strategies

will help in achieving economies of scale.
Vertical integration: if there is vertical integration then there
will be efficient use of raw material due to internal factor
flow.
Financial economies: the firms financial soundness and past
record of financial transactions will help them to get
financial facilities easily.
Economies of risk spreading: having variety of products and
diversification will help them to spread their risk and reduce
losses.
Economies of scale in purchase: when the organization
purchases raw material in bulk reduces the transportation
cost and maintains uniform quality.
11

Factors causing economies of

scale
3

External Factors
1.

Better repair and maintenance facilities: When the

machinery and equipments are repaired and maintained,
then the production process never gets affected.

2.

Research and Development: research facilities will provide

opportunities to introduce new products and process
methods.

3.

Training and Development: continuous training and

development of skills in the managerial, production level will
achieve economies of scale.

4.

Economies of location: the plant location plays a major role

in cutting down the cost of materials, transport and other
expenses.

5.

Economies of Information Technology: advanced Information

technology provides timely accurate information for better
decision making and for better services.

6.

Economies of by-products: Organizations can increase the

economies of scale by minimizing waste and can be

12