By Muhammad Shahid Iqbal

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By Muhammad Shahid Iqbal
Engineering Economics
Module No. 06 Theory of Cost
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The Concepts of cost

• Should I go to work today?
• Should I go to college after high school?
• Should the government spend money on a new weapon
  system?
• These are decisions that are made everyday
  however, what is the cost of our decisions?
• What is the cost of going to work, or the
  decision not to go to work?
• What is the cost of University, or not to go to
  University?
• Finally what is the cost of buying that weapon
  system, or the cost of not buying that weapon?
• In economics it is called opportunity cost.

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The Concepts of cost

• Opportunity cost is the cost we pay when we give
  up something to get something else. There can be
  many alternatives that we give up to get
  something else, but the opportunity cost of a
  decision is the most desirable alternative we
  give up to get what we want.
• Opportunity cost of an input is the return that
  it could earn in its best alternative use.

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The Concepts of cost

• Accounting Costs and Economic Costs
• A firms cost of production includes all the
  opportunity costs of making its output of goods
  and services.
• Explicit and Implicit Costs
• A firms cost of production include explicit
  costs and implicit costs.
• Explicit costs All cash payments which the firm
  makes to other factor owners for purchasing or
  hiring the various factors.

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The Concepts of cost

• Implicit costs The normal return on
  money-capital invested by the entrepreneur and
  wages or salary of his services and money rewards
  for other factors which the entrepreneur himself
  owns and employs them in his own firm.
• Economic Cost Accounting costs Implicit costs

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Economic Profit v/s Accounting Profit

• Economists measure a firms economic profit as
  total revenue minus total cost, including both
  explicit and implicit costs.
• Accountants measure the accounting profit as the
  firms total revenue minus only the firms
  explicit costs.
• When total revenue exceeds both explicit and
  implicit costs, the firm earns economic profit.
• Economic profit is smaller than accounting profit

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Total and Variable Costs
The total expenditure put up by an entrepreneur
to produce a certain amount of a good is called
TC C(Q) FC VC Fixed costs are those costs
that do not vary with the quantity of output
produced Variable costs are those costs that do
vary with the quantity of output produced
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The elements of cost

• Fixed costs or overhead cost can be classified
  into factory overhead, administration overhead,
  selling overhead and distribution overhead.
• Variable costs can be further classified into
  direct material, direct labor and direct
  expenses.
• Market price it is the price that a good or
  service is offered at, or will fetch, in the
  marketplace
• The selling price is derived as shown below
• Direct material cost Dir. labor cost Direct
  expenses Prime cost
• Prime cost Factory overhead factory cost
• Factory cost office and administrative overhead
  cost of production
• Cost of production opening finished stock
  Closing finished stock cost of goods sold
• cost of goods sold selling and distribution
  overhead cost of sales
• cost of sales profit Sales
• Sales/quantity sold selling price per unit

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The elements of cost
Sunk Cost A cost that is forever lost after it
has been paid. ACME Coal paid 5000 to lease a
rail car. Under the terms of the lease 1000 of
this payment is refundable if the rail car is
returned within two days of signing the
lease. Average cost average cost or unit cost is
equal to total cost divided by the number of
goods produced (the output quantity, Q). It is
also equal to the sum of average variable costs
(total variable costs divided by Q) plus average
fixed costs (total fixed costs divided by Q).
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The elements of cost

• Marginal Cost The marginal cost of a product is
  the cost of producing an additional unit of that
  output. More formally, the marginal cost is the
  derivative of total production costs with respect
  to the level of output.
• Marginal Revenue (MR) is the extra revenue that
  an additional unit of product will bring. It is
  the additional income from selling one more unit
  of a good sometimes equal to price. It can also
  be described as the change in total revenue
  divided by the change in the number of units
  sold. i.e. Q 40,000 - 2000P
• Marginal cost and average cost can differ
  greatly.  For example, suppose it costs 1000 to
  produce 100 units and 1020 to produce 101
  units.  The average cost per unit is 10, but the
  marginal cost of the 101st unit is 20

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Break Even Analysis

• Break-even point (BEP) is the point at which cost
  or expenses and revenue are equal there is no
  net loss or gain. The main objective of
  break-even analysis is to find the cut-off
  production volume from where a firm will make
  profit.
• X TFC/P-V
• X TFC/Unit Contribution
• Contribution Sales TVC
• Margin of Safety Sales Break Even sales

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Break Even Analysis

• Profit Volume Ratio (P/V Ratio), The ratio of
  contribution to sales is P/V ratio or C/S ratio.
  It is the contribution per rupee of sales and
  since the fixed cost remains constant in short
  term period, P/V ratio will also measure the rate
  of change of profit due to change in volume of
  sales.
• The P/V ratio may be expressed as follows
• Profit Contribution Fixed cost
• P/V ratio Sales Variable costs
  Contribution Sales Sales
• BEP F.C
• P/V ratio

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Some Definitions
Average Total Cost ATC AVC AFC ATC
C(Q)/Q Average Variable Cost AVC
VC(Q)/Q Average Fixed Cost AFC FC/Q Marginal
Cost MC DC/DQ
ATC
AVC
AFC
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Derivation of Average costs

• Q FC VC TC AFC AVC ATC MC
• 0 2000 0
• 76 400
• 248 800
• 492 1200
• 784 1600
• 1100 2000
• 1416 2400
• 1708 2800
• 1952 3200
• 2124 3600
• 2200 4000

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Relationship b/w Average Marginal Cost

• whenever MC is below AC curve, the average curve
  is falling. The low MC Drags down the Average.
• when MC is above AC curve, it pull the average
  up the AC curve rises.
• When MC equal AC, it has a neutral effect. AC
  curve is flat. It has reached its lowest point.
  Thus MC curve cuts through the lowest point on
  the ATC curve. MC also cuts AVC through its
  lowest point.

AVC
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LR Cost Functions Economies of Scale

• Economies of scale arise when the cost per unit
  falls as output increases. Economies of scale are
  the main advantage of increasing the scale of
  production
• Bulk-buying economies
• Technical economies
• Financial economies
• Marketing economies
• Managerial economies
• lower unit costs as a result of the whole
  industry growing in size.
• Training and education becomes more focused on
  the industry
• Other industries grow to support this industry