What is meant by the Theory of Cost?
The determination of the price for a product or service is not easy. Several other factors govern it. The theory of cost definition states that the costs of a business highly determine its supply and spendings. The modern theory of cost in Economics looks into the concepts of cost, short-run total and average cost, long-run cost along with economy scales.
The cost function varies concerning factors such as operation scale, output size, price of production, and more. The theory of cost production needs to be understood in detail by economists to run their company and increase its profit and productivity. This article covers all you need to know about cost concepts.
Types of Costs
Accounting Costs / Explicit Costs: The cost of production including employee salaries, raw material cost, fuel costs, rent expenses and all the payments made to the suppliers from the accounting costs.
Economic Costs / Implicit Costs: According to the modern theory of cost in economics, the investment return amount of a businessman, the amount that could have been earned but not paid to an entrepreneur and monetary rewards for all estates owned by the businessman form the economic costs. These costs include accounting costs and the money also returned which the owner could have earned from elsewhere apart from the business.
Outlay Costs: These are the recorded account costs or actual expenditure spent on wages, rent, raw materials and more.
Opportunity Costs: These are the missed opportunity costs. They are not recorded in the account books but show the cost of sacrificed or rejected policies.
Direct / Traceable Costs: These costs are easily pointed out or identified expenditures such as manufacturing costs. Such costs cater to specific operations or goods.
Indirect / Non-Traceable Costs: These costs are not related directly or identifiable to any operation or service. Costs such as electric power or water supply are some examples because these expenses vary with output. They generally have a functional relationship with production.
Fixed Costs: Such costs do not vary with output and are fixed expenditure of the company. For example, taxes, rent, interests are all fixed costs as they do not vary within a constant capacity. Any company cannot avoid these costs.
Variable Costs: These costs vary with output and are known as a variable cost. For example, salaries of the employee, raw material costs all fall under variable costs. These directly depend on the fixed amount of resources.
Theory of Cost in Economics
The modern theory of cost in Economics also specifies economies of scale where an increased production decreases the cost per unit of production. The returns to scale first increase, then stabilize for some time and then decrease. Let's take a look at the different types of economies—
Technical: Technical economies include investment in machinery and more efficient capital equipment to increase production efficiency.
Effective Management: When an organization increases operation, they need a better division of labor into various sub-departments for efficient management.
Commercial: A large amount of components and raw materials is needed with increased production. Hence raw material costs decrease. The advertisement cost for a unit of production also falls, which increases.
Finance: With a raised Finance, any company becomes popular. Their banking securities increase and Finance is raised at a much lower cost.
Risk Management: As the firm becomes more diverse, risk-taking factors also increase.
Comparing Short Run and Long Run Costs
As per the theory of cost analysis, during the short run period, a company tries to increase its output by changing only the variable factors such as raw materials or labor. The fixed variables remain untouched. The long-run period is where the company can change any factor to obtain desirable outputs as per their interests. Ultimately all these factors result in cost.
Solved Examples
1. Draw a relationship between Total Cost, Total Fixed Cost and Total Variable Cost of a Business.
For any business,
Total Costs (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC).
2. What is the average fixed cost?
Average fixed cost is defined as the total fixed cost per unit of production. The total fixed cost divided by the number of units gives the average fixed cost.
Fun Facts
The average total cost is the sum of the average variable cost and average fixed cost.
Marginal cost can be calculated as the total change in cost upon a total change in output.
Electricity charges are neither fixed nor variable costs. Instead, they are semi-variable costs.
Stair Step variable cost remains constant for a fixed output. But when the output suddenly exceeds its limit, the cost immediately jumps to a new higher level. The graph of total variable cost v/s output looks exactly like a staircase for such cases.
According to the modern theory of cost in Economics, the positive slope in the long-run total cost average curve is due to diseconomies of scale.
FAQs on Theory of Cost
1. What is the shape of an average Long-run Cost Curve? Why?
The long-run average cost (LAC) curve has a U or L shape. The u-shape is due to the returns to scale. With the expansion of the firm, the returns to scale also increase, then stabilizers decrease. Therefore the LAC curve first moves down then rises eventually.
Long-run average costs have an inverse relation with returns to scale. Falling long-run costs are experienced due to internal and external economies of scale.
In contrast, the rising long-run cost is experienced due to the diseconomies of scale (both external and internal). Whenever the state of Technology is constant, we get the flattened U shape as a result of the traditional theory of cost. According to the modern theory of cost in economics, the state of technology changes in the long run and hence the shape turns from U shape to the modern L shape.
2. What is Marginal Cost and how is it related to Average Cost?
When an addition is made to the production cost by producing extra units of output, the extra cost is known as marginal cost.
Marginal costs are independent of fixed costs but dependent on changes in variable costs. Marginal cost is less than the average cost when due to an increase in the output the average cost falls. But if the opposite happens and the average cost rises with an increase in output, then the marginal cost exceeds the average cost. However, when the marginal cost is minimum, the average cost becomes equal to it. Short-run average costs are also of various types, and they affect the marginal cost, which varies based on the output and average cost.
3. What is the total fixed cost?
Total fixed costs are the sum of non variable consistent expenses that a company must pay. These costs do not change with any given change in the level of output. Examples of total fixed costs are insurance, salaries, rent depreciation etc.
4. Why is the SAC curve U-shaped?
Short run average cost curve is u shaped because of the invisibility of factors of production. The SAC curve first falls when the output increases directly to the richest in minimum point and then starts rising giving it a U shape.
5. What is the Importance of Opportunity Cost?
The concept of opportunity cost is very important in the following areas of managerial decision making:
Decision-Making and Efficient Resource Allocation,Determination of Relative Prices of Goods,Determination of Normal Remuneration of a Factor etc.Hence, it is obvious that the concept of opportunity cost has special importance in management.
6. What Direct Costs and Indirect Costs?
Direct costs are those costs that directly go into the production of goods and rendering of services.
Examples of direct costs are direct materials, consumable supplies,freight ,sales Commission etc.
Indirect costs refer to business expenses that keep operating.
Examples of indirect costs- administrative and general expenses, departmental costs, rent and utilities etc.
7. What are Private and Social Costs?
Private costs are the costs incurred by a firm in producing a commodity or service. These include both explicit and implicit costs. However, the production activities of a firm may lead to economic benefit or harm for others.
On the other hand, production of such services as education, sanitation services, park facilities, etc.
8. What are Incremental Costs and Sunk Costs?
Incremental costs are variable in nature that can change in future as a result of a decision. Example-change in product line or output level, adding or replacing a machine, changes in distribution channels, etc.Sunk costs are the costs that are not affected or altered by a change in the level or nature of business activity.
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