ECONOMIC ANALYSIS

Module 4. Concepts of costs

Lesson 16
FIXED AND VARIABLE COSTS, AVERAGE AND MARGINAL COSTS

16.1 Introduction

The Main objective of any firm is to earn profit. In order to survive and grow in this competitive market conditions, it is necessary that firm has clear idea about different cost concepts so as to frame suitable policies. In producing goods or offering services, resources are used. Value of resources denotes cost. The term cost has various concepts which are described below.

16.2 Real Cost

The term real cost is defined in various ways. According to one of the definition real cost of production of a commodity or offering a services includes work of labour, sacrifice in the form of opportunity cost and social effects of pollution, congestion and environmental distortions. For example real cost of manufacturing milk can is composed of wages of labours, material cost, depreciation of tools which are used for manufacturing can etc. Thus real cost is the summation of real productive resources which goes in the production of a good or offering a service.

Alfred Marshall (1920) defined real cost as "The exertions of all different kinds of labour that are directly or indirectly involved in making it, including waiting required for saving the capital used in making it. All these sacrifices and efforts together are called real cost.

16.3 Nominal or Money Cost

It is the cost of production measured in money terms or expense of production. The expenses are paid to obtain factor of production. They are of two types: explicit and implicit money cost.

a. Explicit Money cost : It refers to actual money paid to obtain physical resources or obtain the services of persons for production purposes. It includes cost of raw materials, wages and salaries, electricity/ power expenses, rent on building, interest payments of capital, insurance premiums, taxes and miscellaneous expenses such as promotional measures.

b. Implicit cost : Opportunity cost of the use of resources which an organization does not purchase but already possess them. e.g. wages the owner might have earned, interest which might have earned on his invested capital, rent of buildings and other assets owned by the owner, normal profit retained in the business.

16.4 Opportunity Cost

Human wants are unlimited and resources to satisfy those wants are limited. A particular resource can be used to satisfy a particular want at a time or it can be put to use to produce any one particular commodity or offer service. Thus opportunity cost is measured in terms of foregone benefits from the next best alternative use of a given resource.

16.5 Fixed and Variable Costs

In short run time period some factors of production cannot be altered or changed. These are fixed factors e.g. machineries, factory building, managerial staff etc. The amount spent by the organization on fixed inputs in the short run is called fixed cost. Fixed costs remain constant irrespective of level of output. At zero level of output also fixed cost remains same.

They are also called supplementary cost or overhead costs. e.g. Rent for buildings, Insurance premium, depreciation and maintenance allowance, taxes, administrative expenses like salaries. Variable factors are the inputs which are varied to change the output level in the short run. e.g. labour raw materials and power etc. The costs incurred on such variable factors are called variable costs. They vary in direct proportion to output. When there is no production, variable cost will be zero and as production increases, variable cost also increases and vice versa. They are also referred to as direct cost or prime cost. e.g. price of raw material, labour wages, fuel and power charges, excise duty, sales tax, transport expenditure etc. Diagrammatic representation of fixed and variable cost is given in the Figure 16.1

Fig. 16.1 Fixed and variable cost

16.6 Total Cost

It is summation of all expenses incurred by the organization in producing given level of commodity or offering a service. Total cost includes all the money costs. In short run total cost is given by

Total Cost = Total fixed cost + Total variable cost

16.7 Average and Marginal Cost

Average cost is the total cost divided by the number of units produced

Marginal cost is the cost of producing one more additional units of output. e.g. If total cost of producing 75 units of a particular commodity is 1050 Rs. the cost of producing 76th unit is 1064. Then marginal cost will be (1064-1050) = Rs. 14.

16.8 Total Fixed Cost

It is cost of fixed inputs in the short run. It remains same in short run at all levels of output. For example an entrepreneur starts a business. The rent for the hired shop is Rs. 2000. He took loan of Rs. 25000/- at 10% and purchased capital equipment worth Rs. 5000. Then his monthly total fixed cost will be as under

Rs.2000 (Rent) + Rs.5000 (equipment cost) + Rs. 250 (Monthly interest on bank loan) = Rs.7250

16.9 Total Variable Cost

It is the cost of Variable input used in short run production. It is obtained by aggregating product of quantities of inputs multiplied by their price. e.g. The entrepreneur cited in the above example employs a skilled labour at the rate of 100 Rs. per unit of output, buys the raw material worth Rs. 2500 and spends Rs. 500 as miscellaneous expenses to produce 5 units.

The total variable cost for producing 5 units of the product will be

Rs.2500 (Raw material) + Rs.5000 (Miscellaneous expenses) + Rs. 500 (Labour Charges) = Rs.3500

16.10 Average Fixed Cost

It is the total fixed cost divided by total units of output. For example in the above cited cost, total units of output are five then

16.11 Average Variable Cost

It is total variable cost divided by total units of output.

16.12 Average Total Cost

It is the total cost dividend by total unit of output.

This can be simply found out by adding average fixed cost and average variable cost

Average total cost = Average fixed cost + Average Variable cost

=1450 + 700

=Rs. 2150 per unit of output.