UNIT 8 SHORT RUN COST ANALYSIS
The analysis of cost is important in
the study of managerial economics. There are two types of cost analysis:
Short
run cost analysis & Long run cost analysis.
Cost Concepts That are Relevant for
Managerial Decisions.
Actual
Costs And Opportunity costs
Actual
costs are those costs, which a firm incurs while
producing or acquiring a good or service like raw materials, labour, rent, etc.
Opportunity
cost is defined as the value of a resource in its
next best use.
Explicit
and Implicit costs
Explicit
costs are those costs that involve an actual payment
to other parties.
implicit
costs represent the value of foregone opportunities
but do not involve an actual cash payment.
Accounting
costs and Economic costs
All the types of costs incurred by a firm while doing business are
called accounting costs. All the actual and implied costs incurred by a firm
are called economic costs.
Controllable
and Non-Controllable costs
Controllable
costs are those which are capable of being
controlled or
regulated
by executive vigilance.
Non-controllable
costs are those, which cannot be subjected to
administrative control and supervision.
Out-of-pocket
costs and Book costs
Out
of pocket costs are those costs that improve current
cash payments to
outsiders.
Book
costs are those business costs, which do not involve
any cash payments
Past
and Future costs
Past
costs are actual costs incurred in the past and they
are always contained
in the
income statements.
Future
costs are those costs that are likely to be incurred
in future periods.
Historical
and Replacement costs
The historical
cost of an asset is the actual cost incurred at the time; the asset
was
originally acquired.
Replacement
cost is the cost, which will have to be incurred if
that asset is purchased now.
Private
Costs and Social Costs
Private
costs are those that accrue directly to the
individuals or firms engaged in relevant activity.
Social
costs are passed on to persons not involved in the
activity in any direct
Way.
Relevant
Costs and Irrelevant Costs
The relevant
costs for decision-making purposes are those costs, which are
incurred
as a result of the decision under consideration.
Costs that are not affected by a decision are called irrelevant costs.
Sunk
Costs and Incremental Costs
Sunk costs
are expenditures that have been made in the past or must be paid
in the
future as part of contractual agreement or previous decision.
Incremental
cost refers to total additional cost of implementing
a managerial decision.
Direct
costs and Indirect costs
Direct costs, which can be directly attributed to
production of a given product.
Indirect costs are those costs which cannot easily
and accurately be
separated
and attributed to individual units of production
Separable
Costs and Common Costs
The costs
that can be easily attributed to a product, a division, or a process are called
separable costs. Common costs are those, which cannot be traced
to any one unit of operation.
TOTAL
COST, AVERAGE COST & MARGINAL COST
Total
cost (TC) of a firm is the sum-total of all the explicit
and implicit expenditures incurred for producing a given level of output.
Average
cost (AC) is the cost per unit of output. That is,
average cost equals
the total
cost divided by the number of units produced (N).
Marginal
cost (MC) refers to the change in total cost associated
with a one unit
change in
output. Marginal cost (MC) is the extra cost of producing one
additional
unit.
FIXED
COSTS AND VARIABLE COSTS
Fixed
costs are that part of the total cost of the firm
which does not change
with
output. Expenditures on depreciation, rent of land and buildings,
property
taxes, and interest payment on bonds are examples of fixed costs.
Variable
costs, on the other hand, change with changes in
output. Examples
of
variable costs are wages and expenses on raw material.
SHORT
RUN AND LONG RUN COSTS
The short
run is defined as a period in which the supply of at least one
element of
the inputs cannot be changed.
Long
run, on the other hand, is defined as a period in
which all inputs are
changed
with changes in output.
Both
short-run and long-run costs are useful in decision-making. 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. If the firm is considering an increase in plant size, it must
examine
the long-run cost of expansion. Long-run cost analysis is useful in
investment
decisions.
SHORT
RUN COST FUNCTIONS
Three
concepts of total cost in the short run must be considered: total fixed
cost
(TFC), total variable cost (TVC), and total cost (TC).
TC
= TFC + TVC
where,
TC = total
cost
TFC =
total fixed costs
TVC =
total variable costs
Average
Fixed Costs
AFC
= TFC/Q
Average
Variable Costs
AVC =TVC/Q
Q = Output
TVC =
total variable costs
AVC =
average variable costs
Average
Total Cost
Average
total cost (ATC) is the sum of the average fixed cost and
average
variable
cost. In other words, ATC is total cost divided by output. Thus,
ATC = AFC
+ AVC = TC/Q
Marginal
Cost
Marginal
cost (MC) is the addition to either total cost or total
variable cost
resulting
from the addition of one unit of output. Thus,
MC = ΔTC/Q =ΔTVC/Q
where,
MC =
marginal cost
ΔQ = change in output
ΔTC = change in total
cost due to change in output
ΔTVC = change
in total variable cost due to change in output
APPLICATION OF SHORT RUN COST ANALYSIS
1.
Determining Optimum Output Level
optimum
output level is the point where average cost is minimum. The optimum output
level is the point where average cost equals marginal cost.
2.
Breakeven Output Level
An analytical
tool frequently employed by managerial economists is the breakeven chart, an
important application of cost functions.
3. Profit Contribution Analysis
In making
short run decisions, firms often find it useful to carry out profit contribution
analysis. The profit contribution is the difference between price and average
variable cost (P – AVC). At low rates of output the firm may be losing money
because fixed costs have not yet been covered. After fixed costs are covered,
the firm will be earning a profit.
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