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: Key Concepts
1. What is the fundamental concept of 'cost' in the economic theory of cost?
In economics, cost refers to the total expenditure incurred by a firm in the process of producing a good or service. Unlike accounting cost, which only considers explicit monetary payments, economic cost includes both explicit costs (like wages and rent) and implicit costs (the opportunity cost of using self-owned resources). This comprehensive view is crucial for understanding a firm's true profitability and making sound business decisions.
2. How are Total Cost (TC), Total Fixed Cost (TFC), and Total Variable Cost (TVC) related in the short run?
The relationship is a foundational formula in cost analysis: TC = TFC + TVC. In the short run:
- Total Fixed Costs (TFC) are expenses that do not change with the level of output, such as rent on a factory or insurance. They are constant.
- Total Variable Costs (TVC) are expenses that change directly with the level of output, such as raw materials and labour wages.
- Total Cost (TC) is the sum of these two. Since TFC is constant, any change in Total Cost is caused exclusively by a change in Total Variable Cost.
3. What is the difference between Explicit Costs and Implicit Costs?
Explicit Costs are direct, out-of-pocket payments made by a firm to others for resources. These are recorded in the books of accounts. Examples include salaries, rent, and raw material costs. Implicit Costs, on the other hand, are the opportunity costs of using a firm's self-owned, self-employed resources. They are not actual cash payments but represent the income forgone. For example, the salary an entrepreneur could have earned working elsewhere is an implicit cost of running their own business.
4. Why is the Short-Run Average Cost (SAC) curve typically U-shaped?
The Short-Run Average Cost (SAC) curve is U-shaped primarily due to the Law of Variable Proportions. Initially, as more variable factors (like labour) are added to fixed factors (like machinery), efficiency increases due to better utilisation of the fixed factor, causing the average cost to fall. After reaching an optimal point (the minimum of the curve), adding more variable factors leads to overcrowding and inefficiency, causing the average cost to rise. This pattern of decreasing, then increasing, marginal productivity results in the U-shape of the SAC curve.
5. How does understanding Opportunity Cost impact a firm's decision-making?
Understanding Opportunity Cost, which is the value of the next-best alternative forgone, is critical for strategic decision-making. It helps a firm:
- Allocate Resources Efficiently: By comparing the potential return of various projects, a firm can choose the one that offers the highest value over its next best alternative.
- Determine Economic Profit: It helps in calculating the true profitability of a venture by considering not just the explicit expenses but also the hidden costs of forgone opportunities.
- Set Product Prices: The price of a product must cover not only its direct production costs but also the opportunity cost of the capital and resources used.
6. What is the relationship between Marginal Cost (MC) and Average Cost (AC)?
The relationship between Marginal Cost (MC) and Average Cost (AC) is a key concept in microeconomics. MC is the addition to total cost from producing one more unit. The relationship is as follows:
- When MC is less than AC, the AC curve is falling.
- When MC is greater than AC, the AC curve is rising.
- When MC equals AC, the AC is at its minimum point. This is why the MC curve always intersects the AC curve at its lowest point.
7. Why is the Long-Run Average Cost (LAC) curve also U-shaped?
The U-shape of the Long-Run Average Cost (LAC) curve is determined by the returns to scale. In the long run, all factors of production are variable. Initially, as a firm expands its scale of operations, it experiences economies of scale (e.g., bulk-buying discounts, specialisation of labour), which cause the average cost per unit to decrease. After reaching an optimal size, the firm may start to experience diseconomies of scale (e.g., management difficulties, coordination problems), which cause the average cost per unit to rise. This creates the characteristic U-shape of the LAC curve.
8. How do businesses use the concepts of fixed and variable costs in the real world?
Businesses use the distinction between fixed and variable costs for several critical decisions:
- Pricing Strategy: To set a price, a company must ensure it covers at least its variable costs per unit. The contribution margin (Price - Variable Cost) then goes towards covering fixed costs and generating profit.
- Shutdown Decisions: In the short run, a firm might continue to operate even at a loss, as long as the price per unit is higher than the average variable cost (AVC). This allows it to cover some of its fixed costs.
- Break-Even Analysis: Companies calculate the break-even point—the level of sales at which total revenue equals total cost—to understand the minimum output required to be profitable.
9. Can a cost be both fixed and variable? Explain with an example.
Yes, certain costs, known as semi-variable or mixed costs, have both fixed and variable components. A common example is an electricity bill. There is often a fixed monthly charge (the fixed component) regardless of usage, plus a variable charge that depends on the amount of electricity consumed (the variable component). Similarly, a salesperson's salary might consist of a fixed base salary plus a variable commission based on sales volume.
